Problem 310 net present value assume that your firm wants to...

Problem 3.10 Net Present Value. Assume that your firm wants to choose between two project options: Project A: $500,000 invested today will yield an expected income stream of $150,000 per year for 5 years, starting in Year 1. Project B: an initial investment of $400,000 is expected to produce this revenue stream: Year 1 = 0, Year 2 = $50,000, Year 3 = $200,000, Year 4 = $300,000, and Year 5 = $200,000. Assume that a required rate of return for your company is 10% and that inflation is expected to remain steady at 3% for the life of the project. Which is the better investment? Why?

Transcript

00:01 So here we are thinking about a project that stretches over five years.

00:05 So we have today, year one, year two, year three, year four, and year five.

00:14 Project a has the following profile, right? and i'm going to write this in thousands.

00:18 You invest five hundred thousand today.

00:21 You get 150 every year for five years.

00:25 We have to calculate the net present value, and this means that, we are going to think about, well, these things are not always in the same units, right? dollars today that we're investing are a lot more valuable than dollars in five years from now.

00:44 We could invest our money and earn interest on the money in particular.

00:50 So we need to convert those dollars back to today's dollars.

00:53 And the information that they give us is that the company requires 10%, and i assume that's a, i'm not sure whether that's nominal or real, and inflation is equal to 3%.

01:11 So we have a little bit of a confusion here, right? is the required rate of return for our company, is this real or nominal? that's the question that's left on set.

01:28 I'm going to assume that the company cares about the real rate of return.

01:32 If the company cares about the nominal rate of return, they're dumb, but who knows, right? so if the company cares about a real rate of return of 10, the nominal rate, the day that we convert between dollars here, the nominal rate i is r plus pi, which would be equal to 13%, right? so we need 13 % more dollars in the future to give us our 10 % real rate of return...

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