Company Z is offering 2 possible investments with the same level of risk. Invest

Question

Company Z is offering 2 possible investments with the same level of risk. Investment A is a perpetuity. with the first cash flow, of $100.00 per year, coming in one year. Investment B is also a perpetuity, paying $100.00 per year, but its first cash flow occurs in two years.

(a) Which investment is more valuable today ? Why ?

(b) Suppose that the difference in today's prices of Investment A and Investment B is $93.46. What discount rate are investors using to value the investments? Show calculation.

Explanation / Answer

for investment A

supposee discount rate is r%

PV1 = 100/r ..................(1)

for invest ment B

PV2 = 100/((r)*(1+r)).............(2)

for equation 1 and 2

investment 1 is more valuable

b)

now,

PV1-PV2 = 93.46

(100/r)-(100/((r)*(1+r)) = 93.46

100/(1+r) = 93.46

1+r = 100/93.46

r = 6.99% = 7% (approx)

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