Question

You are deciding between two investments in the healthcare field. Each investment is projected to produce the following cash flows: Investment One Year Cash 0 -$150,000 1 $10,000 2 $8,000 3 $25,000 4 $50,000 5 $25,000 6 $50,000 Investment Two Year Cash 0 -$100,000 1 0 2 0 3 0 4 0 5 $54,000 6 $65,000

Assume a discount rate of 5%. Which investment would you prefer? Why? Assignment Part 2: How would your analysis change if you assumed 3% inflation per year? Assignment Part 3: If investment one was riskier than investment two, how would your calculations change so that additional risk is taken into account? Also, does this new information change your project preference?

Answer 1

Part 1. NPV:

Both the projects have negative NPV. Hence, none of the project is to be accepted.

Part 2: Assume 3% inflation per year

Since inflation has been provided, we need to convert the discount factor of 5% (which is nominal rate) to real discount rate.

Real discount rate = ((1+ nominal discount rate ) / (1+ inflation rate) )-1

= ((1+5%) / (1+3%)) - 1 = 101.94%-1 = 1.94%

NPV at discount rate of 1.94%:

NPV is higher for Investment two at $6,976. Hence, Investment Two is to be chosen.

Part 3: If investment one was riskier than investment two, how would your calculations change?

If a project is more riskier than the project, a higher discount rate needs to be considered as higher the risk taken, higher will be the return required. Hence, the nominal discount rate used of 5% for Investment Two cannot be used for Investment One.and the discount rate of Investment one should be higher than that of investment two.

Investment two already has higher NPV among the two. If the investment one discount rate is increased than investment two, the NPV of investment one will only further reduce and investment two will still continue to have higher NPV.. Hence the decision will not change and Investment Two is to be chosen.