Question

A new business opportunity has a 70% chance of being worth $500,000 next year and a 30% chance of being worth $100,000. The appropriate expected rate of return is 10%. Assume that the new opportunity will be financed with a $150,000 bank loan. What is the maximum amount of his own money that an owner should be willing to invest in this business?

A) $215,000

B) $195,455

C) $345,455

D) $230,000

Answer 1

Cash flow for next year with 70% probability = $500000, Cash flow for next year with 30% probability = $100000

Expected cash flow next year = 70% x Cash flow for next year with 70% probability + 30% x Cash flow for next year with 30% probability = 70% x 500000 + 30% x 100000 = 350000 + 30000 = 380000

Maximum total amount that can be invested in the project = A

Cash flow in year 0 = - A

For this maximum amount, present value of cash inflows of the project will be equal to present value of cash outflows of the project or NPV of the project should be zero

NPV of the project = Cash flow in year 0 + Present value of cash flow next year discounted at expected rate of return of 10%

0 = -A + 380000/(1+10%)

A = 380000/1.10

A = 345454.54

Maximum own money that can be invested by owner = Maximum total amount that can be invested in the project - Loan = 345454.54 - 150000 = 195454.54 = 195455 (rounded to nearest whole dollar)

Maximum amount of his own money that an owner should be willing to invest in this business = 195455

Answer B)$195455