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A Collection of Investment Questions

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1. Tom's friend is retiring and has offered to sell Tom his existing newsstand that is located in the local mall. All of the equipment is rented so all the expenses and revenues are in cash. The license to operate the newsstand expires in eight years, so Tom assumes he would operate the business for only eight years if he buys it. The annual cash flow is expected to be $75,000. If Tom needs to earn at least 10% on his investment, what is the maximum amount he should pay?

(a) $34,988
(b) $400,119
(c) $503,256
(d) $600,000

2. Mary, who is 25 years old, wishes to retire with $1,000,000 when she is 45. To accomplish this, Mary is going to ask her grandmother for a "nest egg." Assuming she invests the money in a mutual fund that is expected to earn 10%, how much money must she get from granny if she hopes to meet her early retirement goal?

(a) $161,506
(b) $117,458
(c) $42,568
(d) $148,644

3. Susan makes pottery and is considering the purchase of a new kiln. The kiln would cost $7,500 and should last five years at which time it will have no salvage value. Susan would incur $1,000 of annual cash expenses to operate the kiln, but she would avoid $3,500 of costs she has been incurring annually to rent space in other potters' kilns. Susan uses straight line depreciation, and her tax rate is 30%. What is the annual cash flow, after taxes, related to acquiring the new kiln versus continuing to rent kiln space?

(a) $2,200
(b) $2,500
(c) $1,800
(d) $700

4. Smith Inc. is considering replacing an existing machine with a new machine that is more efficient. The following information is available for the proposed project, which has a life of five years:

Cost of new machine $100,000
Salvage value of new machine at the end of year 5 $ 15,000
Book value of the existing machine $ 70,000
Trade-in value of the existing machine $ 20,000
Annual cost savings of new machine $ 18,000
Minimum desired rate of return 12%

What is the net present value of this investment project?

(a) $18,072
(b) $43,397
(c) ($8,765)
(d) ($6,603)

5. Jimmy, a freshman at State University, is considering starting a business in his dorm room that would sell computer supplies to his fellow students. Jimmy estimates he would generate $1,500 in net cash flow each of the next four years. To start the business he would need to acquire a computer that costs $2,000 and has an estimated salvage value of $500 at the end of four years. He must also spend $4,000 for inventory items. All of this money will be recovered at the end of year four. Jimmy's cost of capital is 9%.

What is the net present value of this investment opportunity?

(a) ($786)
(b) $1,694
(c) $2,048
(d) $8,048

6. Wells Inc. is considering acquiring new equipment that management estimates will reduce its cash operating expenses by $50,000 each year for the next five years. After five years, the company believes the equipment will be technologically obsolete and will have no salvage value. The equipment will cost $180,000 and the company will have to spend $20,000 immediately to train its staff to use the equipment.

What is the internal rate of return of this investment project?

(a) 25%
(b) 12%
(c) 8%
(d) 5%

The following pertains to Questions 7 and 8:
Jones Company has been offered an investment opportunity that, if accepted, will require an initial expenditure of $100,000 to acquire a new machine. The machine has an expected life of eight years and no salvage value. Jones uses straight line depreciation. Annual cash revenues from the project are estimated to be $20,000, while annual cash expenses are estimated to be $4,000.

7. What is the payback period of this investment project (rounded to nearest year)?

(a) 6 years
(b) 8 years
(c) 5 years
(d) 29 years

8. What is the unadjusted rate of return of this investment project?

(a) 16.0%
(b) 7.5%
(c) 8.0%
(d) 7.0%

The following pertains to Questions 9 and 10:
Dennis lives in an area that is becoming a popular tourist destination. Dennis is considering starting an off-road jeep tour business by purchasing a four-wheel-drive jeep. Because he plans to work from his house, the jeep is the only asset he will need to purchase. The jeep will cost $20,000 and will have a life of five years and no expected salvage value. Dennis will use the straight line depreciation method. Dennis estimates the net cash flow of the business for the next five years will be as follows:

Year Net Cash Flow
1 $6,000
2 $8,000
3 $7,000
4 $6,000
5 $5,000

9. What is the unadjusted rate of return of this investment?

(a) 12%
(b) 24%
(c) 60%
(d) 64%

10. What is the payback period of this investment (rounded to nearest year)?

(a) 2 years
(b) 3 years
(c) 4 years
(d) more than 5 years

11. Sue was injured in a traffic accident, which was not her fault. The insurance company of the driver responsible for the accident has offered Sue any one of the following four options to settle the case. Whichever option Sue chooses, she plans to invest the money received in an account that pays an annual interest rate of 8%.

Option 1: $65,000 paid immediately.
Option 2: $16,000 paid annually for five years, beginning one year from today.
Option 3: $10,000 paid annually for ten years, beginning one year from today.
Option 4: $4,800 paid semiannually for ten years, beginning in six months

Which option should Sue choose?

(a) Option 1
(b) Option 2
(c) Option 3
(d) Option 4

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In this Solution the author identifies the correct answer and provides calculations to show why the selected option is correct. The Solution is provided in a Microsoft Excel document.