Question

You have a choice of accepting either of two 5-year cash flow streams or lump-sum amounts given

End of year Cash flow stream

Alternative I Alternative II

1 $ 7,000 $ 11,000

2 7,000 9,000

3 7,000 7,000

4 7,000 5,000

5 7,000 3,000

Lump-sum amount

At time zero (t = 0) $28,250 $28,000

Assuming 10 per cent required rate of return, which alternative (I or II) and in which form (Cash flow or lump-sum) would you prefer and why?

Answer 1

Required Return = 10%

Alternative I:

Present Value of Cash Flows = $7,000/1.10 + $7,000/1.10^2 + $7,000/1.10^3 + $7,000/1.10^4 + $7,000/1.10^5
Present Value of Cash Flows = $26,536

Present value of cash flows is lower than the lump-sum payment.

Alternative II:

Present Value of Cash Flows = $11,000/1.10 + $9,000/1.10^2 + $7,000/1.10^3 + $5,000/1.10^4 + $3,000/1.10^5
Present Value of Cash Flows = $27,975

Present value of cash flows is lower than the lump-sum payment.

Lump-sum payment of alternative I is higher than that of alternative II. So, we should choose lump-sum payment of alternative I.