John and Sally Claussen are contemplating the purchase of a hardware store from

Question

John and Sally Claussen are contemplating the purchase of a hardware store from John Duggan. The Claussens anticipate that the store will generate cash flows of $73,000 per year for 20 years. At the end of 20 years, they intend to sell the store for an estimated $430,000. The Claussens will finance the investment with a variable rate mortgage. Interest rates will increase twice during the 20-year life of the mortgage. Accordingly, the Claussens’ desired rate of return on this investment varies as follows: Years 1–5 7 % Years 6–10 9 % Years 11–20 11 % Required: What is the maximum amount the Claussens should pay John Duggan for the hardware store? (Assume that all cash flows occur at the end of the year.) (Use PV of $1 and PVA of $1)

Explanation / Answer

## PVF used for year 1-5 @ 7%

## PVF used for year 6-10 = 9%

## PVF used for year 11-20 = 11%

Since present value of cash inflows is $ 6,88,602, Claussens shouldpay maximum $6,88,602 for the hardware store.

Year Cash Flows PVF @ 7%, 9%, 11% PV 0 1 73000 0.935 68224 2 73000 0.873 63761 3 73000 0.816 59590 4 73000 0.763 55691 5 73000 0.713 52048 6 73000 0.596 43528 7 73000 0.547 39933 8 73000 0.502 36636 9 73000 0.460 33611 10 73000 0.422 30836 11 73000 0.317 23162 12 73000 0.286 20866 13 73000 0.258 18799 14 73000 0.232 16936 15 73000 0.209 15257 16 73000 0.188 13745 17 73000 0.170 12383 18 73000 0.153 11156 19 73000 0.138 10050 20 503000 0.124 62389 PV of Cash Inflows 688602

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