Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100 000 up front, and receive royalties that are expected to total $26 000 at the end of each of the next five years. Alternatively, she can receive $200 000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%? Rule I: The Net Present Value rule
Rule II: The Payback Rule with a payback period of two years
Rule III: The internal rate of return (IRR)Rule
A)Rule III only
B)Rule I only
C)Rule I and II
D)Rule II and III

Question

Quizplus · Accepted Answer

The best rule to use in this scenario is the Net Present Value (NPV) Rule, which is Rule I. The NPV takes into account both the upfront payment and the expected royalties, adjusting them to their present value using the discount rate of 8%. By comparing the NPV of the two options, we can determine which is the better deal.

The NPV of the first option (upfront payment of $100,000 and five annual royalty payments of $26,000) is calculated as follows:

NPV = -$100,000 + $26,000/(1+0.08)^1 + $26,000/(1+0.08)^2 + $26,000/(1+0.08)^3 + $26,000/(1+0.08)^4 + $26,000/(1+0.08)^5
NPV = -$49,581.45

The NPV of the second option (upfront payment of $200,000 and no royalties) is simply:

NPV = -$200,000

Based on these calculations, we can see that the NPV of the first option is higher (less negative) than the NPV of the second option. Therefore, Mary should choose the option of receiving $100,000 upfront and royalties over the next five years.

The other investment rules, the Payback Rule (Rule II) and internal rate of return (IRR) (Rule III), are not as applicable to this scenario. The Payback Rule only considers the time it takes for an investment to recoup its initial cost, and the IRR is used to determine the expected rate of return on an investment. Neither of these rules takes into account the present value of cash flows or the discount rate, and they do not necessarily lead to the same conclusion as the NPV rule in this scenario.

Mary Is in Contract Negotiations with a Publishing House for Her