Question

Imagine we are in a world where there are many years in the future. Ann is made an offer to buy a factory that will cost $1000 today but will earn $500 next year, and $600 two years from now. Show what you need to compare to know if this is a good deal for Ann. Assume interest rate is r.

Use the equation: Present Value = Future Value / ((1+r) ^ t)

t=time and r=interest rate

Answer 1

Answer :

Cost of the factory today = $1000 (Thus negative or cash outflow)

Cash inflow after 1 year from now = $500

Cash inflow after 2 years from now = $600

In order to understand whether this is a good deal or not, we need to calculate the net present value of this deal.

For that we need to discount the given future cash inflows to understand their present value. In order to do that one needs the discount rate which let us assume is = r

Now : NPV = -$1000 / (1+r)^0 + $500 / (1 + r)^1 + 600 / (1 + r)^2

Using the given discount rate in the market one can come to a value of this NPV. If this value is greater than zero then that would imply that it is a good deal and a profitable one.

NPV > 0 (good deal and profitable thus should be accepted)

NPV < 0 (not a good deal and thus should not be accepted)