Question 2: Evaluating investment projects You are planning to invest $30,000 in research & development (R&D). This investment will generate cost savings of $21,000 in year 1 and $15,000 in year 2. After 2 years, the salvage value is zero. The cost of capital is 25% a year. a) Compute the net present value. NPV = $ Should you invest? OYES ONO b) Following a government stimulus program, the cost of capital decreased to 10% a year. Compute the net present value at the new cost of capital. NPV = $ Should you invest now? OYES ONO c) The economy is at full employment and is beginning to overheat (i.e., total demand exceeds the available capacity, which leads to rapid price increases). Firms' investment activity increases total demand and contributes to economic overheating. To prevent high inflation, the Federal Reserve chairman wants to reduce firms' investment activity. The Federal Reserve can control the cost of capital in the economy by adjusting its benchmark interest rate. To reduce the investment activity, the Federal Reserve should: O reduce the interest rate based on (a) and (b), lower cost of capital will reduce investment O increase the interest rate based on (a) and (b), higher cost of capital will reduce investment

Question 2: Evaluating investment projects You are planning to invest $30,000 in research & development (R&D). This investment will generate cost savings of $21,000 in year 1 and $15,000 in year 2. After 2 years, the salvage value is zero. The cost of capital is 25% a year. a) Compute the net present value. NPV = $ Should you invest? OYES ONO b) Following a government stimulus program, the cost of capital decreased to 10% a year. Compute the net present value at the new cost of capital. NPV = $ Should you invest now? OYES ONO c) The economy is at full employment and is beginning to overheat (i.e., total demand exceeds the available capacity, which leads to rapid price increases). Firms' investment activity increases total demand and contributes to economic overheating. To prevent high inflation, the Federal Reserve chairman wants to reduce firms' investment activity. The Federal Reserve can control the cost of capital in the economy by adjusting its benchmark interest rate. To reduce the investment activity, the Federal Reserve should: O reduce the interest rate based on (a) and (b), lower cost of capital will reduce investment O increase the interest rate based on (a) and (b), higher cost of capital will reduce investment

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Example: Evaluating a business investment opportunity • A low-risk, 4-year investment opportunity promises to pay $3,000, $6,000, and $5,000 at the end of the first, second and fourth year, respectively. A cash injection of $1,000 is required at the end of the third year. The investment may be purchased for $10,000, which would have to be borrowed at an effective interest rate of 10%. Use Economic Value Added principle to determine whether the investment should be undertaken.
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