Your consulting firm will produce cash flows of $120,000 this year, and you expect cash flow to keep pace with any increase in the general level of prices. The interest rate currently is 6.4%, and you anticipate inflation of about 2.4%. What is present value for years 1 through 4
$436,551.55
To calculate the present value of cash flows for years 1 through 4, we need to adjust the cash flows for inflation and discount them to the present value using the interest rate.
Step 1: Adjust cash flows for inflation
Since you anticipate inflation of about 2.4%, we need to adjust the cash flows to account for this. To do this, we divide each cash flow by (1 + inflation rate) raised to the power of the respective year.
Cash flow in Year 1 * (1 + inflation rate)^1
Cash flow in Year 2 * (1 + inflation rate)^2
Cash flow in Year 3 * (1 + inflation rate)^3
Cash flow in Year 4 * (1 + inflation rate)^4
In this case, the inflation rate is 2.4%, so we divide the cash flow in each year by (1 + 0.024).
Step 2: Discount the adjusted cash flows to present value
To discount the adjusted cash flows, we use the interest rate of 6.4%. We divide each adjusted cash flow by (1 + interest rate) raised to the power of the respective year.
Adjusted cash flow in Year 1 / (1 + interest rate)^1
Adjusted cash flow in Year 2 / (1 + interest rate)^2
Adjusted cash flow in Year 3 / (1 + interest rate)^3
Adjusted cash flow in Year 4 / (1 + interest rate)^4
In this case, the interest rate is 6.4%, so we divide the adjusted cash flow in each year by (1 + 0.064).
Step 3: Calculate the present value
Now, we sum up the discounted adjusted cash flows to get the present value for years 1 through 4.
Present Value = Discounted adjusted cash flow in Year 1 + Discounted adjusted cash flow in Year 2 + Discounted adjusted cash flow in Year 3 + Discounted adjusted cash flow in Year 4
Plug in the values for the cash flows, inflation rate, and interest rate to calculate the present value for years 1 through 4.