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.
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.
Get Answers For Free
Most questions answered within 1 hours.