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Question 32
Can you try and explain why the discount factors are all multiples of each other’s for the different cash flows?
ThanksThe discount factors are not multiples of each other. The present values have been calculated in the normal way and then for each combination of cash flows they are added together to get the total present value.
It is the probabilities that are multiplied together, which is the normal procedure. The reason is that (for example) since there is a probability of a cash flow of $1M in the first year of 0.1, then this would occur 10 times out of 100. The probability of a cash flow of $2 in the second year is 0.3, and so to get $1M in the first year AND $2M in the second year would happen 0.3 of those 10 time, so 3 times out of a 100, which is a probability of 0.03 of therefore getting a PV of the two which is $2,487M.
To get the expected value, we multiple all by the respective probabilities and add up, as usual.
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