Based on response to 3-6 Finance questionbelow, provide comments to the response
ID: 2770540 • Letter: B
Question
Based on response to 3-6 Finance questionbelow, provide comments to the response.
3-6. You run a construction firm. You have just wona contract to build a government office building. Building itwill require an investment of $10 million to day and $5 million inone year. The government will pay you $20 million in one yearupon the building’s completion. Suppose that the cashflows and their times of payment are certain, and the risk-freeinterest rate is 10%. What is the NPV of theopportunity? How can you firm turn this NPV into cashtoday?
Response:
Today
Payment in 1 year
Payment Upon Completion
Risk-Free Interest Rate
$10 mil
$5 mil
$20 mil
10%
A. What is the NPV of theopportunity? NPV = $3,636,363
1. PV (Benefits) =$20 mil / 1.1 = $18,181,818
2. PV ( Cost) = $10mil + ($5 mil / 1.1) = $14,545,455
3. PV (Benefits)$18,181,818 - PV ( Cost) $14,545,455 = NPV $3,636,363
B. How can your firm turn this NPVinto cash today?
1. The firm could borrow the$10 mil today at the 10% risk-free rate. Borrowing would allow forretaining cash and gaining a NPV increase of $909,091 over a payout today.
i. PV (Benefits) = $20 mil /1.1 = $18,181,818
ii. PV ( Cost) = (($10 mil+$5 mil)/ 1.1) = $13,636,364
iii. PV (Benefits)$18,181,818 - PV ( Cost) $13,636,364 = NPV$4,545,454
Today
Payment in 1 year
Payment Upon Completion
Risk-Free Interest Rate
$10 mil
$5 mil
$20 mil
10%
Explanation / Answer
Accept the Project, if the Project has Positive NPV Reject the Project, if the Project has Negative NPV NPV = (Present Value of Benefits - Present Value ofCosts). Here the NPV of the Project is Positive. Thus, the Project should be accepted. If the firm could borrow the $10million today, thepresent value of the today's Investment is $909,091. Hope this helps youRelated Questions
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