You have just received a sales brochure from a reputable investment firm which describes a financial investment vehicle which pays $300 at the end of year 1,
$500 at the end of year 2 and $100 at the end of year 3. If you are looking for an annual return of 6%, what's the maximum amount you should be willing to purchase this investment certificate for?
Click on the arrows to vote for the correct answer
A. B. C. D.D
The maximum amount you should pay equals the present value of the payments (you would like to pay less!). This equals 300/1.06 + 500/(1.06^2) + 100/(1.06^3)
= $812.
To determine the maximum amount you should be willing to purchase this investment certificate for, we need to calculate the present value of the cash flows and compare it to the purchase price.
The present value (PV) of future cash flows is calculated using the formula:
PV = CF₁/(1+r)¹ + CF₂/(1+r)² + CF₃/(1+r)³ + ...
Where: PV = Present value CF₁, CF₂, CF₃ = Cash flows in each year r = Discount rate (annual return)
Given: CF₁ = $300 CF₂ = $500 CF₃ = $100 r = 6% = 0.06
Now let's calculate the present value of the cash flows:
PV = $300/(1+0.06)¹ + $500/(1+0.06)² + $100/(1+0.06)³
PV = $300/1.06 + $500/1.06² + $100/1.06³ PV = $283.02 + $443.22 + $83.14 PV = $809.38
Therefore, the present value of the cash flows is $809.38.
The maximum amount you should be willing to purchase this investment certificate for is equal to the present value of the cash flows. Among the provided answer choices, the closest value to $809.38 is option D, $812. Therefore, the correct answer is option D, $812.