ch.6 - CHAPTER 6 DISCOUNTED CASH FLOW VALUATION Answers to...

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CHAPTER 6 DISCOUNTED CASH FLOW VALUATION Answers to Concepts Review and Critical Thinking Questions 1. The four pieces are the present value (PV), the periodic cash flow ( C ), the discount rate ( r ), and the number of payments, or the life of the annuity, t . 2. Assuming positive cash flows, both the present and the future values will rise. 3. Assuming positive cash flows, the present value will fall and the future value will rise. 4. It s deceptive, but very common. The basic concept of time value of money is that a dollar today is not worth the same as a dollar tomorrow. The deception is particularly irritating given that such lotteries are usually government sponsored! 5. If the total money is fixed, you want as much as possible as soon as possible. The team (or, more accurately, the team owner) wants just the opposite. 6. The better deal is the one with equal installments. 7. Yes, they should. APRs generally don t provide the relevant rate. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important. 8. A freshman does. The reason is that the freshman gets to use the money for much longer before interest starts to accrue. 9. The subsidy is the present value (on the day the loan is made) of the interest that would have accrued up until the time it actually begins to accrue. 10. The problem is that the subsidy makes it easier to repay the loan, not obtain it. However, ability to repay the loan depends on future employment, not current need. For example, consider a student who is currently needy, but is preparing for a career in a high-paying area (such as corporate finance!). Should this student receive the subsidy? How about a student who is currently not needy, but is preparing for a relatively low-paying job (such as becoming a college professor)? PDF created with pdfFactory Pro trial version www.pdffactory.com
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B-65 SOLUTIONS Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 1. To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a lump sum, we use: PV = FV / (1 + r) t [email protected]% = JOD 1,200 / 1.08 + JOD 600 / 1.08 2 + JOD 855 / 1.08 3 + JOD 1,480 / 1.08 4 = JOD 3,392.09 M [email protected]% = JOD 1,200 / 1.16 + JOD 600 / 1.16 2 + JOD 855 / 1.16 3 + JOD 1,480 / 1.16 4 = JOD 2,845.53 M [email protected]% = JOD 1,200 / 1.30 + JOD 600 / 1.30 2 + JOD 855 / 1.30 3 + JOD 1,480 / 1.30 4 = JOD 2,185.46 M 2. To find the PVA, we use the equation: PVA = C ({1 [1/(1 + r) ] t } / r ) At a 5 percent interest rate: [email protected]%: PVA = SAR 40,000{[1 (1/1.05) 9 ] / .05 } = SAR 284,312.87 [email protected]%: PVA = SAR 60,000{[1 (1/1.05) 5 ] / .05 } = SAR 259,768.60 And at a 22 percent interest rate: [email protected]%: PVA = SAR 40,000{[1 (1/1.22) 9 ] / .22 } = SAR 151,451.40 [email protected]%: PVA = SAR 60,000{[1 (1/1.22) 5 ] / .22 } = SAR 171,818.39 Notice that the PV of Cash flow X has a greater PV at a 5 percent interest rate, but a lower PV at a 22 percent interest rate. The reason is that X has greater total cash flows. At a lower interest rate, the total cash flow is more important since the cost of waiting (the interest rate) is not as great. At a
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