Chapter 02 - How to Calculate Present Values

CHAPTER 2

How to Calculate Present Values

1. Opportunity cost of capital. Which of the following statements are true? The opportunity cost of
capital:
a. Equals the interest rate at which the company can borrow.
b. Depends on the risk of the cash flows to be valued.
c. Depends on the rates of return that shareholders can expect to earn by investing on their own.
d. Equals zero if the firm has excess cash in its bank account.
e. Pays no interest.

1. a. 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.

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

c. 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

d. 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.
d. True

8. Future values. In the five years preceding the end of 2016, the price of Amazon shares rose by 34% a
year. If you had invested $100 in Amazon at the beginning of this period, how much would you
have by the end of the period?

8. FV= Principal × (1 + r)t

FV = $100 × 1.345
FV= $432.04

9. Discount factors.
a. If the present value of $139 is $125, what is the discount factor?
b. If that $139 is received in year 5, what is the interest rate?

9. a. PV = Ct × DFt
DFt = $125 / $139
DFt = .8993

b. Ct = PV × (1 + r)t
$139 = $125 × (1+r)5
r = [$139/$125](1/5) – 1 = 0.0215 or 2.15%

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Chapter 02 - How to Calculate Present Values

14. Present values. 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?

14. a. 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.

PV = $170,000 × ((1 / .14) – {1 / [.14(1.14)(10 – 5)]})

PV = $583,623.76

17. Perpetuities* An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9%, what
is the NPV?

17. NPV = investment + C / r

NPV = − $1,548 + $138 / .09
NPV = −$14.67

22. Annuities* Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and
then $300 a month for the next 30 months. Turtle Motors next door does not offer free credit but
will give you $1,000 off the list price. If the rate of interest is .83% a month, which company is
offering the better deal?

22. The fact that Kangaroo Autos is offering “free credit” tells us what the cash payments are; it does not
change the fact that money has time value.
Present value of payments to Kangaroo Auto:

PV = Down payment + C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $1,000 + $300 × ((1 / .0083) – {1 / [.0083(1 + .0083)30]})
PV= $8,938.02

Present value of car at Turtle Motors:

PV = price of car – discount

PV = $10,000 – 1,000
PV = $9,000

Kangaroo Autos offers the best deal because it has the lower present value of costs.

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Chapter 02 - How to Calculate Present Values

24. Annuities Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He
wishes to invest $20,000 in an annuity that will make a level payment at the end of each year until his
death. If the interest rate is 8%, what income can Mr. Basset expect to receive each year?

24. C = PVA / ((1 / r) – {1 / [r(1 + r)t]})

C = $20,000 / ((1 / .08) – {1 / [.08(1 + .08)12]})
C = $2,653.90

34. Growing annuities You estimate that by the time you retire in 35 years, you will have accumulated
savings of $2 million. If the interest rate is 8% and you live 15 years after retirement, what annual level of
expenditure will those savings support? Unfortunately, inflation will eat into the value of your retirement
income. Assume a 4% inflation rate and work out a spending program for your $2 million in
retirement savings that will allow you to increase your expenditure in line with inflation.

34. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

C = $2,000,000 / ((1 / .08) – {1 / [.08(1 + .08)15]})
C = $233,659.09

b. r (real rate) = (1 + R, nominal rate ) / (1 + h, inflation rate) – 1

r = 1.08 / 1.04 – 1
r = .0385, or 3.85%

PV = C × ((1 / r) – {1 / [r(1 + r)t]})

C = $2,000,000 / ((1 / .0385) – {1 / [.0385(1 +.0385)15]})
C = $177,952.49

The retirement expenditure amount will increase by 4% annually.

40. Compounding intervals You are quoted an interest rate of 6% pa. on an investment of $10
million. What is the value of your investment after four years if interest is compounded:
a. Annually?
b. Monthly?
c. Continuously?

40.
a. FV= PV × (1 + r)t
FV = $10,000,000 x (1.06)4
FV = $12,624,770

b. FV = PV × [1+ (r / m)mt
FV = $10,000,000 × [1 + (.06 / 12)]12 × 4
FV = $12,704,892

b. FV = PV × ert
FV = $10,000,000 × e.06 × 4
FV = $12,712,492

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McGraw-Hill Education.