Question The Saltinero Company is considering two investments. The firm’s cost of capital is 12 percent, and the risk-free rate is 7 percent. The two investments have the following cash flows:
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Investment A |
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Investment B |
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| Year |
Projected cash Flow |
Certainty Equivalent Cash Flow |
|
Projected Cash Flow |
Certainty Equivalent Cash Flow |
|
| 0 |
-1,000 |
-1,000 |
|
-1,000 |
-1,000 |
|
| 1 |
600 |
400 |
|
700 |
600 |
|
| 2 |
600 |
400 |
|
600 |
500 |
|
| 3 |
600 |
400 |
|
500 |
400 |
|
| 4 |
600 |
400 |
|
400 |
300 |
|
a. Compute the NPV of the two investments using the firm’s cost of capital. Identify the preferred investment.
b. Compute the NPV of the two investments using the certainty-equivalent approach. Identify the preferred investment.