Question

Solve in Excel. Show formulas

A) You are considering an investment that will pay you $12,000 the first year, $13,000 the second year, $17,000 the third year, $19,000 the fourth year, $23,000 the fifth year, and $28,000 the sixth year (all payments are at the end of each year).

What is the maximum you would pay for this investment if your opportunity cost is 12%?

B) You are considering an investment that will pay you $12,000 the first year, $13,000 the second year, $17,000 the third year, $19,000 the fourth year, $23,000 the fifth year, and $28,000 the sixth year.

If you pay $70,000 for such an investment, rate of return would you be earning?

C) How much would you be willing to pay for an investment that will pay you and your heirs $16,000 each year in perpetuity if your opportunity cost is 6%?

Answer 1

A) Maximum that one would pay for this investment at opportunity cost of 12% can be calculated using the present value of cash flows.

Time	1	2	3	4	5	6
Cash inflows	$12,000	$13,000	$17,000	$19,000	$23,000	$28,000
Opportunity cost	$0.893	$0.797	$0.712	$0.636	$0.567	$0.507
Present value of cash flows	$10,714.3	$10,363.5	$12,100.3	$12,074.8	$13,050.8	$14,185.7

Maximum to be paid for investment = sum of present value of cash flows

= $72,489.4

B) Rate of return would be the IRR of the project.

Time	0	1	2	3	4	5	6
Cash inflows	-70000	$12,000	$13,000	$17,000	$19,000	$23,000	$28,000

IRR = 13.07%

C) Present value of perpetuity = cash flow / interest rate

= 16000 / 0.06

= $2,66,667