1. avatar says

    Sir, I have a difficulty in solving this question : -

    The following information relates to a two-year project.

    Initial investment $1 mil
    Cash inflow Year 1 $750,000
    Cash inflow Year 2 $500,000
    Cost of capital Year 1 is 10%
    Cost of capital Year 2 is 15%

    What is the net present value of the project (to the nearest $500)?

    (The answer is $77,000)

      • Avatar of johnmoffat says

        I am surprised that BPP do not show workings for the answer!

        All you need do is this:
        For the inflow at time 1, multiply the cash flow by the 1 year discount factor at 10%
        For the cash flow at time 2, multiply by the 1 year discount factor at 10% and then multiply by the 1 year discount factor at 15%. (This discounts 1 year at 10% and 1 year at 15%)

        Hope that helps :-)

      • avatar says

        Why do you times the Year 2 with two cost of capitals (10% & 15%)??
        Why can’t it just times with 15% as it mentions there cost of capital for Year 2?

      • Avatar of johnmoffat says

        Because the cost of capital is 10% for one year and 15% for the other year.

        Discounting at 15% for 2 years would only be correct if the cost of capital was 15% in both years.

        It might help you to watch my free lectures on discounting.

    • Avatar of johnmoffat says

      For individual flows use the present value tables. When there is an equal cash flow each year, then use the annuity table.

      (This is one of the revision lectures – have you watched the main lectures on this topic?)

    • Avatar of johnmoffat says

      The nominal annual interest rate is the actual rate of interest per annum, taking into account the effect of compounding.

      So if, for example, interest is charged at the rate of 5% every six months, then the nominal interest rate (the actual rate per year) is (1.05 x 1.05) – 1 = 0.1025 (or 10.25%)

    • Avatar of johnmoffat says

      @angelang, The lecture does explain it!

      For the payback period we are seeing how many years it will take to get back the original investment of 75000. After 2 years we have got a total of 50000 (20000 + 30000). So we need another 25000 (75000 – 50000). In the third year we get 50000 and so we will get 25000 in half the year. So total is 2.5 years.

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