Homework Clinic
Social Science Clinic => Economics => Topic started by: camac77 on Nov 23, 2022
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Comparing Costs and Returns
You and two of your friends are offered the chance to buy a bar. The revenues from the bar have been steady at $120,000 a year for the past six years and are projected to remain steady in the future. The costs (not including opportunity costs) of operating the bar (including maintenance and repair, depreciation, and salaries) have also been steady at $70,000 a year. If five-year Treasury builds are currently yielding 4.75% interest, what is the maximum amount you will pay to buy the bar assuming any cash flows beyond year 5 are uncertain and therefore considered to be worth zero?
Please round your final answer to two decimal places.
◦ $250,000.00
◦ $217,978.05
◦ $600,000.00
◦ $523,147.31
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$217,978.05
To determine the maximum amount you will pay for the bar, you need to compute the present value of the profits (PV) for the bar, at the discount rate (which is the opportunity cost of buying the bar, 4.75% interest on five-year Treasury bills).
At 4.75%:
PV = Profit1/(1+i) + Profit2/(1+i)^2 + Profit3/(1+i)^3 + Profit4/(1+i)^4 + Profit5/(1+i)^5
Before determining the present value, however, you need to compute the profits for the next five years.
Remember, Profit = Revenues - Cost = 120,000 -70,000 = $50,000
Next, find the present value:
PV = 50,000/1.0475 + 50,000/1.0475^2 + 50,000/1.0475^3 + 50,000/1.0475^4 + 50,000/1.0475^5
PV = 47,732.70 + 45,568.21 + 43,501.87 + 41,529.23 + 39,646.04 = $217,978.05
This is the maximum amount you are willing to pay to buy the bar.