You are planning to invest salvage value is zero. The cost of capital is 2S% a y

Question

You are planning to invest salvage value is zero. The cost of capital is 2S% a year. will generate cost savings of $12,000 in year 1, $8,000 in year 2, and $6,000 in year 3. After 3 years, the Should you Invest? b) Following a government stimulus program, the cost of capital decreased to 10% a year. Compute the net present value at the new cost of capitaL Should you invest now? OYES ONo C) The economy is at full employment and is beginning to overheat (l.e, total demand exceeds the available capacity, which leads to rapid price increases). Firms' Investment activity increases total demand and contributes to economic overheating. To prevent high inflation, the Federal Reserve chairman wants to reduce fims' investment activity. The Federal Reserve can control the cost of capital O increase the interest rate - based on (a) and (b), higher cost of capital will reduce investment

Explanation / Answer

a) STATEMENT SHOWING NPV if cost of capital is 25% Cost Yr PVF @25% Present Value Research & Development Exp 20000 0 1 -20000 Annual Cost Saving 12000 1 0.8 9600 8000 2 0.64 5120 6000 3 0.512 3072 NPV -2208 Since NPV is negative, co should not invest b) STATEMENT SHOWING NPV if cost of capital is 10% Cost Yr PVF @10% Present Value Research & Development Exp 20000 0 1 -20000 Annual Cost Saving 12000 1 0.909091 10909.09 8000 2 0.826446 6611.57 6000 3 0.751315 4507.889 NPV 2028.55 Since NPV is positive, co should invest

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