Which Investment is More Favorable Based on Present Value Calculation?

What are the present values of Investment A and Investment B when using a 5% discount rate? How do we determine which investment is more favorable based on the present value calculations?

Calculating Present Values with a 5% Discount Rate

Investment A and Investment B are expected to generate different annual cash flows over a period of 5 years. By using a discount rate of 5%, we can determine the present value of each cash flow for both investments. Present Value Calculation for Investment A: Year 1: PV = $1000 / (1 + 0.05)^1 = $952.38 Year 2: PV = $2000 / (1 + 0.05)^2 = $1814.06 Year 3: PV = $3000 / (1 + 0.05)^3 = $2592.88 Year 4: PV = $4000 / (1 + 0.05)^4 = $3290.43 Year 5: PV = $5000 / (1 + 0.05)^5 = $3910.02 Present Value Calculation for Investment B: Year 1: PV = $5000 / (1 + 0.05)^1 = $4761.90 Year 2: PV = $4000 / (1 + 0.05)^2 = $1449.28 Year 3: PV = $3000 / (1 + 0.05)^3 = $1723.69 Year 4: PV = $2000 / (1 + 0.05)^4 = $1304.95 Year 5: PV = $1000 / (1 + 0.05)^5 = $783.53

Determining the More Favorable Investment:

To compare the investments, we sum up the present values for each investment: Investment A: $952.38 + $1814.06 + $2592.88 + $3290.43 + $3910.02 = $12,559.77 Investment B: $4761.90 + $1449.28 + $1723.69 + $1304.95 + $783.53 = $10,023.35 Based on the present value calculations, Investment A has a higher total present value ($12,559.77) compared to Investment B ($10,023.35). Therefore, Investment A is more favorable in terms of cash flows when using a 5% discount rate.

Investment A has a higher present value ($12,559.77) compared to Investment B ($10,023.35) when using a 5% discount rate. This means that Investment A is more favorable in terms of cash flows over the 5-year period analyzed. The present value calculation takes into account the time value of money, reflecting the worth of future cash flows in today's terms. By discounting the cash flows at a rate of 5%, we can determine the present value of each investment and compare their attractiveness. In this case, Investment A offers a higher total present value, making it the more lucrative choice between the two investments.

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