Question

You friend has developed a new design of mouse trap that he said works better than any other mouse trap available. He needs money for production, so he has asked you to invest in the new venture. He is offering you a percentage of the profits for the next seven years, and has estimated your share of the cash flows in Year 3 to be $50,000, increasing by $20,000 per year through Year 7 (there will be no cash flows in Years 1 or 2). You have decided this is a pretty risky proposition, so you are requiring a return of 20% in order to invest. What is the most you should be willing to invest in this project?

Answer 1

To determine the maximum amount to invest in the new mouse trap venture, we use the discounted cash flow method with a required return rate of 20%, discounting the estimated annual cash flows from Year 3 to Year 7 to their present value and then summing them.

Step-by-step explanation:

To determine the most you should invest in your friend's new mouse trap venture, we must calculate the present value of the estimated future cash flows you're expected to receive. Given the expected cash flows and your required return of 20%, we can use the discounted cash flow method to arrive at a fair investment amount.

To calculate the present value of the cash flows from Year 3 to Year 7, we will discount each amount by the required return rate of 20% for each year. The cash flows are estimated to be $50,000 in Year 3, and increase by $20,000 each year up to Year 7. We calculate the present value (PV) using the formula:

• PV = Cash Flow / (1 + Rate)^Number of Periods

By calculating the present value of each of these cash flows and summing them up, we can determine the maximum investment you should make to achieve your required return rate of 20%.