November 21st, 2008
A client of a company owes the company $990,000. This debtor says he
will have the cash in a months time, but if they need it immediately,
he is willing to sell a 90-day bank bill with face-value of $1,000,000
and a yield of 5.85% per/anum and give the proceeds of that sale for
complete settlement of the debt. Should the company accept or recect
the offer????(please show all working)Hello ekaj1234!
What we must find here is the present value of both options (collect
debt in 1 month, or accept proceeds from sale of bank bill) for the
company. Then the company should go with the option that has the
highest present value.
In order to find the value of the bank bill, we have to use the
formula for bond pricing. The value of a bond (or bill in this case)
is the present value of the stream of cashflows it will generate. This
particular bill will yield $1,000,000 to its holder in 3 months time.
The appropiate discount factor for the present value is the yield of
the bill. Since 5.85% is the annual yield, then 5.85/4 = 1.4625% is
the 90-day yield. Then we simply calculate:
Value of the bill = 1,000,000 / 1.014625 = $985,610
Therefore, the client will be able to sell the bill for $985,585.
Now let's find the present value of the other option. If the company
doesn't want to accept the offer, it will collect $990,000 next month.
In order to find the present value of this payment, I will assume here
that the firm uses the same 5.85% per annum yield as a discount
factor. The 1-month rate is then 5.85/12 = 0.4875%. Therefore, the
present value of collecting $990,000 in 1 month is:
PV = 990,000 / 1.004875 = $985,197
Since the value of the bill of the bill is higher than the present
value of not accepting the bill (and collecting the debt in 1 month),
the company should accept the client's offer.
Here's an good link on the topic of Present Value:
http://www.investopedia.com/articles/03/101503.asp
Google search terms
"present value"
://www.google.es/search?sourceid=navclient&hl=es&ie=UTF-8&rls=RNWE,RNWE:2004-53,RNWE:es&q=%22present+value%22
I hope this helps! If you have any questions regarding my
answer,please don't hesitate to request a clarification. Otherwise I
await your rating and final comments.
Best wishes!
elmarto
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