Darren and Alice Johnson are in the information technology consulting business.Alice's father just passed away and left her $100,000.They are considering investing her inheritance in a server farm owned by one of their clients.The client has a cash flow problem and has offered the Johnsons the following investment proposal: purchase an investment interest for $100,000 today;receive cash distributions of $6,000,$7,000,and $8,000 respectively over the next three years;and at the end of the third year the owner will purchase back the interest in the server farm for $115,000.Even though the owner is a client the Johnsons trust,they consider the investment to be risky.Darren and Alice feel that they should earn at least 12 percent on the investment in order to be fairly compensated for the investment risk.Should the Johnsons invest in the server farm?
A)Yes,the return equals their required rate of return.
B)Yes,the return exceeds their required rate of return.
C)No,the return meets their required rate of return.
D)No,the return does not meet their required rate of return.

Question

Quizplus · Accepted Answer

To determine whether the investment is worthwhile, we need to calculate the net present value (NPV) of the investment:

NPV = -$100,000 + $6,000/(1+0.12)^1 + $7,000/(1+0.12)^2 + $8,000/(1+0.12)^3 + $115,000/(1+0.12)^3
NPV = -$100,000 + $5,357.14 + $5,741.94 + $6,137.63 + $78,758.51
NPV = -$4,004.78

Since the NPV is negative, the investment would not provide the Johnsons with at least a 12% return and they should not invest in the server farm. Therefore, the answer is D) No, the return does not meet their required rate of return.

Darren and Alice Johnson Are in the Information Technology Consulting