FMChapter 8 practice questions - relevant cash flow for DCF

The questions appear in a random order - question 5 will not always appear as question 5 - so please give me a clue as to which question you are asking about and then I will help you.

Hi John, The question is: A project is expected to earn $5,000 per year (at current prices) in perpetuity, inflating at 4% per year. The first receipt will be in one years time. The cost of capital is 12% What is the present value of the receipts ( to the nearest $100) Answers are: $62,500, 58,000, 41,700, 65,000 I get 41,700 with my calculations but this is not the correct answer I think I am applying incorrectly the perpetuity discount factor? Thanks Yolanda

Because it is an inflating perpetuity you have to discount the current price flow (5,000 per year) at the real (or effective) discount rate. The real rate = 1.12/1.04 - 1 = 0.076923 (or 7.6923%) Discounting the perpetuity at this rate gives: 5,000 / 0.076923 = 65,000 (Alternatively you can use the dividend valuation formula - it works for any inflating perpetuity (not only dividends). So PV = (5,000 x 1.04) / (0.12 - 0.04) = 65,000 )

Thanks very much

You are welcome :-)