Question

. A restaurant is for sale for $200,000. It is estimated that the restaurant will earn $20,000 a year for the next 15 years. At the end of 15 years, it is estimated that the restaurant will sell for $350,000. Which of the following would be MOST LIKELY to occur if the investor’s required rate of return is 15 percent?

(A) Investor would pursue the project

(B) Investor would not pursue the project

(C) Investor would pursue the project if the holding period were longer than 15 years

(D) Not enough information provided

Answer 1

Answer is “investor would not pursue the project”

Cost of Restaurant = $200,000
Annual Revenue = $20,000
Residual Value = $350,000
Time Period = 15 years
Required Return = 15%

Present Value of Cash Inflows = $20,000/1.15 + $20,000/1.15^2 + … + $20,000/1.15^14 + $20,000/1.15^15 + $350,000/1.15^15
Present Value of Cash Inflows = $20,000 * (1 - (1/1.15)^15) / 0.15 + $350,000 * (1/1.15)^15
Present Value of Cash Inflows = $20,000 * 5.847370 + $350,000 * 0.122894
Present Value of Cash Inflows = $159,960.30

Net Present Value = Present Value of Cash Inflows - Cost of Restaurant
Net Present Value = $159,960.30 - $200,000
Net Present Value = -$40,039.70

Investor would not pursue this project as NPV is negative.