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20 April, 02:33

Problem 3.10 Net Present Value. Assume that your firm wants to choose between two project options: Project A: $500,000 invested today will yield an expected income stream of $150,000 per year for 5 years, starting in Year 1. Project B: an initial investment of $400,000 is expected to produce this revenue stream: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000, and Year 5 = $200,000. Assume that a required rate of return for your company is 10% and that inflation is expected to remain steady at 3% for the life of the project. Which is the better investment? Why?

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  1. 20 April, 02:48
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    Project B is a better investment

    Explanation:

    Given:

    Project A's initial investment is $500,000

    Expected cash inflow starting from year 1 for 5 years is $150,000

    Required rate of return is 10% and inflation is 3%. So required rate of return is 13%

    NPV of project A = - 500,000 + Present value of annuity of $150,000, 5 years at 13%

    Present value of annuity factor of $1, 13%, 5 periods = 3.5172

    NPV of project A = - 500,000 + (150,000 * 3.5172)

    = $27,580

    Poject B's initial investment = $400,000

    Use present value factor of $1, 13% to compute present value of cash inflows:

    Year 1 = 0

    Year 2 = 50,000 * 0.7831 = 39,155

    Year 3 = 200,000 * 0.6931 = 138,620

    Year 4 = 300,000 * 0.6133 = 183,990

    Year 5 = 200,00 * 0.5428 = 108,560

    NPV of project B = - 400,000 + (39,155 + 138,620 + 183,990 + 108,560)

    = $70,325

    Since project B's NPV is higher than project A, project B is a better investment.
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