Recall that the net present value (NPV) is a procedure for evaluating consequenc
ID: 2358649 • Letter: R
Question
Recall that the net present value (NPV) is a procedure for evaluating consequences that yield cash flows at different points in time. If xi is the cash flow at year i and r is the discount rate, then the NPV is given by: NPV = ? (xi / (1+r)i ) where the summation is over all future cash flows including the current time x0. a. Suppose that you can invest in one of the two different projects. Each costs $20,000. The first project is riskless and will pay you $10,000 each year for the next 3 years. The second one is risky and there is 50% chance that it will pay $15,000 each year for the next 3 years and a 50% chance that it will pay only $5,000 each year for the next 3 years. Your discount rate is 9%. Calculate the NPV for both projects. What can you conclude about the use of NPV for deciding among risky projects? Discuss in terms of risk attitudes.Explanation / Answer
Proj1: Y0= (20000) y1= 10000/(1+0.09) = 9174 y2= 10000/(1.09)^2 = 8417 y3= 10000/(1.09)^3 = 7722 NPV = 5313 Proj2: Y0= (20000) y1= 15000/(1.09) x0.75 = 10321 y1= 5000/(1.09) x0.25 = 1147 y2= 15000/(1.09)^2 x0.75 = 9467 y2= 5000/(1.09)^2 x0.25 = 1052 y3= 15000/(1.09)^3 x0.75 = 8687 y3= 5000/(1.09)^3 x0.25 = 965 NPV = 31639 The use of NPV for deciding among risky projects have a few aspects. As the project is risky than the returns can be greater and in some cases smaller than if it wouldn't have been a risky project. Hence a risky project will have probabilities of varying results and NPV could be more positive or negative than if would have been for a non risky project. (Note that the reason investor takes a risky project is that, although there is a risk that return might be lower, there's a chance that it could be higher and a chance that investor seems it's worthy to take)
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.