Suppose a third project will cost $20,000 today and yield a return of $2,500 a year indefinitely. What is the present value of the project? What is the present value if the interest rate increases...

Suppose a third project will cost $20,000 today and yield a return of $2,500 a year indefinitely. What is the present value of the project? What is the present value if the interest rate increases to 20%?

Seeing $2500 a year is a perpetuity, as it continues indefinitely, assume the interest rate to be 8%.

Asked on by racin3

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gsenviro | College Teacher | (Level 1) Educator Emeritus

Posted on

That is correct.

The PV of a perpetuity with interest rate of r is given as PV = C/r

where C is the yearly return. 

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gsenviro | College Teacher | (Level 1) Educator Emeritus

Posted on

a correction on scenario 2, the calculations are wrong.

Correct calculations,:

Scenario 2: PV = -20,000 + 2500/(0.2) = -20,000 + 12500 = -$7,500

The outcome is still unfavorable due to high interest rate.

sorry about the error....

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racin3 | (Level 1) Honors

Posted on

I think I'm still confused.

As I understood, the present value of receiving a sum each year forever equals  the amount received each year divided by the interest rate?

When trying to figure this, I used the formula;

Present value of receiving M dollars

each year forever = M (dollars) / I (interest) 

gsenviro's profile pic

gsenviro | College Teacher | (Level 1) Educator Emeritus

Posted on

The present cost = $20,000

The PV of scenario 1 = - 20,000 + 2500/(0.08) = $11,250

For scenario 2, PV = -20,000 + 2500/(0.2) = -$15,000

(using the formula for PV of a perpetuity, PV = C/r, where C is the annual return and r is the rate of interest).

So, in this case, scenario 2, with a higher interest rate is not a favorable outcome, i.e. an increase in interest rate will reduce the PV of the perpetuity.

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