A) NVP = ??? B) NVP = ????? salvage value is zero. The cost of capital is 25% a
ID: 2509154 • Letter: A
Question
A) NVP = ???B) NVP = ?????
salvage value is zero. The cost of capital is 25% a year. 20,000 in research & development (RAD). This investment will investment will generate cost savings of $12,000 in year 1, $8,000 i year 2, and $6,000 in year 3. After 3 years, the cost ·government stimulus program, the cost of capital decreased to 10% a year, compute the net present value at the new cost of capital. NPV-$ c) The economy is at full employment and is beginning to overheat (I.e, total demand exceeds the available capacity, which leads to rapid price increases). Firmst Investment activity increases total demand and contributes to economie overheating. To prevent high inflation, the Federal Reserve charman wants to reduce nrms investrert ty The Federal Reserve control the cost of capital in the economy by adjusting its benchmark interest rate. To reduce the reduce the interest rate- based on (a) and (b), lower cost of capital will reduce investment O increase the interest rate--based on (a) and (b), higher cost of capital will reduce investment
Explanation / Answer
It is assumed that you need answer for a and b bits:
Answer for a)
The NPV of savings generated at the end of year 1:$12000(100%/125%[100%+25%(i.e cost of capital)])=$9600
The NPV of savings generated at end of year 2:$8000(100%/(125%+125%))=$5120
The NPV of savings generated at end of year 3:$6000(100%/(125%+125%+125%))=$3072
Therefore NPV of total savings generated at end of year 3=$9600+$5120+$3072=$17,792
As $17792 is lesser than $20000,it is not recommended to invest.
Now, although answer will be provided for b,I would recommend to try it once yourself for better understanding as it is similar to a.
Answer for b)
NPV at the end of year 1=$12000(100%/[110%(i.e100%+10%)])=$10909.09(approx.)
NPV at the end of year 2=$8000(100%/(110%+110%))=$6611.57(approx.)
NPV at the end of year 3=$6000(100%/(110%+110%+110%))=$4507.89(approx.)
Total NPV at the end of year 3=$10,909+$6611.57+$4507.89=$22,028.55(approx.)
Hence,$22028.55 is more than $20000 and it is recommended to invest in it.
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