Homework Answers
Answer: The following are the details given.
a) Three years ago Kathy Myers has paid $13,000 for 200 shares of Malti Company's common stock.
b) She received $420 cash dividend on the stock at the end of each year for three years.
c) At the end of three years, she sold the stock for $16,000.
d) Kathy would like to earn a return of at least 14% on all of her investments.
Net Present Value (NPV)
A discounted cash flow measure to evaluate the viability of an investment proposal. It serves to determine whether the present value of estimated cash flow exceeds the investment on a project. The Net Present Value is the difference of the sum of discounted cash flows and the outlay.
NPV of cash flow = Present value of all future cash in flows over the life of the project (-) Present value of cash out flow
NPV = [CF1/(1+r)^1+CF2/(1+r)^2+CF3/(1+r)^3+-----------CFn/(1+r)^n] (-) CFo
Where CF1, CF2------Future cash inflows occurring at the end of first year, second year-------etc.
n = life of the project in years.
r = discount rate (cost of capital)
CFo = Present cash out flow
So in this case
CFo = $13,000,
Cash inflows occurring at the end of first year = $420 (Cash dividend), second year = $420 (Cash dividend) and third year = $420 (Cash dividend) and also she sold the stock for $16,000.
Cost of Capital = 14%
Hence, present value of cash inflows = ($420)/(1+0.14)^1+($420)/(1+0.14)^2+($420)/(1+0.14)^3+($16,000)/(1+0.14)^3 =$11,775
Hence, NPV = $11,775 (-) $13,000 = (-) $1,225
From the above it is clear that the net present value is negative. Hence, the Malti Company stock does not provide a 14% return.
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