I601 – Assignment 1 Fall 2023

Solutions

Ans
1) Anything reasonable about institutional power vs weak group of retail
2) 2589.25
3) -13.17%
4) 81289.03
5) 2724.75
6) 1711472.24
7) 207695.92
8) 5.9%

Chapter 1
Question 1 [0.5 Marks]
Corporate ownership varies around the world. Historically, individuals have owned most shares in public
corporations in the United States. This is also the case in Canada, but ownership is more often
concentrated in the hands of a majority shareholder. In Germany and Japan, banks, other financial
institutions, and large companies own most public corporation shares. How do you think these
ownership differences affect the severity of agency costs in different countries?

Solution
We expect agency problems to be less severe in countries with a small percentage of individual
ownership. Fewer individual owners should reduce the number of diverse opinions concerning corporate
goals. The high percentage of institutional ownership might lead to more agreement between owners
and managers on decisions concerning risky projects. In addition, institutions may be better able to
implement effective monitoring mechanisms on managers than individual owners, based on the
institutions’ deeper resources and experiences with their management. The increase in institutional
ownership of stock in the United States and the growing activism of these large shareholder groups may
reduce agency problems for U.S. corporations and a more efficient market for corporate control.

ChatGPT Response:

The concept of agency costs refers to the potential conflicts of interest between the owners
(shareholders) and the managers of a firm. The extent of agency costs can be influenced by the
ownership structure of a company. Let's discuss how ownership differences in the United States, Canada,
Germany, and Japan may affect the severity of agency costs:

1. United States:

 Ownership Structure: Historically, individual investors have owned most shares in public
corporations in the United States.

 Impact on Agency Costs: With dispersed ownership, there is a potential for agency costs
as individual shareholders may have limited control and monitoring capabilities. This
may lead to a separation of ownership and control, creating principal-agent problems.

2. Canada:
 I601 – Assignment 1 Fall 2023
Solutions

 Ownership Structure: Like the U.S., individuals often own shares, but ownership is
sometimes more concentrated in the hands of majority shareholders.

 Impact on Agency Costs: Concentrated ownership can lead to a different set of agency
costs. While it may reduce some problems related to dispersed ownership, it introduces
the risk of majority shareholders exploiting minority shareholders.

3. Germany:

 Ownership Structure: In Germany, banks, financial institutions, and large companies

often own most public corporation shares. This is due to a stakeholder-oriented
corporate governance model.

 Impact on Agency Costs: The presence of institutional and corporate shareholders may
lead to better monitoring and control, potentially reducing agency costs. However, it can
also lead to a different set of agency issues if these entities pursue their own interests at
the expense of other stakeholders.

4. Japan:

 Ownership Structure: Similar to Germany, banks, financial institutions, and large

companies dominate public corporation share ownership in Japan.

 Impact on Agency Costs: This ownership structure might also mitigate certain agency
costs by providing strong monitoring and influence. However, it could potentially lead to
a concentration of power and favoritism, with the risk of managers serving the interests
of these large shareholders over smaller shareholders.

In summary, ownership differences can significantly impact the severity and nature of agency costs in
different countries. Dispersed ownership may lead to challenges in monitoring and controlling managers,
while concentrated ownership introduces its own set of risks. The specific governance mechanisms and
regulatory frameworks in each country also play a crucial role in shaping the dynamics of agency costs.

Chapter 2
Question 1 [0.5 Marks]
Simple City Bank pays 9 percent simple interest on its savings account balances, whereas Compound City
Bank pays 8 percent interest compounded annually. If you made a $10,000 deposit in each bank, how
much more money would you earn from your Compound City Bank account at the end of 10 years?

Solution
The simple interest per year is:
$10,000 × 0.09 = $900
So, after 10 years, you will have:
$900 × 10 = $9,000 in interest.
The total balance will be $10,000 + $9,000 = $19,000
With compound interest, we use the future value formula:
 I601 – Assignment 1 Fall 2023
Solutions

FV = PV(1 + r)t
FV = $10,000(1.08)10 = $21,589.25
The difference is:
$21,589.25 − $19,000 = $2,589.25

Question 2 [0.5 Marks]

Although appealing to more refined tastes, art as a collectible has not always performed so profitably. In
2010, Deutscher-Menzies sold Arkies under the Shower, a painting by renowned Australian painter Brett
Whiteley, at auction for $1,509,767. Unfortunately for the previous owner, he had purchased it three
years earlier for $2,305,825.

What was his annual rate of return on this painting?

Solution
We can use either the FV or the PV formula. Both will give the same answer since they are the inverse of
each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)(1 / t) − 1
r = ($1,509,767 / $2,305,825)1/3 − 1 = −0.1317 or −13.17%

Question 3 [1.0 Marks]

What is the PV of an annuity of $7,500 per year, with the first cash flow received three years from today,
and the last one received 32 years from today? Use a discount rate of 7 percent.

Solution
We can use the PVA annuity equation to answer this question. The annuity has 30 payments, not 29
payments. Since a payment is made in Year 3, the annuity begins in Year 2. So, the value of the annuity in
Year 2 is:
PVA = C({1 − [1/(1 + r) t] } / r )
PVA = $7,500({1 − [1/(1 + 0.07)]30 } / 0.07)
PVA = $93,067.81
This is the value of the annuity one period before the first payment, or Year 2. So, the value of the cash
flows today is:
PV = FV/(1 + r)t
PV = $93,067.81 / (1 + 0.07)2
PV = $81,289.03

Question 4 [0.5 Marks]

What is the value today of a 13-year annuity that pays $750 a year? The annuity’s first payment occurs
six years from today. The annual interest rate is 11 percent for years 1 through 5, and 13 percent
thereafter.

Solution
We need to find the present value of an annuity. Using the PVA equation, and the 13 percent interest
rate, we get:
PVA = C({1 − [1/(1 + r)]t } / r )
 I601 – Assignment 1 Fall 2023
Solutions

PVA = $750({1 − [1/(1 + 0.13)]13 } / 0.13)

PVA = $4,591.36
This is the value of the annuity in Year 5, one period before the first payment. Finding the value of this
amount today, we find:
PV = FV/(1 + r)t
PV = $4,591.36 / (1 + 0.11)5
PV = $2,724.75

Question 5 [1.0 Marks]

Your job pays you only once a year for all the work you did over the previous 12 months. Today,
December 31, you just received your salary of $75,000, and you plan to spend all of it. However, you
want to start saving for retirement beginning next year. You have decided that one year from today you
will begin depositing 6 percent of your annual salary in an account earning 8 percent per year. Your
salary will increase by 3 percent per year throughout your career.

How much money will you have on the date of your retirement, 40 years from today?

Solution
Since your salary grows at 3 percent per year, your salary next year will be:
Next year’s salary = $75,000 (1 + 0.0)
Next year’s salary = $77,250
This means your deposit next year will be:
Next year’s deposit = $77250(0.06)
Next year’s deposit = $4,635.00
Since your salary grows at 4 percent, your deposit will also grow at 4 percent. We can use the present
value of a growing annuity equation to find the value of your deposits today. Doing so, we find:
PV = C/(r − g) {1 − [(1 + g)/(1 + r)]t}
PV = $4,635/(0.08-0.03){1-[(1+0.03)/(1+0.08)]40}
PV = $78,780.66
Now, we can find the future value of this lump sum in 40 years. We find:
FV = PV(1 + r)t
FV = $78,780.66(1 + 0.08)40
FV = $1,711,472.24
This is the value of your savings in 40 years.

Question 6 [1.0 Marks]

A 20-year annuity pays $1,500 monthly, and payments are made at the end of each month. If the interest
rate is 6.25 percent compounded monthly for the first ten years and 5.50 percent compounded monthly
after that, what is the PV of the annuity?

Solution
This question asks for the present value of an annuity, but the interest rate changes during the annuity's
life. We need first to find the present value of the cash flows for the last ten years. The PV of these cash
flows is:
PVA2 = $1,500 [{1 − 1 / [1 + (0.055/12)]120} / (0.055/12)] = $138,215.37
 I601 – Assignment 1 Fall 2023
Solutions

Note that this annuity's PV is exactly ten years from today. Now, we can discount this lump sum to today
as well as find the PV of the annuity for the first 10 years. The value of this cash flow today is:
PV = $138,215.37/ [1 + (0.0625/12)]120 + $1,500 [{1 − 1 / [1 + (0.0625/12)]120} / (0.0625/12)]
PV = $207,695.92

Bonus Question [1.0 Marks]

Your financial planner offers you two different investment plans. Plan A is a $30,000 annual perpetuity.
Plan B is a 15-year, $52000 annual annuity. Both plans will make their first payment one year from today.

At what discount rate would you be indifferent between these two plans?

Solution
Here, we need to find the interest rate that makes us indifferent between an annuity and a perpetuity. To
solve this problem, we need to find the PV of the two options and set them equal. The PV of the
perpetuity is:
PV = $30,000 / r
And the PV of the annuity is:
PVA = $52,000[{1 – [1 / (1 + r)15]} / r ]
Setting them equal and solving for r, we get:
$30,000 / r = $52,000[{1 – [1 / (1 + r)15]} / r ]
$30,000 / $52,000 = 1 – [1 / (1 + r)15]
0.4231 (1/15) = 1 / (1 + r)
r = 1.0590 – 1
r = 0.0590, or 5.90%