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1.1

Question (4.11):

You have the opportunity to invest in a machine that costs $340,000. The

machine generates revenues of $100,000 at the end of each year and requires

maintenance costs of $10,000 at the beginning of each year. The machine

incurs a maintenance cost today because of start-up expenses. If the

economic life of the machine is 5 years and the relevant discount rate is 10

percent, should you buy the machine? What if the relevant discount rate is 9

percent?

Solution:

Calculate the NPV of the machine. Purchase the machine if it has a positive

NPV. Do not purchase the machine if it has a negative NPV.

Since the initial investment occurs today (year 0), it does not need to be

discounted.

PV(Investment) = -$340,000

Discount the annual revenues at 10 percent.

PV(Revenues) = $100,000 / (1.10) + $100,000 / (1.10)

2

+ $100,000 / (1.10)

3

+

$100,000 / (1.10)

4

+ $100,000 / (1.10)

5

= $379,078.68

Since the maintenance costs occur at the beginning of each year, the frst

payment is not discounted. Each year thereafter, the maintenance cost is

discounted at an annual rate of 10 percent.

PV(Maintenance) = -$10,000 - $10,000 / (1.10) - $10,000 / (1.10)

2

- $10,000 /

(1.10)

3

$10,000 / (1.10)

4

= -$41,698.65

NPV = -PV(Investment) + PV(Cash Flows) +

PV(Maintenance)

= -$340,000 + $379,078.68 - $41,698.65

= -$2,619.97

1

Since the NPV is negative, -$2,619.97, you should not buy the

machine.

To fnd the NPV of the machine when the relevant discount rate is nine

percent, repeat the above calculations, with a discount rate of nine percent.

NPV = PV(Investment) + PV(Cash Flows) + PV(Maintenance)

= -$340,000 + $388,965.13 - $42,397.20

= $6,567.93

Since the NPV is positive, $6,567.93, you should buy the machine.

1.2

Question (4.13):

Your aunt owns an auto dealership. She promised to pay you $3,000 for your

car when you graduate one year from now. However, your roommate ofered

you $3,500 for the car now. The prevailing interest rate is 12 percent. If the

future value of the beneft from owning the car for one additional year is

$1,000, should you accept your aunts ofer? You are not planning to buy

another car and will not need the car after you graduate.

Solution:

Compare the PV of your aunts ofer with your roommates ofer. Choose the

ofer with the highest PV. The PV of your aunts ofer is the sum of her

payment to you and the beneft from owning the car an additional year.

PV(Aunt) = PV(Trade-In) + PV(Beneft of Ownership)

= $3,000 / (1.12) + $1,000 / (1.12)

= $3,571.43

Since your roommates ofer occurs today (year 0), it does not need to be

discounted.

PV(Roommate) = $3,500

Since the PV of your aunts ofer, $3,571.43, is higher than your

roommates ofer, $3,500, you should accept your aunts ofer.

1.3.

2

Question (4.18):

Calculate the present value of $5,000 received 12 years from today. Assume a

stated annual interest rate of 10 percent, compounded quarterly.

Solution:

The solution is straightforward

PV(C

12

) = C

T

/ [1+(r / m)]

mT

= $5,000 / [1+(0.10 / 4)]

412

= $1,528.36

1.4.

Question (4.19):

Bank America ofers a stated interest rate of 4.1 percent, compounded quarterly,

while Bank USA ofers a stated annual interest rate of 4.05 percent, compounded

monthly. In which bank should you deposit your money?

Solution:

Deposit your money in the bank that ofers the highest efective annual yield,

EAY. The EAY is the rate of return you will receive after taking into account

compounding. Convert each banks stated annual interest rate into an EAY.

Note that here there are 4 compounding periods so m=4, then you get:

EAY(Bank America) = [1+(r / m)]

m

1

= [1+(0.041 / 4)]

4

1

3

= 0.0416 = 4.16%

EAY(Bank USA) = [1+(r / m)]

m

1

= [1+(0.0405 / 12)]

12

1

= 0.0413 = 4.13%

You should deposit your money in Bank America since it ofers a

higher EAY (4.16%) than Bank USA ofers (4.13%).

4

1.5

Brunel pharmaceuticals is considering a drug project that costs $240,000 today and is

expected to generate end-of-year annual cash flows of $21,000, foreer! "t what

discount rate would Brunel #e indifferent #etween accepting or rejecting the

project$

Solution: %he company would #e indifferent at the interest rate that ma&es the present

alue of the cash flows e'ual to the cost today! (ince the cash flows are a

perpetuity, we can use the )* of a perpetuity e'uation! +oing so, we find,

)* - C . r

$240,000 - $21,000 . r

r - $21,000 . $240,000

r - !0/01 or /!012

1.6

3r! (mart has #een wor&ing on an adanced technology in laser eye surgery! 4is

technology will #e aaila#le in the near term! 4e anticipates his first annual cash flow

from the technology to #e $200,000, receied two years from today! (u#se'uent

annual cash flows will grow at 12 in perpetuity! 5hat is the present alue of the

technology if the discount rate is 102$

Solution: %his is a growing perpetuity! %he present alue of a growing perpetuity is,

)* - 6 . 7r 8 g9

)* - 200,000 . 7!10 8 !019

)* - 4,000,000

:t is important to recogni;e that when dealing with annuities or perpetuities, the

present alue e'uation calculates the present alue one period #efore the first

payment! :n this case, since the first payment is in two years, we hae calculated

the present alue one year from now! %o find the alue today, we simply discount

this alue as a lump sum! +oing so, we find the alue of the cash flow stream

today is,

)* - <* . 71 = r9

t

)* - 4,000,000 . 71 = !109

1

)* - 3,>3>,3>3!>4

1

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