An investment under consideration has a payback of five years and a cost of $1,200. If the required return is 20 percent, what is the worst-case NPV?
To calculate the worst-case Net Present Value (NPV), we need to determine the cash flows associated with the investment and discount them back to their present values. Here are the steps to calculate the worst-case NPV:
Step 1: Identify the cash flows. In this case, we have an initial cost of $1,200, and no further cash flows are mentioned. So, the only cash flow we have in this investment is the initial cost of $1,200.
Step 2: Determine the discount rate. The required return is given as 20 percent. We will use this discount rate to calculate the present value.
Step 3: Calculate the present value of the cash flows. To discount the cash flow, we can use the formula:
Present Value = Cash Flow / (1 + Discount Rate)^n
Since we only have one cash flow and it occurs at time zero, the present value of this cash flow will simply be:
Present Value = Cash Flow / (1 + Discount Rate)^0 = Cash Flow / (1 + Discount Rate) = $1,200 / (1 + 0.20) = $1,200 / 1.20 = $1,000
Step 4: Calculate the worst-case NPV. The worst-case NPV is obtained by subtracting the initial cost from the present value:
Worst-case NPV = Present Value - Initial Cost = $1,000 - $1,200 = -$200.
So, the worst-case NPV for this investment under consideration is -$200.
It's important to note that the negative NPV suggests that the investment might not be a profitable one, as it fails to generate returns that exceed the required rate of return (20%).