Question

A consultant commented that “too often the numbers look good but feel bad.” This comment often stems from estimation error common to capital budgeting proposals that relate to future cash flows. Three reasons for this error often exist. First, reliably predicting cash flows several years into the future is very difficult. Second, the present value of cash flows many years into the future (say, beyond 10 years) is often very small. Third, personal biases and expectations can influence present value computations.

Required

1. Compute the present value of $100 to be received in 10 years assuming a 12% discount rate.

2. Why is understanding the three reasons mentioned for estimation error important when evaluating investment projects? Link this response to your answer for part 1.

Short answer

The present value of $100 is $32.2 and the three reasons are stated in step 2 of the solution.

Step-by-step solution

Step-by-Step SolutionStep 1: Computation of net present value of $100

$$\begin{gathered} \mathbf{Present}\mathbf{}\mathbf{Value}\mathbf{}\mathbf{of}\mathbf{}\mathbf{\$}\mathbf{100}\mathbf{=}\mathbf{Amount}\mathbf{\times }\mathbf{PV}\mathbf{\text{}}\mathbf{factor} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{100}\mathbf{\times }\mathbf{0}\mathbf{.}\mathbf{322} \\ \mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{}\mathbf{=}\mathbf{\$}\mathbf{32}\mathbf{.}\mathbf{2} \end{gathered}$$

Understanding the three reasons mentioned for estimation error

The three reasons which are common to capital budgeting proposals that relate to future cash flows are as follows:

1. It seems to be difficult to predict reliable future cash flows

2. The present value of cash flows many years into the future.

3. It is a very difficult task for personal biases and expectations not to influence present value calculations.