Question

You are offered a four-year investment opportunity costing $100,000 today. The investment will pay $25,000 in the first year, $27,000 in the second year, $30,000 in the third year, and $40,000 in the fourth year. Investments of comparable risk require a 10% rate of return in the financial market. Should you accept the investment opportunity and why?

A.	Yes, those cash payments look good to me because they add up to $122,000.
	B.	Yes, because the investment’s cash payments represent a total return of 22% on the $100,000 investment.
	C.	Yes because the investment’s net present value is greater than zero.
	D.	No, because the investment’s net present value is negative.
	E.	No, because the investment’s net present value is zero.

Answer 1

The NPV is computed as shown below:

= Initial investment + Present value of future cash flows

Present value is computed as follows:

= Future value / (1 + r)ⁿ

So, the NPV is computed as follows:

= - $ 100,000 + $ 25,000 / 1.10¹ + $ 27,000 / 1.10² + $ 30,000 / 1.10³ + $ 40,000 / 1.10⁴

= - $ 5,098.70 Approximately

Since the NPV of the project is negative, hence the firm shall not accept the project.

So, the correct answer is option D i.e. No, because the investment’s net present value is negative.

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