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ch06sm - Chapter 6 Discounted Cash Flows and Valuation...

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Page 1 of 32 Chapter 6 Discounted Cash Flows and Valuation Critical Thinking Questions 6.1 Identify the steps involved in computing the future value when you have multiple cash flows. First, prepare a time line to identify the size and timing of the cash flows. Second, calculate the present value of each individual cash flow using an appropriate discount rate. Finally, add up the present values of the individual cash flows to obtain the present value of a cash flow stream. This approach is especially useful in the real world where the cash flows for each period are not the same. 6.2 What is the key economic principle involved in calculating the present value and future value of multiple cash flows? Regardless of whether you are calculating the present value or the future value of a cash flow stream, the key idea is to discount or compound the cash flows to the same point in time. 6.3 What is the difference between a perpetuity and an annuity?
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Page 2 of 32 A cash flow stream that consists of the same amount being received or paid on a periodic basis is called an annuity . If the same payments are made periodically forever, the contract is called a perpetuity . 6.4 Define annuity due . Would an investment be worth more if it was an ordinary annuity or an annuity due? Explain. When annuity cash flows occur at the beginning of each period, it is called an annuity due. Annuity due will result in a bigger investment than an ordinary annuity because each cash flow will accrue an extra interest payment. 6.5 Raymond Bartz is trying to choose between two equally risky annuities, each paying $5,000 per year for five years. One is an ordinary annuity, and the other is an annuity due. Which of the following statements is most correct? a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due. b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.
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Page 3 of 32 d. If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity. 6.6 Which of the following investments will have the highest future value at the end of three years? Assume that the effective annual rate for all investments is the same. a.
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ch06sm - Chapter 6 Discounted Cash Flows and Valuation...

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