Question

A rich, friendly, and probably slightly unbalanced benefactor offers you the opportunity to invest $1 million...

A rich, friendly, and probably slightly unbalanced benefactor offers you the opportunity to invest $1 million in two mutually exclusive ways. The payoffs are:

a. $2 million after 1 year, a 100% return.

b. $300,000 a year forever.

Neither investment is risky, and safe securities are yielding 7%. Which investment will you take? You can't take both, so the choices are mutually exclusive. Do you want to earn a high percentage return, or do you want to be rich?

Explain how to calculate NPV for a and b.

Homework Answers

Answer #1

NPV of investment A= PV of cash inflow- initial investment

PV of cash inflow= cashflow/(1+r)^n -------where r=yield or discount rate ; n=no of years

NPV of investment A=2000000/(1+7%) -1000000 = 869158.878 $

-

NPV of investment B = PV of perpetuity cashflow- initial investment

PV of perpetuity= Perpetuity/r ------------where r=discount rate or yield

NPV of investment B=300000/.07 -1000000 =3285714.28

--

From NPV calculation, investment B has higher NPV value and hence investment B should be selected.

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