An investor is considering purchase of a new investment for ₹ 15,00,000. The Investor has two options – Option M and Option N and their expected cash inflow are as below: Year Option M (Amount in ₹) Option N (Amount in ₹

CS Executive · Corporate Accounting and Financial Management · PYQS · June 2024
An investor is considering purchase of a new investment for ₹ 15,00,000. The Investor has two options – Option M and Option N and their expected cash inflow are as below: Year Option M (Amount in ₹) Option N (Amount in ₹) 1 1,52,000 3,45,000 2 2,36,000 7,25,000 3 7,00,000 8,00,000 4 5,00,000 3,00,000 5 3,57,000 10,00,000 The investor has a target return of 12%. Risk premium rates are 3% for Investment Option M and 7% for Investment Option N. Discount factors 10.00% 12.50% 15.00% 18.00% 19.00% 1 0.909 0.889 0.870 0.847 0.840 2 0.826 0.790 0.756 0.718 0.706 3 0.751 0.702 0.658 0.609 0.593 4 0.683 0.624 0.572 0.516 0.499 5 0.621 0.555 0.497 0.437 0.419 Which investment should be preferred ?

Answer & Explanation:

Answer 6(a) Calculation of Discount Rate: Target Return = 12% Risk Premium for Option M = 3% Risk Premium for Option N = 7% Discount Rate for Option M = Target Return + Risk Premium M = 12% + 3% = 15% Discount Rate for Option N = Target Return + Risk Premium N = 12% + 7% = 19% Net Present Value (NPV) Calculation: Option M (Discount Rate = 15.00%) Year Cash Inflow (₹) Present Value Factor (PVF) @ 15.00% Present Value (₹) 1 1,52,000 0.870 1,32,240 2 2,36,000 0.756 1,78,416 3 7,00,000 0.658 4,60,600 4 5,00,000 0.572 2,86,000 5 3,57,000 0.497 1,77,429 Total Present Value of Inflows 12,34,685 Outflow -15,00,000 NPV -2,65,315 Option N (Discount Rate = 19.00%) Year Cash Inflow (₹) Present Value Factor (PVF) @ 19.00% Present Value (₹) 1 3,45,000 0.840 2,89,800 2 7,25,000 0.706 5,11,850 3 8,00,000 0.593 4,74,400 4 3,00,000 0.499 1,49,700 5 10,00,000 0.419 4,19,000 Total Present Value of Inflows 18,44,750 Outflow -15,00,000 NPV 3,44,750 Conclusion: The investor will prefer option N for Investment due to higher NPV (₹ 3,44,750) compared to Option M (NPV of -₹ 2,65,315).

Topics: Financial Management

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