Problem 3-A24:Time Value, Uneven Cash Flow

Max Bok was in the business of mining graphite rocks in the hill sides of Bukidnon. Due to erratic weather, the condition of equipment and limited availability of skilled labor, he expected the following pattern of net cash flows from his business.

YEAR 0 1 2 3 4

NET CASH FLOWS (Pesos) (40, 000) 25, 000 40, 000 (10, 000) 30, 000

Bok would like to know whether the cash flows justified his going on with the business. Alternatively, he could invest the P40, 000 he held now in a time deposit account to yield 12 percent after tax. Bok was hoping to retire with a tidy sum of money at the end of four (4) years. a. What is the present value of the business cash flows? b. How much is the tidy sum of money that awaits Bok at the end of four (4) years? c. Determine the equal amount of annual cash flows that is equivalent to the above cash flow. d. Should Bok pursue the business or deposit his money in the bank?

Answer:
a. The present value of the business cash flow is 40, 000.00 b. The tidy sum of money that awaits Bok at the end of four (4) years Investment = 40, 000.00 With an interest rate of 12 % after tax

Year 1

Year 2

Year 3

Year 4

40, 000.00 (12%) = 4, 800.00 44, 800.00 (12%) = 5,376.00 50, 176.00 (12%) = 6,021.12 56, 197.12 (12%) = 6, 743.65

Investment: 40, 000.00 at 12 % interest (compounding) Time Year 1 Year 2 Year 3 Year 4 Future Value 40, 000.00 x (1 + 12 %) = 44, 800.00 x (1 + 12 %) = 50, 176.00 x (1 + 12 %) = 56, 197.00 x (1 + 12 %) = Total 44, 800.00 50, 176.00 56, 197.00 62, 940.77 62, 940.77

Total earnings at the end of four (4) years:

62, 940.77 is the tidy sum of money that awaits Bok in four (4) years. When interest is left in the account to earn additional interest, the investment is said to earn compounded interest. c. Year one (1) d. It would be a wise decision for Bok to set down his money in the bank as time deposit instead of pursuing his business plan. It was clearly shown on the data below that his investment will earn more if he deposits his money at the bank compare to laying up his money on the business. Boks money will earn an interest of 22, 940.17

Business Cash Flow (inflows) Earnings vs. Time Deposit Earnings:

Expected pattern of net cash flows from his business.

Net Cash Flow Year 0 1 2 3 4 Total earnings at the end of four (4) years: (40, 000.00) 25, 000.00 40, 000.00 (10, 000.00) 30, 000.00 45, 000.00

45, 000.00 Total earnings at the end of four (4) years of business venture

40, 000.00 initial investment 5, 000.00 -- profit of 40, 000 at the end of four years

Earnings in setting the money as Time Deposit Investment: 40, 000.00 at 12 % interest (compounding) Time Year 1 Year 2 Year 3 Year 4 Future Value 40, 000.00 x (1 + 12 %) = 44, 800.00 x (1 + 12 %) = 50, 176.00 x (1 + 12 %) = 56, 197.00 x (1 + 12 %) = Total 44, 800.00 50, 176.00 56, 197.00 62, 940.77 62, 940.77

Total earnings at the end of four (4) years:

62, 940. 77 Total earnings at the end of four (4) years -40, 000.00 - Initial investment 22, 940.77 - Interest earned at the end of four (4) years