Question

2.Your company has an investment opportunity, and it is trying to figure out if it's worth it. Here's what's known about this investment opportunity: • Today: the company would need to invest $350,000 • In 1 year: the company would receive a profit of $200,000 • In 2 years: the company would receive a profit of $200,000 • In 3 years: the company would receive a profit of $50,000 • In 4 years: the company would receive a profit of $30,000 • The required return is 11% After doing all sorts of calculations and analyses, the company made the following several conclusions. Which ones are CORRECT and which ones are INCORRECT? (1) The Net Present Value of this investment opportunity equals –$4,407.38. CORRECT !INCORRECT ! (Increase decimal places for any intermediatecalculations, from the default 2 to 6 or higher. Only round your final answer to TWO decimal places: for example, 10,000.23.) (2) Based on the Net Present Value approach, this investment opportunity should be rejected. CORRECT !INCORRECT ! (3) The dollar amount representing the initial cost required for this investment opportunity, is less than the discounted value of all future profits. CORRECT !INCORRECT ! (4) The Profitability Index of this investment opportunity is less than 1. CORRECT !INCORRECT !

Answer 1

Part1:
This statement is incorrect. The net present value of the investment is $398826.17

We calculate the net present value of an investment using the following formula:
Net Present Value= -Initial cash flow + Present value of future cash flows
We have taken initial cash flow as negative because it is a cash outflow.
Given that,
The company would need to invest $350,000 (this is an initial cash outflow). The profits that the company gets in subsequent years are:

Year 1: $200,000
Year 2: $200,000
Year 3: $50,000
Year 4: $30,000
The required rate of return is 11%, we will use this as the discount rate to bring back the future cash flows to present value.
The formula used to calculate the present value of future cash flows (or profits) is given by:
Present value= Cash flow in year 1/(1+ discount rate)^1+Cash flow in year 2/(1+ discount rate)^2+Cash flow in year 3/(1+ discount rate)^3+Cash flow in year 4/(1+ discount rate)^4
Present value of future profits= $200,000/(1+11%)^1+$200,000/(1+11%)^2+$50,000/(1+11%)^3+$30,000/(1+11%)^4
=$200,000/(1.11)^1+$200,000/(1.11)^2+$50,000/(1.11)^3+$30,000/(1.11)^4
=$200,000/1.11+$200,000/1.2321+$50,000/1.367631+$30,000/1.51807041
=$180180.1802+$162324.4866+$36559.56907+$19761.92922
=$398826.1651 or $398826.17 (rounded upto two decimal places)

Net Present Value= -Initial cash flow + Present value of future cash flows
=-$350,000+$398826.1651=$48826.1651

Part 2:
This statement is incorrect. As the net present value is positive, the company should accept this investment opportunity.

Part 3:
This statement is correct.
The dollar amount representing the initial cost required for this investment opportunity=$350,000
Discounted value of all future profits=$398826.1651
So, initial cost is less than discounted value of all future profits.

Part 4:
This statement is incorrect. Profitability Index of this investment opportunity is 1.1395 which is more than 1.
Profitability Index is calculated as:
Profitability Index=(Present value of future cash inflows)/(Present value of initial investment or cash outflow)
Present value of future cash inflows=$398826.1651
Present value of initial investment or cash out flow=$350,000
Profitability Index=$398826.1651/$350,000=1.1395