Question

This module is about making hard financial decisions involving trade-offs between the present and future in the most rational way possible: using Net Present Value and IRR. Review your notes, readings, discussions, and mini-lectures in this module and consider this scenario: Scenario: You've spent $20,000 searching for an investment property. Now, you're considering investing in a cottage near Brighton Beach. You can buy the house for $300,000 with cash, earn $20,000 per year in rent and pay $8,000 per year in HOA, taxes, and other expenses. Assume you'll be able to sell the house in ten years for $400,000 (the "salvage value"). Your second-best investment alternative would earn 6%. 1. Calculate in Excel the NPV and IRR of this investment. Explain in a few sentences whether or not this is a good investment and why, based on the NPV and the IRR.

Answer 1

To evaluate the investment in a cottage near Brighton Beach, calculate the NPV and IRR comparing the net annual income and projected salvage value against a 6% discount rate. A positive NPV and an IRR higher than 6% would generally indicate a good investment compared to the alternative.

Step-by-step explanation:

When considering the investment in a cottage near Brighton Beach, it is key to use financial tools such as Net Present Value (NPV) and Internal Rate of Return (IRR) to evaluate the potential return relative to the risk. The initial investment is $300,000, and the annual return is $20,000 in rent minus $8,000 in expenses, resulting in a net annual income of $12,000. After ten years, the projected salvage value of the property is $400,000. Assuming your next best investment yields a 6% return, this becomes your discount rate.

To calculate NPV in Excel, you would discount each year's net income, including the final salvage value, back to present value using the discount rate of 6%. Summing these up gives you the total NPV. A positive NPV suggests that the project's return exceeds the opportunity cost of capital (6% in this case), implying a good investment.

IRR is the rate at which the NPV of the cash flows breaks even, or becomes zero. It is found by rearranging the NPV equation and solving for the discount rate that zeros out NPV. If the IRR is higher than the opportunity cost, in this case, 6%, it generally indicates a good investment opportunity, as the project is expected to return more than the alternative investments.

Without the exact NPV and IRR calculations included, we cannot make a definitive assessment, but the methodology here provides a rational basis for evaluating investment decisions dealing with present and future financial trade-offs.