Question

Say that over the next three years a company expects profits at the end of the years to be 100, 110 and 120, respectively. If the rate at which future dollars are discounted is 6%, what is the net present value of this profit stream?

Consider a change in expectations in the example above in that yearly profits are now expected to be even higher than mentioned. What would you expect to be the impact on shareholder wealth from this change?

Answer 1

Net present value = 100 x P/F(6%, 1) + 110 x P/F(6%, 2) + 120 x P/F(6%, 3)

= 100 x 0.9434** + 110 x 0.8900** + 120 x 0.8396

= 94.34 + 97.90 + 100.75

= 292.99

Keeping discount rate and number of discounting periods unchanged, the higher the annual cash flow (profit), the higher the net present value of future profit, and therefore, the higher the shareholder wealth.

**From P/F Factor table