Question

At an interest rate of 35 per cent, which of the following sequences of cash flows should you prefer? Would you choose the same sequence of cash flow with an interest rate of 1 per cent? Describe the main effects of a rising interest rate.

	Year 1	Year 2	Year 3
A	500	300	100
B	100	300	700
C	300	300	300
D	Option A or C as they all add up to £900

Answer 1

At an interest rate of 35 per cent, which of the following sequences of cash flows should you prefer - Sequence A

Would you choose the same sequence of cash flow with an interest rate of 1 per cent - No , Sequence B to be chosen since the PV of cash flows is higher.

Describe the main effects of a rising interest rate - WIth interest rates increasing, the present value factor decreases and so does the present value of cash flows.

Workings:

A	1	2	3
Cash flows	500	300	100
Present value factor @35%	0.7407407	0.548696845	0.406442107
Present value of cash flows	370.37037	164.6090535	40.64421074	575.62363
B	1	2	3
Cash flows	100	300	700
Present value factor @35%	0.7407407	0.548696845	0.406442107
Present value of cash flows	74.074074	164.6090535	284.5094752	523.1926
C	1	2	3
Cash flows	300	300	300
Present value factor @35%	0.7407407	0.548696845	0.406442107
Present value of cash flows	222.22222	164.6090535	121.9326322	508.76391
A	1	2	3
Cash flows	500	300	100
Present value factor @1%	0.990099	0.980296049	0.970590148
Present value of cash flows	495.0495	294.0888148	97.05901479	886.19733
B	1	2	3
Cash flows	100	300	700
Present value factor @1%	0.990099	0.980296049	0.970590148
Present value of cash flows	99.009901	294.0888148	679.4131035	1072.5118
C	1	2	3
Cash flows	300	300	300
Present value factor @1%	0.990099	0.980296049	0.970590148
Present value of cash flows	297.0297	294.0888148	291.1770444	882.29556