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 rule
Rule II: The Payback Rule with a payback period of two years
Rule III: The internal rate of return (IRR) Rulea. Rule I onlyb. Rule III onlyc. Rule II and III onlyd. Rule I and II only

Answer 1

Rule I is correct.

Step-by-step explanation:

Year Cash flow Pv at 8% Discounted cash flow

0 100000 1 100000

1 26000 0.9259 24074.074

2 26000 0.8573 22290.809

3 26000 0.7938 20639.638

4 26000 0.7350 19110.776

5 26000 0.6806 17695.163

From the above calculation, the net present value is $203810.46

Option 1 Option 2

NPV 203810.5 200000

Payback 5 years 0 years

IRR No IRR No IRR

NPV (Net present value) option say that former would be selected

So, answer is Rule I only.