Question

1) One year ago, you paid $15,000 for an empty plot of land. Today, you are considering developing it into a parking lot. It will cost you $50,000 today to turn this land into a parking lot. As a parking lot, you anticipate that it will generate $8,000 in revenue each year forever, starting one year from today. The required return for this project is 14% annually. Assume that you have no other ideas for what to do with this land; if you don’t build the parking lot, it will not be used for anything else. Also assume you will never sell this land.

From a financial perspective, is turning this land into a parking lot today a good idea?

Group of answer choices

a. Yes

b. No

c. Cannot be determined

2)

A project requires, as its only cost, an initial investment of $17,000. It then generates positive future cash flows. The appropriate discount rate is 22%. This project has an NPV of -$935 (negative NPV). What can you say about this project’s IRR?

Group of answer choices

a) It is less than 22%.

b) It is equal to 22%.

c) It is greater than 22%.

d) of the above is necessarily true.

Answer 1

1) a. Yes

Turning this land into parking lot is a good idea.

Purchase cost of land i.e $15,000 spent a year is a sunk cost and thus not relevant for decision making.

Present value of Cash flow from parking lot = 8,000/0.14 = $57,142.86

which is greater than developing cost of parking lot.

Therefore, Developing parking on land would be good idea.

2) a. it is less than 22%

Internal rate of return (IRR) is the rate at which NPV of project is zero and if discount rate < IRR then NPV would be positive and If discount rate > IRR then NPV would be negative.

In above case, NPV is negative thus IRR must be less than 22%.

Hope this will help, please do comment if you need any further explanation. Your feedback would be highly appreciated.