3C Flashcards
Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first two years and by $20,000 in Year 3. Present values of an annuity of $1 at 14% are:
Period 1 0.8772
2 1.6467
3 2.3216
Using a 14% cost of capital, what is the present value of these future savings?
62,900
Present value of Year 1 and 2 savings of $30,000 = Savings x Annuity factor for 2 years
= $30,000 x 1.6467
= $49,401
Present value of Year 3 savings of $20,000 = Savings x Difference between second- and third-year annuity factor
= $20,000 x (2.3216 -1.6467)
= $20,000 x 0.6749
= $13,498
Present value of Years 1-3 savings = Present value of Year 1 and 2 savings + Present value of Year 3 savings
= $49,401 + $13,498
= $62,899, or $62,900 rounded
JUST INFORMATIONAL
The net present value method adjusts for the ____
It seeks to determine whether the present value of the estimated net future cash inflows at a desired (or required) rate of return will be greater or less than the cost of the ____
The ____ (or hurdle rate) is the required internal rate of return for projects considered by a company or investor.
time value of money.
True
proposed investment
discount rate
Which of the following is not an implication of income tax on capital budgeting? T/F
The reduction in taxes payable due to depreciation is a cash inflow item that must be included in the analysis. Depreciation is NOT a cash flow.
Cash flows in the form of revenue are taxable and must be computed net of tax.
Cash outflows in the form of expenses are deductible in computing taxes payable and must be computed net of tax.
Salvage value at book value resulting in a gain must be computed net of tax.
Gain or loss on the disposition of an existing facility (piece of equipment) is a taxable gain or a deductible loss for computing income tax.
T T T F -salvage value at book value results in no gain (loss) and has no tax consequences. T
Theamatics, Inc., leased 400 acres of vacant land from Farmco, Inc., on January 1. Theamatics hopes to construct a hotel-shopping center complex on the land. The lease agreement states that title to the land will pass to Theamatics at the end of the lease term. The cost of the land to Farmco was $500,000. The fair value of the land and the present value of the lease payments is $625,000. The collectibility of the lease payments is reasonably predictable, and no important uncertainties surround the amount of unreimbursable costs yet to be incurred by Farmco on the lease. What type of lease is this for Farmco?
Operating lease
Finance lease
Direct financing lease
Sales-type lease
Sales type lease
If at the inception of a lease involving land only, Criterion A1 (transfer of ownership) is met and the lease gives rise to dealer’s profit (loss), the lease is classified as a sales-type lease.
how do you determine if its a finance lease?
When does the title transfer?
The lease contains a ___ option
Lease term is the major part of the reaming ___ life of the asset.
…….Can you lease an asset near the end of its life?
Underlying asset is ___ and not expected to have an alternative use
Present value of lease payments exceed____
end of lease purchase option economic life No you can not. specialized Fair value
How do you determine if its an operating lease?
Upon agreement/commencement, It is ROU. What is ROU
After the agreement, Lease liability gradually ___
Right of use
decreases
How do you detremine if it is a SALES TYPE lease?
- At commencement, Transfer of ___
- What is recognized? By whom?
ownership
gain or loss, the lessor
How do you determine if it is a DIRECT finance lease?
- The lessor will collect the lease payments plus __
Residual value
Contribution margin calculated as sales revenue less
variable costs
An “ordinary annuity” is where payment is due/received at the ___of the period.
An “annuity due” or “annuity in arrears” is where payment is due/received at the ___of the period.
If you see simply “annuity”, assume ___.
end
beginning
ordinary annuity
What is the calculation for the interest payment on a bond?
Stated rate of interest × Par value
Stated rate of interest × Market value
Effective rate of interest × Par value
Effective rate of interest × Market value
Stated rate of interest × Par value
The calculation for the interest payment on a bond is the Stated rate of interest × Par value.
This is the calculation used by the corporation to establish the interest to be paid.
A ___loan is a legal agreement between a borrower and lender where the borrower promises to make interest and principal payments at specific times to the lender for the use of borrowed funds. It is a form of funded debt (long-term debt).
- Do they have disadvantages over bonds/equity issuances?
- How do you get the loans registered w/ the SEC?
- Disadvantage: Issue costs are high
- Interest rates are fixed or variable?
term
- No, they have advantages
- You DONT register w/ the SEC
- False -issue costs are low
- Either or - dont matta
A ___is generally a publicly offered form of long-term debt where the borrower agrees to makes payments of interest and principal on specific dates to the bond holder.
bond
An____is the legal document that contains the terms of the bond issue.
This document is approved by the ___before the
bond issue is offered to the public.
Common provisions in a bond indenture
- ___ - right to redeem before maturity
- ____– retire portion of bond each yr
- ________- conditions must be met by issuer
indenture
SEC
Call Provision
Sinking Fund
Restrictive Covenant
Bond Ratings - determined using a rating system such as Standard & Poor’s, based upon the probability that the issuing corporation will go into ____.
it goes from ___to ___
Default
AAA to D (strong to weak)
Advantages of using the net present value method for decision making include the following:
The time value of money is considered (__of returns).
Given a perfect market, correct __will be obtained.
A correct ranking will be obtained for mutually exclusive projects given similar lives and investments.
An __value is obtained.
Disadvantages of using the net present value method for decision making include the following:
The ____rate is difficult to determine.
___related to cash flows have to be made that may or may not be correct.
compounding
decision advice
T
absolute
Negatives:
Discount Rate
Assumptions
A limitation of using the discounted payback method to evaluate a project is that it ignores which of the following?
Cash flows after the payback period Duration of funds being tied up A project's cost of capital A project's breakeven point The method disregards profitability
Cash flows after payback period & The method disregard profitability
The ___payback is the length of time required to recover the initial cash investment using a sum of the discounted future cash flows.
discounted
An investment in a new product will require an initial outlay of $20,000. The cash inflow from the project will be $4,000 a year for the next six years. The payment will be received at the end of each year. What is the net present value of the investment at 8% using the correct factor from below?
Present value of $1 to be received after 6 periods 0.63017
Present value of an ordinary annuity of $1 per
period for 6 periods 4.62288
Present value of an ordinary annuity due of $1 per period for 6 periods 4.99271
Future value of $1 at the end of 6 periods 1.58687
$(1,508.48)
The present value of an ordinary annuity factor of 4.62288 is used because the payments will be received at the end of each period.
The present value of the future cash returns is the annual cash flow of $4,000 multiplied by the present value of an annuity of $1 a year for six years at 8%, or 4.62288. Thus, the present value of the future cash flows is $18,491.52.
The cost of the machine is $20,000, so the net present value is $18,492 less $20,000, or a negative net present value of $1,508.48.
The payback reciprocal can be used to approximate a project’s ____if the cash flow pattern is relatively stable.
internal rate of return
The payback reciprocal can be used to approximate a project’s:
net present value.
accounting rate of return if the cash flow pattern is relatively stable.
payback period.
internal rate of return if the cash flow pattern is relatively stable.
internal rate of return if the cash flow pattern is relatively stable.
Which of the following statements is true regarding the payback method?
It does not consider the time value of money.
The salvage value of old equipment is ignored in the event of equipment replacement.
It is the time required to recover the investment and earn a profit.
It is a measure of how profitable one investment project is compared to another.
The payback method can be a good screening tool and as a general rule should be used as the primary investment evaluation tool. T/F
It does not consider the time value of money.
False – it should NOT be used
PAYBACK METHOD ILLUSTRATION
Problem: Compute the payback period for an investment opportunity that costs $20,000 and provides equal annual cash flows of $4,000 per year for eight years.
$20,000 Solution: ------- = 5 years
$ 4,000
yep
What type of covenant requires a corporation to maintain, at all times, some minimum level of working capital?
Affirmative Covenant
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges 1% commission on the amount of receivables. The net proceeds would be further reduced by an annual interest charge of 10%. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 90 days is turned over to the finance company?
Note: Interest is last
90,675
Face amount of A/R factored = $100,000
LESS: 6% reserve = .06 x $100,000 = $6,000
1% commission = .01 x $100,000 = $1,000
7,000
Net amount available $ 93,000
LESS: 10% interest = .10 x $93,000 x (90 / 360) =2,325
Cash proceeds $ 90,675
A firm that often factors its accounts receivable has an agreement with its finance company that requires the firm to maintain a 6% reserve and charges 1% commission on the amount of receivables. The net proceeds would be further reduced by an annual interest charge of 10%. Assuming a 360-day year, what amount of cash (rounded to the nearest dollar) will the firm receive from the finance company at the time a $100,000 account that is due in 90 days is turned over to the finance company?
Note: Interest is last
90,675
Face amount of A/R factored = $100,000
LESS: 6% reserve = .06 x $100,000 = $6,000
1% commission = .01 x $100,000 = $1,000
7,000
Net amount available $ 93,000
LESS: 10% interest = .10 x $93,000 x (90 / 360) =2,325
Cash proceeds $ 90,675
Accounts payable and accruals provide instant financing at no cost for a firm T/F
\_\_is an appealing source of financing since it is free; however, the length of this credit is only for a very limited time. \_\_loans are not backed by any collateral and come in a variety of forms.
A variation on the line of credit is the ___that is generally used by large corporations. This is an agreement by a bank to extend credit to a company over a specified period of time
A ___is an international financing tool that guarantees payment to an international supplier upon the safe arrival of the goods by issuing a loan to the purchaser.
___is an unsecured promissory note that is issued by large banks and big corporations to meet short-term cash needs.
True
Trade credit
Unsecured
revolving credit agreement
letter of credit
Commercial paper
Harvey Co. is evaluating a capital investment proposal for a new machine. The investment proposal shows the following information:
Initial cost $500,000
Life 10 Years
Annual net cash inflows $200,000
Salvage value $100,000
If acquired, the machine will be depreciated using the straight-line method. The payback period for this investment is:
2.5 years
The payback method does not take into account the life of the equipment, its salvage value, or how it will be depreciated.
200,000 * 2.5 = $500,000
A company is investing in a machine costing $365,000. The following table shows selected financial data for the company for the next five years:
Year Annual Cash Flows Annual Net Income 1 $50,000 $45,000 2 125,000 120,000 3 150,000 145,000 4 50,000 45,000 5 30,000 25,000 What is the payback period on this machine?
Fuck net income, we just pay attention to Annual cash flow
365,000 - 50000 - 125000 - 150000 = $40,000
$50k is leftover in year 4 so you know its 3 years and some change.
40,000/50,000 = .80.
The answer is 3.80 years
A company invests $100,000 in property. The company has a contract to sell it for $120,000 in one year. The bank has a guaranteed interest rate of 10%. Information on present and future value factors is as follows:
Present value of $1 at 10% at the end of one period: 0.90909
Future value of $1 at 10% at the end of one period: 1.10000
What is the net present value of the company’s investment in the property?
9,091
The present value (PV) of the net cash inflows is calculated and compared to the initial investment. An investment proposal is desirable if its NPV is positive. The PV factor for a single sum for one period at 10% is .90909.
PV = $120,000 × .90909 (rounded) = $109,091
Cash outflow (cost) = (100,000)
Net present value = $ 9,091
Which of the following statements is correct when a corporation is earning excess profits?
Participating preferred stock acts more like equity than cumulative preferred stock.
Cumulative preferred stock acts more like equity than participating preferred stock.
Cumulative preferred stock does not act more or less like equity than participating preferred stock.
No statement can be made comparing cumulative preferred and participating preferred stocks to equity.
Participating preferred stock acts more like equity than cumulative preferred stock
Participating preferred stock acts more like equity than cumulative preferred stock when a corporation is earning excess profits because the stock does not receive a fixed percentage like debt.
When excess profits are earned, the participating preferred stock receives additional dividends.
Information on four investment proposals is as follows:
Proposal Investment Required Net Present Value
A $ 8,000 $3,200
B $12,000 $3,600
C $10,000 $2,500
D $ 4,000 $2,000
Rank the proposals in terms of preference:
DABC
Using the project profitability index to rank the proposals:
NPV Investment
A: $3,200 / $ 8,000 = 0.4
B: $3,600 / $12,000 = 0.3
C: $2,500 / $10,000 = 0.25
D: $2,000 / $ 4,000 = 0.5
The order of preference then should be D, A, B, C.
Note: Project Profitability Index = NPV of Project ÷ Investment Required. The project with the highest project profitability index would be the most desirable.
When the risks of the individual components of a project’s cash flows are different, an acceptable procedure to evaluate these cash flows is to:
compute the net present value of each cash flow using the firm’s cost of capital.
compare the internal rate of return from each cash flow to its risk.
utilize the accounting rate of return.
discount each cash flow using a discount rate that reflects the degree of risk.
Discount Each Cash flow using a discount rate that reflects the degree of risk
An investment advisor is working with a client to be sure that he understands the client’s needs and preferences as he develops recommendations for the client’s portfolio. As he speaks with the client, he ascertains that the client is willing to accept a reasonable level of risk in her portfolio. He further determines that the client expects to be fairly compensated for the level of risk that is assumed by a commensurate increase in value to her portfolio. The investment advisor believes that his client is:
a risk taker.
desirous of having her portfolio on the security market line.
risk adverse.
looking for a passively managed portfolio.
Risk Adverse
The definition of a risk-adverse investor is one who is willing to take risk but believes that they will be reasonably compensated for the level of risk being taken.
The security market line is a theoretical construct that provides a graphic representation of the expected return of a particular security as a function of beta, i.e., nondiversifiable risk
MEASURING PORTFOLIO PERFORMANCE
- If the return reflects the ___
- how ___compare w/ those achieved by peers
- Whether success was due to ___
risk taken
returns
skill or luck
Returns must be adjusted for risk before they can be compared meaningfully. In today’s world, methods of risk adjustment are generally based on _
mean-variance criteria
Yipann Corporation is reviewing an investment proposal; the data for each year are presented as follows. All cash flows are assumed to take place at the end of the year. The salvage value of the investment at the end of each year is equal to its net book value, and there will be no salvage value at the end of the investment’s life.
See question: 400266
k
Internal rate of return (time-adjusted rate of return)—unequal annual cash flows
Illustration: An investment opportunity costs $10,000 and returns $5,000, $4,000, and $3,000, respectively, the first three years. What is the internal rate of return (IRR)?
(1) First attempt: Using an interest rate of 10%, the net present value is $105, computed as follows:
Cash flows:
$5,000 x .9091(given) $ 4,545.50
4,000 x .8264 3,305.60
3,000 x .7513 2,253.90
-----------
Present value cash inflows $10,105.00
-----------
Cash investment (10,000.00)
-----------
Net present value $ 105.00
===========
Second attempt: Using an interest rate of 11%, the net present value is ($55.50), computed as follows:
Cash flows:
$5,000 x .9009 $ 4,504.50
4,000 x .8116 3,246.40
3,000 x .7312 2,193.60
-----------
Present value cash inflows $ 9,944.50
-----------
Cash investment (10,000.00)
-----------
Net present value $ 55.50
k
A project has an initial investment of $100,000 and a project profitability index of 1.15. The firm’s cost of capital is 12%. The net present value of the project is:
15k
Projec profitability index = Present value of future
inflows / Initial investment
1.15 = Present value of future inflows / $100,000
$100,000 x 1.15 = Present value of future inflows
$115,000 = Present value of future inflows
Net present value:
Net present value = Present value of future inflows - Initial investment
= $115,000 - $100,000
= $15,000
Projec profitability index = Present value of future
inflows / Initial investme
Net present value = Present value of future inflows - Initial investment
YEPPPP
400258 study this
Note: For discount rates .. ALWAYS USE PV of $!… not the ORDINARY ANNUITY
k
he use of an accelerated method instead of the straight-line method of depreciation in computing the net present value of a project has the effect of:
raising the hurdle rate necessary to justify the project.
lowering the net present value of the project.
increasing the present value of the depreciation tax shield.
increasing the cash outflows at the initial point of the project.
increasing the present value of the depreciation tax shield.
An accelerated method of depreciation will cause larger amounts of depreciation to be deducted sooner than straight-line.
Although the same amount of tax will be shielded in nominal dollars, the present value of the tax savings (or shield) is greater under accelerated depreciation because less tax is paid out earlier in the project’s life.
A project’s net present value, ignoring income tax considerations, is normally affected by the:
proceeds from the sale of the asset to be replaced.
carrying amount of the asset to be replaced by the project.
amount of annual depreciation on the asset to be replaced.
amount of annual depreciation on fixed assets used directly on the project.
proceeds from the sale of the asset to be replaced.
xpected proceeds from the sale of the asset to be replaced are a future cash inflow, which will affect the proposed project’s net present value.
This is saying the present value is affected by future value.
Of the following decisions, capital budgeting techniques would least likely be used in evaluating the:
acquisition of new aircraft by a cargo company.
design and implementation of a major advertising program.
trade for a star quarterback by a football team.
adoption of a new method of allocating non-traceable costs to product lines.
adoption of a new method of allocating non-traceable costs to product lines.
CAPITAL BUDGETING TECHNIQUES
(1) ___method
(2) _____payback
(3) ____rate of return
(4) ___present value
(5) ____rate of return
(6) ____index
(7) CVP analysis/margin of safety
Payback Discounted Accounting Net Internal Profitability True
Approaches for Detremining FV
- The ___approach to determining fair value is based upon what it would cost to replace the subject item with an asset of like function and capacity.
- The ___approach to determining fair value uses market comparison of identical or comparable assets or liabilities
- The __)approach to determining fair value uses the company’s ability to create earnings or cash inflows and the risk involved in the specific investment.
When measuring fair value over multiple periods, methods should be used consistently Tf
cost
market
income
True
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns closest to:
5
The payback period serves as a fair approximation of the annuity factor value from the table of present values of an annuity.
Using the data given:
Payback = Investment / Annual saving
= $100,000 / $20,000
= 5.00
Thus, internal rate of return can be obtained as a percentage rate from an annuity table for 10 periods nearest the annuity factor of 5.00.
FAIR VALUE HIERARCHY
\_\_\_\_ is when determining fair value, and include such items as prices of assets or liabilities that can be either directly or indirectly observed but do not include the Level 1 quoted market prices.
____- Observable and highest/most desirable to determine FV
____ inputs are unobservable and considered to be the lowest and least desirable level when determining fair value
Level 2
Level 1
Level 3
A disadvantage of the net present value method of capital expenditure evaluation is that it:
is calculated using sensitivity analysis.
computes the true interest rate.
does not provide the true rate of return on investment.
is difficult to adapt for risk.
Doesnt provide true rate of return on investment
Which of the following inputs would be most beneficial to consider when management is developing the capital budget?
Supply/demand for the company’s products
Current product sales prices and costs
Wage trends
Profit center equipment requests
Capital budgeting involves management making decisions about spending money on long-term assets. In order to make these decisions, management must first know what each profit center’s equipment needs are.
Supply and demand for the company’s products, current sales prices and costs, and wage trends would be helpful in order to determine future cash flows as they relate to implementing various capital projects, but these are not the best answers
The discounted payback period is the length of time required for discounted cash flows to recover the cost of the investment. The year two cash inflow for project D which is consistent with a discounted payback period of two years can be calculated as follows:
Investment cost =
Present value of years of cash inflows
400274 do this question
mmmmk
A project should be accepted if the present value of cash flows from the project is:
equal to the initial investment.
less than the initial investment.
greater than the initial investment.
equal to zero.
Greater than investment
What is an internal rate of return?
A net present value
An accounting rate of return
A payback period expected from an investment
A time-adjusted rate of return from an investment
A time-adjusted rate of return from an investment
When evaluating capital budgeting analysis techniques, the payback period emphasizes:
liquidity.
profitability.
cost of capital.
net income.
Liquidity
Payback period is the length of time in years required to recover the cash invested in a project. Payback is computed as net investment divided by average expected annual cash inflow.
Payback focuses on rapid recovery of cash investment (i.e., liquidity).
400260 good luck
lol
Which of the following statements is correct regarding financial decision making?
Opportunity cost is recorded as a normal business expense.
The accounting rate of return considers the time value of money.
A strength of the payback method is that it is based on profitability.
Capital budgeting is based on predictions of an uncertain future.
Capital budgeting is based on predictions of an uncertain future.
Tam Co. is negotiating for the purchase of equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment’s estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam’s predetermined minimum desired rate of return is 12%. Present value of an annuity of 1 at 12% for 10 periods is 5.65. Present value of 1 due in 10 periods at 12% is .322.
What is the accrual accounting rate of return based on initial investment?
10%
Annual accrual accounting “income” = Annual saving - Depreciation
= $20,000 - ($100,000 / 10 years)
= $20,000 - $10,000
= $10,000
Accrual accounting rate of return = Accounting “income” / Investment
= $10,000 / $100,000
= 10%
Accounting Rate of return = (Net cash inflow - depreciation) / investment
Or accounting income/ investment
yep ype yep
For capital budgeting purposes, management would select a high hurdle rate of return for certain projects because management:
believes too many proposals are being rejected.
believes bank loans are riskier than capital investments.
believes capital investment proposals involve average risk.
wants to factor risk into its consideration of projects.
wants to factor risk into its consideration of projects.
Allo Foundation, a tax-exempt organization, invested $200,000 in a 5-year project at the beginning of 2006. Allo estimates that the annual cash savings from this project will amount to $65,000. The $200,000 of assets will be depreciated over their 5-year life on the straight-line basis. On investments of this type, Allo’s desired rate of return is 12%. Information on present value factors is as follows:
AT 12% AT 14% AT 16%
------ ------ ------ PV of 1 for 5 periods 0.5674 0.5194 0.4761 PVof an annuity of 1 for 5 periods 3.6048 3.4331 3.2743
Allo’s internal rate of return on this project is:
Internal rate of return is the interest rate which will result in a net present value (PV) of zero. Therefore:
PV of Cash Savings = PV of Investment Outlay
$65,000 x PV factor = $200,000 x 1.0
$65,000(PV factor) = $200,000
Then dividing by $65,000:
PV factor = $200,000 / $65,000
= 3.08
Referring to the present value factors in the question, the percentage rates for present value of an annuity indicates that a present value factor of 3.08 would relate to an interest rate of more than 16%.
If a project has differing required rates of return over its life, i.e., 8% in the first three years and 12% in the second three years, the analyst should:
choose the highest rate to compare to the firm’s cost of capital.
choose the lowest rate to compare to the firm’s cost of capital.
compute the project’s net present value using both rates for the appropriate years and accept the project if the net present value is at least zero.
use the average of the multiple rates to compare to the firm’s cost of capita
compute the project’s net present value using both rates for the appropriate years and accept the project if the net present value is at least zero.
With differing rates of return in different years, the best way to make a comparison is to calculate the net present value using both rates for the appropriate years and accept those projects with a net present value (NPV) of zero or greater.
Net present value is appropriate because it allows discounting different years using the respective required rates of return for those years.
The profitability index is a variation on which of the following capital budgeting models?
Internal rate of return
Economic value added
Net present value
Discounted payback
NPV
A small vacuum cleaner repair shop is located in a once-quiet, out-of-the way neighborhood. Recently, however, a large entertainment complex that will be used for concerts, basketball games, and other major events was just opened a block from this small business. When determining the fair value of this property, the fair value should be based upon:
the use of the property as a small vacuum cleaner repair shop.
the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol.
the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol only if the current owner plans to sell the property.
the average of the property value based upon its current use and the highest and best use.
the use of the property as a small restaurant serving a variety of light meals, exotic desserts, and alcohol.
he fair value measurement assumes that the business (or item) being valued will be put to the highest and best use that is physically possible, legally permissible, and financially feasible. The result will be the maximization of value. It is important to realize that the highest and best use may not be the current use; therefore, the highest and best use is determined from the viewpoint of the purchaser and not the seller.
In this scenario, the use of the facility as a vacuum cleaner repair shop is clearly not the highest and best use of the property. Due to the need to have small restaurants and bars in the vicinity of a large entertainment complex, the highest and best use of the property would likely be an establishment such as a small restaurant serving light fare for the before-the-event crowd and desserts for the after-the-event group
Which of the following changes would result in the highest present value?
A $100 decrease in taxes each year for four years
A $100 decrease in the cash outflow each year for three years
A $100 increase in disposal value at the end of four years
A $100 increase in cash inflow each year for three years
Two general rules can be developed related to present value calculations:
Increases in cash inflows (decreases in cash outflows) will result in higher present values, all else being equal.
The earlier the cash inflows (the later the cash outflows) the higher the present value, all else being equal.
Given a 10% discount rate with cash inflows of $3,000 at the end of each year for five years and an initial investment of $11,000, what is the net present value?
370
The present value of the payment in the first year is $3,000 ÷ 1.1, or $2,727.
The present value of the payment in the second year is $3,000 ÷ (1.1 × 1.1), or $2,479.
The present value of the payment in the third year is $3,000 ÷ (1.1 × 1.1 × 1.1), or $2,254.
The present value of the payment in the fourth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1), or $2,049.
The present value of the payment in the fifth year is $3,000 ÷ (1.1 × 1.1 × 1.1 × 1.1 × 1.1), or $1,863.
The sum of the present value of the five future payments is $11,372. The cost of the investment is $11,000, so the net present value is $11,372 - $11,000, or $372, rounded to $370.
