Case Study - Understanding Economic "Equivalence"

Enrico has done all his payments monthly and so his unit o time is “month”. He has five types of cash flows:
1.Debt repayment:
The amount of student’s debt is 20,000 and to be repaid over 10 years at an interest rate of 8%
compounded monthly. So monthly repayment amount =$242.6 per month.
The amount of credit card debt is 5,000 and to be repaid over 10 years at an interest rate of 18%
compounded monthly. So monthly repayment amount =$90.10 per month.
Therefore total debt payment=242.6+90.10=$332.7
2.Transportation cost:
The vehicle he want to buy cost 15,000. The best rate for him is 9% compounded monthly for 5 years.
Therefore monthly car payment =$311.4 per month
He plan to replace car , so the insurance cost is 1200 per year and that is 100 per month and budgeted 100
for fuel and maintenance.
Therefore total transportation cost=311.4+100+100=$511.4
3.Housing cost
2 bedroom apartment cost a monthly rent of 800 per month and approximately 150 for electricity and water
and that totals to 950 per month
4.Other living expense
Food $200

Phone $70

Entertainment $100

Misc $150

Subtotal $520
But these expenses are most likely to be variable.
5.Savings
He wish to save 40,000 over 10 years as a down payment on a conda. The best interest he can earn is 6%
compounded monthly and so his savings per month to be 244 per month.
His gross month;y salary =48000/12=$4000
Monthly take home salary =4000*80%=$3200
Retirement saving=3200*10%=$320
Therefore total to save monthly=244+320=$564
Monthly financial plan
Salary $3200

Debt repayment ($332.7)

Transportation cost ($511.4)

Housing cost ($950)

Living expense ($520)

Saving ($564)

Extra money $321.9

He has got an extra money after all the target cost and saving which will help him with un anticipated
increase in cost.
2.8 (Sunk Costs)

Alternative 1.

Live in the apartment for six month and then shift

Total cost=$900 per month for six month.

Present Value(PV) of cost=(Monthly rent)/(1+i)^(N-1)

i=monthly interest rate=(12/12)=1%=0.01

N=Month of rent in the beginning of the month

Calculation of Present value of total cost is given below:

N A B=A/((1+0.01)^(N-1))

Month Rent PV of rent

1 $1,000 1000

2 $1,000 990.09901

3 $1,000 980.29605

4 $1,000 970.59015

5 $1,000 960.98034

6 $1,000 951.46569

Total $ 5,853.43

Alternative 2: Switch to new apartment:

Sunk cost=$1,000
Present Value of monthly rent for six months @ $900 per month

N A B=A/((1+0.01)^(N-1))

Month Rent PV of rent

1 $900 900

2 $900 891.08911

3 $900 882.26644

4 $900 873.53113

5 $900 864.88231

6 $900 856.31912

Total $ 5,268.09

Total Present value of Cost=(5268.09+1000)=$6,268.09

Total cost will be higher by (6268.09-5853.43)= $ 414.66

CONCLUSION:
They should not switch to the new apartment

IF THEY PLAN TO STAY 1 year:

Present cost of Alternative 1=$ 11,367.63

Calculation given below:

N A B=A/((1+0.01)^(N-1))

Month Rent PV of rent

1 $1,000 1000

2 $1,000 990.09901

3 $1,000 980.296049

4 $1,000 970.590148

5 $1,000 960.980344

6 $1,000 951.465688

7 $1,000 942.045235

8 $1,000 932.718055

9 $1,000 923.483222

10 $1,000 914.339824

11 $1,000 905.286955

12 $1,000 896.323718

TOTAL $ 11,367.63

Present cost of Alternative 2(switch to the new apartment)

 N A B=A/((1+0.01)^(N-1))

Month Rent PV of rent

1 $900 900

2 $900 891.089109

3 $900 882.266444

4 $900 873.531133

5 $900 864.88231

6 $900 856.319119

7 $900 847.840712

8 $900 839.446249

9 $900 831.1349

10 $900 822.905842

11 $900 814.758259

12 $900 806.691346

TOTAL $ 10,230.87

Total Cost=Sunk cost+ Present value of 12 month rent=$1,000+$10,230.87=$11,230.87

Net Present cost of switching to new apartment will be less by (11367.63-11230.87)=$137

CONCLUSION:

If they plan to stay one year they should switch to the new apartment
2.10 Copy Machines
2.12 Oil Depletion Allowance

It is given that investor has invested $1000,000 to drill and develop an oil well with reserve capacity of 200,000 barrel.

From the given statistics Depletion amount for wach year can be calculated on basis of $5 unit cost of barrel production.

Taxable income = Net Income – Depletion amount

Tax is applicable @ 45%

So the remaining values of the table will be as follows :

Year Barrel Gross Net Option Option2 Depletion Taxable Tax @45% After Tax
Produced revenue Income 1 ($5 per amount Income (i.e Taxable Income
($20 each (22% of barrel) (Netincome income*45%) (taxable
barrel) GR but – Depletion income –
Upto amount) Tax)
50% of
Net
Income)

1 80,000 1,600,000 1,200,000 352,000 400,000 400,000 800,000 360,000 840,000

2 70,000 1,400,000 1,000,000 308,000 350,000 350,000 650,000 292,000 707,500

3 50,000 1,000,000 500,000 220,000 250,000 250,000 250,000 112,500 387,500

4 30,000 600,000 200,000 132,000 150,000 150,000 50,000 22500 177,500

5 10,000 200,000 50,000 44,000 50,000 50,000 0 0 50,000

Total 1,200,000 2,162,000

Ans 1) Hence it is observed from the above table that Total Depletion amount i.e $ 1,200,000 clearly exceeds investment of $1M of the investor.
SubQue 2) Part A
Given rate of interest = 20%
Initial investment = - $1,000,000 ( -ve sign indicates outflow of money)
PV of After tax income calculation through excel
PV of After tax income Year 1 = PV(20%,1,0,840000) = $700,000.00
PV of After tax income Year 2= PV(20%,2,0,707500) = $491,319.44
PV of After tax income Year 3 = =PV(20%,3,0,387500) = $224,247.69
PV of After tax income Year 4 = =PV(20%,4,0,177500) = $85,599.92
PV of After tax income Year 5 = =PV(20%,5,0,50000) = $20,093.88
Hence PV value of investment is = - $1,000,000 + $700,000.00 + $491,319.44 + $224,247.69 + $85,599.92 + $20,093.88
Present Value of investment = $ 521,260.93
SubQue 2) Part B
Internal rate of return IRR through Excel = IRR(-1000000,700000,491319.44,224247.69,85599.92,20093.88)
IRR = 52.795%