Question

1. Mr. Abdulla wants to determine the present value of a stream of income from an investment asset you expect will offer you a $1,500 annual income, over a period of 5 years, based on the promise of a 6% rate of return, and for which there is no salvage value at the end of the 5 year term. a) Calculate both equation and financial calculator solutions to this problem. (Equation 2 marks and Calculator 1 mark) b) Explain how much would you be prepared to offer for such an investment? (Decision and suggestion 2 Marks) 2. Finally, let’s assume you’ve been offered a business opportunity with an up-front capital cost of $250,000, which business is expected to need annual capital infusions of $10,000 per year for the first three years, and will run at break even for two additional years before it begins to return a positive cash flow of $50,000 a year for the following five years. You believe you can sell this business for $350,000 at the end of 10 years and your opportunity cost of capital is 6%. a) Determine the business opportunity worth the price? b) Calculate both equation and calculator solutions to this problem (3marks) c) Explain the solution you’ve calculated and justify (2marks) 3. Analyze to what extent a cash flow statement is essential in judging the financial performance of a company. (

Answer 1

Part 1

Present value of these 1500 annual income for five year @6% is given by

PV = E(1-(1+r)^-p)/r

Where

E = Annual income =1500

r = annual interest rate = 6%

P = no of year = 5

Therefore

PV = 1500(1-1.06^-5)/.06 = 6318.55$

Part b

The cashflows of this opportunity are

Time(t) cash flows

0 -250000

1 -10000

2 -10000

3 -10000

4 0 breakeven

5 0

6 to 10 50000

10 350000

the worth of the bussiness opportunity = NPV of its cashflows at opportunity cost of capital which is 6% in the qus.

NPV = PV of inflows - PV of outflows

PV of inflows= 50000/1.06^6 +50000/1.06^7 +50000/1.06^8 +50000/1.06^9 + 50000/1.06^10 +350000/1.06^10

= 157386.16 +195438.17 = 352824.33 $

PV of outflows = 250000 + 10000/1.06 +10000/1.06^2 + 10000/1.06^3 =276730.12$

NPV = 352824.33 - 276730.12 = 76094.21 $

Since the NPV is positive then business is worth to invest

Price of a business = its NPV = 76094.21 $

Part c

As we can see for performing above calculation we need cashflows and the only statement which provides us with cashflows is cashflow statement but these are estimated cashflows it doesn't mean that historical cashflows are not important ! they are , because they shows us the liquidity state of the organization because an organisation earnings huge profits can't be said a well performing entity uless these profits and earnings are realised in cash which can be found out by cashflow statement