Question

At a discount rate of 12%, which of the following would be preferred by an investor? a. A lump sum of $1,000 to be received at the end of six years. b. $120 at the end of every year for the next six years. c. $100 at the end of years 1-4 and $135 at the end of years 5 and 6. d. A perpetuity of $60 per year.

Answer 1

a.Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=1000/1.12^6

=506.63(Approx)

b.Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=120/1.12+120/1.12^2+120/1.12^3+120/1.12^4+120/1.12^5+120/1.12^6

=$493.37(Approx)

c.Present value of inflows=cash inflow*Present value of discounting factor(rate%,time period)

=100/1.12+100/1.12^2+100/1.12^3+100/1.12^4+135/1.12^5+135/1.12^6

=$448.73(Approx)

d.Present value of perpetuity=Annual cash flows/discount rate

=60/0.12

=500

Hence investor would prefer option A.