CHAPTER 2
Present Values, The Objectives of the Firm,
and Corporate Governance
Answers to Practice Questions
1.
The face value of the treasury security is $1,000.
If this security earns 5%, then
in one year we will receive $1,050.
Thus:
NPV = C
0
+ [C
1
/(1 + r)] =

$1000 + ($1050/1.05) = 0
This is not a surprising result because 5 percent is the opportunity cost of capital,
i.e., 5 percent is the return available in the capital market.
If any investment
earns a rate of return equal to the opportunity cost of capital, the NPV of that
investment is zero.
2.
NPV =

$1,300,000 + ($1,500,000/1.10) = +$63,636
Since the NPV is positive, you would construct the motel.
Alternatively, we can compute r as follows:
r = ($1,500,000/$1,300,000) – 1 = 0.1539 = 15.39%
Since the rate of return is greater than the cost of capital, you would construct the
motel.
3.
Investment
NPV
Return
(1)
$5,000
1.20
18,000
10,000
=
+

80.0%
0.80
10,000
10,000
18,000
=
=

(2)
$2,500
1.20
9,000
5,000
=
+

80.0%
0.80
5,000
5,000
9,000
=
=

(3)
$250
1.20
5,700
5,000

=
+

14.0%
0.14
5,000
5,000
5,700
=
=

(4)
$1,333.33
1.20
4,000
2,000
=
+

100.0%
1.00
2,000
2,000
4,000
=
=

a. Investment 1, because it has the highest NPV.
b. Investment 1, because it maximizes shareholders’ wealth.
1