Investment Theory and Risk Management, + Website

NPV Revisited

Example 3.4

Using the term structure given earlier, consider a net present value problem with initial outlay equal to $400 and with expected payout of $100 for each of the next five years (payable at the end of each year). What is the net present value of this project?

There are two equivalent ways of solving this problem. We first present the most direct method—and one that will be most intuitively appealing given what we know at this point about the term structure. We have five future cash flows and an initial (period 0) outlay. We want to discount the five future cash flows to the present. To that end, we compute the five discount rates using the spot curve.

Example 3.4 Table A

Then we present value the cash flows and sum them:

Example 3.4 Table B

The net present value of this investment is therefore $12.70.