Midterm Help

Topics: Investment, Net present value, Finance Pages: 1 (282 words) Published: May 20, 2013
There may be a question on the midterm relating to discounting and present value. This topic is covered in Chapter 1 of your text. Here's an example problem.  
The present value of a stream of income or expenses is found the following process.  
First, a discount rate, r, is selected that reflects the opportunity cost of funds involved. For example, a risk free discount rate may be equal to the current rate of Treasury securities, about 2.5% to 3% currently. A discount rate that reflects greater risk, such as a Baa bond rate, is about 5.25%.  

Next, the future income or expenditures flows are determined. For example, if you decide to invest $1000 in a project that is expected to pay out the following amounts:  
End of Year 1: $300
End of Year 2: $500
End of Year 3: $400
 
And the discount rate is 3%, the present value of the future flows is:  
PV = $300/1.03 + $500/(1.032) + $400/(1.033) = $291.26 + $471.30 + $366.06 = $1128.62  
The future stream of income from the project is equal to $1128.62 invested at 3% interest rate (the discount rate).  
Net present value, NPV, is equal to the net of future revenues and costs. Since the cost of buying the investment is $1000 today, the net present value is equal to  
NPV = -$1000 + $1128.62 = $128.62
 
Or this investment pays more than an equivalent investment paying 3% interest.  
Note that for an investment to be a “good choice,” the NPV has to be positive or the present value of current and future earnings or income has to exceed the present value of current and future expenses
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