570 Chapter 14 Evaluating Projected Cash FlowsA Few Words of Caution
The intent of this chapter is to give you a basic understanding of how some of the mathematical
tools we have been using for the time value of money can be used to place a value on future
profits from a business. You should absolutely not mistake this for a thorough or comprehen-
sive discussion of a very complicated subject. Readers who are interested in pursuing these
ideas further will find that a thorough approach to making financial projections and determin-
ing present values for them presents an interesting, but challenging, endeavor.
It also should be understood that the approach of this section takes into account only the
projected profits from a business venture. These need not be the only consideration. If the
bowling alley is located in an area with a hot commercial real estate market, an investor might
be interested in buying the business in the hopes of selling the property for some other use at
a high profit; we were only looking at it based on the profits it can make as a bowling alley.
We also did not take into account the risks of a business; the high-growth solar installa-
tion business might be at a greater risk of failure than the established bowling alley, though
our calculations made no distinction between the two based on this risk. Lastly we also did
not take into account anything other than the profits themselves. A passionate bowler, or a
passionate advocate for renewable energy, might value one business more highly than the
other regardless of the profits either one is expected to earn.
The bottom line here is that, while the examples and techniques presented in this section and
further developed in the exercises are illustrative of one approach to putting a value on a business,
they are by no means the final word. Take them as an indication, not an authoritative absolute.EXERCISES 14.1
A. Present Values and Financial Projections- Suppose you require an 8% rate of return. Which investment would you prefer, using the present value method: one
that pays $50,000 in a lump sum 2 years from now, or one that pays $8,500 per year for the next 7 years? - Suppose you require a 15% rate of return. Which investment would you prefer, using the present value method: one
that pays $50,000 in a lump sum 2 years from now, or one that pays $8,500 per year for the next 7 years? - If you require a 6.5% rate of return, would you rather receive $4,000 in 3 years or $7,500 in 10 years?
- If you require a 7.25% rate of return, would you be happier with $20,000 fi ve years from now or $50,000 eighteen
years from now?
B. Perpetuities- Find the present value of payments of $15,000 per year extending indefi nitely into the future, assuming an 8% rate.
- Find the present value of payments of $23,500 per year extending indefi nitely into the future, assuming a 6.5% rate.
- By moving its factory to a new location closer to a railroad line, a manufacturing company believes that it can save
$200,000 in transportation costs each year for the foreseeable future. If it requires an 8% rate of return, what is the
present value of this cost savings? If the move would cost $4,000,000, is it fi nancially justifi ed by this savings?