Derek owns a perpetuity contract that promises to pay him $1,000 per year in end-of the-year cash flows with the first cash flow beginning one year from today. Derek perceives some risk with the promised cash flows and has discounted them at an annual rate of 10.00% to determine the present value of the contract. Derek has offered to sell a portion of the contract to his brother Cam. The agreement is that Derek will keep the first 25 cash flows and that Cam will keep the remaining cash flows beginning with the first cash flow 26 years from today. What is the present value of the original contract?
What is the present value of the first 25 cash flows? What is the present value of the cash flows received in year 26 and beyond? If Derek makes the deal as described and charges Cam $1,000 for the year 26 and beyond cash flows, which brother is getting a better deal? Please provide dollar values for each of these questions.
PV of contract = $10,000, PV of first 25 cash flows = $9,077.04, PV of remaining cash flows = $922.96. Derek gets the better deal, he is selling cash flows with a PV of $922.96 for $1,000.
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