Question

Suppose you have $10,000 in your bank account and the opportunity to invest in a 5-year project with the following certain cash flows:

Year	1	2	3	4	5
CF	$0	$0	$0	$0	$25,000

The risk-free interest rate in the economy is 10% per year for the next 5 years. Yesterday however, your car suddenly broke down and you need to buy a new one which would cost $10,000. Assume you really need the car to go to work, should you and can you invest in the project? Explain why or why not

Answer 1

The solution is provided by 3 scanned images(pages) as under:

classmate o page 27/04/2010 solution : Given! Initial Certain Risk Investment = $ 10000 cash flow at the end of free interest rate = 10% years - $25000 Present value of certain cash flow to be received at the end of year si - certain cash flow X Present value factor CONF) a for year sat lol . = $25000 x = = (1.105 629 · 62|| $25000 X $15525 If we borrow $10000 amount to be paid year I will be to buy at the the end 1070 card then of = 2 z f 10000 X (1.1095 $10000 X 1.610 § 16100. As we can see that we anly need to pay $ 16100 to repay the loan for car and on the other hand we will beceive $25000 at the end of year s. So we can repay the car loan out of $ 25000 and still we will have a

classmate Date Pago 111 sweeples of end of year $8900 ($25000 - $1600) at the s. Also as per part ci) of the solution the NPU of project is $5328 (15525-10000 'ch as positive Honce we will adopt the following strategy Step 1: Invest $ 10000 in the project and I borrow $ 10000 @ 10% from the market - and purch ase the 1. Step 2 : At the end of years inflow of f 25000 and amount of floloo, and on $ 89oo. receive the cash repay the loan earn the surplus cross Verification: Above siurblus of 18900 can be taken at bresent volué le 8900 X •621 = $5526.?... the - This PV of surplus is equal to NPU of project noe. $5525. NOTE The difference of f 1.9 between NPU of project and pi of surplus is due to approximation