1. A parcel of land costs $500,000. For an additional $800,000 you can build a motel
on the property. The land and motel should be worth $1,500,000 next year.
Suppose that common stocks with the same risk as the investment offer a 10
percent expected return. Would u construct the motel ? Why or why not?
NPV = $1,300,000 + ($1,500,000/1.10) = +$63,636
Since the NPV is positive, you would construct the motel.
Alternatively, we can compute r as follows:
r = ($1,500,000/$1,300,000) – 1 = 0.1539 = 15.39%
Since the rate of return is greater than the cost of capital, you would
construct the motel.
2. 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
NVP of $5000 at discount rate of 12%.
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%.
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.
NPV = ($50,000 + $20,000) + ($38,000/1.05) = $6,190.48
The NPV is higher than the NPV of the office building ($5,000); therefore, we
should accept E. Coli’s offer.
b. Suppose you are not sure E. Coli will pay. You observe that the other investors
demand a 10% return on their loans to E. Coli Assume that the other investors have
correctly assessed the risk that E. Coli will not be able to pay. Should you accept
E.Coli's offer?
NPV = ($50,000 + $20,000) + ($38,000/1.10) = $4,545.45
The NPV is less than the NPV of the office building, so we should not accept the
offer.