Question

A company has $250,000 to invest. Their cost of capital is 6% compounded annually. They are...

A company has $250,000 to invest. Their cost of capital is 6% compounded annually. They are looking at two investment options and each of these options require an initial investment of $250,000: (I) A perpetuity paying $15,750 at the end of each year. (II) An investment with net cashflows of $32,500 at the end of each year for 10 years. Which of the following is a correct statement? A. You shouldn’t invest in either of these options as each of them has a negative NPV. B. Invest in I because it has the highest NPV and its NPV is greater than 0. C. Invest in ether I or II because each of them has a NPV greater than 0. D. Invest in II because it has the highest NPV and its NPV is greater than 0.

  • A.

    You shouldn’t invest in either of these options as each of them has a negative NPV.

  • B.

    Invest in I because it has the highest NPV and its NPV is greater than 0.

  • C.

    Invest in ether I or II  because each of them has a NPV greater than 0.

  • D.

    Invest in II because it has the highest NPV and its NPV is greater than 0.

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Homework Answers

Answer #1

The NPV of Investment I is computed as shown below:

= - $ 250,000 + $ 15,750 / 6%

= $ 12,500

The NPV of Investment II is computed as shown below:

= Initial investment + Annual amount x [ (1 – 1 / (1 + r)n) / r ]

= - $ 250,000 + $ 32,500 x [ (1 - 1 / (1 + 0.06)10 ) / 0.06 ]

= - $ 250,000 + $ 32,500 x 7.360087051

= - $ 10,797.17 Approximately

So, the correct answer is option B.

Feel free to ask in case of any query relating to this question      

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