Question

Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, given a discount rate of 8%?Rule I: The Net Present Value ruleRule II: The Payback Rule with a payback period of two yearsRule III: The internal rate of return (IRR) RuleA) Rule II and IIIB) Rule I and IIC) Rule III onlyD) Rule I only

Answer 1

D) Rule I only

Step-by-step explanation:

The net present value value can be calculated by subtracting the amount that would be gotten now from the present value of the amount that would be gotten for the next five years.

The NPV can be found using a financial calculator

Cash flow for year 0 = $-100,000

Cash flow each year for year 1 - 5 = $26,000

I = 8%

NPV = $3810.46

The present value of the investment is $203,810.46 which is greater than $200,000. Mary should pick the first option.

The NPV is appropriate because the present value of both options can be compared.

The IRR is the discount rate which equates the after tax cash flows from an investment to the amount invested. The IRR cannot be used because the second option doesn't have a stream of cash flows to which to calculate its IRR.

The payback period measures how long it takes for the amount invested to be recouped from cash flows. The payback period cannot be used because there are no cash flows for the second option.

I hope my answer helps you.