You have just inherited $1,000,000 and are considering a number of investment op
ID: 1133831 • Letter: Y
Question
You have just inherited $1,000,000 and are considering a number of investment options. Among the investment projects offered you there is a service/gas station whose present owner is asking exactly $1,000,000 for it. The information he has provided you indicates that the sales and the expenses of the station have been relatively stable for the past 10 years. In fact, the present owner claims that he is so confident about the performance of the station that he is willing to provide the buyer with a money-back guarantee after three years. That is, after three years, if the buyer is not satisfied, he would buy the station back from him/her at exactly the same price. Based on the information given to you, you have estimated the annual costs and revenues of the station for the next three years as follows:
Assuming a risk-adjusted 4 percent discount (interest) rate, what price would you put on this service station? Would you buy it at the asking price? Explain.
Explanation / Answer
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Answer-
Cost price
$1,000,000
Periods
Revenue
Cost
Benefit
Adjusting for PV
1
6,90,000
5,50,000
140000.00
134615.38
2
7,50,000
6,60,000
90000.00
83210.06
3
8,00,000
6,80,000
120000.00
106679.56
$3,50,000.00
$3,24,505.01
PV of Initial investment
$ 8,88,996.36
The person can take the offer as the petrol station is giving positive returns even after discounting the actual returns with the 4% present value.
We have taken the benefit by subtracting the cost from revenue. The present value has been calculated using the formula PV = Cash flow/(1+r)^n for each year. Here n = number of year, r =rate of return and Cash flow is the benefit yearly.
Still we see that the cash flow is positive. Hence the person can accept the offer and then after 3 years if he is not satisfied then he can return back the petrol pump.
Even after the PV of initial investment is calculated after 3 years by discounting we have the amount of $ 8,88,996.36 which if added with the benefit from the petrol pump will be $12,13,501.37. Which is much higher than the expected amount.
Cost price
$1,000,000
Periods
Revenue
Cost
Benefit
Adjusting for PV
1
6,90,000
5,50,000
140000.00
134615.38
2
7,50,000
6,60,000
90000.00
83210.06
3
8,00,000
6,80,000
120000.00
106679.56
$3,50,000.00
$3,24,505.01
PV of Initial investment
$ 8,88,996.36
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