Question

The following additional investment opportunities are available to an investment center manager:  

Project	Initial Investment	Annual Earnings
A	$800,000	$130,000
B	100,000	20,000
C	300,000	25,000
D	400,000	68,000

The investment center manager is currently making a return on investment (ROI) of 16 percent. Assume annual earnings are before finance charges, and the manager is evaluated on ROI (return on investment).   The cost of capital for the firm is 11%.

  Assuming economic rationality, and the availability of adequate funds, the manager will select:

• A. None of the four projects
• B. Projects A, B, and D
• C. Project B
• D. Projects B and D
• E. All the four projects

Answer 1

Answer: option B. Projects A,B and D

Explanation:

Given cost of capital = 11%

For project A

Initial investment = $800,000

Perpetual cash flow = annual earnings = $130,000

PV of cash flow = annual earnings / cost of capital = 130,000/11% = $1,181,818.18

NPV= PV of cash flow- Initial investment = $1,181,818.18- $800,000

= $381,818.18

For project B

Initial investment = $100,000

Perpetual cash flow = annual earnings = $20,000

PV of cash flow = annual earnings / cost of capital = 20,000/11% = $181,818.18

NPV= PV of cash flow- Initial investment = $181,818.18- $800,000

= $81,818.18

For project C

Initial investment = $300,000

Perpetual cash flow = annual earnings = $25,000

PV of cash flow = annual earnings / cost of capital = 25,000/11% = $227,272.72

NPV= PV of cash flow- Initial investment = $227,272.72- $300,000

= -$72,727.27

For project D

Initial investment = $400,000

Perpetual cash flow = annual earnings = $68,000

PV of cash flow = annual earnings / cost of capital = 68,000/11% = $618,181.82

NPV= PV of cash flow- Initial investment = $618,181.82- $400,000

= $218,181.82

According to NPV rule, project with positive NPV value is accepted.

From the above calculations, we see that Projects A,B and D have positive NPV and project C has negative NPV

So Projects A,B and D are to be chosen.