Discounting A potential investor is considering knocking down some old homes in

Question

Discounting A potential investor is considering knocking down some old homes in downtown Davis to make way for condominiums (condos) . The homes and land will cost $5 million, and permitting and associated legal fees cost another $3 million. Over the next 5 years, the investor will have to pay $1 million per year in construction costs. After 5 years, the condos can be sold for $15 million. The discount rate is 5% (or 0.05). (a) What is the present value of costs? ( b) What is the present value or returns? (c) What is the NPV of this project? (d) Should the investor invest?

Explanation / Answer

(a) PV of costs = $5 mill + $3 mill + ($1 mill x present value interest factor of annuity, 5%, 5 years)

= $8 mill + [$1 mill x 4.3295 (From PVIFA table)]

= $12.33 mill

(b) PV of returns = $15 mill / (1.05)5

= $11.75 mill

(c) NPV = PV of returns - PV of costs

= $(11.75 mill - 12.33 mill) = - $0.58 mill

(d) Investor should not invest, since net present value is negative.

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