Investment Decisions

Investment opportunity and business decisions making based on net present value and rate of return.

Net Present Value
Net present value can be calculated by subtracting the required investment from the present value.

NPV = PV - Investment

Example 1.
The price of a flat is \$100,000. But it could be sold out for \$130,000 after two years. If the prevailing interest rate is 10% whether the investment is a good opportunity?
Solution:
First find present value of the selling price after two years

Now, calculate the Net Present Value

Since, the Net Present Value is positive. In this case it is \$7,438 means your wealth will be increased by \$7,438. So, it is a good investment opportunity.

Investment Decision Rule-I
Accept investments that have positive net present value.

Present Values and Rates of Return
Rate of return is simply profit as a proportion of the initial investment

Example 2.
The price of a flat is \$100,000. But it could be sold out for \$130,000 after two years. If the interest rate on a risk less government bond is 10% but a corporate bond is offering 20% attractive rates, then whether the investment in purchasing the flat is a good opportunity if the risk on purchasing the flat and corporate bond is equal?
Solution:
In this case, the rate for opportunity cost of capital is 20%. And, the rate of return in purchasing flat is

Since, the 30% return on flat exceeds the 20% opportunity cost. So, it is a better investment opportunity.

Investment Decision Rule-II:
Accept investments that offer rates of return in excess of their opportunity costs of capital.

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