Question

On 1/1/2004, an insurance company invested $1,000,000 developing an annuity product that will produce returns of...

On 1/1/2004, an insurance company invested $1,000,000 developing an annuity product that will produce returns of $150,000 per year for the next 10 years (assume at the end of each year) following which the product will have to be abandoned.

The net present value of the project is $100,000.

At the end of 5 years, the opportunity cost of capital for the project decreased by 3 percentage points (or 3%), with the rest of the project remaining unchanged.

The insurance company recalculates the net present value as the present value of the remaining cash flows at the new opportunity cost of capital.

Find the value of the project on 1/1/2009.

Answer choices:

A. 485,000

B. 535,000

C. 585,000

D. 635,000

E. 685,000

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Answer #1

Answer:

Correct answer is:

E. 685,000

Explanation:

On 1/1/2004:

Initial investment = $1,000,000

NPV = $100,000

As such:

Present value of cash inflows = PV = $1000000 + 100000 = $1,100,000

Annual cash flows = PMT = $150,000

NPER = 10 YEARS

Opportunity cost of capital = RATE (nper, pmt, pv, fv, type)

= RATE (10, 150000, -1100000, 0, 0)

= 6.08%

On 1/1/2009 (after 5 years):

Opportunity cost of capital for the project decreased by 3 percentage points (or 3%).

New opportunity cost = 6.08% - 3% = 3.08%

Remaining NPER = 5

PMT = $150,000

Net present value remaining cash flows = PV (rate, nper, pmt, fv, type)

= PV (3.08%, 5, -150000, 0, 0)

= $685,390

Closest option from answer choices is E. 685,000

As such option E is correct and other options A, B, C, and D are incorrect.

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