A research project would require initial investment of 100,000. There are three

Question

A research project would require initial investment of 100,000. There are three possible outcomes for this project: 30% probability that investment yields annual income of 35,000 for six year (starting from year 1 to year six) and zero salvage value 50% probability that investment yields annual income of 25,000 for six year (starting from year 1 to year six) and zero salvage value 20% probability of failure that yields zero annual income but salvage value of 75,000 dollar at the end of year 1 Calculate expected Rate of Return for this investment. Explain your work in detail including all the required equations and calculations.

Explanation / Answer

The rate of return , i, can be calculated by equating the initial investment to the present value of all possibility of cash inflow:

100,000 = 0.3 x 35000(1-(1+i)-6)/i + 0.5x25000 (1-(1+i)-6)/i + 0.2 x 75000(1+i)-1

100,000 =23000 (1-(1+i)-6)/i + 15000(1+i)-1

By using different combinations we get i=15.5%

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