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We could then discount this amount back one period and add it to the Year 3 cash flow:

($1,943.40/1.06) + 1,000 = $1,833.40 + 1,000 = $2,833.40

This process could be repeated as necessary. Figure 6.6 illustrates this approach and the remaining calculations.

You are offered an investment that will pay you $200 in one year, $400 the next year, $600 the next year, and $800 at the end of the fourth year. You can earn 12 percent on very similar investments. What is the most you should pay for this one?

We need to calculate the present value of these cash flows at 12 percent. Taking them one at a time gives:

$200 X 1/1.121 = $200/1.1200 = $ 178.57 $400 X 1/1.122 = $400/1.2544 = 318.88 $600 X 1/1.123 = $600/1.4049 = 427.07 + $800 X 1/1.124 = $800/1.5735 = 508.41 Total present value = $1,432.93

Ross et al.: Fundamentals I III. Valuation of Future I 6. Discounted Cash Flow I I © The McGraw-Hill of Corporate Finance, Sixth Cash Flows Valuation Companies, 2002

Edition, Alternate Edition

CHAPTER 6 Discounted Cash Flow Valuation 163

If you can earn 12 percent on your money, then you can duplicate this investment's cash flows for $1,432.93, so this is the most you should be willing to pay.

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