April 3, 2019

CHAPTER 6

DISCOUNTED CASH FLOW VALUATION

Answers to Concepts Review and Critical Thinking Questions

1. The four pieces are the present value (PV), the periodic cash flow (C), the discount rate (r), and the number

of payments, or the life of the annuity, t.

2. Assuming positive cash flows, both the present and the future values will rise.

3. Assuming positive cash flows, the present value will fall and the future value will rise.

4. It’s deceptive, but very common. The basic concept of time value of money is that a dollar today is not

worth the same as a dollar tomorrow. The deception is particularly irritating given that such lotteries are

usually government sponsored!

5. If the total money is fixed, you want as much as possible as soon as possible. The team (or, more

accurately, the team owner) wants just the opposite.

6. The better deal is the one with equal installments.

7. Yes, they should. APRs generally don’t provide the relevant rate. The only advantage is that they are easier

to compute, but, with modern computing equipment, that advantage is not very important.

8. A freshman does. The reason is that the freshman gets to use the money for much longer before interest

starts to accrue. The subsidy is the present value (on the day the loan is made) of the interest that would

have accrued up until the time it actually begins to accrue.

9. The problem is that the subsidy makes it easier to repay the loan, not obtain it. However, ability to repay

the loan depends on future employment, not current need. For example, consider a student who is currently

CHAPTER 6 B-69

10. In general, viatical settlements are ethical. In the case of a viatical settlement, it is simply an exchange of

cash today for payment in the future, although the payment depends on the death of the seller. The

purchaser of the life insurance policy is bearing the risk that the insured individual will live longer than

expected. Although viatical settlements are ethical, they may not be the best choice for an individual. In a

policy.

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps.

Due to space and readability constraints, when these intermediate steps are included in this solutions manual,

rounding may appear to have occurred. However, the final answer for each problem is found without rounding

during any step in the problem.

Basic

1. To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a lump sum,

we use:

PV = FV / (1 + r)t

2. To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)]t } / r )

At a 5 percent interest rate: