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

1. “Draw” timelines (tables), showing cash flows of each investment.
2. Suppose Linda’s discount rate is 12%. Which project should she choose?
3. At which discount rate would Linda be indifferent between her two choices?

Answer 1

a.

note in choice 2 cash flow in year 2 = cash flow in year 1 *(1+G) / (R-G) = $42000*(1+0.05) / (0.12-0.05) = $630000

where

G is growth rate

R is discount rate

b.

use irr method is selection .

choice 1 have higher irr so we go with choice 1

irr = =irr(value) = select all cash flow in value.

C.

if we use average irr as discount rate then NPV will be same for both choice so indifferent between choice

average irr = (89% + 88% ) / 2 = 88.5%