CorporateFinance 1028951 Yuka SENGA

Corporate Finance
Semester 1 2015
Assignment 1
Question 1 (2 marks)

Tirade Owens, a professional athlete, currently has a contract that will pay him a large
amount in the first year of his contract and smaller amounts thereafter. He and his agent have
asked the team to restructure the contract. The team, though reluctant, obliged. Tirade and his
agent came up with a counteroffer. What are the present values of each of the contracts using
a 14 percent discount rate? Which of the three contacts has the highest present value?
Current Contract Team’s Offer Counteroffer
Year
1 $8,125,000 $4,000,000.00 $5,250,000.00
2 $3,650,000 $3,825,000.00 $7,550,000.00
3 $2,715,000 $3,850,000.00 $3,625,000.00
4 $1,822,250 $3,925,000.00 $2,800,000.00
Answer:
Current Contract
PV=8,125,000/1.14 +3,650,000/(1.14)2+2,715,000/(1.14)3+1,822,250/(1.14)4
=7,127,192.98+2,808,556.48+1,832,547.67 + 1,078,918.29

= $12,847,215.41

Team’s Offer
PV=4,000,000.00/1.14 + 3,825,000.00/1.142 + 3,850,000.00/1.143 +3,925,000.00/1.144
= 3,508,771.93 + 2,943,213.30 + 2,598,640.34 + 2,323,915.09

= $11,374,540.65

Counteroffer
PV= 5,250,000.00/1.14 + 7,550,000.00/1.142 +3,625,000.00/1.143 +2,800,000.00/1.144

= 4,605,263.16 + 5,809,479.84 + 2,446,771.75+ 1,657,824.78

= $14,519,339.52

The counteroffer has the best value for the player.

Question 2 (2 marks)
 CorporateFinance 1028951 Yuka SENGA

The top prize for the state lottery is $100,000,000. You have decided it is time for you to take
a chance and purchase a ticket. Before you purchase the ticket, you must decide whether to
choose the cash option or the annual payment option. If you choose the annual payment
option and win, you will receive $100,000,000 in 25 equal payments of $4,000,000─one
payment today and one payment at the end of each of the next 24 years. If you choose the
cash payment, you will receive a one-time lump sum payment of $59,194,567.18. If you can
invest the proceeds and earn 6 percent, which option should you choose?

Answer:
The Present Value of the cash flow from the annual payment option to use 6%
discount rate.
Annuity PV factor = (1-1/(1.06)25)/0.06 = 12.783
Annuity PV 25 = PMT ×PV annuity Factor
= $4,000,000 ×12.783
= $51,132,000
Annuity Value Due = PVA25 ×(1+r)
=51,132,000 (1+0.06)
= 54,199,920
This annuity payment less than lump sum payment of
$59,194,567.18. You are better taking the lump sum payment
option.


 CorporateFinance 1028951 Yuka SENGA

Question 3 (2 marks)

BabuBaradwaj is saving for his son’s college tuition. His son is currently 11 years old and
will begin college in seven years. Babu has an index fund investment of $7,500 that is
earning 9.5 percent annually. Total expenses at the University of Maryland, where his son
says he plans to go, currently total $15,000 per year but are expected to grow at roughly 6
percent each year. Babu plans to invest in a mutual fund that will earn 11 percent annually to
make up the difference between the college expenses and his current savings. In total, Babu
will make seven equal investments with the first starting today and with the last being made a
year before his son begins college.

a. What will be the present value of the four years of college expenses at the time that
Babu’s son starts college? Assume a discount rate of 5.5 percent.

Annual cost of college tuition today - $15,000

Expected increase in annual tuition costs – 6%

Years From now FV caluculation Tuition costs

7 15000(1.06)7 22,554.45
8 15000(1.06)8 23,907.72
9 15000(1.06)9 25,342.18
10 15000(1.06)10 26,862.72

Discount Rate = 5.5%

PV
First year 22,554.45/(1.055) =21,378.63
Second year 23,907.72/(1.055)2= 21,479.95
Third year 25,342.18/(1.055)3= 21,581.75
Forth year 26,862.72/(1.055)4=21,684.03
$86,124.36
 CorporateFinance 1028951 Yuka SENGA

b. What will be the value of the index mutual fund when his son just starts college?
Future Value of the index mutual fund at t =7

Present Value of index fund investment = PV = $7,500

Return on fund = 9.5%
FV= PV(1+r)t = 7,500(1+0.095)7=14,156.64

c. What is the amount that Babu will have to have saved when his son turns 18 if Babu
plans to cover all of his son’s college expenses?

Target savings needed t = 7

PV of tuition costs – FV of investment=86,124.36-14,156.64 = $71,967.72

d. How much will Babu have to invest every year in order for him to have enough funds
to cover all his son’s expenses?

Return on fund = 11%

Amount need to be saved as FV=71,967.72
FV = PMT ((1+r)t-1/r)
PMT = FV/((1+r)t-1/1)(1+r) =71,967.72/((1.11)7-1/0.11)×(1.11)
=71,967.72/9.7833×1.11
=6,627.21
 CorporateFinance 1028951 Yuka SENGA

Question 4 (2 marks)

You are planning to purchase a caravan for $40,000, and you have $10,000 to apply as a
down payment. You may borrow the remainder under the following terms: a 10-year loan
with semi-annual repayments and a stated interest rate of 6 %. You intend to make $6,000
payments, applying the excess over your required payment to the reduction of the principal
balance.
a. Given these terms, how long (in years) will it take you to fully repay your loan?
In 3 years

Is already give us he would make payment $6,000. We could make spreadsheet on this based
information.

Using a spreadsheet to amortize a loan

Loan
amount: $30,000
Interest rate: 0.06
Loan term: semi-annual
Loan
payment: $6,000

Amortization table:

Year Beginning Total Interest Principal Ending

  Balance Payment Paid Paid Balance
0.5 30,000.00 6,000.00 900.00 5,100.00 24,900.00
1 24,900.00 6,000.00 747.00 5,253.00 19,647.00
1.5 19,647.00 6,000.00 589.41 5,410.59 14,236.41
2 14,236.41 6,000.00 427.09 5,572.91 8,663.50
2.5 8,663.50 6,000.00 259.91 5,740.09 2,923.41
3 2,923.41 3,011.11 87.70 2,923.41 0.00
Totals 33,011.11 3,011.11 30,000.00

b. What will be your total interest cost?

$3,011.11
 CorporateFinance 1028951 Yuka SENGA

c. What would your interest cost be if you made no prepayments and repaid your loan by
strictly adhering to the terms of the loan?

$15,381.66
To calculate Total payment to use formula
40,000 = PMT [1 – 1 / 1.0320] / .03
 PMT= 1,624.26
 Interest Paid = Beginning Balance * Rate (8%)
 Principal Paid = Total Payment – Interest Paid
 Ending Balance = Beginning Balance – Principal Paid
   
  Loan amount: 40,000.00
  Interest rate: 0.06
  Loan term: semi-annual
  Loan payment: 1,624.26
     
  Amortization table:  
           
  Year Beginning Total Interest Principal Ending
    Balance Payment Paid Paid Balance
  0.5 40,000.00 1,624.26 1,200.00 424.26 38,375.74
  1.0 38,375.74 1,624.26 1,151.27 472.99 36,751.48
  1.5 36,751.48 1,624.26 1,102.54 521.72 35,127.22
  2.0 35,127.22 1,624.26 1,053.82 570.44 33,502.96
  2.5 33,502.96 1,624.26 1,005.09 619.17 31,878.70
  3.0 31,878.70 1,624.26 956.36 667.90 30,254.44
  3.5 30,254.44 1,624.26 907.63 716.63 28,630.18
  4.0 28,630.18 1,624.26 858.91 765.35 27,005.92
  4.5 27,005.92 1,624.26 810.18 814.08 25,381.66
  5.0 25,381.66 1,624.26 761.45 862.81 23,757.40
  5.5 23,757.40 1,624.26 712.72 911.54 22,133.14
  6.0 22,133.14 1,624.26 663.99 960.27 20,508.88
  6.5 20,508.88 1,624.26 615.27 1,008.99 18,884.62
  7.0 18,884.62 1,624.26 566.54 1,057.72 17,260.36
  7.5 17,260.36 1,624.26 517.81 1,106.45 15,636.10
  8.0 15,636.10 1,624.26 469.08 1,155.18 14,011.84
  8.5 14,011.84 1,624.26 420.36 1,203.90 12,387.58
  9.0 12,387.58 1,624.26 371.63 1,252.63 10,763.32
  9.5 10,763.32 1,624.26 322.90 1,301.36 9,139.06
  10.0 9,139.06 1,624.26 274.17 1,350.09 7,514.80
  10.5 7,514.80 1,624.26 225.44 1,398.82 5,890.54
 CorporateFinance 1028951 Yuka SENGA

  11.0 5,890.54 1,624.26 176.72 1,447.54 4,266.28

  11.5 4,266.28 1,624.26 127.99 1,496.27 2,642.02
  12.0 2,642.02 1,624.26 79.26 1,545.00 1,017.76
  12.5 1,017.76 1,017.76 30.53 987.23 0.00
      40,000.00 15,381.66 24,618.34  

Tutorial Presentation (2marks)

TOTAL (10 marks)