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An independent film maker is considering producing a new movie.The initial cost for making this movie will be $20 million today.Once the movie is completed,in one year,the movie will be sold to a major studio for $25 million.Rather than paying for the $20 million investment entirely using its own cash,the film maker is considering raising additional funds by issuing a security that will pay investors $11 million in one year.Suppose the risk-free rate of interest is 10%.
-Refer to the information above.Without issuing the new security,the net present value (NPV)for this project is closest to what amount? Should the film maker make the investment?
A)$1.7 million; Yes
B)$1.7 million; No
C)$2.7 million; Yes
D)$2.7 million; No
E)$5.0 million; Yes.

Question

Quizplus · Accepted Answer

The net present value (NPV) is calculated as the present value of the future cash flows minus the initial investment. In this case, the future cash flow is the $25 million sale price in one year, discounted at the risk-free rate of 10% to get a present value of $22.73 million. Subtracting the initial investment of $20 million gives an NPV of $2.73 million. As this is a positive NPV, the film maker should make the investment. The option to issue the new security is not needed as the project already has a positive NPV.

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