?A risky $1,000 investment is expected to generate the following cash flows: ? Year 1 2 3 $600 $600 $600. a. If the firm's cost of capital is 10 percent, should the investment be made? b. An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually and repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management believes that the cash inflows from the risky investment are only equivalent to 70 percent of the certain investment. Does this information alter the decision in (a)?
What will be an ideal response?
a.The net present values if the firm's cost of capital is 10 percent: $600(PVAIF 10I, 3N) - $1,000 = $600(2.487) - $1,000 = $492.20.?The net present value is positive. The investment should be made.?b.If the cash flows are considered to be only 70 percent certain and the risk-free, certain discount rate is 5 percent, the net present value is (0.7)$600(PVAIF 5I, 3N) - $1,000 = $420(2.723) - $1,000 = $143.66.?The adjusted net present value remains positive, so the investment should be made.?
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