Question

 

A company has identified the following investments as looking promising. Each requires an initial investment of $1.2 million. Which is the best investment?

A. a perpetuity that generates a cash flow at the end of year 1 of $100,000, has a growth rate of 1.25%, and a cost of capital of 10.7%

B. a perpetuity that generates a cash flow at the end of year 1 of $800,000, has a growth rate of 2.25%, and a cost of capital of 12%

C. an investment that generates a cash flow of $400,000 at the end of each of the next five years, when the cost of capital is 6.5%

D. an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when the cost of capital is 6.5%

Answer 1

NPV (A) = -1.2 M + 0.1M/( 10.7% - 1.25%) =	-$141,798.94	IV
NPV (B) = -1.2 M +0.8M / (12% - 2.25%) =	$7,005,128.21	I
NPV(C) (calculated below)	$462,271.78	II
NPV(D) (calculated below)	$237,766.04	III
Year	Cash Flow	PV @ 6.5%	Present Value
0	-$1,200,000.00	1.0000	-$1,200,000.00
1	$400,000.00	0.9390	$375,586.85
2	$400,000.00	0.8817	$352,663.71
3	$400,000.00	0.8278	$331,139.64
4	$400,000.00	0.7773	$310,929.24
5	$400,000.00	0.7299	$291,952.33
		NPV(c)	$462,271.78
Press 2nd FV to clear the financial keys. Enter the numbers into the appropriate keys: 5 into N, 6.5 into I/Y, and 400000 (a cash inflow) into PMT. Now press CPT PV to solve for the present value. The answer is -1,662,271.78.This is negative because it represents cash outflow, add initial investment $1,200,000. The NPV is $462,271.78
Year	Cash Flow	PV @ 6.5%	Present Value
0	-$1,200,000.00	1.0000	-$1,200,000.00
1	$200,000.00	0.9390	$187,793.43
2	$200,000.00	0.8817	$176,331.86
3	$200,000.00	0.8278	$165,569.82
4	$200,000.00	0.7773	$155,464.62
5	$200,000.00	0.7299	$145,976.17
6	$200,000.00	0.6853	$137,066.82
7	$200,000.00	0.6435	$128,701.24
8	$200,000.00	0.6042	$120,846.24
9	$200,000.00	0.5674	$113,470.65
10	$200,000.00	0.5327	$106,545.21
		NPV(D)	$237,766.04
Press 2nd FV to clear the financial keys. Enter the numbers into the appropriate keys: 10 into N, 6.5 into I/Y, and 200000 (a cash inflow) into PMT. Now press CPT PV to solve for the present value. The answer is -1,437,766.04.This is negative because it represents cash outflow, add initial investment $1,200,000. The NPV is $237,766.04