Cash Flow Example 2 Present value as function of interest rate

1. Year 0 1 2 3 4 Sum Project A -1 000 420 420 420 420 680 Project B -1 700 650 650 650 650 900 Project C - 850 580 400 300 100 530 Cash Flow Example 2Present value as function of interest rate As shown in the table, we have three projects A,B and C. The table shows the cash flow for each year from year 0 to year 4. All sums are given in 1000 NOK. We see that all projects have negative cash flow in year 0. We consider this year as the investment year. In the right side of table we see sum of cash flows for each of projects. Which project do you prefer to choose? (Look from a pure economic viewpoint) Http://www.prosjektledelse.ntnu.no

2. PRESENT VALUE (1000 NOK) 900 PROJECT B 800 700 PROJECT A 600 500 400 PROJECT C 300 200 100 0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 % Year 0 1 2 3 4 Sum - Discount Factor 1,00 0,91 0,83 0,75 0,68 INTEREST RATE Discounted Amount -1 000 382 349 315 286 332 We see that with annual payments happening at the end of each year, the present value of project A by an interest rate on 10% becomes 332000 NOK. We look at annual payments of ??. Present value of project A with interest rate of 10% becomes 332000 NOK. With similar calculation at interest rate of 20%, the present value of project A becomes 87000 NOK. We calculate the present value for different interest rates. We can plot them in a diagram. We see that the choice of interest rate becomes crucial. The interest rate is the minimum return that is demanded for project. That’s why it is often set equal to market interest. We see that the choice of interest rate becomes crucial. The figure demonstrates the present value as function of interest rates. With interest rate of for example 16% we will choose project C that has the largest present value among three projects. With interest rate of for example 6%, we will choose project B that has the largest present value among three projects. Http://www.prosjektledelse.ntnu.no