june 2011

Part (a) of the question only wanted you to consider the flows for the first 4 years, but in fact the project is going to continue generating returns after the 4 years.

Part (b) wants you to comment on this, and then to calculate the PV of the flows after 4 years.
You know what the flows will be – the question says for this bit to assume there is no more inflation and so from year 5 to infinity the amount will be the same as you already calculated for year 4 in part (a). (In fact, as you can see in his answer, because the question was not well worded, you could assume that the flows from year 5 to infinity were 3% higher than those in year 4 – it gives a different answer, but either answer got full marks).

To discount the flows, you multiply by 1/r as always for a perpetuity. However, multiplying by 1/r gives the PV when the flows are from year 1 to infinity. Because here the perpetuity starts 4 years late (at time 5 instead of time 1) you then need to discount for an extra 4 years by multiplying by the normal 4 year discount factor.