2581-Advanced Financial Management-2425_S2

For project 1, the question states that the first positive cash flow occurs 3 years from now and grows at 0.5% forever. When a cash flow is expected to occur forever, the Present Value is calculated using the perpetuity formula.

Here, some students ask why the discounting period in the perpetuity formula is 2 years instead of the 3 years stated in the question. The answer is that the perpetuity formula provides the PV of a stream of CFs, where the first CF occurs at the end of the first year.

Thus, when applying the formula to the CF of 10,000 in 3 years, the perpetuity formula gives the value in the year before, that is, in year 2. Therefore we then discount 2 periods to get the PV at t=0.

For project 2, it is stated in the question that cash flows will start in year 3 and will grow at 2.5% for three years (i.e. from year 3-4, 4-5, and 5-6). Students have asked why the annuity has been powered to 4, despite the cash flows only growing during the next 3 years.

The logic behind powering the annuity to 4 years is that there is a cash flow in year 3 itself as well, and so in total there are 4 periods in which the CFs are expected to be received. Hence, we are going to consider the year 3, year 4, year 5 and year 6 CFs to arrive at the annuity value.

Students may be confusing the period here, as in some other exercises we have only taken into consideration the CFs in the years when there is growth and the initial CF is discounted separately when it does not have growth.