Question

Question 2: Evaluating investment projects You are planning to invest $40,000 in research & development (R&D). This investment will generate cost savings of $28,000 in year 1 and $20,000 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? YES NO 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? YES NO 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: c increase the interest rate -- based on (a) and (b), higher cost of capital will reduce investment C reduce the interest rate -- based on (a) and (b), lower cost of capital will reduce investment

Answer 1

a) Net Present value Year Reseach & development $40,000.00 $0.00 $0.00 Annual Cost saving $0.00 $28,000.00 $20,000.00 PV of $1 Net cash flow @ 25% $40,000.00 1 $28,000.00 0.8 $20,000.00 0.64 Net preesent value Present value of cash flows $40,000.00 $22,400.00 $12,800.00 -$4,800.00 Should you invest NO b) Net Present value Annual Cost Year Net cash flow development $40,000.00 $0.00 $0.00 saving $0.00 $28,000.00 $20,000.00 PV of $1 @10% $40,000.00 1 $28,000.00 0.909 $20,000.00 0.826 Net preesent value Present value of cash flows $40,000.00 $25,452.00 $16,520.00 $1,972.00 Should you invest YES INCREASE THE RATE -- based on (a) and (b), Higher cost of capital would reduce investment