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Suppose you are considering buying an asset that will pay $100 next year, $120 in 2...

Suppose you are considering buying an asset that will pay $100 next year, $120 in 2 years, $140 in 4 years and $500 in 6 years. If the interest rate is 10%, what is the maximum amount of money you should be willing to pay for this asset? Why? Explain clearly and show your work.

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Answer #1

Capital budgeting, or investment decision, depends heavily on forecasts of the cash inflow and a correct calculation of the firm’s cost of capital.1 Given the cost of capital, i.e., the appropriate discount rate, and a reasonable forecast of the inflows, the determination of a worthwhile capital investment is straightforward. An investment is desirable when the present value of the estimated net inflow of benefits (or net cash inflow for pure financial investments) over time, discounted at the cost of capital, exceeds or equals the initial outlay on the project.

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