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- How do I evaluate an investment opportunity?
- The NPV approach involves assigning a rate of return r that is reasonable for, and specific to, the project and then computing the present value of the expected stream of payments. The investment is then made when NPV is positive—since this would add to the net value of the firm.
- Carrying out an NPV analysis requires estimating investment and revenues and identifying an appropriate rate of return.
- Interest rates of 15%–20% are common for evaluating the NPV of projects of major corporations.
- Suppose that, without a university education, you’ll earn $25,000 per year. A university education costs $20,000 per year, and you forgo the $25,000/year that you would have earned for 4 years. However, you earn $50,000 per year for the following 40 years. At 7%, what is the NPV of the university education?
- Now that you’ve decided to go to the university based on the previous answer, suppose that you can attend East State U, paying $3,000 per year for 4 years and earning $40,000 per year when you graduate, or you can attend North Private U, paying $22,000 per year for the 4 years and earning $50,000 per year when you graduate. Which is the better deal at 7%?
- A bond is a financial instrument that pays a fixed amount, called the face value, at a maturity date. Bonds can also pay out fixed payments, called coupons, in regular intervals up until the maturity date. Suppose a bond with face value $1,000 sells for $900 on the market and has annual coupon payments starting a year from today up until its maturity date 10 years from now. What is the coupon rate? Assume r = 10%.
- The real return on stocks averages about 4% annually. Over 40 years, how much will $1,000 invested today grow?
- You have made an invention. You can sell the invention now for $1 million and work at something else, producing $75,000 per year for 10 years. (Treat this income as received at the start of the year.) Alternatively, you can develop your invention, which requires working for 10 years, and it will net you $5 million in 10 years hence. For what interest rates are you better off selling now? (Please approximate the solution.)
- A company is evaluating a project with a start-up fee of $50,000 but pays $2,000 every second year thereafter, starting 2 years from now. Suppose that the company is indifferent about taking on the project—or not. What discount rate is the company using?