Question

The present value of a capital asset is the sum obtained after discounting the expected future yields over its entire life at the market rate of interest.

Short answer

Answer: The process to determine the present value of a capital asset involves four steps: 1) estimating the expected future cash flows (yields) over the entire life of the asset, 2) determining the appropriate market rate of interest to be used as the discount rate, 3) using the discount rate to calculate the present value of each cash flow, and 4) summing up the present values of all cash flows to get the total present value of the capital asset. This process helps investors assess the attractiveness of potential investments considering the time value of money and the opportunity cost of capital.

Step-by-step solution

1. Understanding Present Value

The present value (PV) is the current value of a future cash flow, considering the time value of money. In simpler terms, it tells us how much a cash flow or series of cash flows in the future is worth in today's terms. The concept of present value is essential in finance and investment decisions, as it helps us to compare different alternatives with cash flows occurring at different periods.

2. Discounting Future Yields

Discounting is the process of calculating the present value of future cash flows, considering the time value of money. The time value of money means that a dollar received today is worth more than a dollar received in the future because the money received today can be invested to earn a return. The discount rate is the rate used to convert future cash flows to their present value. This can be represented by the equation: PV = FV / (1 + r)^n where PV is the present value, FV is the future value, r is the discount rate, and n is the number of periods.

3. Market Rate of Interest

The market rate of interest is the rate of return required by an investor in the market. It is used for discounting future payments, representing the current opportunity cost of capital. The opportunity cost of capital is the rate of return that an investor foregoes by investing in a specific project or asset instead of an alternative investment with the same level of risk.

4. Present Value of a Capital Asset

The present value of a capital asset is the sum of the present values of its expected future yields over its entire life, discounted at the market rate of interest. To calculate it, we can follow these steps: 1. Estimate the expected future cash flows (yields) over the entire life of the asset. 2. Determine the appropriate market rate of interest to be used as the discount rate. 3. Use the discount rate to calculate the present value of each cash flow. 4. Sum up the present values of all cash flows to get the total present value of the capital asset. By following these steps, we can estimate the present value of a capital asset and evaluate investment decisions based on this information. The present value concept helps investors assess the attractiveness of potential investments, considering the time value of money and the opportunity cost of capital.