Question

2. Tom Associates is building a new office complex. To pay for the construction Tom Associates is selling a security that will pay the investor the lump sum of $6750 in five years. The current market price of the security is $5896.

a. Assuming that you can earn an annual return of 3.75% on your next most attractive investment, how much is the security worth today?

b. From a financial standpoint, should you invest in the Tom security?

c. Why or why not? - because the cost (market value) of the security is greater than the discounted value of the security future cash flow - because the discounted value of the security future cash flow is greater than the cost of the security

Answer 1

QUESTION a

Using the basic time value of money concept, we would first need to calculate the PV of the future promised cashflow of $6,750 (made after 5 years) at 3.75%.

By basic TVM concept:

FV = PV * (1 + r)ⁿ

6750 = PV * (1 + 3.75%)⁵

PV = 6750/1.2021 = $5,615.17

QUESTION b

Market price quoted for this security is $5,896, which is higher than the intrinsic value that we calculated above. This means it is overvalued. Hence, we should not buy it.

QUESTION c

Don’t Invest – because the cost (market value) of security is greater than the discounted value of security’s future cash flow.