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Week 1 Problem Set (Solutions)

GMU MBA 643 Week 1 Practice and Solutions

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15 views

Week 1 Problem Set (Solutions)

GMU MBA 643 Week 1 Practice and Solutions

Uploaded by

hollandnguyen
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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School of Business

MBA 643
Week 1: Time Value of Money
Solutions
1. As winner of a lottery, you can choose one of the following prizes. Rank them in your
order of preference. The interest rate is 12%.
a. $403,200 at the end of 5 years.

N=5, I=12, FV=403,200, PMT=0


PV in year 0 = 228,786.51

b. $41,600 a year (starting from Year 1), for the next 10 years.

N=10, I=12, PMT=41,600, FV=0


PV in year 0 = 235,049.28

c. $67,200 a year, starting from Year 5, and ending in Year 13.

N=13-5+1=9, I=12, PMT=67,200, FV=0


PV in year 4 = 358,058.39
PV in year 0 = 358,058.39/1.124 = 227,552.58

2. Calculate the present value of the following cash flow streams.


a. $4000 in Year 3 and $2000 in Year 6. Interest rate is 10%.

PV of 4000 in year 0 = 3005.26 (N=3, I=10, PMT=0, FV=4000)


PV of 2000 in year 0 = 1128.95 (N=6, I=10, PMT=0, FV=2000)
PV in year 0 = 3005.26 + 1128.95 = 4134.21

Or, you can use the CF function:


CF0=0
CF1=0, F1=2
CF2=4000, F2=1
CF3=0, F3=2
CF4=2000, F4=1
I=10
NPV=4134.21

b. An annuity of $750 a year for 30 years, starting from Year 1. The interest rate is
expected to be 6%.

N=30, I=6, PMT=750, FV=0


PV in year 0 =10,323.62

c. An annuity of $750 a year for 30 years, starting from Year 1. The interest rate is
expected to be 10% for the next 20 years and 14% thereafter.

Due to the change in interest rate, essentially we have two annuities: one
from year 1 to 20 with r=10%, and the other from year 21 to 30 with r=14%.

N=20, I=10, PMT=750, FV=0


PV (of annuity from year 1 to 20) in year 0 = 6385.17

N=10, I=14, PMT=750, FV=0


PV (of annuity from year 21 to 30) in year 20 = 3912.09
N=20, I=10, PMT=0, FV=3912.09
PV (of annuity from year 21 to 30) in year 0 = 581.51

Add up:
PV in year 0 = 6385.17 + 581.51 = 6966.68

3. A factory costs $400,000. It will produce an inflow after operating costs of 100,000 in
year 1, $200,000 in year 2, and $300,000 in year 3. The opportunity cost of capital is
12%. Should you invest in the factory? Calculate the Net Present Value of this
investment.
Or use the CF function (2ND + CLR WORK to clear earlier records):

CF0=-400,000
CF1=100,000, F1=1
CF2=200,000, F2=1
CF3=300,000, F3=1
I=12
NPV= 62,258.56

4. Kingston Development Corp. purchased a piece of property for $2.79 million. The
firm paid a down payment of 15 percent in cash and financed the balance. The loan
terms require monthly payments for 15 years at an annual percentage rate of 7.75%,
compounded monthly. What is the amount of each mortgage payment?

Amount financed = $2,790,000 × (1 - 0.15) = $2,371,500

N=15*12=180
I=7.75/12=0.6458
PV=2,371,500 (amount received from bank, cash inflow)
FV=0
PMT=?
Solve for PMT=22,321.81
5. Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The
forecasted revenues are $5 million a year and operating costs are $4milion. A major
refit costing $2 million will be required after both the fifth and tenth years. After 15
years, the ship is expected to be sold for scrap at 1.5 million. What is the NPV if the
opportunity cost of capital if 8%?

NPV = – Investment – PV (refits) + PV (operating cash flows) + PV (scrap value)

PV (refits) = $2 / 1.085 + $2 / 1.0810 = 2.29

PV (operating cash flows) and PV (scrap value) : using financial calculator

N = 15, I = 8, PMT = 5 – 4 = 1, FV = 1.5  PV = – 9.03


NPV = – 8 – 2.29 + 9.03 = – 1.26

6. If the interest rate is 7%, what is the value of the following three investments?
a. An investment that offers you $100 a year in perpetuity with the payment at
the end of each year.
b. A similar investment with the payment at the beginning of each year

(a) PV = C/r = 100/0.07 = 1428.57

(b) PV = C + C/r = 100 + 1428.57 = 1528.57

7. Several years ago, The Wall Street Journal reported that the winner of the
Massachusetts State Lottery prize had the misfortune to be both bankrupt and in
prison for fraud. The prize was $9,420,713, to be paid in 19 equal annual
installments. (There were 20 installments, but the winner had already received the
first payment.) The bankruptcy court judge ruled that the prize should be sold off to
the highest bidder and the proceeds used to pay off the creditors.

a. If the interest rate was 8%, how much would you have been prepared to bid
for the prize?

b. Enhance Reinsurance Company was reported to have offered $4.2 million.


What rate of return was the company looking for?
(a) PMT = 9,420,713 / 19 = 495,827, N=19, I=8, FV=0,

Computer for PV = – 4,761,724

(b) PV = – 4,200,000, PMT = 9,420,713 / 19 = 495,827, N=19, FV=0


Compute for I = 9.81%

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