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An investment would provide end-of-year annual income of $2,000. The client’s required rate of return is...

An investment would provide end-of-year annual income of $2,000. The client’s required rate of return is 12.5 percent. What price should the client be willing to pay for the investment?

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Answer #1

What price should the client be willing to pay for the investment?

Answer: $16,000

Working

Price the client will be willing to pay for the investment will be the present value of the future returns (i.e. end of year annual income). Since duration of the return is not provided it is considered as perpetual. Formula for calculating Present value of perpetual annuity return is as follows;

Present Value = Annual Income ÷ required rate of return

                        = $2,000 ÷ 0.125

                        = $16,000

Where,

Annual Income = $2,000 (provided in the question)

Required rate of return = 12.5% (I.e. 0.125, provided in the question)

Note: since returns are uniform this is an annuity.

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