A company has identified the following investments as looking promising. Each re

Question

A company has identified the following investments as looking promising. Each requires an initial investment of $1.2 million. Which is the best investment?

Question 6 options:

1) a perpetuity that generates a cash flow at the end of year 1 of $100,000, has a growth rate of 1.25%, and a cost of capital of 10% 2) a perpetuity that generates a cash flow at the end of year 1 of $80,000, has a growth rate of 2.25%, and a cost of capital of 12% 3) an investment that generates a cash flow of $400,000 at the end of each of the next five years, when the cost of capital is 6% 4) an investment that generates a cash flow of $200,000 at the end of each of the next ten years, when the cost of capital is 6%

Explanation / Answer

1.

Annual cash flow=$1,00,000

Discount Rate=10%

Growth Rate=1.25

Annual Cash Flow/Discount Rate-Growth rate           

=$1,00,000/(.10-.0125)

=$1,00,000/.0875

=$11,42,857               

2.

Annual cash flow=$80,000

Cost of Capital=12%

Growth Rate=2.25

Annual Cash Flow/(Cost of capital-Growth rate)

=$80,000/(.12-.0225)

=$80,000/.0975

=8,20,512

3.

PVAF(R% of 5 Years)

1/(.06)5

=4.212*4,00,000

=16,84,800

4.

PVAF(R%of 10 Years)

=1/(1.06)10

=7.36*2,00,000

=14,72,000

Option 3 is best investment.

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