Solution to Problem

Advanced Financial Manage

Question 1

The wealthy donor needs to set aside an amount equal to the PV of the salary.
a)
b)
c)

1,067,478
1,250,000
2,500,000

Using the annuity formula: (100000/0.08)*(1-1/(1.08^25))
Using the perpetuity formula: 100000/0.08
Using the growing perpetuity formula: 100000/(0.08-0.04)

Question 2
a) The cashflows from the pipeline are a growing perpetuity where the growth rate is nagativ

Present Value = C/(r-g)

###

Using the growing perpetuity formula

b) Plant operates for 20 years

Discount Rate
Year
flows (in $M)
scount Factor
Flow (CF*DF)

11%
0

Value (in $M) =

1
2
3
2
1.920
1.843
0.9009009 0.81162243 0.73119138
1.8018018 1.55831507 1.34773195

$12.60 millions
$12.60

Summing PV of all CFs: SUM(D22:W22
Alternate method: Discounting each

Question 3

Discount Rate
Year
Cash Flow
scount Factor
Flow (CF*DF)

18%
0
$

1
470.0 $
0.847
398.31

2
3
4
640.0 $ 4,350.0 $ 2,750.0
0.718
0.609
0.516
459.64
2,647.54
1,418.42

a) PV CFs (1 + 4)
b) Starting Value for Growing Perpituity (CF in 5)

$
$

Growth rate of perpetuity
Discount Rate
PV of Growing Perpetuity (Value at t=4)
PV of Growing Perpetuity (Value at t=0)
$
c) Would be willing to pay up to the PV of All Cashflows$
d) Now the Cash Flows are

4,924
1,600
5%
18%
12,308
6,348
11,272

Summing PV of CFs 1-4

Using the growing perpe
Multiplying Value at t=4
Summing answers a) an

Year
Cash Flow
scount Factor
Flow (CF*DF)

0
$

1
470.0 $
0.847
398.31

PV CFs (1 + 4) (Unchanged)
Starting CF for Level Perpetuity (t=5)
PV of Level Perpetuity (Value at t=4)
PV of Level Perpetuity (Value at t=0)
PV for All Cash Flows
e) Value Due to Long Term NPV Projects

2
3
4
640.0 $ 4,350.0 $ 2,750.0
0.718
0.609
0.516
459.64
2,647.54
1,418.42
$
$
$
$
$
$

4,924
1,950
10,833
5,588
10,512
760
6.75%

Using the perpetuity for
Multiplying Value at t=4
Summing PV of CFs 1-4
Differnce in NPV Calcula
As a fraction of the valu

Question 4

Key Idea: The cash flows in a growing perpetuity start at some level and grow at a constant r

Note: This is the earliest we could apply the growing perpetuity formula to accurately compu
Cash flows before this date would need to discounted back to the present indivuallly as we d
a)

Year
1
2
3
4
5
Cash Flow
120.0
135.5
200.0
220.0
242.0
Cash Flow Growth Rate* 12.9%
47.6%
10.0%
10.0%
* E.G. CF growth rate from t=1 to t=2 is computed as (135.5-120)/120 (Same calcualtion for
Year 3
b)

Year
1
2
3
4
5
Cash Flow
600.0
800.0
300.0
320.0
380.0
Cash Flow Growth Rate
33.3%
-62.5%
6.7%
18.8%
Year 5
c)

Year
1
2
3
4
5
Cash Flow
7,000.0
8,000.0
9,000.0
10,000.0
12,500.0
Cash Flow Growth Rate
14.3%
12.5%
11.1%
25.0%
Year 4

Question 5

Discount Rate
3%
My Salary (t= $
85,000
Growth Rate (
5.5%
Years to work
30
Partner Salary $100,000
Growth Rate (
3.5%
Years to work
25
Bequest to Ch
0
Desired Growt
2%

Use this for part e)

Find this Using Solver (or Trial and Error) to Set Diff B
Consumption $

148,227

Solver may need to be added to excel: (Windwows menu, excel options, add-in

Year
1
Discount Fact 0.97087379
Income (Me) ( $
85,000
Income (Partn $ 100,000
Total HH Inco $ 185,000
PV HH Income $ 179,612

2
0.94259591
$
89,675
$ 103,500
$ 193,175
$ 182,086

3
0.91514166
$
94,607
$ 107,123
$ 201,730
$ 184,611

4
0.88848705
$
99,811
$ 110,872
$ 210,682
$ 187,188

5
0.86260878
$ 105,300
$ 114,752
$ 220,052
$ 189,819

HH Consumpti $ 148,227
PV Cons Each $ 143,909

$ 151,191
$ 142,512

$ 154,215
$ 141,129

$ 157,299
$ 139,758

$ 160,445
$ 138,402

Saving (Withd $
Account Bala $
Savings Rate

36,773 $
36,773 $
20%

PV of HH Inco $6,155,274
PV of HH Cons $6,155,274
Diff PV Total $
(0)

41,984 $
47,515 $
53,383 $
59,607
79,860 $ 129,771 $ 187,047 $ 252,265
22%
24%
25%
27%

This is the sum of the PV of Total HH Income in Each Period: SUM
This difference set to zero

The key idea needed to solve this - the present value of consumption must be equal to the pr
The PV of Housheold income is caluclated by simple discounting and is invariant to the consu
The household consumption path is set by adjusting the expenditure in the first year. By the
The level of the consumption in the first period is set so that the PV of all consumption is equ
Savings account balance: grows (falls) with savings (withdrawals/borrowing) and interest plus

a) Amount Spent
$ in
148,227
Year 1

Savings Rate
20%
b) Savings Rate Year 12
38%
c) Bank balance
$ t 987,821
= 12

This is the amount of year 1 income that is saved as a fraction o
This is the amount of year 1 income that is saved as a fraction o
Computed above. Could be caluclated independently as the futu

d) Bank Balance
$5,811,173
t = 30
Computed above. Could be caluclated independently as the futu
e) This is solved by adding $500,000 to household consumption at year t=55 and recomputin

Consumption plan is found by looking for the starting level of consumption (including this beq
Amount Spent $ 145,857
Reduction in $
2,369

n to Problem Set I

d Financial Management

*(1-1/(1.08^25))

000/(0.08-0.04)

growth rate is nagative 4%
ing perpetuity formula: 2000000/(0.11-(-0.04))

4
5
6
7
8
9
1.769
1.699
1.631
1.566
1.503
1.443
0.65873097 0.59345133 0.53464084 0.48165841 0.4339265 0.39092477
1.16560601 1.00809169 0.87186308 0.75404375 0.65214594 0.56401811

all CFs: SUM(D22:W22)
od: Discounting each cash flow: NPV(0.11,D79:W79)

$

5
1,600.0
0.437

umming PV of CFs 1-4: SUM(C33:F33)

sing the growing perpetuity formula: 1600/(0.18-0.05)
ultiplying Value at t=4 by discount factor from t=4 to get PV
umming answers a) and b)

$

5
1,950.0
0.437

sing the perpetuity formula: 1950/0.18
ultiplying Value at t=4 by discount factor from t=4 to get PV
umming PV of CFs 1-4 with PV of Perpituity from 5 onwards
ffernce in NPV Calculated in c) and d)
s a fraction of the value estimated in part c)

d grow at a constant rate from that point onwards.
a to accurately compute the PV of all ongoing cash flows into the distant future
ent indivuallly as we did in question 3 for CFs 1-4

10.0%

6
266.2

(Same calcualtion for all other rates)

6
456.0
20.0%

6
15,625.0
25.0%

and Error) to Set Diff Between PV of Cons And PV of HH Income to Zero

wows menu, excel options, add-ins, solver add-in). It is then found in "Data" menu.

6
0.83748426
$ 111,092
$ 118,769
$ 229,860
$ 192,504

7
0.81309151
$ 117,202
$ 122,926
$ 240,127
$ 195,245

8
0.78940923
$ 123,648
$ 127,228
$ 250,876
$ 198,044

9
0.76641673
$ 130,448
$ 131,681
$ 262,129
$ 200,900

10
0.74409391
$ 137,623
$ 136,290
$ 273,913
$ 203,817

11
0.72242128
$ 145,192
$ 141,060
$ 286,252
$ 206,795

$ 163,654
$ 137,058

$ 166,927
$ 135,727

$ 170,266
$ 134,409

$ 173,671
$ 133,104

$ 177,145
$ 131,812

$ 180,687
$ 130,532

$
66,206 $
73,200 $
80,610 $
88,458 $
96,768 $ 105,565
$ 326,039 $ 409,021 $ 501,901 $ 605,416 $ 720,347 $ 847,522
29%
30%
32%
34%
35%
37%
continues………
me in Each Period: SUM(B133:AE133)

must be equal to the present value of income.
invariant to the consumption plan
the first year. By the 2% growth rate this set the consumption level for all remaining years.
all consumption is equal to the PV of all income. This ensures a zero bank balance at death.
wing) and interest plus interest earned (or owed) on previous years balance.

s saved as a fraction of total income for that year.
s saved as a fraction of total income for that year.
ependently as the future value at t=12 of all savings from 1 to 12.

ependently as the future value at t=30 of all savings from 1 to 30.
r t=55 and recomputing the consumption plan using solver (or trial and error)
tion (including this bequest) that renders the PV of all consumption equal to the PV of Income.

10
11
12
13
14
15
1.385
1.330
1.276
1.225
1.176
1.129
0.35218448 0.31728331 0.28584082 0.25751426 0.23199482 0.20900435
0.48779945 0.4218806 0.36486971 0.31556299 0.27291935 0.23603835

12
0.70137988
$ 153,178
$ 145,997
$ 299,175
$ 209,835

13
0.68095134
$ 161,603
$ 151,107
$ 312,710
$ 212,940

14
0.66111781
$ 170,491
$ 156,396
$ 326,886
$ 216,110

15
0.64186195
$ 179,868
$ 161,869
$ 341,737
$ 219,348

16
0.62316694
$ 189,761
$ 167,535
$ 357,295
$ 222,655

17
0.60501645
$ 200,197
$ 173,399
$ 373,596
$ 226,032

$ 184,301
$ 129,265

$ 187,987
$ 128,010

$ 191,747
$ 126,767

$ 195,582
$ 125,537

$ 199,494
$ 124,318

$ 203,483
$ 123,111

$ 114,874 $ 124,722 $ 135,139 $ 146,155 $ 157,802 $ 170,113
$ 987,821 $1,142,178 $1,311,583 $1,497,086 $1,699,800 $1,920,907
38%
40%
41%
43%
44%
46%

ning years.
e at death.

PV of Income.

16
17
18
19
20
1.084
1.041
0.999
0.959
0.921
0.1882922 0.16963262 0.15282218 0.13767764 0.12403391
0.20414128 0.17655462 0.15269589 0.13206131 0.11421519

18
0.58739461
$ 211,208
$ 179,468
$ 390,676
$ 229,481

19
0.57028603
$ 222,825
$ 185,749
$ 408,574
$ 233,004

20
0.55367575
$ 235,080
$ 192,250
$ 427,330
$ 236,602

21
0.53754928
$ 248,009
$ 198,979
$ 446,988
$ 240,278

22
0.5218925
$ 261,650
$ 205,943
$ 467,593
$ 244,033

23
0.50669175
$ 276,041
$ 213,151
$ 489,192
$ 247,869

$ 207,553
$ 121,916

$ 211,704
$ 120,732

$ 215,938
$ 119,560

$ 220,257
$ 118,399

$ 224,662
$ 117,249

$ 229,155
$ 116,111

$ 183,123 $ 196,869 $ 211,392 $ 226,731 $ 242,931 $ 260,036
$2,161,656 $2,423,376 $2,707,469 $3,015,424 $3,348,818 $3,709,319
47%
48%
49%
51%
52%
53%

24
0.49193374
$ 291,223
$ 220,611
$ 511,834
$ 251,789

25
0.47760557
$ 307,240
$ 228,333
$ 535,573
$ 255,793

26
27
28
29
0.46369473 0.45018906 0.43707675 0.42434636
$ 324,138 $ 341,966 $ 360,774 $ 380,617
$ 324,138
$ 150,301

$ 341,966
$ 153,949

$ 360,774
$ 157,686

$ 380,617
$ 161,513

$ 233,738
$ 114,984

$ 238,413
$ 113,867

$ 243,182
$ 112,762

$ 248,045
$ 111,667

$ 253,006
$ 110,583

$ 258,066
$ 109,509

$ 278,096 $ 297,160 $
80,957 $
93,921 $ 107,768 $ 122,550
$4,098,694 $4,518,815 $4,735,336 $4,971,317 $5,228,224 $5,507,621
54%
55%
25%
27%
30%
32%

30
31
32
33
0.41198676 0.39998715 0.38833703 0.37702625
$ 401,551

34
0.3660449

35
0.3553834

$ 401,551
$ 165,434
$ 263,227
$ 108,446

$ 268,492
$ 107,393

$ 273,862
$ 106,351

$ 279,339
$ 105,318

$ 284,926
$ 104,296

$ 290,624
$ 103,283

$ 138,323 $ (268,492) $ (273,862) $ (279,339) $ (284,926) $ (290,624)
$5,811,173 $5,717,016 $5,614,665 $5,503,766 $5,383,953 $5,254,847
34%

36
37
38
39
40
0.34503243 0.33498294 0.32522615 0.31575355 0.30655684

$ 296,437
$ 102,280

$ 302,366
$ 101,287

$ 308,413
$ 100,304

$ 314,581
$
99,330

$ 320,873
$
98,366

41
0.297628

$ 327,290
$
97,411

$ (296,437) $ (302,366) $ (308,413) $ (314,581) $ (320,873) $ (327,290)
$5,116,055 $4,967,171 $4,807,774 $4,637,426 $4,455,676 $4,262,056

42
43
44
45
46
47
0.28895922 0.28054294 0.27237178 0.26443862 0.25673653 0.24925876

$ 333,836
$
96,465

$ 340,513
$
95,528

$ 347,323
$
94,601

$ 354,270
$
93,683

$ 361,355
$
92,773

$ 368,582
$
91,872

$ (333,836) $ (340,513) $ (347,323) $ (354,270) $ (361,355) $ (368,582)
$4,056,081 $3,837,251 $3,605,045 $3,358,927 $3,098,340 $2,822,708

48
49
50
51
0.2419988 0.23495029 0.22810708 0.22146318

$ 375,954
$
90,980

$ 383,473
$
90,097

$ 391,142
$
89,222

$ 398,965
$
88,356

52
53
0.2150128 0.20875029

$ 406,944
$
87,498

$ 415,083
$
86,649

$ (375,954) $ (383,473) $ (391,142) $ (398,965) $ (406,944) $ (415,083)
$2,531,435 $2,223,906 $1,899,481 $1,557,500 $1,197,281 $ 818,116

54
55
0.20267019 0.19676717

$ 423,385
$
85,807

$ 431,853
$
84,974

$ (423,385) $ (431,853)
$ 419,274 $
(0)