What rate of return should be used to compute the NPV of a proposed purchase of Smiley's,an operating business?

Question

Quizplus · Accepted Answer

The most appropriate rate of return to use in calculating the NPV of a proposed purchase of Smiley's is the discount rate applicable to other investments with similar risks. This rate of return takes into account the opportunity cost of investing in the business as opposed to other investment options with similar risks. It provides a realistic assessment of the expected return on the investment and is based on market conditions and investor expectations. Using Smiley's current return on equity or net profit percentage may not accurately reflect the risks associated with the investment or the opportunity cost of capital. The rate of interest charged by a bank for a loan similar in size to the cost of the purchase may not reflect the true cost of capital as it only considers the borrowing cost and not the returns that must be generated on the investment. A discount rate that makes the NPV of the proposed purchase positive is subjective and does not provide a reliable benchmark for evaluating the investment.

What Rate of Return Should Be Used to Compute the NPV