Bus Week 1 Assignment

A generous university benefactor has agreed to donate a large amount of money for student scholarships. The money can be provided in one lump sum of $12 million in Year 0 (the current year), or in parts, in which $7 million can be provided at the end of Year 1, and another $7 million can be provided at the end of Year 2.

a. Assuming the opportunity interest rate is 8%, what is the present value of the second alternative mentioned above? Which of the two alternatives should be chosen and why?

Opportunity Interest Rate = 8%

Cash inflows in case of 2nd alternative are as follows:

Year 1 = $7 million

Year 2 = $7 million

Present Value = CFt/(1+ Discount Rate)^t

Where CFt = Cash Flow in Year t

Present Value of the 2nd options =

PV = 7/ (1.08) + 7/ (1.08) ^2 = $12.48 million

1st altenative the PV of payments received equals $12 million versus option 2 the PV of the payments equals $12.48 million. Present Value of 2nd alternative is more favorable since it is higher.

How would your decision change if the opportunity interest rate is 12%?

New Opportunity Interest Rate = 12%

Present Value of the 2nd =

PV = 7/ (1.12) + 7/ (1.12) ^2 = $11.83 million

Present Value of payments received under the 2nd alternative is lower than the Present Value of the payment received under the 1st alternative ($12 million). Consequently the 1st alternative should be chose if the opportunity interest rate is 12%.

c. Provide a description of a scenario where this kind of decision between two types of payment streams applies in the “real-world” business setting

A real-world example of decision making based on Present Value of cash flows is the sale of land. The business owner has the two options of either receiving the full payment of $180,000 today or receive $250,000 at the end of two years. In such scenarios the business owner should use the Present Value of Money formula to identify which alternative has...