Tutorial Answers Jan 29

1. (1) Both would still invest in their friend’s business. A invests and receives $121,000 for
his investment at the end of the year (which is greater than the $120,000 it would receive
from lending at 20%). G also invests, but borrows against the $121,000 payment, and
thus receives $100,833 today. This is an illustration on how free access to a well-
functioning financial market reconciles preferences for current and future consumption.

(2a) He could consume up to $200,000 now (foregoing all future consumption) or up to

$216,000 next year (200,000 × 1.08, foregoing all consumption this year). To choose the
same consumption (C) in both years, C = (200,000 – C) × 1.08 or C = $103,846.
Dollars Next Year

220,000

216,000

203,704

200,000
Dollars Now

(2b) He should invest all of his wealth to earn $220,000 next year. If he consumes all this
year, he can now have a total of $203,703.7 = (200,000 × 1.10/1.08) this year, by
borrowing against his future income next year at an 8% interest rate; or he can consume
$220,000 next year, foregoing all consumption this year. If he consumes C this year, the
amount available for next year’s consumption is (203,703.7 – C) × 1.08. To get equal
consumption in both years, set the amount consumed today equal to the amount next
year: C = (203,703.7 – C) × 1.08 or solve out C = $105,769.2.

As the figure illustrates, the straight lines are the inter-temporal budget constraints and
the slope measures the relative price of consumption next year to this year, which is
(1+8%). The presence of a project with 10% rate of return extends his budget constraint
and access to a well-functioning capital market further extends his budget constraint.

The opportunity Casper is given has a positive NPV (-200,000 + 200,000× 1.10/(1+0.08)
> 0) or equivalently has a rate of return larger than the opportunity cost of capital (10% >
8%). Therefore Casper is surely better off with the presence of this investment
opportunity and access to a well-functioning capital market—he has more consumption
in both years ($105,769.2 > $103,846).

Someday when you become a financial manager, make sure you accept all projects with
positive NPV (or equivalently with a rate of return larger than the opportunity cost of
capital); because when you do so, you can rest assured that you have best acted in the
interest of the shareholders.

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 2. (a) This calls for the growing perpetuity formula with a negative growth rate (g = –0.04):
$2 million $2 million
PV= = = $14 . 29 million
0 . 10 − (−0 . 04) 0 . 14
(b) Let’s solve this question using three methods.
First, if you recognize this is a 20-year annuity with negative constant growth rate, you
can directly apply the t-period growing annuity formula:
(1−0 . 04 )20
PV =$2 million×
[ 1
−
1
×
0 .10−(-0 . 04 ) 0. 10−(-0 . 04 ) (1+0 . 10)20 ]
= $13. 35 million

Second, you may treat this project as the difference between a regular perpetuity and a
delayed perpetuity. The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash
flows last forever, is:
20
C C (1 + g)
PV 20= 21 = 1
r−g r−g
With C1 = $2 million, g = – 0.04 and r = 0.10:
($2 million )×(1−0 . 04 )20 $0 .884 million
PV 20= = =$6 .314 million
0 . 14 0 . 14
Next, we convert this amount to PV today, and subtract it from the answer to Part (a):
$6 .314 million
PV=$14 .29 million− = $13 .35 million
(1. 10)20
Finally, if you start with definition and apply the general DCF formula, the PV should be
defined as in equation (1):
19
2 2 × ( 1−0.04 ) 2 × (1−0.04 )
PV = + 2
+ …+ 20
(1)
1+ 0.1 ( 1+0.1 ) ( 1+0.1 )
You can surely apply the geometric progress formula to solve out (1), but why not do it
1−0.04
yourself with a little trick? Let’s multiply on both sides of equation (1). It will
1+0.1
give us equation (2):
2 20
1−0.04 2× (1−0.04 ) 2× ( 1−0.04 ) 2× ( 1−0.04 )
PV = 2
+ 3
…+ 21
(2)
1+0.1 ( 1+ 0.1 ) ( 1+0.1 ) ( 1+0.1 )
Using equation (1) to minus equation (2), we get
20
1−0.04 2 2 × ( 1−0.04 )
( 1−
1+ 0.1 )
PV =
1+ 0.1
−
( 1+0.1 )
21

Now multiplying (1+ 0.1) and dividing (0.1-(-0.04)) on both sides, we get once again
20
1 1 (1−0.04 )
PV =$ 2 million ×
( − ×
0.1−(0.04 ) 0.1−(0.04) ( 1+0.1 )20
=$ 13.35 million
)
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3. ( a) Assuming the cost of the car does not appreciate over those five years, the money
you need to set aside now with a 5% interest rate is PV = 10,000/(1+0.05)5 = $7,835.26.
(b) This is a 6-year annuity with an interest rate 8%. Apply the formula in Table 2.2,
you need to set aside (12,000 × 6-year annuity factor) = 12,000 × 4.623 = $55,476.
(c) You have invested $60,476. But since you have to set aside $55,476 right now, at
the end of 6 years you would have (1+ 0.08)6 × (60,476 - 55,476) = $7,934 with an 8%
interest rate.

(a) t=0 t=1 t=2 t=3 t=4 t=5

FV 7835.26 8227.02 8638.37 9070.29 9523.81 10000.00

(b) t=0 t=1 t=2 t=3 t=4 t=5 t=6

FV 55,475 59,913 51,746 42,925 33,400 23,111 12,000
school fee 12,000 12,000 12,000 12,000 12,000 12,000
net FV 47,913 39,746 30,925 21,400 11,111 0

(c) one way t=0 t=1 t=2 t=3 t=4 t=5 t=6
FV 60,476 65,314 57,579 49,225 40,203 30,459 19,936
school fee 12,000 12,000 12,000 12,000 12,000 12,000
net FV 53,314 45,579 37,225 28,203 18,459 7,936

alternatively t=0 t=1 t=2 t=3 t=4 t=5 t=6

net FV 5,001 5,401 5,833 6,300 6,803 7,348 7,936

4. (a) PV = $100,000
(b) Apply the DCF formula directly,
PV = $180,000/(1+0.12)5 = $102,136.83
(c) Apply the formula for perpetuity,
PV = $11,400/0.12 = $95,000

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(d) Apply the formula for a 10-year annuity,

1 1
PV=$19,000 ×
[ −
0 .12 0. 12× (1 . 12)10]= $107,354 .24

(e) Apply the formula for growing perpetuity,

PV = $6,500/(0.12 - 0.05) = $92,857.14

Prize (d) is the most valuable because it has the highest present value.