Question

(a) Consider a wooden bridge costing $3,000 whose life is only three years and which offers the
prospect of a series of yields of $2,000 in each of three years, and the interest rate is 10%. Use the
information above to calculate present value of investment and explain why the company should or
should not undertake it. (6)
(b) With the help of a diagram explain permanent income hypotheses. (8)
(c) Briefly explain the accelerator model of inventories.

Answer 1

a) Initial cost = $3000

Yeilds in year 1,2 and 3 = $2000 each

Interest rate = 10%

So the present value of the yeilds = (2000 / 1.1)+ (2000/1.1²) + (2000/1.1³)

= 1818.18+ 1652.89 + 1502.63

= $4973.7

So the net present value of the investment at interest rate of 10% = $4973.7 - $3000 = $1973.7

So we can see that the present value of the investment is $1973.7, which is greater than 0, so we can say that the investment is profitable and the company should undertake this investment.