Question

9) You have $600 to invest, and are choosing between two projects, both of which cost $600 up front and will yield six years of returns. The returns for the first investment will start at $120 (in nominal $) a year from now and increasing at 3% annually. The returns for the second start at $130 (in real $) and increase at 1% annually. If your real hurdle rate is 5% and the expected inflation rate is 2.5%, which of these investments should you choose (if any)?

Answer 1

In this type of project inflows annually the present value factor should also be considered .

• In the first project the inflows will be :

Annual returns are $120 per annum up to 6 years .

Increasing rate is 3 %

Inflows up to 6 years .

Formula goes : present value = C * (1 + (1+i)^-n/ i)

In first case there will be returns of 120 + 3 % increase

Total cash inflows are $650 (approximately ).

• In second case the cash inflows are $ 130 p.a

With growth rate of 1 %

The return will be 753 ( approximately) .

Therefore it is wise to go with the second project as the return is higher than the first project .