Question

5. Present value

Which of the following is true about finding the present value of cash flows?

Finding the present value of cash flows in future years tells you how much you would need to invest today so that it would grow to equal the given future amount.

Finding the present value of cash flows is important for financial theory, but it does not have much relevance to actual business decision making.

Finding present value tells you what a cash flow will be worth in future years.

What is the value today of a $87,000 cash flow expected to be received 12 years from now based on an annual interest rate of 8%?

$34,549

$219,081

$27,639

$53,551

Your broker called earlier today and offered you the opportunity to invest in a security. As a friend, she suggested that you compare the current, or present value, cost of the security and the discounted value of its expected future cash flows before deciding whether or not to invest. The decision rule that should be used to decide whether or not to invest should be:

Everything else being equal, you should invest if the present value of the security’s expected future cash flows is less than the current cost of the security.

Everything else being equal, you should invest if the current cost of the security is greater than the present value of the security’s expected future cash flows.

Everything else being equal, you should invest if the discounted value of the security’s expected future cash flows is greater than or equal to the current cost of the security.

Now that you’ve thought about the decision rule that should be applied to your decision, apply it to the following security offered by your broker:

Jing Associates, LLC, a large law firm in Denver, is building a new office complex. To pay for the construction, Jing Associates is selling a security that will pay the investor the lump sum of $17,500 in six years. The current market price of the security is $12,372.

Assuming that you can earn an annual return of 6.75% on your next most attractive investment, how much is the security worth to you today?

$11,826

$9,461

$15,965

From strictly a financial perspective, should you invest in the Jing security?

Yes

No

Why or why not?

Because the cost of the security is greater than the discounted value of the security’s future cash flows.

Because the discounted value of the security’s future cash flows is greater than the cost of the security.

Answer 1

Which of the following is true about finding the present value of cash flows?

Present Value of a Cash Flow is the Future Cash Flow Discounted Back in order to arrive at the value of cash flow today.Future Cash Flows .

Present Value is computed using the Formula = Cash Flow/ (1+R)^n where R is the Interest Rate and N is the no, of years after which the cash flow is to be received/Paid

The option :- Finding the present value of cash flows is important for financial theory, but it does not have much relevance to actual business decision making. - is Incorrect as business descisons are taken considering the time value of Money concept.

The Option :- Finding present value tells you what a cash flow will be worth in future years. - Is Incorrect as Present Value Tells us the Today's Value of Future Cash Flow.

The correct Answer is :- Finding the present value of cash flows in future years tells you how much you would need to invest today so that it would grow to equal the given future amount.

What is the value today of a $87,000 cash flow expected to be received 12 years from now based on an annual interest rate of 8%?

Time Given = 12 Years

Interest Rate = 8% (Annual)

Cash Flow after 12 Years = $ 87000

Present Value is computed using the Formula = Cash Flow/ (1+R)^n where R is the Interest Rate and N is the no, of years after which the cash flow is to be received/Paid

Therefore Present Value = $ 87000/ (1.08)^12

Present Value = $ 34549

Your broker called earlier today and offered you the opportunity to invest in a security. As a friend, she suggested that you compare the current, or present value, cost of the security and the discounted value of its expected future cash flows before deciding whether or not to invest. The decision rule that should be used to decide whether or not to invest should be:

The option :-

Everything else being equal, you should invest if the present value of the security’s expected future cash flows is less than the current cost of the security.

Everything else being equal, you should invest if the current cost of the security is greater than the present value of the security’s expected future cash flows.

Both are Incorrect as one should invest in a stock if teh value derived out of it is More or Equal to cost paid, which means that future Expected cash flows when discounted back should be more or atleast equal to the value of stock which is paid today.

Therefore the correct answer is  Everything else being equal, you should invest if the discounted value of the security’s expected future cash flows is greater than or equal to the current cost of the security.

Jing Associates, LLC, a large law firm in Denver, is building a new office complex. To pay for the construction, Jing Associates is selling a security that will pay the investor the lump sum of $17,500 in six years. The current market price of the security is $12,372.

Assuming that you can earn an annual return of 6.75% on your next most attractive investment, how much is the security worth to you today?

We need to discount the future cash flow to arrive at its present value to determine the value of the security today.

Cash Flow = $ 17500

Years = 6 Years

Rate of Interest = 6.75%

Present Value is computed using the Formula = Cash Flow/ (1+R)^n where R is the Interest Rate and N is the no, of years after which the cash flow is to be received/Paid

Therefore Present value = 17500/ (1.0675)^6 = $ 11826

From strictly a financial perspective, should you invest in the Jing security?

Yes - Incorrect Option

No - Correct Option because - the Present Value of Expected cash flow is less than the cost paid today

Why or why not?

Because the cost of the security is greater than the discounted value of the security’s future cash flows. - Correct. the Present Value of Expected cash flow is less than the cost paid today

Because the discounted value of the security’s future cash flows is greater than the cost of the security.- Incorrect