Corporate Finance I

Homework 1: Reference Solution

Part (A). The Time Value of Money

Question 1. (10 points) Your grandfather put some money in an account for you on
the day you were born. You are now 18 years old and are allowed to withdraw the
money for the first time. The account currently has $3996 in it and pays an 8%
interest rate.
a. How much money would be in the account if you left the money there until
your 25th birthday?
b. What if you left the money until your 65th birthday?
c. How much money did your grandfather originally put in the account?

Solution:
a. Timeline:
18 19 20 21 25
0 1 2 3 7

3,996 FV = ?
7
FV = 3, 996(1.08)
= 6, 848.44

b. Timeline:
18 19 20 21 65
0 1 2 3 47

3,996 FV = ?
47
FV = 3, 996(1.08) = 148, 779
 c. Timeline:
0 1 2 3 4 18

PV=? 3,996
3, 996
PV = 18
= 1, 000
1.08

Question 2. (20 points) You have just turned 30 years old, have just received your
MBA, and have accepted your first job. Now you must decide how much money to
put into your retirement plan. The plan works as follows: Every dollar in the plan
earns 7% per year. You cannot make withdrawals until you retire on your sixty-
fifth birthday. After that point, you can make withdrawals as you see fit. You decide
that you will plan to live to 100 and work until you turn 65. You estimate that to
live comfortably in retirement, you will need $100,000 per year starting at the end
of the first year of retirement and ending on your 100th birthday. You will
contribute the same amount to the plan at the end of every year that you work. How
much do you need to contribute each year to fund your retirement?

Solution:
Timeline:
30 31 32 65 66 67 100
0 1 2 35 36 37 70

– – –
C C C 100 100 100
The present value of the costs must equal the PV of the benefits. So begin by
dividing the problem into two parts, the costs and the benefits.
Costs: The costs are the contributions, a 35-year annuity with the first payment
in one year:

C æ 1 ö
PVcosts = ç1 - 35 ÷
.
0.07 è (1.07 ) ø
 Benefits: The benefits are the payouts after retirement, a 35-year annuity paying
$100,000 per year with the first payment 36 years from today. The value of this
annuity in year 35 is:

The value today is just the discounted value in 35 years:

Since the PV of the costs must equal the PV of the benefits (or equivalently the
NPV of the cash flow must be zero):

Solving for C gives:

Part (B). Valuing Bonds

Question 3. (10 points) Suppose you purchase a 10-year bond with 6% annual
coupons. You hold the bond for four years, and sell it immediately after receiving
the fourth coupon. If the bond’s yield to maturity was 5% when you purchased and
sold the bond,
a. What cash flows will you pay and receive from your investment in the bond per
$100 face value?
b. What is the internal rate of return of your investment?
Solution:
a. First, we compute the initial price of the bond by discounting its 10 annual
coupons of $6 and final face value of $100 at the 5% yield to maturity.

NPER Rate PV PMT FV Excel Formula

Given: 10 5.00% 6 100
=
Solve For PV: (107.72) PV(0.05,10,6,100)

Thus, the initial price of the bond = $107.72. (Note that the bond trades above
par, as its coupon rate exceeds its yield.)
Next, we compute the price at which the bond is sold, which is the present value
of the bonds cash flows when only 6 years remain until maturity.

NPER Rate PV PMT FV Excel Formula

Given: 6 5.00% 6 100
=
Solve For PV: (105.08) PV(0.05,6,6,100)

Therefore, the bond was sold for a price of $105.08. The cash flows from the
investment are therefore as shown in the following timeline.

Year 0 1 2 3 4

Purchase Bond –$107.72

Receive Coupons $6 $6 $6 $6
Sell Bond $105.08
Cash Flows –$107.72 $6.00 $6.00 $6.00 $111.08

b. We can compute the IRR of the investment using the annuity spreadsheet. The
PV is the purchase price, the PMT is the coupon amount, and the FV is the sale
price. The length of the investment N = 4 years. We then calculate the IRR of
investment = 5%. Because the YTM was the same at the time of purchase and
sale, the IRR of the investment matches the YTM.
 NPER Rate PV PMT FV Excel Formula
Given: 4 –107.72 6 105.08
Solve For Rate: 5.00% = RATE(4,6,–107.72,105.08)

Question 4. (25 points) Assume there are four default-free bonds with the following
prices and future cash flows:

Do these bonds present an arbitrage opportunity? If so, how would you take
advantage of this opportunity? If not, why not?

Solution:
To determine whether these bonds present an arbitrage opportunity, check whether
the pricing is internally consistent. Calculate the spot rates implied by Bonds A, B,
and D (the zero-coupon bonds), and use this to check Bond C. (You may
alternatively compute the spot rates from Bonds A, B, and C, and check Bond D,
or some other combination.)
1000
934.58 = Þ YTM1 = 7.0%
(1 + YTM1 )

1000
881.66 = Þ YTM 2 = 6.5%
(1 + YTM 2 )2

1000
839.62 = Þ YTM 3 = 6.0%
(1 + YTM 3 )3

Given the spot rates implied by Bonds A, B, and D, the price of Bond C should be
$1,105.21. Its price really is $1,118.21, so it is overpriced by $13 per bond. Yes,
there is an arbitrage opportunity.
To take advantage of this opportunity, you want to (short) Sell Bond C (since it is
overpriced). To match future cash flows, one strategy is to sell 10 Bond Cs (it is
not the only effective strategy; any multiple of this strategy is also arbitrage). This
complete strategy is summarized in the table below.
 Today 1 Year 2Years 3Years
Sell Bond C 11,182.10 –1,000 –1,000 –11,000
Buy Bond A –934.58 1,000 0 0
Buy Bond B –881.66 0 1,000 0
Buy 11 Bond D –9,235.82 0 0 11,000
Net Cash Flow 130.04 0 0 0

Notice that your arbitrage profit equals 10 times the mispricing on each bond
(subject to rounding error).

Part (C). Valuing Stocks

Question 5. (10 points) Procter & Gamble will pay an annual dividend of $0.65
one year from now. Analysts expect this dividend to grow at 12% per year thereafter
until the fifth year. After then, growth will level off at 2% per year. According to the
dividend-discount model, what is the value of a share of Procter & Gamble stock if the
firm’s equity cost of capital is 8%?

Solution:
Value of the first 5 dividend payments:

0.65 æ æ 1.12 ö5 ö
PV1-5 = ç1 - ÷ = $3.24.
( 0.08 - 0.12) çè çè 1.08 ÷ø ÷ø

Value on date 5 of the rest of the dividend payments:

0.65 (1.12 ) 1.02
4

PV5 = = 17.39.
0.08 - 0.02

Discounting this value to the present gives

17.39
PV0 = = $11.83.
(1.08 )
5

So the value of Gillette is: P = PV1-5 + PV0 = 3.24 + 11.83 = $15.07.

Question 6. (25 points) Sora Industries has 60 million outstanding shares, $120
million in debt, $40 million in cash, and the following projected free cash flow for
the next four years:

a. Suppose Sora’s revenue and free cash flow are expected to grow at a 5% rate
beyond year 4. If Sora’s weighted average cost of capital is 10%, what is the
value of Sora’s stock based on this information?
b. Sora’s cost of goods sold was assumed to be 67% of sales. If its cost of goods
sold is actually 70% of sales, how would the estimate of the stock’s value
change?
c. Let’s return to the assumptions of part (a) and suppose Sora can maintain its
cost of goods sold at 67% of sales. However, now suppose Sora reduces its
selling, general, and administrative expenses from 20% of sales to 16% of sales.
What stock price would you estimate now? (Assume no other expenses, except
taxes, are affected.)
d. Sora’s net working capital needs were estimated to be 18% of sales (which is
their current level in year 0). If Sora can reduce this requirement to 12% of sales
starting in year 1, but all other assumptions remain as in part (a), what stock
price do you estimate for Sora? (Hint: This change will have the largest impact
on Sora’s free cash flow in year 1.)
Solution:
a. V(3) = 33.3 / (10% – 5%) = 666
V(0) = 25.3 / 1.10 + 24.6 / 1.102 + (30.8 + 666) / 1.103 = 567
P(0) = (567 + 40 – 120) / 60 = $8.11

Year 0 1 2 3 4 5
Earnings Forecast ($000s) 8% 10% 6% 5% 5%
1 Sales 433.00 468.00 516.00 546.96 574.31 603.02
2 Cost of Goods Sold (327.60) (361.20) (382.87) (402.02) (422.12)
3 Gross Profit 140.40 154.80 164.09 172.29 180.91
4 Selling, General & Admin. (93.60) (103.20) (109.39) (114.86) (120.60)
6 Depreciation (7.00) (7.50) (9.00) (9.45) (9.92)
7 EBIT 39.80 44.10 45.70 47.98 50.38
8 Income tax at 40% (15.92) (17.64) (18.28) (19.19) (20.15)
9 Unlevered Net Income 23.88 26.46 27.42 28.79 30.23
Free Cash Flow ($000s)
10 Plus: Depreciation 7.00 7.50 9.00 9.45 9.92
11 Less: Capital Expenditures (7.70) (10.00) (9.90) (10.40) (10.91)
12 Less: Increases in NWC (6.30) (8.64) (5.57) (4.92) (5.17)
13 Free Cash Flow 16.88 15.32 20.94 22.92 24.07

b. Free cash flows change as follows:

Hence V(3) = 458, and V(0) = 388. Thus, P(0) = $5.13.
Year 0 1 2 3 4 5
Earnings Forecast ($000s) 8% 10% 6% 5% 5%
1 Sales 433.00 468.00 516.00 546.96 574.31 603.02
2 Cost of Goods Sold (313.56) (345.72) (366.46) (384.79) (404.03)
3 Gross Profit 154.44 170.28 180.50 189.52 199.00
4 Selling, General & Admin. (74.88) (82.56) (87.51) (91.89) (96.48)
6 Depreciation (7.00) (7.50) (9.00) (9.45) (9.92)
7 EBIT 72.56 80.22 83.98 88.18 92.59
8 Income tax at 40% (29.02) (32.09) (33.59) (35.27) (37.04)
9 Unlevered Net Income 43.54 48.13 50.39 52.91 55.55
Free Cash Flow ($000s)
10 Plus: Depreciation 7.00 7.50 9.00 9.45 9.92
11 Less: Capital Expenditures (7.70) (10.00) (9.90) (10.40) (10.91)
12 Less: Increases in NWC (6.30) (8.64) (5.57) (4.92) (5.17)
13 Free Cash Flow 36.54 36.99 43.92 47.04 49.39

c. New FCF:
Now V(3) = 941, V(0) = 804, P(0) = $12.07
d. Inc. in NWC in yr1 = 12% Sales(1) – 18% Sales(0)
Inc in NWC in later years = 12% × change in sales
 Year 0 1 2 3 4 5
Earnings Forecast ($000s) 8% 10% 6% 5% 5%
1 Sales 433.00 468.00 516.00 546.96 574.31 603.02
2 Cost of Goods Sold (313.56) (345.72) (366.46) (384.79) (404.03)
3 Gross Profit 154.44 170.28 180.50 189.52 199.00
4 Selling, General & Admin. (93.60) (103.20) (109.39) (114.86) (120.60)
6 Depreciation (7.00) (7.50) (9.00) (9.45) (9.92)
7 EBIT 53.84 59.58 62.10 65.21 68.47
8 Income tax at 40% (21.54) (23.83) (24.84) (26.08) (27.39)
9 Unlevered Net Income 32.30 35.75 37.26 39.13 41.08
Free Cash Flow ($000s)
10 Plus: Depreciation 7.00 7.50 9.00 9.45 9.92
11 Less: Capital Expenditures (7.70) (10.00) (9.90) (10.40) (10.91)
12 Less: Increases in NWC 21.78 (5.76) (3.72) (3.28) (3.45)
13 Free Cash Flow 53.38 27.49 32.65 34.90 36.64

New FCF:
Now V(3) = 698, V(0) = 620, P(0) = $9.00