Solution Manual for Corporate Finance Canadian 3rd

Edition by Berk DeMarzo Stangeland ISBN 0133055299

9780133055290
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Corporate Finance, 3Ce (Berk, DeMarzo, Strangeland)

Chapter 5
Interest Rates

5-1.

6 1 1
a. Since six months is  of two years, using our rule 1  0.2  4  1.0466 the equivalent six-month
24 4
rate is 4.66%.

1
b. Since one year is half of two years 1.2 2  1.0954 , the equivalent one-year rate is 9.54%.

1 1
c. Since one month is of two years, using our rule 1  0.2  24  1.00763 , the equivalent one-month
24
rate is 0.763%

If you deposit $1 into a bank account that pays 5% per year for three years you will have 1.05   1.15763
3
5-2.
after three years.

If the account pays 2 12 % per six months, then you will have 1.025   1.15969 after three years, so
6
a.
you prefer 2 12 % every six months.

If the account pays 7 12 % per 18 months, then you will have 1.075   1.15563 after three years, so you
2
b.
prefer 5% per year.

c. If the account pays 1

2 % per month, then you will have 1.005 36  1.19668 after three years, so you
1
prefer 2 % every month.

5-3. Timeline:

0 7 14 42

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 43

70,000 70,000 70,000

Because 1.06   1.50363 , the equivalent discount rate for a seven-year period is 50.363%, using the
7

annuity formula

70, 000  1 
PV   1 6
 $126, 964.
0.50363  1.50363 

Copyright © 2015 Pearson Canada Inc.

44 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

5-4. For a $1 investment in an account with 10% APR with monthly compounding, you will have

 1  0.1   $1.10471 .
12

 
 12 
So the EAR is 10.471%.
For a $1 investment in an account with 10% APR with annual compounding, you will have

1  0.1  $1.10 .
So the EAR is 10%.
For a $1 investment in an account with 9% APR with daily compounding, you will have

 1  0.09   1.09416 .
365

 
 365 
So the EAR is 9.416%.

5-5. Using Eq. 5.2 we get the implied effective rate per month from the new bank to be
0.08
= 0.006666 = 0.6666% per month .
12
To match this, you would have to earn over six months the following amount (using Eq. 5.1):

6-month effective rate = 1  0.006666   1  0.0406726  4.06726% per six months.

6

5-6. Use formula 5.1 to first convert the EAR into the implied effective rate needed for the APR quote. Let k be
the compounding frequency of the APR, therefore 1/k will be the length of the period for the required
implied effective rate of the APR.

years = 1  .05
1 1
Effective rate per k
1
k
Then, using Eq. 5.2 and solving for the APR, we get


APR  Implied Effective rate per
1 
years  k .
 k 
With annual payments k = 1, so APR = 5%.
With semiannual payments k = 2, so APR = 4.939%.
With monthly payments k = 12, so APR = 4.889%.

5-7. Using the PV of an annuity formula with N = 10 payments and C = $100 with r = 4.067% per six-month
interval, since there is an 8% APR with monthly compounding: 8% / 12 = 0.6667% per month, or
(1+0.006667)6 – 1 = 4.067% per six months.
1  1 
PV  100  1    $808.38
.04067  1.0406710 

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 45

5-8. First determine the effective amount of interest you earn over eight months. 50/1000 is 5%. Since this is an
effective rate you can use it to determine the future value of a single cash flow as long as you express number
of periods accordingly. (I.e., your periods must be expressed in eight-month units.)

FV  1000  1  .05
6
a. 8
 $1037.27 , so given $1000 invested, the interest is $37.27.

FV  1000  1  .05
12
b. 8
 $1075.93 , so given $1000 invested, the interest is $75.93.

FV  1000  1  .05
18
c. 8
 $1116.03 , so given $1000 invested, the interest is $116.03.

5-9. First solve for the required implied effective rate needed for your APR, and then use Eq. 5.2 to determine the
APR.
a. With an effective rate per six months (needed for the APR) and our FV formula, we use 10 six-month
periods:
1
 134.39  10
134.39  100  1  r  so 1  r     1.02999875
10

 100 
 r  2.999875% per 6 months and using equation 5.2 we get
APR=0.02999875  2  0.05999749  5.999749% per year compounded semiannually.
b. With an effective rate per one month (needed for the APR) and our FV formula, we use 60 one-month
periods:
1
 134.39  60
134.39  100  1  r  so 1  r     1.00493842
60

 100 
 r  0.493842% per 1 month and using equation 5.2 we get
APR=0.00493842  12  0.05926101  5.926101% per year compounded semiannually.

Note: If we had already solved for the effective six-month rate in (a), we could have used Eq. 5.1 to
convert it to the effective one month rate for part (b) and then continued as above using Eq. 5.2 to get the
final APR for part (b).

5-10. Timeline:

1
0 2 1 4
0 1 2 8

10,000 10,000 10,000

4%
4% APR (semiannual) implies a semiannual discount rate of  2% .
2
So,

10, 000  1 
PV  1  8 
0.02  1.02   .
 $73, 254.81

Copyright © 2015 Pearson Canada Inc.

46 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

5-11. You need to convert the rate per year compounded semiannually to an effective rate per month. 5%/2 = 2.5%
per six months. Therefore, the rate per month is
(1.025)1/6 – 1 = 0.41239%.
This is the percent of the outstanding principal that will be paid as interest each month.

5-12. Timeline:

0 1 2 3 4 60

–8,000 C C C C C
5.99 APR in this case would be monthly compounding and implies a discount rate of

5.99
 0.499167% .
12
Using the formula for computing a loan payment,
8, 000
C  $154.63 .
1  1 
1  60 
0.00499167  1.00499167  

5-13. Timeline:

0 1 2 3 4 360

–150,000 C C C C C
1
1  0.05375 12  1.0043725

So 5 83 % EAR implies a discount rate of 0.43725%.

Using the formula for computing a loan payment,

150, 000
C  $828.02 .
1  1 
1  360 
0.0043725  1.0043725  

5-14. The original mortgage had 30  12 = 360 payments. So far, (4 12) + 8 = 56 payments have been made,
leaving 360 – 56 = 304 payments remaining. The timeline is as follows:

56 57 58 360
0 1 2 304

2,356 2,356 2,356

Copyright © 2015 Pearson Canada Inc.
 Chapter 4 Interest Rates 47

To find out what is owed, compute the PV of the remaining payments using the loan interest rate to compute
the discount rate:

6.2
Interest Rate Per Semiannual Period   3.1%
2
1 6
Effective Rate Per Month = (1+0.031) -1=0.5101168%

2, 356 1  1   $363,514.33
PV   304 
0.005101168  1.005101168  

5-15. First we need to compute the original loan payment,

Timeline #1:

0 1 2 3 360

–800,000 C C C C
7.75% APR (compounded semiannually) implies an effective semiannual rate of 7.75/2 = 3.875%, and this
can be converted into an effective monthly rate as follows: (1.03875) 1/6-1=0.63564616%.
Using the formula for a loan payment,

800, 000  0.0063564616

C  $5,663.87 .
 1 
 1  1.0063564616 360 
 
Now we can compute the PV of continuing to make these payments.
Timeline #2: (you have already made 222 payments or 18.5 years of payments)

222 223 224 225 360

0 1 2 3 138

5,663.87 5,663.87 5,663.87 5,663.87

Using the formula for the PV of an annuity to determine what principal is still owed,

5, 663.87 1 
PV  1  138 
 $519,382.89 .
0.0063564616  1.0063564616  

(Note, if you used the unrounded payment, the PV would be $519,382.49.)

So, you would keep $1,000,000 – $519,382.89 = $480,617.11.

Copyright © 2015 Pearson Canada Inc.

48 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

a. APR of 6.5% compounded semiannually ÷ 2 = 3.25% per semiannual period.

The effective monthly rate is (1+0.0325)1/6-1 = 0.53447401%.
500,000
Payment =  $3,132.01 .
1  1 
 1  
.0053447401  1.0053447401360 
Total payments in one year = 3,132.01 × 12 = $37,584.12.

Loan balance at the end of one year = $3132.01 

1  1 
1    $494,319 .
.0053447401  1.0053447401348 
Therefore, 500,000 – 494,319 = $5681 in principal that is repaid in the first year, and 37,584 – 5681 =
$31,903 in interest that is paid in the first year.
b. Loan balance in 19 years (or 360 – 19×12 = 132 remaining pmts) is
1  1 
$3,132.01  1    $296,054 .
.0053447401  1.0053447401132 

1  1 
Loan balance in 20 years = $3,132.01  1    $276,901 .
.0053447401  1.0053447401120 
Therefore, 296,054 – 276,901 = $19,153 in principal is repaid, and $37,584 – 19,153 = $18,431 in
interest is repaid.

5-17.
a. First you must convert the 8% APR (compounded semiannually) to the effective monthly rate. Use Eq.
5.2 to get the implied effective rate per six months: 8%/2 = 4% per six months. Then use Eq. 5.1 to get
the effective rate per month:

1  .04
1
6
 1  0.006558197  0.6558197% per month.
The outstanding mortgage is just the present value of the remaining 300 payments. Use the annuity
formula:

1500  1 
PV  1  300 
 $196,537.42 .
.006558197  1  .006558197  

b. First you must convert the 5% APR (compounded semiannually) to the effective monthly rate. Use Eq.
5.2 to get the implied effective rate per six months: 5%/2 = 2.5% per 6 months. Then use Eq. 5.1 to get
the effective rate per month:

1  .025
1
6
 1  0.004123915  0.4123915% per month.

Then solve for the mortgage payments that give a present value of $150,000.

C  1 
150, 000  1  300 
.004123915  1  .004123915 
150, 000  .004123915
C   $872.41
 1 
1  300 
 1  .004123915 

The minimum mortgage payment the bank would be willing to accept would be $872.41.

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 49

5-18. We begin with the timeline of our required payments:

(1) Let’s compute our remaining balance on the student loan. As we pointed out earlier, the remaining
0 1 2 47 48

–500 –500 –500 –500

balance equals the present value of the remaining payments. The loan interest rate is 9% APR, or 9% /
12 = 0.75% per month, so the present value of the payments is

PV 
500  1 - 1   $20, 092.39 .
 48 
0.0075  1.0075 
Using the annuity spreadsheet to compute the present value, we get the same number:

N I PV PMT FV
48 0.75 % 20,092.39 –500 0

Thus, your remaining balance is $20,092.39.

If you prepay an extra $100 today, you will lower your remaining balance to $20,092.39 – 100 =
$19,992.39. Though your balance is reduced, your required monthly payment does not change. Instead,
you will pay off the loan faster; that is, it will reduce the payments you need to make at the very end of
the loan. How much smaller will the final payment be? With the extra payment, the timeline changes:

That is, we will pay off by paying $500 per month for 47 months, and some smaller amount, $500 – X,
in the last month. To solve for X, recall that the PV of the remaining cash flows equals the outstanding
balance when the loan interest rate is used as the discount rate:

19, 992.39 
500 1  1  X .
 48 
0.0075  (1  0.0075)  1.0075
48

Solving for X gives

X
19,992.39  20, 092.39 
1.007548 .
X  $143.14

So the final payment will be lower by $143.14.

Copyright © 2015 Pearson Canada Inc.

50 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

You can also use the annuity spreadsheet to determine this solution. If you prepay $100 today, and make
payments of $500 for 48 months, then your final balance at the end will be a credit of $143.14:

N I PV PMT FV
48 0.75 % 19,992.39 -500 143.14

(2) The extra payment effectively lets us exchange $100 today for $143.14 in four years. We claimed that
the return on this investment should be the loan interest rate. Let’s see if this is the case:

$100  1.0075 
48
 $143.14 , so it is.

Thus, you earn a 9% APR (the rate on the loan).

5-19. The timeline in this case is

0 1 2 N

20,092.39 -750 -750 -750

and we want to determine the number of monthly payments N that we will need to make. That is, we need to
determine what length of annuity with a monthly payment of $750 has the same present value as the loan
balance, using the loan interest rate as the discount rate. As we did in Chapter 4, we set the outstanding
balance equal to the present value of the loan payments and solve for N:

750
0.0075 
1
1
1.0075N  20, 092.39

1
1
1.0075 N
20, 092.39  0.0075
750
 0.200924

1
 1- 0.200924  0.799076
1.0075N
1.0075N  1.25145
Log(1.25145)
N  30.02.
Log(1.0075)
We can also use the annuity spreadsheet to solve for N:

N I PV PMT FV
30.02 0.75 % 20,092.39 –750 0

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 51

So, by prepaying the loan, we will pay off the loan in about 30 months, or 2 ½ years, rather than the four
years originally scheduled. Because N of 30.02 is larger than 30, we could either increase the 30 th payment by
a small amount or make a very small 31st payment. We can use the annuity spreadsheet to determine the
remaining balance after 30 payments:

N I PV PMT FV
30 0.75 % 20,092.39 –750 –13.86

If we make a final payment of $750.00 + $13.86 = $763.86, the loan will be paid off in 30 months.

5-20. From the solution to problem 5.10, the monthly payment on the mortgage is $828.02. So if we make
828.02
payments of  $414.01 every 2 weeks the timeline is
2

0 1 2 3 N

414.01 414.01 414.01 414.01

Now since there are 26 two-week periods in a year,
1
1.05375 26 =1.002016
So, the discount rate is 0.2016%.
To compute N we set the PV of the loan payments equal to the outstanding balance

414.01  1 
150, 000  1 
0.002016  1.002016 
N

and Solve for N

N

1
 1   150, 000  0.002016  0.7303
 1.002016  414.01
N
 1   0.2697
 1.002016 

log  0.2697
N  650.79 .
 1 
log 
 1.002016 

So it will take 651 payments to pay off the mortgage. Since the payments occur every two weeks this will
take 651  2  1302 weeks, or approximately 25 years. (It is shorter because there are slightly more than 52
weeks a year.)

5-21. The principal balance does not matter, so just pick 100,000. Begin by computing the monthly payment. The
semiannual effective rate is 6% so the effective monthly discount rate is (1+.06)1/6 –1= 0.97587942%

Copyright © 2015 Pearson Canada Inc.

52 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

Timeline #1:

0 1 2 360

100,000 –C –C –C
Using the formula for the loan payment,
100, 000  0.0097587942
C  $1,006.39 .
1  1 
 1.0097587942360 

Next we write out the cash flows with the extra payment:
Timeline #2:

0 1 6 7 18 19 N

100,000 –1006.39 –1006.39 –1006.39 –1006.39 –1006.39 –1006.39

–1006.39 –1006.39
The cash flow consists of 2 annuities.

i. The original payments. The PV of these payments is

   ,
N
1, 006.39 1
PVorg   1 
0.0097587942   1.0097587942  

the extra payment every Christmas. There are m such payments, where m is the number of years you
keep the loan. (For the moment we will not worry about the possibility that m is not a whole number.)
Since the time period between payments is one year, we first have to compute the discount rate as an
effective annual rate:

1.0097587942 12  1  12.36%

2
Note, this is the same as (1.06) -1=12.36%
So the discount rate is 12.36%
If we use the present value annuity formula on the annual extra payments that begin in month 6 and
continue each year following, and we assume there are m of them, we get a present value discounted to
month –6 (or one year before the first extra payment). Thus we need to adjust the present value
calculated to get the PV at time zero by multiplying by (1.06), recalling that 6% is the effective
semiannual rate.

1, 006.39  1 
PVextra, at month -6   1 
0.1236 1.1236 m 
1, 006.39  
 1  .06 .
1
so PVextra =  1 m
0.1236  1.1236 
To find out how long it will take to repay the loan, we need to determine the number of years until the
value of our loan payments has a present value at the loan rate equal to the amount we borrowed.
Because the number of monthly payments N = 12×m, we can write this as the following expression
which we need to solve for m:

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 53

100, 000  PVorg  PVextra

     1, 006.39  1 
12 m

 1.06 .
1, 006.39 1 1
100, 000    0.1236 

1.1236 m 
1
0.0097587942   1.0097587942 

The only way to find m is to iterate (guess) or use solver on Excel (see spreadsheet solution). The answer
is m  19.35 years , or approximately 19 years.

In fact, after exactly 19 years the PV of the payments is

   1, 006.39  
228

PV 
1, 006.39
1
1  1
 1.06  $99,548.82.
  1.0097587942 
  0.1236  1  19 
0.0097587942  1.1236 
2
Because the mortgage will take about 19.35 years to pay off this way— which is close to 3
of its life of
30 years—your friend is right.

5-22. You can use any money that you don’t spend on the car to pay down your credit card debt. Paying down the
loan is equivalent to an investment earning the loan rate of 15% APR. Thus, your opportunity cost of capital
is 15% APR (monthly) and so the discount rate is 15 / 12 = 1.25% per month. Computing the present value of
option (b) at this discount rate, we find

PV(b)  5000  (500)  1 1  1   5000  12, 444  $17, 444 .

.0125  1.012530 

You are better off taking the loan from the dealer instead of paying $18,000 now. If you take the loan, you
can use the remaining funds to pay down your credit card debt.

5-23.
a. First we calculate the outstanding balance of the mortgage. There are 25 × 12 = 300 months remaining
on the loan, so the timeline is
Timeline #1:

0 1 2 300

1,402 1,402 1,402

To determine the outstanding balance we discount at the original rate after converting it to an effective
monthly interest rate. 9% APR with semiannual compounding implies an effective semiannual rate of
9%÷2=4.5%. Converting the effective semiannual rate to an effective monthly rate we get
(1+0.045)1/6-1=0.73631230%:

1402  1 
PV   1 300 
 $169,328.30 .
0.0073631230  1.0073631230  
Next we calculate the loan payment on the new mortgage.
Timeline #2:

0 1 2 360

169,328.30 –C –C –C

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54 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

6.625
The effective monthly discount rate on the new loan is the new loan rate:  0.55208333% ,
12
using the formula for the loan payment:

169, 328.30  0.0055208333

C  $1,084.23 .
  1  
360

  1.0055208333  
1 
 

169, 328.30  0.0055208333

b. C  $1,156.58
  1  
300

  1.0055208333  
1 
 
1402  1 
c. PV   1   $169,328.30  N  199.6 months (You can use
0.0055208333  1.0055208333 N 
trial and error or the annuity calculator to solve for N).


1402 1 
PV   1 300 
 $205,259.23
d. 0.0055208333  1.0055208333 
 you can keep 205,259.23  169,328.30  $35,930.93
(Note: results may differ slightly due to rounding.)

5-24. The discount rate on the original card is

15
 1.25% .
12
Assuming that your current monthly payment is the interest that accrues, it equals
0.15
$25, 000   $312.50 .
12
Timeline:

0 1 2

312.50 312.50
This is a perpetuity. So the amount you can borrow at the new interest rate is this cash flow discounted at the
12
new discount rate. The new discount rate is  1% .
12
312.50
So PV   $31, 250 .
0.01
So by switching credit cards you are able to spend an extra 31, 250  25, 000  $6, 250 .

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 Chapter 4 Interest Rates 55

You do not have to pay taxes on this amount of new borrowing, so this is your after-tax benefit of switching
cards. (Beware, though, many cards charge an extra fee when doing a balance transfer; the benefit may
actually be less than what is shown above.)

r  i 0.07782  0.12299
5-25. rr    4.02229762%
1 i 1.12299
The purchasing power of your savings declined by 4.02229762 % over the year.

1 r
5-26. 1  rr  implies 1  r  (1  rr )(1  i)  (1.03)(1.05)  1.0815 .
1 i
Therefore, a nominal rate of 8.15% is required.

5-27. By holding cash, an investor earns a nominal interest rate of 0%. Since an investor can always earn at least
0%, the nominal interest rate cannot be negative. The real interest rate can be negative, however. It is
negative whenever the rate of inflation exceeds the nominal interest rate.

5-28.
a. NPV = –100,000 + 150,000 / 1.055 = $17,529.
b. NPV = –100,000 + 150,000 / 1.105 = –$6862
c. The answer is the IRR of the investment: IRR = (150,000 / 100,000)1/5 – 1 = 8.45%.

5-29.
a. Timeline:

0 1 2 3 4 5

1,000 2,000
Since the opportunity cost of capital is different for investments of different maturities, we must use the
cost of capital associated with each cash flow as the discount rate for that cash flow:
1, 000 2, 000
PV    $2, 652.15 .
1.0241 2
1.0332 5
b. Timeline:

0 1 2 3 4 5

500 500 500 500 500

Since the opportunity cost of capital is different for investments of different maturities, we must use the
cost of capital associated with each cash flow as the discount rate for that cash flow. Unfortunately we
do not have a rate for a four-year cash flow, so we linearly interpolate:

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56 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

1 1
r4   2.74    3.32   3.03
2 2
500 500 500 500 500
PV       $2, 296.43 .
1.0199 1.0241 1.0274  1.0303 1.0332 5
2 3 4

c. Timeline:

0 1 2 3 20

2,300 2,300 2,300 2,300

Since the opportunity cost of capital is different for investments of different maturities, we must use the
cost of capital associated with each cash flow as the discount rate for that cash flow. Unfortunately we
do not have a rate for a number of years, so we linearly interpolate:
1 1
r4   2.74    3.32 
2 2
 3.03
1 1
r6   3.32    3.76 
2 2
 3.54
2 1
r8   3.76    4.13
3 3
 3.883
1 2
r9   3.76    4.13
3 3
 4.0067
9 1
r11   4.13   4.93
10 10
 4.21
8 2
r12   4.13   4.93
10 10
 4.29
r13  4.37
r14  4.45
r15  4.53
r16  4.61
r17  4.69
r18  4.77
r19  4.85

2,300 2,300 2,300 2,300

PV     ... 
1  r1 1  r2  1  r3 
2 3
1  r20 
20

2,300 2,300 2,300 2,300

    ... 
1.0493
2 3 20
1.0199 1.0241 1.0274
 $30, 636.56

Copyright © 2015 Pearson Canada Inc.

 Chapter 4 Interest Rates 57

5-30. PV = 100 / 1.0199 + 100 / 1.02412 + 100 / 1.02743 =$285.61.

To determine the single discount rate that would compute the value correctly, we solve the following for r:
PV = 285.61 = 100/(1 + r) + 100 / (1 + r) 2 + 100/(1 + r)3 = $285.61.
This is just an IRR calculation. Using trial and error or the annuity calculator, r = 2.49891816%. Note that
this rate is between the one-, two-, and three-yr rates given.

5-31. The yield curve is increasing. This is often a sign that investors expect interest rates to rise in the future.

5-32.
a. The one-year interest rate is 6%. If rates fall next year to 5%, then if you reinvest at this rate over two
years you would earn (1.06)(1.05) = 1.113 per dollar invested. This amount corresponds to an EAR of
(1.113)1/2 – 1 = 5.49881516% per year for two years. Thus, the two-year rate that is consistent with these
expectations is 5.49881516%.
b. We can apply the same logic for future years (note that rates have been rounded to two decimal places;
normally, you should not round so much):
Year Future Interest Rates FV from reinvesting EAR
1 6% 1.0600 6.00%
2 5% 1.1130 5.50%
3 2% 1.1353 4.32%
4 3% 1.1693 3.99%
5 4% 1.2161 3.99%
6 5% 1.2769 4.16%
7 6% 1.3535 4.42%
8 6% 1.4347 4.62%
9 6% 1.5208 4.77%
10 6% 1.6121 4.89%
c. We can plot the yield curve using the EARs in (b); note that the 10-yr rate is below the one-year rate
(yield curve is inverted).

5-33. We can use the interest rates that each must pay on a five-year loan as the discount rate.
PV for Sherritt = 700 / 1.06385 = $513.80 < $525 today, so take the money now.
PV for Gov’t of Canada = 700 / 1.01315 = $655.90 > $525 today, so take the promise.

5-34. After-tax rate = 4%(1 – .30) = 2.8%, which is less than your tax-free investment which pays 3%.

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58 Solutions Manual for Berk/DeMarzo/Stangeland • Corporate Finance, 3rd Canadian Edition

a. The regular savings pays 5.5% EAR. The money market savings pays 5.25% per year with daily
compounding, so this gives 5.25% ÷ 365 = 0.014383562% per day. The effective annual rate for the money
market savings is thus (1 + 0.00014383562)365-1 = 5.38985833%. So the regular savings account pays the
higher rate.
b. After tax your friend’s best savings account only earns 5.5% × (1-0.35) = 3.575%. So your friend should
first pay down the credit card debt and then the car loan as their after-tax costs (which are the same as their
before-tax costs) are substantially higher than 3.575%. In addition, your friend should move his money
from the money-market savings into the regular savings as the regular savings gives a higher return (as we
saw from part a).

5-36. 8% is the appropriate cost of capital for a new risk-free investment, since you could earn 8% without risk by
paying off your existing loan and avoiding interest charges.

5-37. Because the prize is in pounds, we should use the pound interest rate (comparable risk). (1.05) (1/12) – 1 =
.4074%. 0.4074% × 90k = 366.67 pounds per month, or $733.34 per month at the exchange rate of 1 British
Pound = 2 US dollars.

5-38. Compare to the cost of $32,000 if paid now:

a. The payments are as risky as the firm’s other debt. So opportunity cost = debt rate. PV(36 month annuity
of 1000 at 6%/12 per month) = $32,871. So pay cash; it’s cheaper than the PV of the payments.
b. PV(annuity at 18%/12 per mo) = $27,661. So pay over time; the PV of the payments is less than $32,000
if paid all at once now.

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