BUS306 Financial Management

Week 3: Seminar 2: Introduction and How to calculate Present Values

Question 1

Kodak declared bankruptcy. How can you reconcile a bankruptcy declaration with a management
pledged to maximize shareholder wealth?

Question 2:

Which of the following statements are true? The opportunity cost of capital:

i. Equals the interest rate at which the company can borrow

ii. Depends on the risk of the cash flows to be valued
iii. Depends on the rates of returns that shareholders can expect to earn by investing on their
own
iv. Equals zero if the firm has excess cash in its bank account and the bank account pays no
interest

Question 3:

If the PV of $139 is $125, what is the discount factor?

Question 4:

If the rate of return is 9%, what is the PV of $374 paid in year 9?

Question 5:

What is the present value of $800 to be received at the end of eight years, assuming the following
annual interest rate?

a) 4 percent, discounted annually

b) 8 percent, discounted annually

Question 6

A factory costs $800,000. You reckon that it will produce an inflow after operating costs of $170,000
a year for 10 years. If the opportunity cost of capital is 14%, what is the net present value of the
factory? What will the factory be worth at the end of five years?

Solutions
Question 1

By declaring bankruptcy, Kodak hoped to protect itself from the claims of creditors while it sought
a way to either sell or restructure its assets. Presumably, the management at Kodak thought that the
bankruptcy declaration would provide it with an opportunity to restructure itself, while it was
protected from the pressures of making burdensome interest and other payments to creditors.
Question 2

i. False. The opportunity cost of capital varies with the risks associated with each individual
project or investment. The cost of borrowing is unrelated to these risks.

ii. True. The opportunity cost of capital depends on the risks associated with each project and
its cash flows.

iii. True. The opportunity cost of capital is dependent on the rates of returns shareholders can
earn on the own by investing in projects with similar risks

iv. False. Bank accounts, within FDIC limits, are considered to be risk-free. Unless an
investment is also risk-free, its opportunity cost of capital must be adjusted upward to account
for the associated risks.

Question 3

PV = Ct / DFt
DFt = $125 / $139
DFt = 0.8993
Question 4

Using Formula

PV = Ct / (1 + r)t
PV = $374 / (1.09)9
PV = $172.21
Using PV tables

See table 2 (PVIF), look for PV factor at r = 9% and t = 9%

PV = Ct x PVIF (r, t)

PV = Ct x PVIF (0.09, 9)

PV = $374 x 0.460

PV = $172.04

Question 5

a) Using Formula

PV = Ct / (1 + r)t
PV = $800 / (1.04)8
PV = $584.53
 Using PV tables

See table 2 (PVIF), look for factor at r = 4% and n = 8

PV = Ct x PVIF (r, t)

PV = Ct x PVIF (0.04, 8)

PV = $800 x 0.731

PV = $584.80

b) Using Formula

PV = Ct / (1 + r)t
PV = $800 / (1.08)8
PV = $432.22
Using PV tables
See table 2 (PVIF), look for factor at r = 8% and n = 8

PV = Ct x PVIF (r, t)

PV = Ct x PVIF (0.08, 8)

PV = $800 x 0.540

PV = $432.00

Question 6

a. The net cash (in)flow is considered as an annuity. Hence we solve this question using PV
annuity table 4 or annuity formula noted in table 4
Using PV annuity interest factor (PVIFA)
NPV = -C0 + Ct [PVIFA (r, t)] (find PVIFA from table 4 at r = 14% and n = 10)
NPV = -C0 + Ct [PVIFA (0.14, 10)]
NPV = –$800,000 + [$170,000 × 5.216]
NPV = –$800,000 + $886,720
NPV = $86,720.
Using Formula (see formula in table 4 of PVIFA)
NPV = – Investment + C × ((1 / r) – {1 / [r(1 + r)t]})
NPV = –$800,000 + $170,000 × ((1 / .14) – {1 / [.14(1.14)10]})
NPV = $86,739.66
b. After five years, the factory’s value will be the present value of the five remaining year’s of
cash flows.
Find the PVIFA factor from table 4
PV = Ct [PVIFA (r, t)]
PV = Ct [PVIFA (0.14, 5)]
PV = [$170,000 × 3.433]
PV = $583,610
Using Formula (see formula in table 4 of PVIFA)
PV = $170,000 × ((1 / .14) – {1 / [.14(1.14)(10 – 5)]})
PV = $583,623.76