Question

you are offered an investment that promises to pay you $1.20 one year from today, $1.12 a year for the following two years, and then a final payment of $14.20 four years from now. What is the most you would pay for this investment today if you require a rate of return of 18.7%?

Answer 1

The most we would pay is present value of future cash flows. Formula is as under

Present value of cash flows formula= Cash flows for relevant year * P.V.F.

P.V.F. formula = Cash flow for n year/(1+i)^n

for 1st year 1/(1+18.7%)^1,. for second year 1/(1+18.7%)^2. and so on.

Year . Cash flows P.V F.

1 1.2 0.8424599832

2 1.12 0.7097388232

3 1.12 0.597926557

4 14.2 0.5037291972

Total of present values

So, most we would like to pay today for this investment is $9.63

The most we would pay is present value of future cash flows. Formula is as under

Present value of cash flows formula= Cash flows for relevant year * P.V.F.

P.V.F. formula = Cash flow for n year/(1+i)^n

for 1st year 1/(1+18.7%)^1,. for second year 1/(1+18.7%)^2. and so on.

Year . Cash flows. P.V F. P.V

1 . 1.2 0.8424599832 1.01095198

2. 1.12. 0.7097388232 0.794907482

3 1.12. 0.597926557. 0.6696777439

4 14.2. 0.5037291972 7.1529546

----------------------

Total of present values 9.628491806

So, most we would like to pay today for this investment is $9.63