Question

You are offered an investment in a new store. For this problem, assume away taxes. The store will sell furniture, and historically furniture prices have kept pace with inflation. The current revenue from the store is 20K a year. The current nominal interest rate is 7% and inflation is running at 3% a year. You expect this trend to continue for the 10 years of the contract. Should you make the required 140K investment?

Answer 1

To determine whether an Investment is worth making or not can be decided based on its Net Present Value (NPV).

• If NPV >0, invest in the project.
• If NPV <0, donot invest in the project.

NPV = Present Value of Inflow - Present Value of Inflow.

In the given question,

Since it has been clearly stated that the prices of furniture have kept with inflation, we would grow the revenue each year by 3% and discount the future cash flow at inflated rate of 10% ( 7% +3%)

Calculation of PV of Cash inflow

Year	Revenue	PV factor @ 10%	Present Value
1	20.00	0.909	18.18
2	20.60	0.826	17.02
3	21.22	0.751	15.94
4	21.85	0.683	14.93
5	22.51	0.621	13.98
6	23.19	0.564	13.09
7	23.88	0.513	12.25
8	24.60	0.467	11.47
9	25.34	0.424	10.74
10	26.10	0.386	10.06
	Total		137.67

NPV = 137.67K - 140K = (2.33K)

Therefore the investment of 140k should not be made