Question

A firm has initial fund of $200. The market rate of return is 15 per cent. The firm has identified good investment opportunities to invest $160 at an average 40 per cent rate of return. Find the net present value of the firm for the investment decision under Two-Period Perfect Certainty Model?

Answer 1

Under two period certainty model, the three distinct period are:

1. Current Time = T0,

2. Time after 1 period = T1

3. Time after two period = T2

The total fund available for investment in T0  = 200

out of this 160 would be invested in a postive NVP project(say P1) with a return of 40% in two years, and the rest would be invested in market at a rate of return of 15%.(say P2)

NPV of P1 = PV(Future Value of Invetment after two period) -initial outlay

= 160*(1+return)2/(1+discount rate)2 -160 = 160*(1.40)2/(1.15)2 -160 = 237.1267 - 160 = 77.1267

NPV of P2 = 40*(1.15)2/(1.15)2 -40 = 40 - 40 = 0

Therefore net present value of the firm = PV (funds) + NPV(P1) +NPV(P2) = 200 + 77.1267 + 0 = 277.1267 dollars