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Answer :
Final answer:
To calculate the maximum price Honeywell should be willing to pay for an investment opportunity that generates revenue starting from year 5, we assume an 8% discount rate to calculate the present value of an annuity. The value calculated is then further discounted back to the present day.
Explanation:
This problem is a financial management case that deals with calculating the present value (PV) of a stream of future cash inflows discounted at a specified rate. In this case, Honeywell is expected to generate $20,000 revenues per year for six years starting at the end of year five, while the discount rate is 8%, represented by the earnings on its investments.
With no revenue for the first four years, the value at that point is zero. The first inflow ($20,000) would occur at the end of year 5, second ($20,000) at the end of year 6, and so on until the end of year 10. Since each cash inflow is identical and occurs at regular intervals, this constitutes an annuity.
The present value (PV) of an annuity is calculated as:
PV = C * (1 - (1 + r)^-n) / r
Where,
C = annuity amount ($20,000)
r = discount rate or earnings rate (8% or 0.08 as a decimal)
n = number of periods (6, from year 5 to year 10)
Substituting these values into the formula gives:
PV = 20,000 * (1 - (1 + 0.08)^-6) / 0.08
The result yields the present value of these cash inflows. However, remember these inflows will start at the end of year 5, so the derived present value should be discounted back to today (year 0). The result will indicate the amount Honeywell should be willing to pay maximum for this investment opportunity today.
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