NOTE: This assignment is in two parts, one is quantitative problem, the other a short paper. You need to turn in both Part I and Part II to receive full credit for this assignment. Part I: This part of the assignments tests your ability to calculate present value. A. Suppose your bank account will be worth $15,000.00 in one year. The interest rate (discount rate) that the bank pays is 7%. What is the present value of your bank account today? What would the present value of the account be if the discount rate is only 4%? B. Suppose you have two bank accounts, one called Account A and another Account B. Account A will be worth $6,500.00 in one year. Account B will be worth $12,600.00 in two years. Both accounts earn 6% interest. What is the present value of each of these accounts? C. Suppose you just inherited an gold mine. This gold mine is believed to have three years worth of gold deposit. Here is how much income this gold mine is projected to bring you each year for the next three years: Year 1: $49,000,000 Year 2: $61,000,000 Year 3: $85,000,000 Compute the present value of this stream of income at a discount rate of 7%. Remember, you are calculating the present value for a whole stream of income, i.e. the total value of receiving all three payments (how much you would pay right now to receive these three payments in the future). Your answer should be one number – the present value for this gold mine at a 7% discount rate but you have to show how you got to this number. Now compute the present value of the income stream from the gold mine at a discount rate of 5%, and at a discount rate of 3%. Compare the present values of the income stream under the three discount rates and write a short paragraph with conclusions from the computations. Part II: Read the following three sample business plans: Ice Dreams-http://www.bplans.com/shaved_ice_beverage_business_plan/executive_summary_fc.php R J Wagner & Associates Realty-http://www.bplans.com/real_estate_brokerage_business_plan/executive_summary_fc.php Interstate Travel Center-http://www.bplans.com/truck_stop_business_plan/executive_summary_fc.php Which of these three projects do you think should have the highest risk from the point of view of investors (potential providers of funds) and would therefore be evaluated using the highest discount rate? Which one do you think should have the lowest? Write a paper explaining your reasoning. In your assessment of the business plans consider the possible risk of each plan. Risk is one of the main considerations when deciding whether a plan should be evaluated and discounted to present value using a high or a low discount rate. Note: you are not expected to fully analyze the numbers and financial statements in these business plans. There are only forecasts and projections. Nobody really believes them anyway. Use your intuition rather than calculations to assess risk and potential of each of these plans. Assignment Expectations Turn in both Part I and Part II in one Word document when completed. Part I should be two pages long and contain your calculations. Part II should be two pages long

Computation of Present Value

Part I
A
Present Value (PV)= Future Value (FV)*(1/(1+r^n)
(1/(1+r^n) is the present value factor
Where n= number of years 
r=interest rates/discount rate
FV after one year=$15000
r=7%
PV=15000*(1/1.07^1)
Present Value today= $14018.69
When r=4%
PV=15000*(1/1.04^1)
Present value=$14423.08
B
After one year
Bank A Bank B
$6,500  $12,600 
r 6% 6%
n 1 years  2 years
Present Value of A= 6500*(1/1.06^1)
PV Bank A=$6132.08
Present Value of B= 12600*(1/1.06^2)
PV Bank B=$11213.96
C
When r=7%
Year  Income(000) present value factor Present Value (Income*PV factor)
1 49000 (1/1.07^1) 45794392.52
2 61000 (1/1.07^2) 53279762.42
3 85000 (1/1.07^3) 69385319.54
Present Value (PV)= $168,459,474.48 
When r=5%
Year  Income(000) present value factor Present Value (Income*PV factor)
1 49000 (1/1.05^1) 46666666.67
2 61000 (1/1.05^2) 55328798.19
3 85000 (1/1.05^3) 73426195.88
Present Value (PV)= $175,421,660.74 
When r=3%
Year  Income(000) present value factor Present Value (Income*PV factor)
1 49000 (1/1.03^1) 47572815.53
2 61000 (1/1.03^2) 57498350.46
3 85000 (1/1.03^3) 77787041.05
Present Value (PV)= $182,858,207.04 

 

Conclusion

From the above computations of present value, it is evident that present value and interest rates (r) are moving in different directions that is the higher the discount rate the lower the present value and the lower the discount rate the higher the present value. 

part II

Financial Risks

Risk is the probability of losing something that has potential value. The loss is caused by vulnerabilities that maybe internal or external. Financial risk is defined as the possibility of investors losing money they have invested in a certain company. The risk is due to a company having debts that take up the company’s revenues to pay the debt. Investors stand to lose their money when the cash flow of the company is inadequate and does not meet the company’s financial obligations. In cases where the government or corporation defaults to pay bonds the bondholders stand to lose their money. Interest rates increase the possibility of incurring financial risks. The interest rates increase the cost of operating a business hence high expenses and low income return. Interest rates that are adjustable increases the rate of fluctuation providing an economy that is unstable (Saunders 2010)

Interstate Travel Center is a travel center that will provide convenience stores, a restaurant, Gas Island and amenities that cater for the demands in trucking business. The startup cost to facilitate the construction of the center is estimated to be $2.75 million. The two owners Janet and Steve will provide $250,000 while the remaining $2.5 million they will borrow inform of a loan. The Interstate Travel Center stands to suffer the highest risk. The centers start-up cost is very high which entails that they have to borrow funds. Borrowing indicates that the business will depend on debts which leads to rise of financial risks.

Due to the start-up nature of the business they are not liable to any discount rate from the financial provider hence high rates for evaluation. The trucking business is unpredictable and there are no estimated returns that will fully repay the debts. Defaults are likely to occur when the center experiences cash deficiency or high budgets cost that exceed the center’s income. Increase in the interest rate of the borrowed money will put the center at a financial risk of paying more money than expected. Investors will lose their money due to increased debt payment as debts have to be paid first before investors. High debts may lead to the collapsing of the center (Hallikas, 2004)

RJ Wagner & Associates Realty, Inc. is a corporation that has a stockholder and one owner who is Regina. The owner is licensed to buy and sell assets in place of other and will be providing funds for the firm. The firm will offer real estate services in Texas. The firm may face low risks due to the presence of the owner who will finance the start-up of firm. Investors face minimal risk as there are no debts to pay. Having a credible sponsor will attract many investors as financial resources to run the firm are available.

Also, the good reputation of the sponsor will give investors the assurance of security on their money hence gaining high returns from their investments. Involving licensed real estate agents will provide quality services minimizes on unproportioned decisions. Availability of a marketing plan will enable the firm to identify risks associated to their operations and mitigate them. Change in the economy is the likely factor to cause financial risks decreasing the rate of returns.

Ice Dreams Company will be selling shave ice and other soft drinks in California. Construction of the company will be on a private owned property. This business is a sole proprietor business owned by Ofelia R. Arellano. Ice Dreams will be a bit risker than the real estate business but incur low investment cost. The start-up cost will be financed by a short-term loan. The short-term loan involves small amount of money that will be paid within a short period. Financial risks are likely to face the company if there is inadequacy of cash flow. 

References

Hallikas, J., Karvonen, I., Pulkkinen, U., Virolainen, V. M., & Tuominen, M. (2004). Risk   

management processes in supplier networks. International Journal of Production Economics, 90(1), 47-58.

Sarasvathy, D. K., Simon, H. A., & Lave, L. (1998). Perceiving and managing business risks: Differences between entrepreneurs and bankers. Journal of economic behavior & organization, 33(2), 207-225.

Saunders, A., & Allen, L. (2010). Credit risk management in and out of the financial crisis: new approaches to value at risk and other paradigms (Vol. 528). John Wiley & Sons.

Math Index. (2010, May 04). About: Math is fun. Retrieved from Math is fun website: https://www.mathsisfun.com/money/present-value.html

 

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