NPV and rate of return II

[flora33]

I have taken a finance course in the last year but it was probably about a year ago. I am quite rusty so please bear with me! I am including the question here with both parts a and b included. Essentially what I have done is added my stream of thoughts for part a. I would like some assistance to see if I am headed in the right direction with it:


4.
In Section 2.1, we analyzed the possible construction of an office building on a plot of land appraised at $50,000. We concluded that this investment had a positive NPV of $5,000 at a discount rate of 12 percent. (There is more information included in the chapter that includes the cost of building an office building in addition to buying the land. A real estate advisor believes that in one year the land and building could be sold for $420000 and your initial investment is going to be $370000. I am not sure if this information is actually relevant to the question, but want to include it for your expert opinion!)

Suppose E. Coli Associates, a firm of genetic engineers, offers to purchase the land
for $58,000, $20,000 paid immediately and $38,000 after one year. U.S. government securities maturing in one year yield 5 percent.

a. Assume E. Coli is sure to pay the second $38,000 installment. Should you take its offer or start on the office building? Explain.
The investment has a NPV of $5000. We need to know what the future value of the land will be in one year. This would be 50000 * 1.05 = 52500. The land would be worth less than the offer price of 58000. The 38000 to be paid in one year has a PV of 36,190 if you use the formula for calculating NPV. Then add 36190 + 21000 = 57190 or 36190 + 22400 = 58590
Would you do: 20000 * 1.12 = 22400 because you could receive and invest the 20000 and have it be worth 22400 in one year or 20000 * 1.05 = 21000 because it is the current government securities yield? This is the point where I feel I become "stuck". Any input is greatly appreciated and I think it will help me move on to section b.

b. Suppose you are not sure E. Coli will pay. You observe that other investors demand a 10 percent return on their loans to E. Coli. Assume that the other investors have correctly assessed the risks that E. Coli will not be able to pay. Should you accept E. Coli’s offer?

Flora

 

[tkhunny]

First, given the NPV of $5,000 at the beginning of the investment, and the lack of additional information at any other time period, please do not accumulate anything. Only discount on this one.

Second, the offer price is not $58,000. It is two payments at different times. Not until you have them all at the same time can you comapre them. At 5%, your offer NOW is $56,190.48, which, to me, seems like it might be greater than $50,000 Property + $5,000 NPV, but I'm not real clear on the other elements or whether we already own the property.

Third, and I won't quite answer this one. Your $5,000 NPV is based on 12%. Are you SURE you want to accumulate it at 5%?

Fourth, if you switch E. Coli to a 10% return, their offer is now $54,545.45 < %50,000 Property + $5,000 NPV (Which value, of course, still has the same problems as the last time I brought it up.)

Fifth, and finally, Why would you want to do business with a company called "E. Coli"? Blech!!

 

[flora33]

First, given the NPV of $5,000 at the beginning of the investment, and the lack of additional inforamtion at any other time period, please do not accumulate anything. Only discount on this one.

Second, the offer price is not $58,000. It is two payments at different times. Not until you have them all at the same time can you comapre them. At 5%, your offer NOW is $56,190.48, which, to me, seems like it might be greater than $50,000 Property + $5,000 NPV, but I'm not real clear on the other elements or whether we already own the property. **No, we are purchasing the land for 50,000. With the intent to build an office building for 320,000. The Realtor believes this investment would generate $420,000 in one year.

Third, and I won't quite answer this one. Your $5,000 NPV is based on 12%. Are you SURE you want to accumulate it at 5%? **No, I see now that I should be using 12%. So the future value of the land in one year is: 50000 * 1.12 = 56000.

Fourth, if you switch E. Coli to a 10% return, their offer is now $54,545.45 < %50,000 Property + $5,000 NPV (Which value, of course, still has the same problems as the last time I brought it up.) **Based on the observation of the other investors' demands for a 10% return I would choose not to accept E. Coli's offer because of the risk they won't be able to pay.

Fifth, and finally, Why would you want to do business with a company called "E. Coli"? Blech!!

Haha! It sounds like trouble to me! I wouldn't want to do lunch with them...

Thank you for your help on this!
Flora