Question

1. What are the techniques for establishing cash flow equivalence with compound-interest?

2. Explain in which situation is the life of the proposed project is perpetual?

Need answer without plagarism

Answer 1

Q-1)

The technique for establishing the cash floe equivalence lies in the fact that the cash flow should be matched with the periodic interest rate. So first you have to bring the interest rate in sync with the period in which the cash flow is occurring since the cash flow period can not be changed. Lets take for example a cash flow is occurring every year for 10 years and the interest rate is 12% per annum compounded monthly, so here since the cash flow is occurring annually you have to use the effective annual interest rate,

=(1+0.12/12)^12 -1 = 12.68%

Lets say if the cash flow occurring was monthly so you simply would have divided the 12%/12 = 1%, here the periodic rate would have been 1%.

You have to match the periodic cash flow with the periodic interest rate.

Q2)

The perpetual cash flow is when the cash flow is going to occur forever. Let’s take for example you want to donate a sum of $10,000 annually to a college which you believe is doing great work in the area of science. Now you want this cash flow to be donated each year forever, even after you are gone. For these kind of cash flows, we use the term perpetual cash flows.

Now if you want to make sure that the stated amount is donated each year to the educational institution and the interest rate in the market is 10%. So today you will create a trust with a deposit of $100,000 for the annual donation of $10,000

10000/0.10 = $100,000