Question

You have the opportunity to invest in a coffee house. The managers plan to pay a dividend at the end of one year. After analyzing the history of this establishment you conclude that you have a 5% chance of receiving a $2000 dividend, a 25% chance of receiving a $1500, a 35% chance of receiving a $1000 dividend, and a 35% chance of receiving nothing. At a rate of return (discount rate) of 7% per annum, what is the expected future value of this investment? What is the expected present value of the investment?

Answer 1

A) The Expected future value of the investment is calculated by

Expected return = W1R1 +W2R2+W3R3+....WNRN

Where W1 is the weight for first probability and R1 is the return expected of it

W2 is the weight of second probability and R2 is the return expected for it and so on

So, we have given 5% chance of receiving a $2000 dividend, a 25% chance of receiving a $1500, a 35% chance of receiving a $1000 dividend, and a 35% chance of receiving nothing

Expected Return = 5%*2000 + 25%*1500 + 35%*1000 + 35%*0

Expected Future value = $825

B) ) Now, We have given that the future value if investment is $825 which is after 1 year, so to calculate present value of it, we will discount it by discount rate 7%

Present value = Future value / (1+rate)^number rof year

= 825 / (1+7%)^1

= 825 / 1.07

Present value =$771.02