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Cash Flow and Fair Market Value: Unveiling the Worth of Your Money
Cash Flow and Fair Market Value: Unveiling the Worth of Your Money
In previous lessons, we focused on annuities as a series of payments. Now, let's broaden our perspective and explore the concept of cash flow, which encompasses all inflows and outflows of cash in a given situation. We'll also delve into fair market value, which represents the price a willing buyer and seller would agree upon in a fair market.
Get ready to:
Define cash flow and fair market value, understanding their significance in financial decision-making.
Analyze cash flow streams, identifying patterns and calculating their present and future values.
Determine the fair market value of a cash flow stream that includes an annuity, using your knowledge of present value calculations.
Compare the fair market value of different cash flow streams, enabling you to make informed investment choices.
By the end of this lesson, you'll be able to confidently evaluate cash flow streams, assess their fair market value, and make savvy financial decisions based on a comprehensive understanding of cash flow dynamics. Let's unlock the secrets of cash flow and fair market value!
Activity: The Investment Opportunity
Activity: The Investment Opportunity
Scenario: You have two investment options:
Option A: Receive ₱10,000 today.
Option B: Receive ₱2,000 at the end of each year for the next 6 years.
Which option seems more attractive to you? Explain your reasoning. Consider factors like the total amount received, the timing of the payments, and any potential risks or benefits.
Analysis: Analyzing the Investment Choices
Analysis: Analyzing the Investment Choices
How does the concept of time value of money influence your decision between the two investment options?
f the interest rates were to increase significantly, how might that change your preference between Option A and Option B?
If you could reinvest the annual payments from Option B at a 5% annual interest rate, would that make Option B more or less attractive?
Think about a real-life situation where you might need to compare different cash flow streams. How could the concepts of present value and fair market value help you make a decision?
This lesson delves into the concepts of cash flow and fair market value, essential for making informed financial decisions.
Example
Example
Problem: Mr. Ribaya received two offers on a lot that he wants to sell. Mr. Ocampo has offered P50,000 and a P1,000,000 lump sum payment 5 years from now. Mr. Cruz has offered P50,000 plus P40,000 every quarter for 5 years. Compare the fair market value of the two offers if money can earn 5% compounded annually. Which offer has a higher market value.
Mr. Ocampo: P50,000 upfront + P1,000,000 in 5 years.
Mr. Cruz: P50,000 upfront + P40,000 quarterly for 5 years.
Which offer has a higher fair market value if the discount rate is 5% compounded annually?
Solution:
We need to calculate the present value (fair market value) of both offers on the focal date (today).
Mr. Ocampo's Offer:
Down Payment = P50,000
Future Value = P1,000,000
m = 1
r = 0.05
t = 5 years
i = 0.05
n = 5
Using the Present Value Formula: P = P783,526.17
FAIR MARKET VALUE = Down Payment + Present Value
FMV = P50,000 + P783,526.17 = P833,526.17
Mr. Cruz's Offer:
Down Payment = P50,000
R = P40,000
m1 = 4
m2 = 1
r(m2) = 0.05
t = 5 years
i = 0.01227223
Using the Present Value Formula: P = P705,572.68
FAIR MARKET VALUE = Down Payment + Present Value
FMV = P50,000 + P705,572.68 = P755,572.68
Hence, Mr. Ocampo's offer has a higher market value.
Don't have a physical calculator? Use this online Scientific Calculator to solve this problems!
Make smarter investment decisions! Here's a video lesson to understand more about cash flow, fair market value, and how they relate to annuities!
Let's explore the world of cash flow and fair market value! This assessment evaluates your understanding of these concepts and your ability to calculate the fair market value of a cash flow stream, including annuities. You'll also compare different cash flows and make informed decisions based on market value.
Application: Put it into action
Application: Put it into action
Instruction: Use online resources, critical thinking, and the provided information to answer the following questions. Justify your answers with explanations and calculations. Upload your documents on this google drive link: Module 2 Lesson 5 Activity Outputs
(Note: Make sure your file name will be your Section-Year-Surname-Given_Name-Module#-Lesson#-Output#, for example: [GAS11-DelaCruz-Juan-Module1-Lesson1-Output1]. Wrong file name will subject to score deduction.)
Understanding Cash Flow and Fair Market Value:
Explain the difference between cash inflows and cash outflows. Provide three examples of each from a business perspective and three examples from a personal finance perspective.
Why is it essential to determine the fair market value of a cash flow stream, especially when comparing different investment or payment options?
How does the concept of the time value of money relate to calculating the fair market value of future cash flows?
Calculations:
Investment Property Decision: You are considering purchasing a rental property. The seller offers two payment options:
Option A: P2,000,000 down payment and P100,000 at the end of each year for the next 10 years.
Option B: P1,500,000 down payment and P15,000 at the end of each month for the next 10 years.
If you can earn a 6% annual return on your investments, which option has a lower fair market value (i.e., which is the better deal for you)?
Comparing Business Investments: Your company is evaluating two projects with different cash flow projections:
Project A: An initial investment of P500,000 is expected to generate cash inflows of P100,000 at the end of each year for 10 years.
Project B: An initial investment of P750,000 is expected to generate cash inflows of P200,000 at the end of each year for 5 years.
Assuming a discount rate of 8%, calculate the fair market value (also known as net present value) of each project. Which project is the more profitable investment?
Critical Thinking:
In the example of Mr. Ribaya selling his lot, what factors other than the fair market value might influence his decision between the two offers?
How would a change in the discount rate (the rate of return you could earn elsewhere) affect the fair market value of a future cash flow stream? Explain using an example.
Cash flow looking good? Time to unlock the secrets of deferred annuities in Lesson 6!
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