Asset X is expected to deliver 3 future payments. They have present values of, respectively, \(1,000, \)2,000, and \(7,000. Asset Y is expected to deliver 10 future payments, each having a present value of \)1,000. Which of the following statements correctly describes the relationship between the current price of Asset X and the current price of Asset Y?

  1. Asset X and Asset Y should have the same current price.

  2. Asset X should have a higher current price than Asset Y.

  3. Asset X should have a lower current price than Asset Y.

Short Answer

Expert verified

The correct option is (a): Asset X and Asset Y should have the same current price.

Step by step solution

01

Step 1. Explanation of correct option

The total present value of Asset X is $10,000 (=$1,000 + $2,000 + $7,000). The total present value of Asset Y is $10,000 (=$1,000 * 10). When the present value is the same, the current price will also be the same.

The time frame for the delivery of payments isn't specified, however, it is irrelevant, as the present value will reflect distant payments as less valuable.

Additionally, the real value of each payment can't be determined, however, the real value is included in the present value calculation.

That is why the 10 payments are still equal to the 3 payments because present value accounts for both the time and monetary value of future returns.

(the 10th payment may be years away but its real dollar value is much greater, however, its present value is $1000)

02

Step 2. Explanation for incorrect option

Options (b) and (c) are incorrect as the present value provides all the necessary information to the value of the payments. If the present values are equal, then the difference in time of payment and dollar value is accounted for.

Unlock Step-by-Step Solutions & Ace Your Exams!

  • Full Textbook Solutions

    Get detailed explanations and key concepts

  • Unlimited Al creation

    Al flashcards, explanations, exams and more...

  • Ads-free access

    To over 500 millions flashcards

  • Money-back guarantee

    We refund you if you fail your exam.

Over 30 million students worldwide already upgrade their learning with Vaia!

One App. One Place for Learning.

All the tools & learning materials you need for study success - in one app.

Get started for free

Most popular questions from this chapter

Identify each of the following investments as either an economic investment or a financial investment.

a. A company builds a new factory.

b. A pension plan buys some Google stock.

c. A mining company sets up a new gold mine.

d. A woman buys a 100-year-old farmhouse in the countryside.

e. A man buys a newly built home in the city.

f. A company buys an old factory.

Suppose that a risk-free investment will make three future payments of \(100 in one year, \)100 in two years, and $100 in three years. If the Federal Reserve has set the risk-free interest rate at 8 percent, what is the proper current price of this investment? What is the price of this investment if the Federal Reserve raises the risk-free interest rate to 10 percent?

If an investment has 35 percent more non-diversifiable risk than the market portfolio, its beta will be:

  1. 35

  2. 1.35

  3. 0.35

What is compound interest? How does it relate to the formula Xt = (1 + i)t X0? What is present value? How does it relate to the formula Xt/(1 + i)t = X0?

Consider an asset that costs \(120 today. You are going to hold it for 1 year and then sell it. Suppose that there is a 25 percent chance that it will be worth \)100 in a year, a 25 percent chance that it will be worth \(115 in a year, and a 50 percent chance that it will be worth \)140 in a year. What is its average expected rate of return? Next, figure out what the investment’s average expected rate of return would be if its current price were $130 today. Does the increase in the current price increase or decrease the asset’s average expected rate of return? At what price would the asset have a zero average expected rate of return?

See all solutions

What do you think about this solution?

We value your feedback to improve our textbook solutions.

Study anywhere. Anytime. Across all devices.

Sign-up for free