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HW1 Solution

# HW1 Solution - ARIZONA STATE UNIVERSITY W.P Carey School of...

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ARIZONA STATE UNIVERSITY W.P. Carey School of Business FIN 361 Problem Set 1 Spring 2008 Part I: Investment, Consumption, and the Net Present Value Rule 1. Calculate the Net Present Value and rate of return for each of the following investments. The opportunity cost of capital is 20% for all of the investments. Investment Initial Cash Flow Cash flow in Year 1 1 -10,000 +18,000 2 -5,000 +9,000 3 -5,000 +5,700 Solution: NPV NPV at 20% Rate of Return Rate of Return 1(18000/1.2)-10000 5000(18000-10000)/10000 0.8 2 (9000/1.2)-5000 2500 (9000-5000)/5000 0.8 3 (5700/1.2)-5000 -250 (5700-5000)/5000 0.14 2. A parcel of land costs \$500,000. For an additional \$800,000 you can build a motel on the property. The land and motel should be worth \$1,500,000 next year. Suppose that assets with comparable risk to this project offer a 10% expected return. Would you construct the motel? Why or why not? Solution: We can treat the purchase of land for \$500,000 and the \$800,000 cost of construction as an initial investment in a project with a payoff next year of \$1,500,000. Using the 10% discount rate used for projects of similar risk, the NPV of this project is –500,000 - 800,000 + 1,500,000/1.1 = 63636.36. Therefore the motel is a positive NPV project and could be profitably built. 3. Suppose you have \$100,000 available to support consumption now (Period 0) and next year (Period 1). You want to consume exactly the same amount in each period. The interest rate is 8% and there is no risk. You may find it useful to draw graphs as in the Lecture Notes.

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HW1 Solution - ARIZONA STATE UNIVERSITY W.P Carey School of...

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