Calculate the maximum price Honeywell should be willing to pay for an investment opportunity
What is the maximum price Honeywell should be willing to pay for an investment opportunity that provides no revenues in the first 4 years but starting at the end of year 5, revenue is expected to be $20,000 per year for 6 years if Honeywell earns 8% on its investment?
Given data:
- No revenues for the first 4 years
- Revenue of $20,000 per year for 6 years starting at the end of year 5
- Discount rate of 8%
Answer:
The maximum price Honeywell should be willing to pay for an investment opportunity under these conditions is nearest to a specific value calculated using the present value of an annuity formula.
To determine the maximum price Honeywell should be willing to pay for the investment opportunity, we need to calculate the present value of the future cash inflows at a discount rate of 8%.
Explanation:
This financial management case involves calculating the present value (PV) of a series of future cash inflows that are discounted at a specified rate. In this scenario, Honeywell will start generating revenues of $20,000 per year for six years beginning at the end of year five. The discount rate is set at 8%, which reflects Honeywell's earnings on investments. With no revenue for the first four years, the value at that point is zero.
The cash inflows of $20,000 will occur annually from the end of year 5 to the end of year 10. As these inflows are uniform and occur at regular intervals, they form an annuity. The present value of an annuity can be calculated using the formula:
PV = C * (1 - (1 + r)^-n) / r
Where:
- C = annuity amount ($20,000)
- r = discount rate (8% or 0.08 as a decimal)
- n = number of periods (6, from year 5 to year 10)
By substituting these values into the formula, we can determine the present value of the cash inflows. However, since these inflows start at the end of year 5, we need to discount this present value back to the present day (year 0). The result will give us the maximum amount that Honeywell should be willing to pay for this investment opportunity today.