Question

What is the maximum amount you would pay for an asset that generates an income of $150,000 at the end of the first year and increases by $25,000 for each year for five years if the opportunity cost of using funds is 10 percent?

Answer 1

The maximum price paid for the asset is the sum of the present values of the income it generates over five years, discounted back at a 10% opportunity cost.

Step-by-step explanation:

Calculating the Maximum Price for an Asset

To calculate the maximum price you would pay for an asset that generates increasing income over a period, you need to discount each income amount back to its present value. Given an opportunity cost of 10%, the cash flows are $150,000 in the first year increasing by $25,000 each subsequent year for five years. To find the present value, each amount is divided by (1 + 0.10)^n, where n is the number of years into the future the cash flow occurs.

• Year 1: $150,000 / (1 + 0.10)^1
• Year 2: $175,000 / (1 + 0.10)^2
• Year 3: $200,000 / (1 + 0.10)^3
• Year 4: $225,000 / (1 + 0.10)^4
• Year 5: $250,000 / (1 + 0.10)^5

The sum of these present values would give the maximum price you'd be willing to pay for the asset to achieve a 10% return on your investment.