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    Calculating which investment option has the higher present value

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    Investment X offers to pay you $2,000 per year for 10 years, whereas Investment Y offers to pay you $4,000 per year for 4 years. Which of these cash flow streams has the higher present value if the discount rate is 5%? If the discount rate is 15%?

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    Solution Preview

    Refer to the attachment for the complete solution.

    There are two ways you could go about this problem:

    1) you could discount back one period at a time, or
    2) you could calculate the present values individually and then add them up.

    For purposes of illustration, I'll demonstrate calculating the present values than adding them all up.

    Remember - the present value of a cash flow is the future value multiple by 1/1+Discount Rate.

    Let's say for example you had investment Z, this investment will give you 3 payments of 5,000 for 3 years. Let's assume the discount rate 15%.

    The cash flows would be as ...

    Solution Summary

    The solution presents very clear instructions for how to calculate the present value of a future stream of payments. Two methods are mentioned; one is demonstrated. Then the set up for the problems in this posting are done and explained.