2. Time value of money: 13 marksYou have inherited $50,000 from your Great Aunt...

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Accounting

2. Time value of money: 13 marks
You have inherited $50,000 from your Great Aunt Daisy. You havedetermined that you have
two different investment opportunities available to you. The moneycan be placed on deposit
at the bank. The interest rate you can earn is 6% compoundedannually. Alternatively, you
can invest in a business opportunity with Lima’s bakery and receivethe following cash flows
(note: the cashflows are received at the end of each year):
Years 1-2 $10,000 each year
Years 3-4 $12,000 each year
Year 5 $22,000
Required:
(a) Work out the present value of the investment at the bank andthe present value of the
business opportunity with Lima’s bakery using a discount rate of 6%p.a.

(b) (i) Based on your present value analysis, which investmentrepresents the better
opportunity? Why? (1 mark – 50 words maximum)
(ii) Explain why using 6% to calculate the present value of Lima’sbakery opportunity
may not be realistic. (2 marks – 80 words maximum)
(iii) Discuss two other factors you would consider before makingyour final decision.
(2 marks – 80 words maximum)

(c) Discuss how inflation affects your required rate of return.

Answer & Explanation Solved by verified expert

3.7 Ratings (614 Votes)

	Present Value (PV) of Cash Flow:
	(Cash Flow)/((1+i)^N)
	i=Discount Rate=6%=0.06
	N=Year of Cash Flow
	Future Value=
	ALTERNATIVE 1
	Present value (PV) of Deposit at Bank	$50,000
	N	A	PV=A/(1.06^N)
	Year	Cash Flow	Present value
	1	$3,000	$ 2,830
	2	$3,000	$ 2,670
	3	$3,000	$ 2,519
	4	$3,000	$ 2,376
(50000+3000)	5	$53,000	$ 39,605
			$ 50,000
	Business Opportunity
	N	A	PV=A/(1.06^N)
	Year	Cash Flow	Present value
	1	$10,000	$ 9,434
	2	$10,000	$ 8,900
	3	$12,000	$ 10,075
	4	$12,000	$ 9,505
(50000+22000)	5	$72,000	$ 53,803
		SUM	$ 91,717
	Present value of cash Inflows	$ 91,717
	Business Opportunity gives higher present Value
	Hence,Business is better opportunity

(ii)	Business Opportunity involves risks
	6% is riskfree rate
	Hence using 6% rate for business return discounting is not correct
	It should be discounted with riskpremium at higher rate

(iii)	Other factors tobe considered:
	Pay BackPeriod
	InternalRate of Return

.(c)	Real rate of return(Inflation adjusted return)=(Nominalreturn)- Inflation Rate
	Inflation reduces real return
	Hence, if there is inflation, real return will reduce

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In: Accounting2. Time value of money: 13 marksYou have inherited $50,000 from your Great Aunt Daisy....2. Time value of money: 13 marksYou have inherited $50,000 from your Great Aunt Daisy. You havedetermined that you havetwo different investment opportunities available to you. The moneycan be placed on depositat the bank. The interest rate you can earn is 6% compoundedannually. Alternatively, youcan invest in a business opportunity with Lima’s bakery and receivethe following cash flows(note: the cashflows are received at the end of each year):Years 1-2 $10,000 each yearYears 3-4 $12,000 each yearYear 5 $22,000Required:(a) Work out the present value of the investment at the bank andthe present value of thebusiness opportunity with Lima’s bakery using a discount rate of 6%p.a.(b) (i) Based on your present value analysis, which investmentrepresents the betteropportunity? Why? (1 mark – 50 words maximum)(ii) Explain why using 6% to calculate the present value of Lima’sbakery opportunitymay not be realistic. (2 marks – 80 words maximum)(iii) Discuss two other factors you would consider before makingyour final decision.(2 marks – 80 words maximum)(c) Discuss how inflation affects your required rate of return.