Question

Linda Jones is deciding between two investment projects.

Choice 1 Linda can invest into a young biotech firm. She expects that she will need to pay this firm $35,000 at the end of each year for the next two years. After that, she expects to receive back from the firm $90,000 at the end of each year for 18 years.

Choice 2 Linda can invest $200,000 today into an AI firm. She expects to be paid $42,000 at the end of the year, and expects cash flows from the AI firm to increase by 5% every year, paid at the end of each year in perpetuity

a. “Draw” timelines (tables), showing cash flows of each investment.

b. Suppose Linda’s discount rate is 12%. Which project should she choose?

c. At which discount rate would Linda be indifferent between her two choices?

Answer 1

Solution :- (A)

(B)

NPV of Project 1 :-

NPV of Project 2 :-

Present value of Cash inflows upto perpetuity calculated by

= Cash flow / (Discount Rate - Growth Rate)

= 42000 / (12% - 5%) = $600,000

Net Present Value = $600,000 - $200,000 = $400,000

Project 1 Should be Selected as it has higher Net Present Value

As NPV is higher the Better