Asked by Kundan Singh on Sep 23, 2024
Verified
If the interest rate is 25%,but cash flows change such that the investment renders a cash flow of $500 in year 1 and $800 in year 2 instead of year 3,would the investment take place?
A) Yes since NPV>0
B) No since NPV<0
C) Yes since the present value of the cash flows is greater than zero
D) No since the present value of the cash flows is lesser than zero
Interest Rate
The proportion, typically expressed as a percentage, at which interest is charged by lenders on loans or paid by banks on deposits.
Cash Flows
The total amount of money being transferred into and out of a business, especially as affecting liquidity.
Net Present Value
The difference between the present value of cash inflows and the present value of cash outflows over a period of time.
- Analyze the selection of investments across diverse financial cost environments.
Verified Answer
AM
Akshay Mathur2 days ago
Final Answer :
B
Explanation :
At an interest rate of 12%, the cash flows can be discounted as follows:
Year 0: -900
Year 1: 500/(1.12) = $446.43
Year 2: 0
Year 3: 800/(1.12)^3 = $549.59
NPV = -900 + 446.43 + 549.59 = $96.02
NPV is positive, so the investment would take place.
At an interest rate of 25%, the cash flows would be:
Year 0: -900
Year 1: 500/(1.25) = $400
Year 2: 800/(1.25)^2 = $512
NPV = -900 + 400 + 512 = $12
NPV is positive at 25%, but the cash flows have been rearranged. Since the cash flows are not the same as before, we cannot directly compare the NPV at 12% and 25%. However, since the NPV is much lower at 25%, it is unlikely that the investment would take place at the higher interest rate. Therefore, the best answer is B.
Year 0: -900
Year 1: 500/(1.12) = $446.43
Year 2: 0
Year 3: 800/(1.12)^3 = $549.59
NPV = -900 + 446.43 + 549.59 = $96.02
NPV is positive, so the investment would take place.
At an interest rate of 25%, the cash flows would be:
Year 0: -900
Year 1: 500/(1.25) = $400
Year 2: 800/(1.25)^2 = $512
NPV = -900 + 400 + 512 = $12
NPV is positive at 25%, but the cash flows have been rearranged. Since the cash flows are not the same as before, we cannot directly compare the NPV at 12% and 25%. However, since the NPV is much lower at 25%, it is unlikely that the investment would take place at the higher interest rate. Therefore, the best answer is B.
Learning Objectives
- Analyze the selection of investments across diverse financial cost environments.