Question

Ch 7

You have been offered a very​ long-term investment opportunity to increase your money one hundredfold. You can invest $ 1,000 today and expect to receive $ 100,000 in 40 years. Your cost of capital for this​ (very risky) opportunity is 25 %. What does the IRR rule say about whether the investment should be​ undertaken? What about the NPV​ rule? Do they​ agree?

What is the IRR​?

The IRR of this investment opportunity is _______%

Answer 1

IRR Rule:

Amount of investment= $1,000

Future Value receivable in 40 years is given as $100,000

IRR= [(100,000/1,000)^(1/40)] – 1 = (100^0.025)-1 = 12.201845%

Since IRR is less than cost of capital (given as 25%), the investment shall not be taken up.

NPV Rule:

Required cost of capital is given as 25%

NPV at 25% = PV of FV – Amount of investment.

PV of amount receivable= $100,000/(1+25%)^40 = 100,000/7523.163845 = 13.292280

NPV= 13.292280-1,000 = -$986.71 (Negative)

As per NPV rule, the investment shall be undertaken only if the NPV is equal to or more than 0. Since NPV in this case is negative, the investment shall not be undertaken.