QUESTIONS AND ANSWERS ON NET PRESENT VALUE

1. Put the concepts of future value and present value into your own words. How would you explain these
concepts to someone hearing about themfor the first time?

The purpose of this question is to get students to think about the time value of money. By doing so, and by trying
to explain concepts to others for the first time, they come to a better and deeper understanding of the concept
themselves.

2. Explain the difference between compounding and discounting.

Compounding finds the future value of a present value using a compound interest rate. Discounting finds the
present value of some future value, using a discount rate. They are inverse relationships. This is perhaps best
illustrated by demonstrating that a present value of some future sumis the amount which, if compounded using
the same interest rate and time period, results in a future value of the very same amount.

3. Assume someone wishes to have $80,000 ten years fromnow as a college education fund for a child.

a) How much money would have to be invested today at 6 percent compound interest? At 8 percent?

Since compounding and discounting are inverse relationships, this question can be answered by finding the PV of
a $80,000 FV using a 6% discount rate and a 10 year term, which would be: $80,000 0.55839 =$44,671.20
(Appendix Table 4). It can also be solved by setting up the FV equation (Appendix Table 2) and solving for the
unknown, PV.

PV 1.7908 = $80,000, so PV =80,000/1.7908 = $44,672.77

(The differences in the answers are due to rounding in the coefficients.)

For the 8% rate the answers would be $37,055.20 and $37,055.91, respectively.

b) How much would have to be invested annually at 6 percent compound interest? At 8 percent?

This amount can be found by setting up the FV equation for an annuity and solving for the PMT. (Appendix
Table 3)

PMT 13.1808 = $80,000, so PMT =80,000/13.1808 = $6,069.43 for a 6% rate, and

PMT 14.4866 = $80,000, so PMT =80,000/14.4866 = $5,522.34 for the 8% rate.

The answers can be quickly checked by finding the FV of an annuity with a PMT of these amounts.

4. If farmland is currently worth $1,750 per acre and is expected to increase in value at a rate of 5 percent
annually, what will it be worth in 5 years? In 10 years? In 20 years?

This is the FV of a lump sumproblem. The answers are the same as if the $1,750 had been put in a savings
account at 5 percent interest for the specified times. (Appendix Table 2)

5 years: $1,750 1.2763 = $2,233.52
10 years: $1,750 1.6289 = $2,850.58
20 years: $1,750 2.6533 = $4,643.28


5. If you require an 7 percent rate of return, how much could you afford to pay for an acre of land which has annual net
cash revenues of $60 per acre for 10 years, and an expected selling price of $2,500 per acre in 10 years?

Solving this problemrequires finding the present value fromtwo sources of cash flows, the flow of net cash revenues (an
annuity) and the expected selling price, and summing the results.

Present value of annual net cash revenues (Appendix Table 5): $60 7.0236 = $ 421.42
Present value of expected selling price (Appendix Table 4): $2,500 0.50835 = $1,270.87

Total $1,692.29 per acre

The $60 annual net cash return alone does not provide a 7 percent return on the computed payment price. Most of the
required return comes fromthe expected increase in selling price and not the annual earnings of the land.


6. Assume you have only $20,000 to invest and must choose between the two investments below. Analyze each using
all four methods discussed in this chapter and an 8 percent opportunity cost for capital (discount rate). Which
investment would you select? Why?


Investment A ($) Investment B ($)

Initial cost 20,000 20,000
Net cash revenues:
Year 1 6,000 5,000
Year 2 6,000 5,000
Year 3 6,000 5,000
Year 4 6,000 5,000
Year 5 6,000 5,000
Terminal value (year 5) 0 8,000


Payback method: 3.33 years 4 years (A preferred over B)

Simple rate of return: (6,000 - 4,000)/20,000 (5,000 - 2,400)/20,000

=10 percent =13 percent (B preferred over A)

Net present value: $3,956.20 $5,408.14 (B preferred over A)

Internal rate of return: 15.2% 16.3% (B preferred over A

Investment B would be the better investment based on the simple rate of return, the net present value and internal rate of
return methods. While the payback method rates investment A higher, it does not give any consideration to the returns
in later years and, in particular, the terminal value of investment B. Only the last two methods consider all cash flows
over the entire investment period.

7. Discuss economic profitability and financial feasibility. How are they different? Why should both be considered
when analyzing a potential investment?

Economic profitability refers to an investment having a NPV greater than zero and an IRR greater than the
opportunity cost of capital. This means the investment will earn a rate of return at least equal to this opportunity
cost so there will be an economic profit. Cash flow needed to make principal and interest payments are not
included in these analyses because it is assumed that the results are independent of how the investment is
financed. Financial feasibility is concerned with the periodic net cash flows fromthe investment and becomes
particularly important when capital must be borrowed to finance the investment. It is entirely possible for an
investment to be economically profitable but result in negative net cash flows for several time periods. This often
occurs when the loan must be paid off in a relatively short period of time and the investment produces little initial
cash flow but larger flows in later time periods.

8. What two approaches can be used to account for the effects of income taxes in investment analysis?

a) All cash flows can be estimated on a before-tax basis and a tax-free discount rate can be used.

b) All cash flows can be adjusted by the amount by which income taxes would increase or decrease
themand an after-tax discount rate used (before-tax rate multiplied by 1 minus the marginal tax rate).

9. What two approaches can be used to account for the effects of inflation in investment analysis?

a) All cash flows can be estimated as real values (current dollars) and the discount rate used can be a
real rate (subtract the expected rate of inflation fromthe nominal discount rate).

b) All cash flows can be increased over time by their expected rates of inflation and a nominal
discount rate can be used.

10. Why would capital budgeting be useful in analyzing an investment of establishing an orchard where the trees
would not become productive until 6 years after planting?

Many tree and vine crops have several years of expenses with little or no income while the planting reaches its
productive age. There is a serious mismatch in the timing of cash expenses and cash revenue. The only way to
analyze an investment of this type is to use capital budgeting so the timing of all cash flows is taken into account
using an appropriate discount rate or opportunity cost of capital.

11. What advantages would present value techniques have over partial budgeting for analyzing the orchard
investment in question 10?

A partial budget would compare the orchard investment with some other alternative using changes in average
annual expenses and revenues. It would be difficult to estimate average annual expenses and revenues for the
orchard because they are different for every year. To do it correctly, adjustments must be made for differences in
the timing of revenue and expenses. In most cases it will be easier and less time consuming to use present value
techniques on a problemof this type. However, the concept of added and reduced cash flows can also be used
with capital budgeting techniques.