The following show four mutually exclusive investments.Which is the best investment?
A)Initial investment: $1.1 million;Cash flow in year 1: $160,000;Annual Growth Rate: 2%;Cost of Capital: 9.0%
B)Initial investment: $1.2 million;Cash flow in year 1: $150,000;Annual Growth Rate: 2%;Cost of Capital:7.0%
C)Initial investment: $1.3 million;Cash flow in year 1: $160,000;Annual Growth Rate: 1%;Cost of Capital: 6%
D)Initial investment: $1.4 million;Cash flow in year 1: $150,000;Annual Growth Rate: 2%;Cost of Capital: 8%

Question

Quizplus · Accepted Answer

We need to calculate net present value (NPV) for each investment and choose the one with the highest NPV. Assuming cash flows continue in perpetuity, NPV can be calculated using the formula:
NPV = CF1/(r-g) - Initial investment

where CF1 is cash flow in year 1, r is the cost of capital, and g is the annual growth rate.

For investment A, NPV = 160,000/(0.09-0.02) - 1,100,000 = $2,000.

For investment B, NPV = 150,000/(0.07-0.02) - 1,200,000 = $1,666.67.

For investment C, NPV = 160,000/(0.06-0.01) - 1,300,000 = $2,133.33.

For investment D, NPV = 150,000/(0.08-0.02) - 1,400,000 = $1,250.

As we can see, investment C has the highest NPV of $2,133.33, making it the best choice.

The Following Show Four Mutually Exclusive Investments