Describe the determinants of the discount factor

Reference no: EM131153078

Module - Home

Present Value

Modular Learning Outcomes

Upon successful completion of this module, the student will be able to satisfy the following outcomes:

•Case ?Explain the concept of present value.
?Calculate the present value of a future stream of income.
?Describe the determinants of the discount factor.
?Explain the determinants of present value.

•SLP ?Explain the concept of present value.
?Describe the determinants of the discount factor.
?Explain the determinants of present value.

•Discussion ?Explain the concept of present value.
?Describe the determinants of the discount factor.

Module Overview

In order to value assets such as stocks, bonds, or investment projects, you need to be able to place a value on payments that you will receive in the future. If you as a financial manager with to invest in some new equipment, you need to be able to place a value on the total amount of additional profits your company will receive over the next several years due to this new purchase.

In general, people prefer to have money paid to them today rather than tomorrow. The value of one dollar today is exactly one dollar. But what about being paid one dollar exactly one year from now? Would you pay a dollar for the that dollar to be paid to you in one year? Definitely not! Of course you pay significantly less than one dollar for a promise of being paid one dollar in the future. Inflation is just one factor that you would have to consider when you decide how much you should pay for the promise of a future dollar to be paid to you. The amount you are willing to pay for income to be paid in the future is called the present value.

Most assets, such as stocks and bonds, provide payoffs not today but in the distant future. This is the same with an investment project a corporation takes on, including equipment or other big purchases. But in order to make decisions that affect your payoffs in the future, you have to be able to estimate the present value of these future payoffs.

Note: It will be helpful to you if you use an Excel spreadsheet for the computations of present values.
Module 2 - Case

Present Value

Assignment Overview

NOTE: This assignment is in two parts, one is quantitative problem, the other a short paper. You need to turn in both Part I and Part II to receive full credit for this assignment.

Part I: This part of the assignments tests your ability to calculate present value.

A. Suppose your bank account will be worth $15,000.00 in one year. The interest rate (discount rate) that the bank pays is 7%. What is the present value of your bank account today? What would the present value of the account be if the discount rate is only 4%?

B. Suppose you have two bank accounts, one called Account A and another Account B. Account A will be worth $6,500.00 in one year. Account B will be worth $12,600.00 in two years. Both accounts earn 6% interest. What is the present value of each of these accounts?

C. Suppose you just inherited an gold mine. This gold mine is believed to have three years worth of gold deposit. Here is how much income this gold mine is projected to bring you each year for the next three years:

Year 1: $49,000,000

Year 2: $61,000,000

Year 3: $85,000,000

Compute the present value of this stream of income at a discount rate of 7%. Remember, you are calculating the present value for a whole stream of income, i.e. the total value of receiving all three payments (how much you would pay right now to receive these three payments in the future). Your answer should be one number - the present value for this gold mine at a 7% discount rate but you have to show how you got to this number.

Now compute the present value of the income stream from the gold mine at a discount rate of 5%, and at a discount rate of 3%. Compare the present values of the income stream under the three discount rates and write a short paragraph with conclusions from the computations.

Part II: Read the following three sample business plans:

Ice Dreams

R J Wagner & Associates Realty

Interstate Travel Center

Which of these three projects do you think should have the highest risk from the point of view of investors (potential providers of funds) and would therefore be evaluated using the highest discount rate? Which one do you think should have the lowest? Write a paper explaining your reasoning.

In your assessment of the business plans consider the possible risk of each plan. Risk is one of the main considerations when deciding whether a plan should be evaluated and discounted to present value using a high or a low discount rate.

Note: you are not expected to fully analyze the numbers and financial statements in these business plans. There are only forecasts and projections. Nobody really believes them anyway. Use your intuition rather than calculations to assess risk and potential of each of these plans.

Assignment Expectations

Turn in both Part I and Part II in one Word document when completed. Part I should be two pages long and contain your calculations. Part II should be two pages long.

Module 2 - SLP

Present Value

One specialized type of security is called an equity futures. This is a contract that guarantees you a share of a particular company to be delivered to you not today, but sometime in the future, at a price that is determined by the market right now. This price is usually called the futures price of the stock (note - the term is plural - "futures"). If you 'buy' this futures, you don't pay for the shares now. You are actually signing a contract whereby you are committed to pay that price in a particular date in the future, and you are guaranteed to receive one share of the company at that time, irrespective of its actual market price at that future date. Suppose for example that the futures price of the XYZ company is $40. Suppose you 'buy' a 6-months futures contract. If six months later the share price is $45, you gain $5 per share. If the market price in 6 months is only $35, then you lose $5.

Using the Yahoo Finance take a look at the five year chart for your reference company (the one you chose for SLP1). Using this chart and other information you can find on this company, write a paper answering the following question:

What do you think would the futures price of 100 shares of your reference company to be delivered to you in one year be right now?

SLP Assignment Expectations

The paper is to be two pages long. You DO NOT need to use complex mathematical formulas for this assignment. Instead, think about how much do you think the market value of 100 shares of your company will be in one year? In considering the possible answer please reflect also on the following:

Do you expect the price of the shares in one year to be much higher? Or lower? Or only a little bit higher?

How risky the stock is. Is its price prone to wild swings up and down? Or has the price been relatively stable the last few years?

What alternative investments you have access to. What rate does your bank give you on a savings account or certificate of deposit? The greater return you can get on other investments, the less you would be willing to pay for an equity future.

Reference no: EM131153078

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