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(1800010000)/10000
0.8
2 (9000/1.2)5000
2500
(90005000)/5000
0.8
3 (5700/1.2)5000
250
(57005000)/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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 Spring '08
 moorhead
 Time Value Of Money, Net Present Value, Annuity factor

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