Investment Analysis: Net Present Value Calculation

What is the Net Present Value (NPV) of an investment if Fred borrows $10,000 from Ricky and promises cash flows of $5000 for the next three years with a cost of capital of 10%? The Net Present Value (NPV) of the investment for Fred is -$165.75. NPV is used to assess the profitability of an investment by comparing the present value of expected cash inflows to the initial investment cost.

Understanding Net Present Value (NPV)

Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment project by comparing the present value of expected cash inflows with the initial investment cost. In this case, Fred is considering borrowing $10,000 from Ricky and promising cash flows of $5000 for the next three years.

Calculation of Net Present Value (NPV)

To calculate the NPV, we need to discount the future cash flows back to their present value using Fred's cost of capital, which is 10%. Let's break down the calculation:

  • Year 1: $5000 / (1 + 10%)^1 = $4545.45
  • Year 2: $5000 / (1 + 10%)^2 = $4132.23
  • Year 3: $5000 / (1 + 10%)^3 = $3756.57

After discounting the cash flows for each year, we sum up the present values and subtract the initial investment of $10,000:

NPV = $4545.45 + $4132.23 + $3756.57 - $10,000 = -$165.75

Therefore, the Net Present Value (NPV) of the investment for Fred is -$165.75. A negative NPV indicates that the investment may not be profitable based on the cost of capital and expected cash flows.

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