CORPORATE FINANCE
Solutions to Problem Set 2
Question 1
Your grandmother has been putting $1000 into a savings account on every birthday since your
first (i.e. when you turned one). The account pays an interest rate of 3%. How much money
will be in the account immediately after your grandmother makes the deposit on your 18th
birthday?
The deposits are an 18-year annuity.
(1+𝑟)𝑛 −1 (1+0.03)18 −1
FVA 𝑛 = 𝐶 × [ 𝑟
] = 1000 × [
0.03
] = 23,414.44
Question 2
Consider a business project that generates a stream of cash flows of $600 every year. Assume
that the appropriate discount rate to evaluate the cash flows of this project is 16%.
a) What is the present value of the project if it will generate a yearly $600 forever?
b) What is the present value of the project if it will generate a yearly $600 for the next 10
years and then ends?
c) What is the present value of the project if it will generate a yearly $600 for the next 25
years and then ends?
a)
Present Value of a Perpetuity
𝐶 600
𝑃𝑉 = = = $3750
𝑟 0.16
b)
Present Value of an annuity
1 − (1 + 𝑟)−𝑛 1 − (1 + 0.16)−10
𝑃𝑉 = 𝐶 [ ] = 600 [ ] = $2,900
𝑟 0.16
c)
1 − (1 + 𝑟)−𝑛 1 − (1 + 0.16)−25
𝑃𝑉 = 𝐶 [ ] = 600 [ ] = $3,658
𝑟 0.16
The discount rate does not have to be the interest rate.
If the number of payments and discount rate are high enough, the present value of the annuity
will approach the value of the perpetuity. (The cash flows that will be received far in to the
future are discounted so many times that their PV becomes very very small). Although cash
flows seldomly really are forever, in corporate finance we can use a perpetuity as an
approximation for payments that continue into the foreseeable future.
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CORPORATE FINANCE
Question 3
The interest rate is 10% p.a. What is the present value of a stream of five annual payments of
$50 each, if …
a) the first payment is received three years from now?
b) the first payment is received today?
a)
The formula for the PV of an annuity gives us the PV one period before the first payment.
(same holds of the formula for the PV of a perpetuity.
1 − (1 + 𝑟)−𝑛 1 − (1 + 0.10)−5
PV2 = 𝐶 [ ] = 50 [ ] = $189.54
𝑟 0.10
𝐹𝑉 189.54
PV0 = =
(1 + 𝑟)𝑛 (1 + 0.10)2
b)
There is no need to discount the first payment, since it is received today.
This stream is an annuity of 4 payments, plus $50.
1 − (1 + 𝑟)−𝑛
𝑃𝑉0 = 𝐶 + (𝐶 [ ])
𝑟
1 − (1 + 0.10)−4
PV0 = ($50 [ ]) + $50 = $208.50
0.10
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CORPORATE FINANCE
Question 4
Your client is interested in buying a small company that has fairly reliable cash flows in the
future. The projected cash flows are as follows. What is the maximum price that your client
should pay for this company if the appropriate discount rate for evaluating this type of company
is 12%?
YEAR NET CASH INFLOW
1 $20,000
2-5 $30,000
6-infinity $50,000
Present Value of Single Sum
𝐹𝑉 20,000
𝑃𝑉 = = = $17,857.14
(1+𝑟)𝑛 (1.12)1
Present Value of Annuity
1 − (1 + 𝑟)−𝑛 1 − (1.12)−4
𝑃𝑉1 = 𝐶 [ ] = 30,000 × [ ] = $91,120.48
𝑟 0.12
$91,120.48
𝑃𝑉0 = = $81,357.57
1.121
Present Value of Perpetuity
𝐶 50,000
𝑃𝑉5 = = = $416.666.67
𝑟 0.12
416.666.67
𝑃𝑉0 = = $236,427.86
1.125
Total Project:
𝑃𝑉 = 17,857.14 + 81,357.57 + 236,427.86 = $335,643
Therefore, it follows that the client should not pay more than $335,643 for the
company. It might be helpful to draw a timeline for this problem.
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CORPORATE FINANCE
Question 5
Five years ago, Chris entered into a mortgage agreement with Bangkok Bank to borrow
$200,000 and repay the loan over 20 years through equal monthly instalments. If the interest
rate was fixed at 8% p.a. for the entire term of the loan, what is the amount of each monthly
instalment?
A mortgage with equal monthly instalments (amortizing mortgage) is an example of an
annuity.
If we know the PV, we can use the formula to solve for C.
PV0 = $200,000 (amount originally borrowed)
r = 0.08/12 = 0.00667
n = 20 years x 12 = 240
1 − (1 + r)−n
PV0 = C [ ] = $200,000
r
1 − (1.00667)−240
C[ ] = $200,000
0.00667
C = $1,673.64
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