Southern Tours is considering acquiring Holiday Vacations. Management believes Holiday Vacations can generate cash flows of $187,000, $220,000, and $245,000 over the next three years, respectively. After that time, they feel the business will be worthless. If the desired rate of return is 13.5 percent, what is the maximum Southern Tours should pay today to acquire Holiday Vacations?

The answer is: the maximum amount Southern Tours should pay to acquire Holiday Vacations is $503,098

Explanation:

We have to calculate the present value of the 3 future cash flows of Holiday Vacations. After the third year, Holiday Vacations will shut down, so no more cash flows are expected.

Cash flow year 1 = 187,000

Cash flow year 2 = 220,000

Cash flow year 3 = 245,000

We can use an excel spreadsheet to calculate the present value, but since the operations are quite simple, we can also do them by ourselves.

PV = (187,000 / 1.135) + (220,000 / 1.135²) + (245,000 / 1.135³) = $164,758 + $170,778 + $167,563 = $503,098