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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. 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. 9. 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)?
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CHAPTER 27 B-2 10. In general, viatical settlements are ethical. In the case of a viatical settlement, it is simply an exchange of cash today for payment in the future, although the payment depends on the death of the seller. The purchaser of the life insurance policy is bearing the risk that the insured individual will live longer than expected. Although viatical settlements are ethical, they may not be the best choice for an individual. In a Business Week article (October 31, 2005), options were examined for a 72 year old male with a life expectancy of 8 years and a $1 million dollar life insurance policy with an annual premium of $37,000. The four options were: 1) Cash the policy today for $100,000. 2) Sell the policy in a viatical settlement for $275,000. 3) Reduce the death benefit to $375,000, which would keep the policy in force for 12 years without premium payments. 4) Stop paying premiums and don’t reduce the death benefit. This will run the cash value of the policy to zero in 5 years, but the viatical settlement would be worth $475,000 at that time. If he died within 5 years, the beneficiaries would receive $1 million. Ultimately,
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