Question

2. Time value of money: 13 marks
You have inherited $50,000 from your Great Aunt Daisy. You have determined that you have
two different investment opportunities available to you. The money can be placed on deposit
at the bank. The interest rate you can earn is 6% compounded annually. Alternatively, you
can invest in a business opportunity with Lima’s bakery and receive the following cash flows
(note: the cashflows are received at the end of each year):
Years 1-2 $10,000 each year
Years 3-4 $12,000 each year
Year 5 $22,000
Required:
(a) Work out the present value of the investment at the bank and the present value of the
business opportunity with Lima’s bakery using a discount rate of 6% p.a.

(b) (i) Based on your present value analysis, which investment represents the better
opportunity? Why? (1 mark – 50 words maximum)
(ii) Explain why using 6% to calculate the present value of Lima’s bakery opportunity
may not be realistic. (2 marks – 80 words maximum)
(iii) Discuss two other factors you would consider before making your final decision.
(2 marks – 80 words maximum)

(c) Discuss how inflation affects your required rate of return.

Answer 1

	Present Value (PV) of Cash Flow:
	(Cash Flow)/((1+i)^N)
	i=Discount Rate=6%=0.06
	N=Year of Cash Flow
	Future Value=
	ALTERNATIVE 1
	Present value (PV) of Deposit at Bank	$50,000
	N	A	PV=A/(1.06^N)
	Year	Cash Flow	Present value
	1	$3,000	$                   2,830
	2	$3,000	$                   2,670
	3	$3,000	$                   2,519
	4	$3,000	$                   2,376
(50000+3000)	5	$53,000	$                39,605
			$                50,000
	Business Opportunity
	N	A	PV=A/(1.06^N)
	Year	Cash Flow	Present value
	1	$10,000	$                   9,434
	2	$10,000	$                   8,900
	3	$12,000	$                10,075
	4	$12,000	$                   9,505
(50000+22000)	5	$72,000	$                53,803
		SUM	$                91,717
	Present value of cash Inflows	$         91,717
	Business Opportunity gives higher present Value
	Hence,Business is better opportunity
(ii)	Business Opportunity involves risks
	6% is riskfree rate
	Hence using 6% rate for business return discounting is not correct
	It should be discounted with riskpremium at higher rate
(iii)	Other factors tobe considered:
	Pay BackPeriod
	InternalRate of Return
.(c)	Real rate of return(Inflation adjusted return)=(Nominalreturn)- Inflation Rate
	Inflation reduces real return
	Hence, if there is inflation, real return will reduce