4. Present value

Which of the following is true about finding the present value of cash flows?

Finding present value tells you what a cash flow will be worth in future years.

Finding the present value of cash flows in future years tells you how much you would need to invest today so that it would grow to equal the given future amount.

Finding the present value of cash flows is important for financial theory, but it does not have much relevance to actual business decision making.

What is the value today of a $87,000 cash flow expected to be received seventeen years from now based on an annual interest rate of 7%?

$42,690

$27,542

$34,428

$274,817

Your broker called earlier today and offered you the opportunity to invest in a security. As a friend, he suggested that you compare the current, or present value, cost of the security and the discounted value of its expected future cash flows before deciding whether or not to invest.

The decision rule that should be used to decide whether or not to invest should be:

everything else being equal, you should invest if the discounted value of the securitys expected future cash flows is greater than or equal to the current cost of the security.

everything else being equal, you should invest if the current cost of the security is greater than the present value of the securitys expected future cash flows.

everything else being equal, you should invest if the present value of the securitys expected future cash flows is less than the current cost of the security.

Now that youve thought about the decision rule that should be applied to your decision, apply it to the following security offered by your broker:

Jing Associates, LLC, a large law firm in Denver, is building a new office complex. To pay for the construction, Jing Associates is selling a security that will pay the investor the lump sum of $6,750 in five years. The current market price of the security is $5,896.

Assuming that you can earn an annual return of 3.75% on your next most attractive investment, how much is the security worth to you today?

$5,615

$7,019

$5,334

From strictly a financial perspective, should you invest in the Jing security?

Yes

No

Why or why not?

Because the discounted value of the securitys future cash flows is greater than the cost of the security.

Because the cost (market value) of the security is greater than the discounted value of the securitys future cash flows.