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Hello Sir John, Please help on this question on IA:
An investor has a cost of capital of 10%. He is due to receive a 5 year annuity starting in 3 year’s times of $7,000 Per annum. What amount lump sum would you need to offer today to make him indifferent between the annuity and your offer?
A. $26,537
B. $19,936
C. $16,667
D. $21,924You must have an answer to this question in the same book in which you found the question.
In future you must ask about whatever it is in the answer that you are not clear about, and then I will help you.You need the present value of an annuity of 7,000 per year from years 3 to 7.
To get the discount factor, you subtract the 2 year annuity factor at 10% from the 7 year annuity factor at 10%.
This is a Paper F2 type rather than Paper F9!
The free Paper F2 lectures on interest and discounting explain in full how to deal with annuities.Dear John
I would like to follow up on this question.
It is regarding to the number of years that the annuity needs to be counted for.The question says that there are 5 years to be received and it will start in 3 years time.
Do I added the 5 + 3 – 1 being the first year and it should be zero?Many thanks
AlexI do not understand what you mean by ‘it should be zero’ !!!
Don’t simply learn rules – count on your fingers!!
The first receipt is at time 3, the second is at time 4, and so on. If you do it 5 times then the last receipt is at time 7.
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