The Western Railway Company (WRC) has been offered a 100-year contract
QUESTION
The Western Railway Company (WRC) has been offered a 100-year contract to haul a fixed amount of coal each year from Wyoming to Illinois. Under the terms of the agreement, WRC will receive $4,200,000 now in exchange for its hauling services valued at $360,000 at the end of year (EOY) one, $375,000 a
Here we have to compare $4.2M with A= $360,000 for n=100 yrs & Kd = 12% To find g, we see that FV=PV*(1 g)^n so for 1 year, we have 375000 = 360000*(1 g)^1 ie g = 4.17% As n is quite large, we consider this as a growing perpetuity PV of a gowing perpetuity is PVAg = A/(Kd-g) where A = First Payment, Kd = cost of capital per period g = Growth rate so PVAg = 360000/(12%-4.17%) =
97,701 Since PVAg is greater than $4.2M, It may be better for WRC to take annual payments for 100 yrs, if there is no unceratinity on future payments. But considering the quantum of payments & the long period of 100 yrs, it may be wise to take $4.2M now.
ANSWER:
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