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Assignment-1

Corporate finance
Part 1:-

A. Whats the future value of $100 to be received in 3 years if it earns 10%, annual
compounding?
Answer- FV can be solved by using the step-by-step, financial calculator, and
spreadsheet methods.
Inputs N=3, I/YR=10, PV=-100, PMT=0
FV3 = PV(1 + i)3
= $100(1 10)3 = $100(1 331)1.10) = $100(1.331)
= $133.10.
(Using table FVIF = 3Y AND 10% = 1.3310)

B. What is the present value of $100 to be released in 3 years if the interest rate is
10% annual compounding?
Answer- The PV shows the value of cash flows in terms of todays purchasing
power.
Inputs N=3, I/YR=10, PMT=0, FV=100
PV = FVN /(1 + I)N
PV = FV3 /(1 + I)3
= $100/(1.10)3
= $75.13

C. What annual interest rate would cause $100 to grow to $125.97 in 3 years?

Answer = fv=pv (1 + i) ^3
125.97 = 100 (1 + r/100) ^3
= 100 (100 + r) (100+ r) (100 +r)
------------------------------------
1000000

125.97 x 10000 = (100 + r) ^3


1259700 = (100 + r) ^3
r = 8%
PV = $100, FV = $125.97, N = 3, I = 7.999657063%
So the interest is about 8% annually.

D. If a companys sales are growing at a rate of 20% annually, how long it will take
sales to double?

Answer- solving the general FV equation for N

Inputs- I/YR=20, PV=-1, PMT=0, FV=2

Fv = pv (1 + i) ^n
2=1n(1+20) ^n
N= 3.8 years
*( Hard to solve without a financial calculator or spreadsheet.)

E. If you have $600 in the bank and the expected real rate of return is 4% but
expected inflation rate is 6%, what is the expected value of your bank balance?
Answer:- bank balance=$600 rate of return=4% rate of inflation=6%
Interest at the end of year=600*4/100=$24
Inflation at the end of the year=600*6/=$36
As inflation rate is > rate of return, so that the expected value of the bank balance
will be< PV value of the bank
Expected value of the bank=$600+ (I-IR) =$600+ ($24-$36)
=$600+ (-$12)=$600-$12=$500

F. What is the difference between ordinary annuity and an annuity due? What type
of annuity shown here? How would you change it to other type of annuity?
0 1 2 3

0 100 100 100

Answer- the payments made at the end of every period are called ordinary
annuity. This is because ordinary annuity is the usual state of affairs. Usually all
annuities are paid at the end of the period. Alternatively, when annuity payments
are made in advance, we call them annuity due. The difference in the formula to
calculate the two different types of annuities is very small. Also, the difference in
amounts is not expected to be large either.

The annuity shown here is an ordinary annuity as all the annuitys are paid at the
end of period.

We can change this annuity by making this payment advance


Ordinary annuity
0 1 2 3
I%

PMT PMT PMT


Annuity due
0 1 2 3
I%

PMT PMT PMT

G. 1. What is the future value of a 3-year, $100 ordinary annuity if the annual
interest rate is 10%?
Answer- $100 payment occur at the end of each period, but there is no PV.
Inputs N=3, I/YR=10, PV=0, PMT=-100

FVA = $100[(1+0.10)3 -1/0.10]


= $100[(1.10)3-1/0.10]
= $100[1.331-1/0.10]
= $100[0.331/0.10]
= $100[3.31]
FV= $331
2. What is the present value?
Answer- $100 payment still occur at the end of each period, but now there is no FV.
Inputs N=3, I/YR=10, FV=0, PMT=100
PVA = $100[1-(1+0.10)-3/0.10]
= $100[1-(1.10)-3/0.10]
= $100[1-0.751314/0.10]
= $100[0.248686/0.10]
= $100[2.48686]
PV= $248.69
3. What would the future and present values be if it was an annuity due?
Answer- now payment occur at the beginning of each period.
Solving for FV:

FVAD = $100*{[(1+0.10)3 -1/0.10]}*(1+0.10)


= $100*{[(1.10)3-1/0.10]}*(1.10)
= $100*{[1.331-1/0.10]}*(1.10)
= $100*{[0.331/0.10]}*(1.10)
= $100{[3.31]}*(1.10)
=$364.10
Inputs N=3, I/YR=10, PV=0, PMT=-100
Solving for PV:-
Again, $100 payment occur at the beginning of each period.

PVAdue=PVAord(1+I)
PVAD = $100*{[1-(1+0.10)-3/0.10]}*(1+0.10)
= $100*{[1-(1.10)-3/0.10]}*(1.10)
= $100*{[1-0.751314/0.10]}*(1.10)
= $100*{[0.248686/0.10]}*(1.10)
= $100*{[2.48686]}*(1.10)
=$248.69(1.10)=$273.55
Inputs N=3, I/YR=10, FV=0, PMT=100.

H. A- 5 year $100 ordinary annuity has an annual interest rate of 10%.


1. What is its present value?
Answer-

PVA = $100[1-(1+0.10)-5/0.10]
= $100[1-(1.10)-5/0.10]
= $100[1-0.62092/0.10]
= $100[0.37908/0.10]
= $100[3.7908]
Inputs N=5, I/YR=10, PMT=-100, FV=0.
PV=$379.08.
2. What would be the present value be if it was a 10 year annuity?
Answer-

PVA = $100[1-(1+0.10)-10/0.10]
= $100[1-(1.10)-10/0.10]
= $100[1-0.38554/0.10]
= $100[0.61446/0.10]
= $100[6.1446]
Inputs N=10, I/YR=10, PMT=-100, FV=0
PV=$614.46.

3. What would be the present value be if it was a 25 year annuity?


Answer-
PVA = $100[1-(1+0.10)-25/0.10]
= $100[1-(1.10)-25/0.10]
= $100[1-0.09229/0.10]
= $100[0.90771/0.10]
= $100[9.0771]
Inputs N=25, I/YR=10, PMT=-100, FV=0
PV=$907.70.
4. What would be the present value if this was a perpetuity?
Answer-
PV=PMT/I
PV=$100/0.1=$1000.

I. A 20 year old student wants to save $3 a day for the retirement. Every day she
places $3 in a drawer. At the end of each year, she invest the accumulated
savings ($1095) in a brokerage account with an expected annual return of 12%.
1. If she keep saving in this manner, how much will she have accumulated at the
age 65?
Answer-
Inputs N=45, I/YR=12, PV=0, PMT=-1095
FVAN= PMT / I * [(1+I) ^N -1]
= 1095 / 0.12 * [(1+0.12) ^45 1]
= $1,487,261.89, when she is 65

FV=$1487261.89

2. If a 40 year old investor began savings in this manner, how much would he have
at age 65?
Answer-
Inputs N=25, I/YR=12, PV=0, PMT=-1095
FVAN= PMT / I * [(1+I) ^N -1]
= 1095 / 0.12 * [(1+0.12) ^25 1]
= $146,000.59.
FV=$146000.59
This is $1.3 million less than if starting at age 20.

3. How much would the 40 year old investor have to save each year to accumulate
the same amount at 65 as the 20 year old investor?
Answer-
To find the required annual contribution enter the number of years until retirement
and the final goal of $1487261.89
Inputs N=25, I/YR=12, PV=0, FV=1487262.
PMT = FVAN* I / [(1+I) ^N 1]
= 1487262 * 0.12 / [(1+0.12) ^25 1]
= $11,154.42
PMT=-11154.42
It means 40 year old investor have to contribute approx. $31 every day.

J. What is the present value of the following uneven cash flow steam? The annual
interest rate is 10%?

0 1 2 3 4 years
10%

0 100 300 300 -50

Answer-
PV of this uneven cash flow:
0 1 2 3 4 years

10%

0 100 300 300 -50


90.91
247.93
225.39
-34.08
530.08 = PV

Inputs CF0=0, CF1=100, CF2=300, CF3=300, CF4=-50.


I/YR=10
(NPV=PV HERE)
PV=$530.087.
K.
1. Will the future value be longer or smaller if we compound an initial amount more
often than annually (e.g., semiannually, holding the stated (nominal) rate
constant)? Why?
Answer-
LARGER, as the more frequently compounding occurs, interest is earned on
interest more often.
Annually: FV3 = $100(1.10)3 = $133.10
Semiannually: FV6 = $100(1.05)6 = $134.01

2. Define (A) the stated (or quoted or nominal) rate, (B) the periodic rate, and (C)
the effective annual rate (EAR or EAF%).
Answer-
Nominal rate (INOM) also called the quoted or stated rate. An annual rate that
ignores compounding effects.
INOM is stated in contracts. Periods must also be given, e.g. 8% quarterly or 8%
daily interest.
Periodic rate (IPER) amount of interest charged each period, e.g. monthly or
quarterly.
IPER = INOM/M, where M is the number of compounding periods per year. M =
4 for quarterly and M = 12 for monthly compounding.
Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest
actually being earned, accounting for compounding.
EFF% for 10% semiannual investment
EFF% = ( 1 + INOM/M )M 1
= ( 1 + 0.10/2 )2 1 = 10.25%
Should be indifferent between receiving 10.25% annual interest and receiving
10% interest, compounded semiannually
Investments with different compounding intervals provide different effective
returns.
To compare investments with different compounding intervals, you must look at
their effective returns (EFF% or EAR).

3. What is the EAR corresponding to a nominal rate of 10% compounded


semiannually? Compounded quarterly? Compounded daily?

Answer-
See how the effective return varies between investments with the same nominal
rate, but different compounding intervals.
EARANNUAL 10.00%
EARQUARTERLY 10.38%
EARMONTHLY 10.47%
EARDAILY (365) 10.52%

INOM - Written into contracts, quoted by banks and brokers. Not used in
calculations or shown on time lines.
IPER - Used in calculations and shown on time lines. If M = 1, INOM =
IPER = EAR.
EAR - Used to compare returns on investments with different payments per
year. Used in calculations when annuity payments dont match compounding
periods.

4. What is the future value of $100 after 3 years under 10% semiannual
compounding? Quarterly compounding?
Answer-

L. When will the EAR equal the nominal (quoted) rate?


Answer-
Yes, but only if annual compounding is used, i.e., if M = 1.
If M > 1, EFF% will always be greater than the nominal rate.

M.
1. What is the value of the end of year 3 of the following cash flow stream if interest
is 10%, compounded semiannually? (Hint: you can use the EAR and treat cash
flow as an ordinary annuity or use the periodic rate and compound the cash flow
individually.)

0 1 2 3 4 5 6 periods
5%
0 100 100 100

Answer-
Payments occur annually, but compounding occurs every 6 months.
Cannot use normal annuity valuation techniques
Method1:-
FV3 = $100(1.05)4 + $100(1.05)2 + $100
FV3 = $331.80

Method2:- financial calculator


Find the EAR and treat as an annuity.
EAR = (1 + 0.10/2)2 1 = 10.25%.
Inputs N=3, I/YR=10.25, PV=0, PMT=-100.
Output FV=331.80

2. What is the PV?


Answer-
Could solve by discounting each cash flow, or
Use the EAR and treat as an annuity to solve for PV.
Inputs: N=3, I/YR=10.25, FV=0, PMT=100.
Output: PV=-247.59
So the PV is the 247.59

3. What would be wrong with your answer to L(1) and L(2) if you used the nominal
rate, 10%, rather than the EAR or the periodic rate, INOM/2=10%/2=5% to solve
the problems?

Answer:-
If I would have used the nominal rate, 10% rather than the EAR or the periodic
rate INOM/2=10%/2=5% then,
FV value of 10%< FV value with the EAR or periodic rate as
Using 5% semiannually rate would be consider 10.25% annually (EAR = (1 +
0.10/2)2 1 = 10.25%).
And in the end of the process the future value would have less than EAR or the
periodic rate INOM/2=10%/2=5%.

N.
1. Construct an amortization schedule for a $1000, 10% annual interest loan with 3
equal installments.
Answer-
Amortization tables are widely used for home mortgages, auto loans, business
loans, retirement plans, etc.
Financial calculators and spreadsheets are great for setting up amortization
tables.

All input information is already given, just remember that the FV = 0 because the
reason for amortizing the loan and making payments is to retire the loan

The balance at the end of the period, subtract the amount paid toward principal
from the beginning balance.

END BAL= BEG BAL PRIN


= $1,000 $302.11
= $697.89
The borrower will owe interest upon the initial balance at the end of the first year.
Interest to be paid in the first year can be found by multiplying the beginning balance by
the interest rate.
INTt = Beg balt (I)
INTt = $1,000(0.10)
= $100
If a payment of $402.11 was made at the end of the first year and $100 was paid toward
interest, the remaining value must represent the amount of principal repaid.
PRIN= PMT INT
= $402.11 $100
= $302.11
Notice that the absorption anniversary year declines because the alpha
accommodation antithesis is declining. Since the transaction is constant, but the
absorption basic is declining, the arch claim allocation is accretion anniversary year.
12 = 360 account payments if you get a 30-year, anchored bulk mortgage The
absorption basic is an bulk which is deductible to a business or a homeowner, and it
is taxable assets to the lender. If you buy a house, you will get a agenda complete
like ours, but longer, with 30
The transaction may accept to be added by a few cents in the final year to yield
affliction of rounding errors and accomplish the final transaction aftermath a aught
catastrophe balance.
The lender accustomed a 10% bulk of absorption on the boilerplate bulk of money
that was invested anniversary year, and the $1,000 accommodation was paid off.
This is what acquittal schedules are advised to do.
Most banking calculators accept acquittal functions congenital in.
Part 2:-
Q1:
Was Robert correct in stating that NPV, PI and IRR necessarily will yield the
same ranking order? Under what situations might the NPV, PI and IRR methods
provide different rankings? Why is it possible?
Answer:
Although all methods might grant projects acceptable ratings, NPV, PI, and IRR
will not necessarily yield the same ranking order. Such a phenomenon is the
result of different cash inflows over time (projects A and B), time horizons
(projects E and F) and/or project sizes (projects C and D). No. While, in general,
it is true that when one discounted cash flow method (NPV, PI, or IRR) gives a
project an acceptable rating, the other two methods also give this project an
acceptable rating; it is not necessarily true that these discounted cash flow
methods will rank these acceptable projects in the same order. Ranking
differences may occur as a result of (a) the time disparity problem resulting from
differences in the cash inflow patterns over time between two projects; (b) the
size disparity problem, resulting from the comparison of projects requiring initial
cash outflows of differing size; or (c) the life disparity problem, resulting from
projects with differing lives. These problems are illustrated in the case with
Projects A and B representing the time disparity problem, C and D, the size
disparity problem, and with E, F, G, and H, the life disparity problem. The ranking
problems incurred using the discounted cash flow methods are generally a
function of the different assumptions made about the reinvestment opportunities
for cash inflows over the life of the project.

Q2:
What are the NPV, PI and IRR for projects A and B? What has caused the
ranking conflicts? Should project A or B be chosen? Might your answer change if
project B is a typical project in the plastic molding industry? For example, if
projects for RLMC generally yield approximately 12%, is it logical to assume that
the IRR for project B of approximately 33% is correct calculation for ranking
purposes?

Answer:
Project A: Project B:
NPV = $34015.40 NPV = $31932.40
PI = 1.4535 PI = 1.4258
IRR = 27.194% IRR = 32.919%

In this case, the ranking conflicts have come as a result of different assumptions
made as to the reinvestment opportunities available for cash inflows over the life
of the project. The NPV and PI methods assume they can be reinvested at the
IRR rate. Thus, the correct investment decision as to acceptance of project A or
Project B becomes a function of which assumption is more accurate. When the
reinvestment rate is unknown, the more conservative approach is to use the net
present value criterion as it uses the required rate of return as its reinvestment
rate. Since no project will be accepted returning less than this value, this must be
at least a minimum reinvestment rate, and, for this reason, is preferred. Here
project A should select as it has a higher NPV. If however, project B is a typical
project, its IRR of 33% becomes a good approximation for the reinvestment rate
for ranking purpose, and Project B should then be selected as the IRR
assumption now appears more valid. Finally, if it is true that HPMC projects
typically yield approximately 12%, then the 33% IRR of project B is somewhat
overstated for ranking purpose.

Q3:
What are the NPV, PI and IRR for projects C and D? Should Project C or D be chosen?
Does your answer change if these projects are considered under a capital constraint?
What return on the marginal $12000 not employed in project C is necessary to make
one indifferent to choosing one project over the other under a capital rationing situation?
Answer:
The formula of NPV: Cash flow [1- {1/ (1+k) ^n}]/k Initial Outlay
IRR for each year cash flow: Cash flow/ (1+k) = Initial Outlay
Profitability Index (PI): Present value of cash flow/Initial outlay
So, NPV, IRR & PI of project C & D are-

Project (k=10%, n=1) NPV IRR PI


C 2000 37.5% 1.25
D 2727 25% 1.14

Project D should be chosen as it provides higher NPV than project C.


Under the situation of capital constrain it is better to choose project C though its NPV is
less than project D. In project C
Internal Rate of Return (IRR) > Discount rate K. and
Profitability Index (PI) is greater than 1 and higher than Project D.
These indicates that under the situation of capital constrain project C will generate more
profit than project D in spite of its lower NPV. So, project C will be chosen under a
capital constrain.
If marginal $12000 employed in project C as Initial outlay than
Project NPV IRR PI
C -2000 -8.3% 0.833

Under a capital rationing situation, project that generates higher profit within budget has
to be chosen. If marginal $12000 employed than project C will generate negative NPV,
IRR< K and PI<1. In this condition project D will be chosen over project C.

Q4:
What are the NPV, PI and IRR for projects E and F? Are these projects comparable
even though they have unequal lives? Why? Which project should be chosen? Assume
that these projects are not considered under a capital constraint.

Answer:
Project E Project F
Initial Outlay ($30,000) ($271,500)
CF in Year 1 210,000-30,000= $ 180,000 $100000
CF in Year 2 210,000-30,000= $ 180,000 $100000
CF in Year 3 210,000-30,000= $ 180,000 $100000
CF in Year 4 210,000-30,000= $ 180,000 $100000
CF in Year 5 210,000-30,000= $ 180,000 $100000
CF in Year 6 210,000-30,000= $ 180,000 $100000
CF in Year 7 210,000-30,000= $ 180,000 $100000
CF in Year 8 210,000-30,000= $ 180,000 $100000
CF in Year 9 210,000-30,000= $ 180,000 $100000
CF in Year 10 $210,000 $100000
NPV Calculation:
NPV of Project E= (180,000/1.1) + (180,000/1.1^2) + (180,000/1.1^3) + (180,000/1.1^4)
+ (180,000/1.1^5) + (180,000/1.1^6) + (180,000/1.1^7) + (180,000/1.1^8) +
(180,000/1.1^9) + (210,000/1.1^10) 30,000 =$ 1,087,588
NPV of Project F= 100,000 [1-1/1.1^10]/.1 -217,500
=$ 342,958
As per NPV project E should be chosen as the NPV is higher.
IRR Calculation: Project E:
(180,000/k) + (180,000/k^2) + (180,000/k^3) + (180,000/k^4) + (180,000/k^5) +
(180,000/k^6) + (180,000/k^7) + (180,000/k^8) + (180,000/k^9) + (210,000/k^10) = $
30,000
Suppose, k1=15%, L.H.S= $ 910,794
Suppose, k2= 20%, L.H.S= $ 776,157
IRR of Project E= .15+ [{(30,000-910,794)/ (776,157- 910,794)}/(.2-.15)] = 32.71%

Project F:
100,000 [1-1/(1+k)^10]/k = $ 271,500
Suppose, k1=15%, L.H.S= $ 501,877
Suppose, k2= 20%, L.H.S= $ 419,247
IRR of Project F= .15+ [{(271,500- 501,877)/ (419,247- 501,877)}/(.2-.15)] = 28.94%
As per IRR Project E should be chosen as the IRR is higher.

Profitability Index Calculation:


Profitability Index of Project E= 1,117,588.38/ 30,000 = 37.25
Profitability Index of Project F= 614,458/ 271,500 = 2.26
As per IRR Project E should be chosen as the IRR is higher.
Projects NPV IRR PI
Project E $ 1,087,588 32.71% 37.25
Project F $ 342,958 28.94% 2.26

Initially the projects are not comparable as Project E has a lifespan of 1 year, whereas
Project F will continue for 10 years. In such circumstance, the NPV, IFF and Profitability
Index are not comparable. Since Project E earns its cash inflow of $ 210,000 at the end
of the Year 1, while in Project F has same cash inflow of $ 100,000 for next ten years, it
has been argued that the appropriate comparison is with the cash flow of the earlier
project repeated ten more times. Thus both the projects become comparable and the
best project can be chosen, based on NPV, IRR and Profitability Index.

Q5:
What are the NPV, PI and IRR for projects G and H? Are these projects comparable
even though they have unequal lives? Why? Which project should be chosen? Assume
that these projects are not considered under a capital constraint.

Answer:
For project G:
i). We know that, PV Annuity = C*(PVIFA)
= C {[1-(1/ (1+i)n)]/i}
So, NPV= C {[1-(1/ (1+i)n)]/i}-IO
NPV=225000{[1-(1/(1.1)5]/.1}-500000=352927

ii). Profitability Index (PI)


PI= C {[1-(1/ (1+i)n)]/i}/ IO
PI=225000{[1-(1/(1.1)5]/.1}/500000
PI=1.71
iii). Internal rate of return (IRR)
IRR: C {[1-(1/ (1+i)n)]/i}= IO
IRR: 225000{[1-(1/(1+i)5)]/i}=500000
At, K=15%, L.H.S of equation,
=225000{[1-(1/(1.15)5]/.15}
=754234
At, k=20%, L.H.S of equation,
=225000{[1-(1/(1.2)5]/.2}
=672887
IRR = 15% + ((500000-754234)/(672887-754234))*(20%-15%)
IRR=30.61%

For project H:
i). Net present value (NPV)
We know that, PV Annuity = C*(PVIFA)
= C {[1-(1/(1+i)n)]/i}
NPV= C {[1-(1/(1+i)n)]/i}-IO
NPV=150000{[1-(1/(1.1)9]/.1}-500000=363853

ii). Profitability Index (PI)


PI= C {[1-(1/(1+i)n)]/i}/ IO
PI=150000{[1-(1/(1.1)9]/.1}/500000
PI=1.73
iii). Internal rate of return (IRR)
IRR: C {[1-(1/(1+i)n)]/i}= IO
IRR: 150000{[1-(1/(1+i)9)]/i}=500000
At, k=15%, L.H.S of equation,
=150000{[1-(1/(1.15)9]/.15}
=715737
At, k=20%, L.H.S of equation,
=150000{[1-(1/(1.2)9]/.2}
=604645
IRR=15% + ((500000-715737)/(604645-715737))*(20%-15%)
IRR=24.71%
Yes, those projects are comparable even though they have unequal lives.

Project G Project H
NPV 363853 352927
IRR 24.71% 30.61%
PI 1.73 1.71
(H-G) OF NPV=363853-352927=10926
Year Project H Project G Cash flow (H- G)
0 -500000 -500000 0
1 150000 225000 -75000
2 150000 225000 -75000
3 150000 225000 -75000
4 150000 225000 -75000
5 150000 225000 -75000
6 150000 150000
7 150000 150000
8 150000 150000
9 150000 150000

IRR: -75000{[1-(1/(1+i)5)]/i}+ 150000{[1-(1/(1+i)4)]/i}*(1*(1+k)^5)


At, k=5%,
IRR: -75000{[1-(1/(1+.05)5)]/.05}+ 150000{[1- (1/(1+.05)4)]/.05}*(1*(1+.05)^5)=92041
At, k=10%,
IRR: -75000{[1-(1/(1+.1)5)]/.1}+ 150000{[1-(1/(1+.1)4)]/.1}*(1*(1+.1)^5)=10927
IRR= 5% + ((0-92041)/(10927-92041))*(10%-5%)
IRR=10.67%
Project H should be chose.
Reference:-
1 Dividend Irrelevance Theory. (2015). Boundless. [online] Available at:
https://www.boundless.com/finance/textbooks/boundless-finance-
textbook/dividends-15/introduction-to-dividends-113/dividend-irrelevance-theory-
477-8290/ [Accessed 23 Sep. 2015].
2 Coursehero.com, (2015). A. (2) Explain briefly the dividend irrelevance theory
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