Question

Consider the following opportunities. Opportunity 1 requires a $4,000 cash payment now (Year 0) but will result in $14,000 cash received in Year 5. Opportunity 2 requires no cash outlay and results in $3,500 cash received in Year 3 and Year 5.

Required:
Use a 6 percent discount rate and determine whether Opportunity 1 or Opportunity 2 results in a greater NPV.

Answer 1

Opportunity 1 results in a greater NPV.

Step-by-step explanation:

NPV of Opportunity 1 = (Cash received in Year 5 / (100% + Discount rate)^Number of years) - Cash payment now = ($14,000 / (100% + 6%)^5) - $4,000 = $10,461.61 - $4,000 = $6,461.61

NPV of Opportunity 2 = (Cash received in Year 3 / (100% + Discount rate)^Number of years) + (Cash received in Year 5 / (100% + Discount rate)^Number of years) = ($3,500 / (100% + 6%)^3) + ($3,500 / (100% + 6%)^5) = $2,938.67 + $2,615.40 = $5,554.07

Since NPV of Opportunity 1 which is $6,461.61 is greater than NPV of Opportunity 2 which is $5,554.07, this implies that Opportunity 1 results in a greater NPV.