On January 2, 20X1, Bruce Greene invested $10,000 in the stock market and purcha

Question

On January 2, 20X1, Bruce Greene invested $10,000 in the stock market and purchased 500 shares of Heartland Development Inc. Heartland paid cash dividends of $2.60 per share in 20X1 and 20X2; the dividend was raised to $3.10 per share in 20X3. On December 31, 20X3, Greene sold his holdings and generated proceeds of $13,000. Greene uses the net present value method and desires a 16% return on investments. Prepare a chronological list of the investment's cash flows. Note: Greene is entitled to the 20X3 dividend. Compute the investment's net present value, rounding calculations to the nearest dollar. I'm using your answer to double check my work.

Explanation / Answer

Yvonne, the initial investment of 10K can be included or excluded as one of the cash flows; the two different approaches only give two versions of the same comparison. It's analogous to the fact that " a > b" and "a - b > 0" are equivalent statements. What your problem boils down to is determining if the present value of the sequence of cash inflows generated by the investment is greater than the amount of the initial 10K investment. One approach is to discount all the cash flows--including the negative cash flow of 10K--at the given required rate of return. Then see if the sum of all the individual present values is > zero. (Remember that the present value of any cash flow occurring immediately is just the amount of the cash flow itself.) Equivalently, you could just discount all the positive cash flows (i.e., the cash inflows) generated by the investment, and see if the sum of their PVs exceeds the initial investment of 10K. If you denote the sum of the present values of the cash inflows by "PV", you'll see that the first approach is PV - 10,000 > 0 ? ...whereas the second approach is PV > 10,000 ?

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