You plan to analyze the value of a potential investment by calculating the sum o

Question

You plan to analyze the value of a potential investment by calculating the sum of the present values of its expected cash flows. Which of the following would lower the calculated value of the investment?

A. The cash flows are in the form of a deferred annuity, and they total to $100,000. You learn that the annuity lasts for only 5 rather than 10 years, hence that each payment is for $20,000 rather than for $10,000.
B. The discount rate increases.
C. The riskiness of the investment’s cash flows decreases.
D. None of the above

Explanation / Answer

The answer is B, the discount rate increases. The discount rate is a measure of how much future money is worth in today's dollars. For example, I would rather have a dollar today than a dollar a year from now. Or, said another way, a dollar a year from now is worth less to me than a dollar is today. As the discount rate increases, future money is worth less and less. Therefore, the net present value decreases if the discount rate goes up. It might help using arbitrary numbers for 2 years to illustrate the point. Let's say you are getting a dollar today and a dollar a year from now. If the discount rate is 0%, then the present value is 1+1=2. If the discount rate is 10%, then the dollar a year from now is only worth $0.90 to me today. Therefore, the present value is 1+0.9=$1.9. If the discount rate is 20%, present value is 1+0.8=1.8 and so on.

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