Question

F: You are planning to invest $25,000 in research & development (R&D). This investment will generate cost savings of $17,500 in year 1 and $12,500 in year 2. After 2 years, the salvage value is zero. The cost of capital is 25% a year.

a) Compute the net present value.
NPV = $
Should you invest? YES NO



b) Following a government stimulus program, the cost of capital decreased to 10% a year. Compute the net present value at the new cost of capital.
NPV = $
Should you invest now? YES NO


c) The economy is at full employment and is beginning to overheat (i.e., total demand exceeds the available capacity, which leads to rapid price increases). Firms' investment activity increases total demand and contributes to economic overheating. To prevent high inflation, the Federal Reserve chairman wants to reduce firms' investment activity. The Federal Reserve can control the cost of capital in the economy by adjusting its benchmark interest rate. To reduce the investment activity, the Federal Reserve should:

reduce the interest rate -- based on (a) and (b), lower cost of capital will reduce investment
increase the interest rate -- based on (a) and (b), higher cost of capital will reduce investment    

Answer 1

a)	Net Present Value
	Year	Particulars	Amount ($)	Discount Rate	PV ($)
	0	Investment Amount	-25,000	1.000	-25,000
	1	Cost savings	17,500	0.800	14,000
	2	Cost savings	12,500	0.640	8,000
	Net Present Value	-3,000
	Should you Invest	No
b)	Net Present Value
	Year	Particulars	Amount ($)	Discount Rate	PV ($)
	0	Investment Amount	-25,000	1.000	-25,000
	1	Cost savings	17,500	0.909	15,909
	2	Cost savings	12,500	0.826	10,331
	Net Present Value	1,240
	Should you Invest	Yes
c)	The Federal Reserve should increase the interest rate -- based on (a) and (b), higher cost of capital will reduce Investment