Question

3

An investment, which has an expected return of 9.5%, is expected to make annual cash flows forever. The first annual cash flow is expected in 1 year and all subsequent annual cash flows are expected to grow at a constant rate of 2.5% per year. We know that the cash flow expected in 1 year from today is expected to be $4,500. What is the present value (as of today) of the cash flow that is expected to be made in 3 years from today?

a.

$3,600.96 (plus or minus $10.00)

b.

$3,943.05 (plus or minus $10.00)

c.

$4,390.24 (plus or minus $10.00)

d.

$3,690.98 (plus or minus $10.00)

e.

None of the above is within $10.00 of the correct answer

Answer 1

Ans:- Present Value (PV) = Future Value (FV) / (1+r)^n, where r is the rate of return or discount rate, and n is the number of periods.

FV at the end of year 1 will be $4,500

FV at the end of year 2 will be $4,500*(1+g),where g is the growth rate = $4,500*(1+2.5%)

FV at the end of year 3 will be $4,500*(1+2.5%)^2

Now the PV = $4,500*(1+2.5%)^2 / (1+9.5%)^3 = $3,600.96 (approx).

Therefore, the Present Value for the expected cash flow is $3,600.96. option (a) is the right answer.

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