Answer to Question #245962 in Financial Math for azaz

Question

Hogsmeade village is evaluating the proposal of opening a new shop. Hogsmeade’s required rate of return

is 10%. Should the project be accepted if Hogsmeade wants to make atleast a profit of $6,000 as in today’s

value? Explain why? Which technique have you applied to make decision and why?

The estimated cashflows (in $) from the project are given below: (Round off your values. No need to put

digits after decimal)

Year Zonko’s Joke Shop

0 (30,000)

1 7,500

2 7,500

3 7,500

4 7,500

5 7,500

Answer 1

The given problem relates to capital budgeting decisions. Since the timing of cash flows associated with investment proposal is different, we need to compute 'NET PRESENT VALUE' of the proposal. Net present value (NPV) is excess of present value of cash inflows over present value of cash outflows. A proposal should be accepted if net present value is positive. However, in the given case proposal will be accepted if NPV is greater than expected profit of Hogsmeade village i.e $6,000.

Computation of NPV

Since NPV < $6,000 , Proposal should be REJECTED