Ralph is considering purchasing an ostrich, which he can graze for free in his b

Question

Ralph is considering purchasing an ostrich, which he can graze for free in his backyard. Once the ostrich reaches maturity (in exactly three years), Ralph will be able to sell it for $2, 000. The ostrich costs $1, 500. Suppose that interest rates are 8%. Calculate the net present value of the ostrich investment. Does the NPV indicate that Ralph should buy the ostrich? Suppose that Ralph passes on the ostrich deal, and invests $1, 500 in his next-best opportunity: a safe government bond yielding 8%. How much money will he have at the end of three years? Is this outcome better or worse than buying the ostrich? Calculate the net present value of the ostrich if interest rates are 11%. Does the NPV method indicate that Ralph should buy the ostrich? If Ralph passes on the ostrich deal, and invests in a government bond yielding 11%, how much money will he have at the end of three years? Is this outcome better or worse than buying the ostrich? Based on your answers to (b) and (d), how well does the NPV method capture the concept of opportunity cost?

Explanation / Answer

11.

a.

initial price = $1500

value of Payment after 3 years = $2000

Interest rate R = 8%

Thus,

NPV = present value of cash inflows – initial investment = 2000/(1+R)^3 - 1500

NPV = 2000/(1+8%)^3 - 1500 = $87.67

Since, NPV is positive. Thus, Ralph should buy Ostrich.

b.

Principal amount P = $1500

Time = 3 years

Interest rate R= 8%

Future value of investment in 3 years = 1500*(1+R)^3 = 1500*1.08^3 = $1889.57

This income is worse than the outcome achieved in the case of buying an Ostrich as Ralph is getting only $1889.57 instead of $2000.

c.

If interest rate R = 11%

Thus,

NPV = present value of cash inflows – initial investment = 2000/(1+R)^3 - 1500

NPV = 2000/(1+11%)^3 - 1500 = - $37.62

Now, Ralph should not buy Ostrich as NPV has become negative.

d.

Interest rate R= 11%

Future value of investment in 3 years = 1500*(1+R)^3 = 1500*1.11^3 = $2051.45

Now, it is a better outcome than the buy an Ostrich in part C .

e.

NPV focuses on one particular given opportunity and its value changes with the change of cash inflows , cash outflows, time and discount rate. Here, NPV can be compared to identify the best opportunity available that can maximize the wealth. But, one NPV in isolation does not capture the second best opportunity.

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