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Using a present value of an annuity table is a simpler approach. Exhibit 2 is a
partial table of present value of annuity factors. These factors are merely the sum of
the present value of $1 factors in Exhibit 1 for the number of annuity periods. Thus,
3.605 in the annuity table (Exhibit 2) is the sum of the five individual present value of $1
Factors at 12% . Multiplying $100 by 3.605 yields the same amount ($360.50) that was
determined in the preceding illustration by five successive multiplications.
Present Value of an Annuity of $1 at Compound Interest
NET PRESENT VALUE METHOD The net present value method analyzes
capital investment proposals by comparing the initial cash investment with the
present value of the net cash flows. It is sometimes called the discounted cash
flow method. The interest rate (return) used in net present value analysis is set
by management. This rate is often based on factors such as the nature of the
business, the purpose of the investment, the cost of securing funds for the investment,
and the minimum desired rate of return. If the net present
value of the cash flows expected from a proposed investment equals or exceeds
the amount of the initial investment, the proposal is desirable.
To illustrate, assume a proposal to acquire $200,000 of equipment with an
expected useful life of 5 years(no residual value) and a minimum desired rate of
return of 10%. As shown at the top of the next page, the present value of the net
cash flow for each year is computed by multiplying the net cash flow for the year
by the present value factor of $1 for that year. For example, the $70,000 net cash
flow to be received on December 31,2004, is multiplied by the present value of
$1 for one year at 10%(0.909).Thus, the present value of the $70,000 is $63,630.
Likewise, the $60,000 net cash flow on December 31,2005, is multiplied by the
present value of $1 for two years at 10%(0.826) to yield $49,560, and so on. The
amount to be invested, $200,000, is then subtracted from the total present value of the net cash flows, $202,900, to determine the net present value, $2,900, as shown
in the following illustration. The net present value indicates that the proposal is expected
to recover the investment and provide more than the minimum rate of return of 10%.
When capital investment funds are limited and the alternative proposals involve
different amounts of investment ,it is useful to prepare a ranking of the proposals by
using a present value index. The present value index is calculated by dividing the