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In the above mentioned question, there is a paragraph written as:
MMC has forecast the following end of year cash flows for the four-year sales period of the game.
Year 1 2 3 4
Cash flows ($ million) 25 18 10 5MMC will spend $7 million at the start of each of the next two years to develop the game, the gaming platform, and to pay for the exclusive rights to develop and sell the game. Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game.
The examiner’s answer shows this:
Year Current 1 2 3 4 5 6
Cash flows ($) –7m –7m –35m 25m 18m 10m 5mI don’t understand why the examiner started with the current year. The question clearly says ” at the start of each of the next two years ” so he should have started with an outflow of 7m in year one and another outflow of 7m in year 2. Also, he says ” Following this, the company will require $35 million for production, distribution and marketing costs at the start of the four-year sales period of the game.” So the outflow of 35M should be at the start of the four year sales period. i.e it should be at time/year three why has he kept it in year two? This all is so confusing, please explain.
The time periods for discounting are points in time – not years.
Time 0 is now; time 1 is 1 year from now, and so on.
So…..the first year starts now (time 0) and finishes in 1 years time (time 1)
The second year starts in 1 years time (time 1) and finishes in 2 years time (time 2).So, in respect to this particular question, the start of the first year is now (time 0), and the starts of the second year is in one years time (time 1).
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In the answer it shows that
year 0 is cash outflow of 7
Year 1 is cash outflow of 7
Year 2 is cash outflow of 35Why is the $35m in a separate year, and not included within the year 1 inflow i.e $25m?
Why is the exercise price 35 and not (7+6.31+28.42) $41.71m OR even present value of $35m (28.42)
The question says that the game will be available to buy in 2 years (22 months + 2 months) and that 35M will be required at the start of the sales period – i.e. in 2 years time, or time 2.
As I wrote in my previous reply, it is time 0, time 1, time 2 etc – they are points in time that are 1 year apart, they are not whole years.
The exercise price is 35M because that is the amount that they will have to spend in 2 years time if they decide to continue.
But they have said that the game will be available to buy after 24 months, so from the start of year 3, the game can be purchased and therefore also the sales is accounted for in Time 3 (year 3) so why not put the $35M in year three, the start of the sales period?
The 35M would have to be paid at the start of year 3. Year 3 starts in 2 years time i.e. time 2.
(It is only the operating flows that we assume occur at the ends of years, so revenue and costs in the third year occur at time 3)
Could you explain this further “ear 3 starts in 2 years time i.e. time 2.” I don’t quite understand
The first year starts now (time 0) and ends in 1 years time (time 1).
The second year starts in 1 years time (time 1) and ends in 2 years time (time 2)
The third year starts in 2 years time (time 2) and finishes in 3 years time (time 3).
This is not just for this question – the timing is relevant for all questions.
It is important that time 0, time 1 etc are points in time that are 1 year apart – the way we discount is dealing with yearly intervals. We certainly don’t discount day-by-day (which is what we would need to do if costs/revenues were being spread over a year).
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