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The following shows four mutually exclusive investments. Which one is the best investment?Question 13Answera.Initial investment: $1.1 million; Cash flow in year 1: $160,000; Annual Growth Rate: 2%; Cost of Capital: 9.1%b.Initial investment: $1.2 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of Capital: 7.2%c.Initial investment: $1.3 million; Cash flow in year 1: $160,000; Annual Growth Rate: 1%; Cost of Capital: 5.6%d.Initial investment: $1.4 million; Cash flow in year 1: $150,000; Annual Growth Rate: 2%; Cost of Capital: 8.4%

Question

The following shows four mutually exclusive investments. Which one is the best investment?Question 13Answera.Initial investment: 1.1million;Cashflowinyear1:1.1 million; Cash flow in year 1: 160,000; Annual Growth Rate: 2%; Cost of Capital: 9.1%b.Initial investment: 1.2million;Cashflowinyear1:1.2 million; Cash flow in year 1: 150,000; Annual Growth Rate: 2%; Cost of Capital: 7.2%c.Initial investment: 1.3million;Cashflowinyear1:1.3 million; Cash flow in year 1: 160,000; Annual Growth Rate: 1%; Cost of Capital: 5.6%d.Initial investment: 1.4million;Cashflowinyear1:1.4 million; Cash flow in year 1: 150,000; Annual Growth Rate: 2%; Cost of Capital: 8.4%

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Solution

To determine the best investment, we need to calculate the Net Present Value (NPV) for each investment. The NPV is the sum of the present values of cash flows. A higher NPV means a better investment.

Here's how to calculate the NPV:

  1. Calculate the present value (PV) of each cash flow by using the formula: PV = Cash flow / (1 + r)^n, where r is the cost of capital and n is the year.

  2. Sum up all the present values. Subtract the initial investment.

Let's calculate the NPV for each investment:

a. The cash flow grows at a rate of 2% per year. So, the cash flow in year n is 160,000∗(1+2160,000 * (1 + 2%)^(n-1). The cost of capital is 9.1%. The NPV is the sum of the present values of cash flows from year 1 to infinity, minus the initial investment of 1.1 million.

b. Similarly, we can calculate the NPV for investment b, c, and d.

c. After calculating the NPV for each investment, compare them. The investment with the highest NPV is the best investment.

Please note that this is a simplified explanation. In reality, the calculation can be more complex due to factors such as inflation, tax, and risk.

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