One of the basic financial principles is that the value of any asset (whether it

Question

One of the basic financial principles is that the value of any asset (whether it be a stock, a bond, or a firm as a whole) is the present value of that asset’s future cash flows. As you learned in this chapter, finding present values requires determining a discount rate. Assume you want to buy a business, and you want to find the present value of its future cash flows. Name at least one variable you should consider in determining the correct discount rate to use and explain its role in discount rate determination. If possible, try to identify a variable that has not yet been mentioned by your classmates.

Explanation / Answer

As we know for calculating present value of future cash flows we have to adjust future cash flows with a suitable discount rate because it helps in knowing real value of future cash flows in present time.

So as per requirement of the question let’s understand the important variables that need to considering while choosing a discount rate. So I am discussing here 2 main variables;

1. First of all we will select a suitable interest rate that refers to overall interest rate and we need to calculate periodic interest rate in decimal form because future cash flows need to be divided by such decimal interest rate to know actual present value of future cash flows. For example if interest rate is 10% then we will convert it to decimal form like .10 and then future cash flows will be divided by (1 + .10) = 1.10

2. We also need to know total number of period like is you receive future cash flows in coming 4 years and cash flows is received on semiannual basis then total number of period will be (4 * 2) = 8

Related Questions

Navigate

• Browse (All)
• Browse O
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.