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Mr A is assesing a project in which the first four annual lease payments has been agreed at $120,000. This is payable in one year time subsequent payments will rise by 4% per annum. His money cost of capital is 8%.
What is the present value of Mr A lats payment hat will be made in 4 years time nearest to ‘000?
Answer-
Cash flow-120,000×1.043 the power 3 = $134984
Preset value = 134984/1.08 the power 4 = $99,217
Answer to the nearest thousand is 99000.Could you please explain this, its very simple question I know, I can’t get my head around this one.
Thanks
First we calculate the actual/nominal cash flow in 4 years time and to do this we multiply the amount by 1.04 each each year to inflated it. $120,000 is the actual payment in 1 years time, so the payment in 4 years time (i.e. 3 years later) will be 120,000 x 1.04^3 = $134,984
To get the PV of this amount we discount for 4 years at the money/nominal cost of capital of 8%. You can either multiply by the 4 year discount factor from the tables (which is the most sensible way to do it) or alternatively calculate the discount factor yourself in the normal way which is 1/(1.08^4).
You really must watch my free lectures because there is almost always a full Section C question in the exam on discounting with inflation.
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