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# Prof. Thomas J.

Chemmanur
MF807: Corporate Finance

Solutions to Practice Problem Set - I

How to Calculate Present Values

1.
a. PV = \$100/1.0110 = \$90.53

b. PV = \$100/1.1310 = \$29.46

c. PV = \$100/1.2515 = \$ 3.52

d. PV = \$100/1.12 + \$100/1.122 + \$100/1.123 = \$240.18

1
2. a. DF1   0.905  r1 = 0.1050 = 10.50%
1 r1

1 1
b. DF2    0.819
(1  r2 ) 2
(1.105)2

c. AF2 = DF1 + DF2 = 0.905 + 0.819 = 1.724

d. PV of an annuity = C  [Annuity factor at r% for t years]
Here:
\$24.65 = \$10  [AF3]
AF3 = 2.465

e. AF3 = DF1 + DF2 + DF3 = AF2 + DF3
2.465 = 1.724 + DF3
DF3 = 0.741

3. The present value of the 10-year stream of cash inflows is:

 1 1 
PV  \$170,000    10 
 \$886,739.6 6
 0.14 0.14  (1.14) 
Thus:

NPV = –\$800,000 + \$886,739.66 = +\$86,739.66

1210 5.571.379.7 5  C    20   0.095.000 \$50.15 1.7 5     \$38.08 0.000 NPV   t   \$380.08)30 = \$382.018.000      t0 (1.78  0.0286)  b.14)  4. the factory’s value will be the present value of the five remaining \$170.018.12 7 1.000    5   \$583.0286 0.000 cash flows:  1 1  PV  \$170.08 0.08) t 30 30 (40.24    t 1 (1.000 \$68.08 / 1.24    30   \$760. At the end of five years.76  0.12 2 1.08)   1 1  C  \$382. PV(salary) x 0.05 = \$38.08  (1. Let St = salary in year t 30 St 30 40.000 (1.0286) t  1 1   38. a.08) 20  . 1 1  PV  C    t  r r  (1  r)   1 1  \$382. 05) 38.000 \$75.75 c.000 \$57.000/1.12 5 \$92.000 \$85.000       \$23.000 \$92.12 1.12 9 1.623.96 Future value = \$38.571.14 0.965.12 8 1.12 3 1.08) t t 1 (1.05) t 1 PV     t 1 (1.12) 1.14  (1.0286  (1.08  (1.2 1  0.96 x (1.696.000 \$80. 10 Ct \$50.000 \$80.12 6 1.571.05) t t 1 (1.12 4 1.095.

288 million  Sale for scrap brings in revenue of \$1.400/0.000/1. PV = \$6.07 Total = NPV = \$62. PV = \$11.288 million + \$0.354.08 0. . Then.559 million  0.000/1.)  Cost of the ship is \$8 million PV = \$8 million  Revenue is \$5 million per year. operating expenses are \$4 million. PV = (\$2 million)/1. (All dollar figures are in millions.83 c.08  (1.000  1 1  d.5 million/1.78 3 +300.438.000    10   \$107. operating cash flow is \$1 million per year for 15 years.559 million  \$2.534.12 = + 89.000 b.000/1.12  0. Period Present Value 0 400.12 = \$95.136.0810 = \$2.0815 = \$0.473 million Adding these present values gives the present value of the entire project: NPV = \$8 million + \$8.12)  e.285. PV = \$1.125 = \$102.  1 1  PV  \$1 million    15   \$8.00 1 +100. the sum of the present values of the separate cash flows is the present value of the entire project. Thus.12 0.000/1.256 million 8. such that the sum of these separate cash flows is the total cash flow. We can break this down into several different cash flows. and will occur at times t = 5 and t = 10.085 + (\$2 million)/1. PV = \$100.14 Prize (d) is the most valuable because it has the highest present value. PV = \$180. PV  \$19.258.2 4  0.05) = \$92.857.123 = +213.71 2 +200.12  (1.56 7.6.000.122 = +159.500/(0.08)   Major refits cost \$2 million each.5 million at t = 15. a.473 million NPV = \$1.

000 x(1. That is its present value.276 .10  (1.464 + 1.10)  Another approach is to find the value of the savings at the time the boat is purchased.418  0.653. If x is the amount to be put aside each year.276  0. The unknown is the annual payment.105) = \$20.000 now.08 0. Using the present value of an annuity formula.10)  Because PV(savings) must equal PV(boat):  1 1  Annual savings    5   \$12.000) we can solve for the amount to be put aside each year.10 0.90  0. From this equation.10  (1.08)   1 1  C  \$20.418  1 1  PV(savings) = Annual savings    5   0.10)1 + x = \$20.08  (1.10 0. Because the amount in the savings account at the end of five years must be the price of the boat (\$20. then: x(1.10 + 1) = \$20.210 + 1.000 x(6.10)   1 1  Annual savings  \$12. we have: 1 1  PV  C    t  r r  (1  r)   1 1  \$20.08  (1.10)3 + x(1.10)2 + x(1. One approach to solving this problem is to find the present value of the cost of the boat and then equate that to the present value of the money saved.08)12  10.331 + 1.9.000     \$2.10  (1.000/(1.000 x = \$ 3. Mr. Assume the Zhangs will put aside the same amount each year. PV(boat) = \$20.10 0. we can solve for the amount to be put aside each year.10)4 + x(1.000  C    12   0.418   5   \$3. Basset is buying a security worth \$20.10)5 = \$12.08 0.

15 (1.554 1. The fact that Kangaroo Autos is offering “free credit” tells us what the cash payments are.05) 2 \$100.11.938  0.000    \$371 1.000 at 5%  NPV  \$170.0083  (1. the lower present value of cost.000    \$25.000 320..0083)  A car from Turtle Motors costs \$9.83% The present value of the payments to Kangaroo Autos is:  1 1  \$1.10) 2 \$100.991 1.011 1.05 (1.15) 2 The figure below shows that the project has zero NPV at about 11%.e.000 \$320. NPV at 11% is: \$100. 12.000 at 15%  NPV  \$170. i.000    \$3. it does not change the fact that money has time value. A 10% annual rate of interest is equivalent to a monthly rate of 0.05 0.83%: rmonthly = rannual /12 = 0.0083 = 0.10 0. The NPVs are: \$100.11 (1.11) 2 30 20 10 NPV NPV 0 -10 -20 0. As a check. Therefore.0083 0.000 320.000 cash.10 (1.000 320.000 NPV  \$170.000 at 10%  NPV  \$170. Kangaroo Autos offers the better deal.15 Rate of Interest .000  \$300    30   \$8.000    \$14.10/12 = 0.

57 = \$1.57 c.528. a.57 r 0.13. because: e0.10 r 0.0677 = 1.0677 Note that the pattern of payments in part (b) is more valuable than the pattern of payments in part (c).0700 Thus: C \$100 PV    \$1.428. This is worth the PV of stream (a) plus the immediate payment of \$100: PV = \$100 + \$1.477. you receive the cash more quickly.77%. The continuously compounded equivalent to a 7% annually compounded rate is approximately 6. and hence: C \$100 PV    \$1.07 b. with the former pattern of payment. This is the usual perpetuity. It is preferable to receive cash flows at the start of every year than to spread the receipt of cash evenly over the year. .428.