1. Consider the following two projects Project A: Costs $10,000 today. It only i
ID: 2715024 • Letter: 1
Question
1. Consider the following two projects Project A: Costs $10,000 today. It only increases profit two years from today by $11, 500 Project B: Costs $15,000 today. Increases profit next year by $5000, two years from now by $8000 and three years from now by $3700 Both projects have no value beyond the given time frames. A firm faces a rate to borrow money of 7% and has the option of investing money with almost no risk at 4%. a) If the firm has $30,000 on hand, with only these two project to choose from, will they invest in A, B, neither or both? Show the calculations that lead to your conclusions. Explain whether you answers would be different for either project if the firm had no money on hand to invest. (2 points) b) Explain, based on your calculations in (a), why the rate of return on project B must be somewhere between 4% and 7%. Set up (but do not solve) an equation that would find the rate of interest where the firm is indifferent between investing in project B, and not investing in project B. (1 point) c) Use the data in (a) to bound the rate of return for project A, then use an equation like the one in (b) to actually find the rate of return of project A written as a percentage rounded to 2 decimal places. Verify that it is consistent with the bound you found. (2 points)
Explanation / Answer
1)
Net present value for the project A is as follows:
Particulars
Project A
Initial investment
10,000
Cash flows
Year 1-2
11,500
Discount factor @7%
1.808
Present value of cash flows
20,792
Net present value
10,792
Thus, the NPV is $10,792.
2)
Net present value for the project B is as follows:
Year
Cash flows
Discount factor @7%
Present value
Year 0
-15,000
1
-15,000
Year 1
5,000
0.9345
4,673
Year 2
8,000
0.8734
6,987
Year 3
3,700
0.8162
3,020
-320
Thus, the NPV is ($320).
Since, the NPV is positive for project A; it has to be selected.
Particulars
Project A
Initial investment
10,000
Cash flows
Year 1-2
11,500
Discount factor @7%
1.808
Present value of cash flows
20,792
Net present value
10,792
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