Workshop 1 SOL

WORKSHOP 1 SOLUTION: TOPIC 1
1.1
Question (4.11):
You have the opportunity to invest in a machine that costs $340,000. The
machine generates revenues of $100,000 at the end of each year and requires
maintenance costs of $10,000 at the beginning of each year. The machine
incurs a maintenance cost today because of start-up expenses. If the
economic life of the machine is 5 years and the relevant discount rate is 10
percent, should you buy the machine? What if the relevant discount rate is 9
percent?
Solution:
Calculate the NPV of the machine. Purchase the machine if it has a positive
NPV. Do not purchase the machine if it has a negative NPV.
Since the initial investment occurs today (year 0), it does not need to be
discounted.
PV(Investment) = -$340,000
Discount the annual revenues at 10 percent.
PV(Revenues) = $100,000 / (1.10) + $100,000 / (1.10)
2
+ $100,000 / (1.10)
3
+
$100,000 / (1.10)
4
+ $100,000 / (1.10)
5
= $379,078.68
Since the maintenance costs occur at the beginning of each year, the frst
payment is not discounted. Each year thereafter, the maintenance cost is
discounted at an annual rate of 10 percent.
PV(Maintenance) = -$10,000 - $10,000 / (1.10) - $10,000 / (1.10)
2
- $10,000 /
(1.10)
3
$10,000 / (1.10)
4
= -$41,698.65
NPV = -PV(Investment) + PV(Cash Flows) +
PV(Maintenance)
= -$340,000 + $379,078.68 - $41,698.65
= -$2,619.97
1
Since the NPV is negative, -$2,619.97, you should not buy the
machine.
To fnd the NPV of the machine when the relevant discount rate is nine
percent, repeat the above calculations, with a discount rate of nine percent.
NPV = PV(Investment) + PV(Cash Flows) + PV(Maintenance)
= -$340,000 + $388,965.13 - $42,397.20
= $6,567.93
Since the NPV is positive, $6,567.93, you should buy the machine.
1.2
Question (4.13):
Your aunt owns an auto dealership. She promised to pay you $3,000 for your
car when you graduate one year from now. However, your roommate ofered
you $3,500 for the car now. The prevailing interest rate is 12 percent. If the
future value of the beneft from owning the car for one additional year is
$1,000, should you accept your aunts ofer? You are not planning to buy
another car and will not need the car after you graduate.
Solution:
Compare the PV of your aunts ofer with your roommates ofer. Choose the
ofer with the highest PV. The PV of your aunts ofer is the sum of her
payment to you and the beneft from owning the car an additional year.
PV(Aunt) = PV(Trade-In) + PV(Beneft of Ownership)
= $3,000 / (1.12) + $1,000 / (1.12)
= $3,571.43
Since your roommates ofer occurs today (year 0), it does not need to be
discounted.
PV(Roommate) = $3,500
Since the PV of your aunts ofer, $3,571.43, is higher than your
roommates ofer, $3,500, you should accept your aunts ofer.
1.3.
2
Question (4.18):
Calculate the present value of $5,000 received 12 years from today. Assume a
stated annual interest rate of 10 percent, compounded quarterly.
Solution:
The solution is straightforward
PV(C
12
) = C
T
/ [1+(r / m)]
mT
= $5,000 / [1+(0.10 / 4)]
412
= $1,528.36
1.4.
Question (4.19):
Bank America ofers a stated interest rate of 4.1 percent, compounded quarterly,
while Bank USA ofers a stated annual interest rate of 4.05 percent, compounded
monthly. In which bank should you deposit your money?
Solution:
Deposit your money in the bank that ofers the highest efective annual yield,
EAY. The EAY is the rate of return you will receive after taking into account
compounding. Convert each banks stated annual interest rate into an EAY.
Note that here there are 4 compounding periods so m=4, then you get:
EAY(Bank America) = [1+(r / m)]
m

1
= [1+(0.041 / 4)]
4
1
3
= 0.0416 = 4.16%
EAY(Bank USA) = [1+(r / m)]
m

1
= [1+(0.0405 / 12)]
12
1
= 0.0413 = 4.13%
You should deposit your money in Bank America since it ofers a
higher EAY (4.16%) than Bank USA ofers (4.13%).
4
1.5
Brunel pharmaceuticals is considering a drug project that costs $240,000 today and is
expected to generate end-of-year annual cash flows of $21,000, foreer! "t what
discount rate would Brunel #e indifferent #etween accepting or rejecting the
project$
Solution: %he company would #e indifferent at the interest rate that ma&es the present
alue of the cash flows e'ual to the cost today! (ince the cash flows are a
perpetuity, we can use the )* of a perpetuity e'uation! +oing so, we find,
)* - C . r
$240,000 - $21,000 . r
r - $21,000 . $240,000
r - !0/01 or /!012
1.6
3r! (mart has #een wor&ing on an adanced technology in laser eye surgery! 4is
technology will #e aaila#le in the near term! 4e anticipates his first annual cash flow
from the technology to #e $200,000, receied two years from today! (u#se'uent
annual cash flows will grow at 12 in perpetuity! 5hat is the present alue of the
technology if the discount rate is 102$
Solution: %his is a growing perpetuity! %he present alue of a growing perpetuity is,
)* - 6 . 7r 8 g9
)* - 200,000 . 7!10 8 !019
)* - 4,000,000
:t is important to recogni;e that when dealing with annuities or perpetuities, the
present alue e'uation calculates the present alue one period #efore the first
payment! :n this case, since the first payment is in two years, we hae calculated
the present alue one year from now! %o find the alue today, we simply discount
this alue as a lump sum! +oing so, we find the alue of the cash flow stream
today is,
)* - <* . 71 = r9
t
)* - 4,000,000 . 71 = !109
1
)* - 3,>3>,3>3!>4
1

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WORKSHOP 1 SOLUTION: TOPIC 1

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