Two mutually exclusive investment opportunities require an initial investment of $5 million.Investment A then generates $1.5 million per year in perpetuity,while investment B pays $1 million in the first year,with cash flows increasing by 3% per year after that.At what cost of capital would an investor regard both opportunities as being equivalent?
A)3%
B)6%
C)9%
D)10%
E)12%

Question

Quizplus · Accepted Answer

To find the cost of capital where both investments are equivalent, calculate the present value of each investment's cash flows and set them equal. Investment A's perpetuity formula is $1.5 million / r = $5 million. For Investment B, use the growing perpetuity formula: $1 million / (r - 0.03) = $5 million. Solving these equations simultaneously gives r = 9%.

Two Mutually Exclusive Investment Opportunities Require an Initial Investment of $5