AFW360 Corporate Finance

Tutorial 1: Problem Sets

Dr. Gary John Rangel

School of Management
 Chapter 1 Concept Question 1
Who owns a corporation? Describe the process whereby the owners control
the firm’s management. What is the main reason that an agency relationship
exists in the corporate form of organization? In this context, what kinds of
problems can arise?
Answer:
In the corporate form of ownership, the shareholders are the owners of the
firm. The shareholders elect the directors of the corporation, who in
turn appoint the firm’s management. This separation of ownership from
control in the corporate form of organization is what causes agency
problems to exist. Management may act in its own or someone else’s
best interests, rather than those of the shareholders. If such events occur,
they may contradict the goal of maximizing the share price of the equity
of the firm.
 Chapter 1 Concept Question 10
Why is the goal of financial management to maximize the current value of the
company's stock? In other words, why isn't the goal to maximize the future
value?
Answer:
Maximizing the current share price is the same as maximizing the future
share price at any future period. The value of a share of stock depends on
all of the future cash flows of company. Another way to look at this is that,
barring large cash payments to shareholders, the expected price of the stock
must be higher in the future than it is today. Who would buy a stock for $100
today when the share price in one year is expected to be $80?
 Chapter 4 Problem 7
Imprudential, Inc., has an unfunded pension liability of $425 million that
must be paid in 20 years. To assess the value of the firm’s stock, financial
analysts want to discount this liability back to the present. If the relevant
discount rate is 5.9 percent, what is the present value of this liability?
Answer:
𝐹𝑉𝑡
𝑃𝑉 =
1+𝑟 𝑡
$425 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑃𝑉 = = $135.04 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
1 + 0.059 20
 Chapter 4 Problem 7
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Keystrokes Display Description
20, N N = 20.00 Stores number of periods
5.9, I/Y I/Y = 5.90 Stores interest rate
0, PMT PMT = 0.00 Stores the periodic payment
-425, PMT FV = 425.00 Stores the future value
CPT, PV PV = 135.04 Compute present value
The present value of this liability is $135.04 million.
 Chapter 4 Problem 9
An investor purchasing British consol is entitled to receive annual payments
from the British government forever. What is the price of a consol that pays
$75 annually if the next payment occurs one year from today? The market
rate is 3.1 percent.
Answer:
𝐶
𝑃𝑉 =
𝑟
$75
𝑃𝑉 = = $2,419.35
0.031

Price of the consol is $2,419.35.

 Chapter 4 Problem 17
First National Bank charges 11.4 percent compounded monthly on its
business loans. First United Bank charges 11.6 percent compounded
semiannually. As a potential borrower, to which bank would you go for a new
loan?
Answer:
𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
12
0.114
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒𝐹𝑖𝑟𝑠𝑡 𝑈𝑛𝑖𝑜𝑛 𝐵𝑎𝑛𝑘 = 1 + − 1 = 0.1201
12
= 12.01%
2
0.116
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒𝐹𝑖𝑟𝑠𝑡 𝑈𝑛𝑖𝑡𝑒𝑑 𝐵𝑎𝑛𝑘 = 1 + − 1 = 0.1194
2
= 11.94%
 Chapter 4 Problem 52
You are saving for the college education of your two children. They are two
years apart in age; one will begin college 15 years from today and the other
will begin 17 years from today. You estimate your children’s college
expenses to be $72,000 per year per child, payable at the beginning of each
school year. The appropriate interest rate is 7.9 percent. How much money
must you deposit in the account of each year to fund your children’s
education. Your deposits begin one year from today. You will make your last
deposit when your oldest child enters college. Assume four years of college
for each child.
Answer:
1 1
𝑃𝑉 = 𝐶 −
𝑟 𝑟 1+𝑟 𝑇
Step 1: Find the present value of the 4 years annuity payment for college
1 1
𝑃𝑉 = $72,000 −
0.079 0.079 1 + 0.079 4
𝑃𝑉 = $72,000 12.65822785 − 9.338715177
𝑃𝑉 = $239,004.91
 Chapter 4 Problem 52
Answer:
Step 2: Find the present value of a lump sum to fund the first child.
𝐹𝑉𝑡
𝑃𝑉 =
1+𝑟 𝑡
$239,004.91
𝑃𝑉 = = $82,434.04
1 + 0.079 14
Step 3: Find the present value of a lump sum to fund the second child.
$239,004.91
𝑃𝑉 = 16
= $70,804.96
1 + 0.079
Step 4: Sum the two present values for the two children
Total for both children = $82,434.04 + $70,804.96 = $153,239
Step 5: Find the yearly annuity payment of the sum found in Step 4
1 1
𝑃𝑉 = 𝐶 −
𝑟 𝑟 1+𝑟 𝑇
 Chapter 4 Problem 52
Answer:
1 1
$153,239 = 𝐶 −
0.079 0.079 1 + 0.079 15
$153,239 = 𝐶 12.65822785 − 4.046236268
$153,239 = 8.611991582𝐶
$153,239
𝐶= = $17,793.68
8.611991582
You need to save $17,793.68 each year in order to fund the two children
through college.
 Chapter 4 Problem 52
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 1: Find the present value of the 4 years annuity payment for college
Keystrokes Display Description

4, N N = 4.00 Stores number of periods

7.9, I/Y I/Y = 7.90 Stores the interest rate

72,000, +/-, PMT PMT = -72,000.00 Stores the periodic payment

0, FV FV = 0.00 Stores the future value

CPT, PV PV = 239,004.91 Compute present value

 Chapter 4 Problem 52
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 2: Find the present value of a lump sum to fund the first child.
Keystrokes Display Description

14, N N = 14.00 Stores number of periods

7.9, I/Y I/Y = 7.90 Stores the interest rate

0, PMT PMT = 0.00 Stores the periodic payment

239,004.91, +/-, FV FV = -239,004.91 Stores the future value

CPT, PV PV = 82,434.04 Compute present value

 Chapter 4 Problem 52
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 3: Find the present value of a lump sum to fund the second child.
Keystrokes Display Description

16, N N = 16.00 Stores number of periods

7.9, I/Y I/Y = 7.90 Stores the interest rate

0, PMT PMT = 0.00 Stores the periodic payment

239,004.91, +/-, FV FV = -239,004.91 Stores the future value

CPT, PV PV = 70,804.96 Compute present value

Step 4: Sum the two present values for the two children
Total for both children = $82,434.04 + $70,804.96 = $153,239
 Chapter 4 Problem 52
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 5: Find the annual payment of the sum found in Step 4
Keystrokes Display Description

15, N N = 15.00 Stores number of periods

7.9, I/Y I/Y = 7.90 Stores the interest rate

153,239, PV PV = 153,239 Stores the present value

0, FV FV = 0.00 Stores the future value

CPT, PMT PMT = -17,793.68 Computes the periodic payment

You need to save $17,793.68 each year in order to fund the two children
through college.
 Chapter 4 Problem 54
You have recently won the super jackpot in the Washington State Lottery.
After reading the fine print, you discover that you have the following two
options:
a. You will receive 31 annual payments of $250,000, with the first payment
being delivered today. The income will be taxed at 28 percent. Taxes will
be withheld when the checks are issued.
b. You will receive $530,000 now, and you will not have to pay taxes on
this amount. In addition, beginning one year from today, you will receive
$200,000 each year for 30 years. The cash flows from this annuity will
be taxed at 28 percent.
Using a discount rate of 5.85 percent, which option would you select?
 Chapter 4 Problem 54
Answer:
Step 1: Calculate the annual after-tax cash flows for option 1
$250,000 × 1 − 0.28 = $180,000
Step 2: Calculate the present value of the annuity payments. Note that since
the first payment is immediate, the annuity is an annuity due.
1 1
𝑃𝑉 = 𝐶 + 𝐶 −
𝑟 𝑟 1+𝑟 𝑇
1 1
𝑃𝑉 = $180,000 + $180,000 −
0.0585 0.0585 1 + 0.0585 30
𝑃𝑉 = $180,000 + $180,000 17.09401709 − 3.10540511
𝑃𝑉 = $180,000 + $180,000 13.98861198
𝑃𝑉 = $2,697,950.16
 Chapter 4 Problem 54
Answer:
Step 3: Calculate the annual after-tax cash flows for option 2
$200,000 × 1 − 0.28 = $144,000
Step 4: Calculate the present value of the annuity payments. Note that the
first payment is immediate.
1 1
𝑃𝑉 = 𝐶 + 𝐶 −
𝑟 𝑟 1+𝑟 𝑇
1 1
𝑃𝑉 = $530,000 + $144,000 −
0.0585 0.0585 1 + 0.0585 30
𝑃𝑉 = $530,000 + $144,000 17.09401709 − 3.10540511
𝑃𝑉 = $530,000 + $144,000 13.98861198
𝑃𝑉 = $2,544,360.13

Since the present value of option 1 is greater than the present value of
option 2, option 1 should be selected.
 Chapter 4 Problem 54
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 1: Calculate the annual after-tax cash flows for option 1
$250,000 × 1 − 0.28 = $180,000
Step 2: Calculate the present value of the annuity payments. Note that since
the first payment is immediate, the annuity is an annuity due.
Keystrokes Display Description

2ND, BGN BGN Change to Begin mode

2ND, ENTER BGN Set to Begin mode

31, N N = 31.00 Stores number of periods

5.85, I/Y I/Y = 5.85 Stores the interest rate

180,000, PMT PMT = 180,000 Stores the periodic payment

0, FV FV = 0.00 Stores the future value

CPT, PV PV = -2,697,950.15 Computes the present value

 Chapter 4 Problem 54
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 3: Calculate the annual after-tax cash flows for option 2
$200,000 × 1 − 0.28 = $144,000
Step 4: Calculate the present value of the annuity payments.
Keystrokes Display Description

30, N N = 30.00 Stores number of periods

5.85, I/Y I/Y = 5.85 Stores the interest rate

144,000, PMT PMT = 144,000 Stores the periodic payment

0, FV FV = 0.00 Stores the future value

CPT, PV PV = -2,014,360.13 Computes the present value

$530,000 + $2,014,360.13 = $2,544,360.13

Since the present value of option 1 is greater than the present value of
option 2, option 1 should be selected.
 Chapter 4 Problem 57
Bilbo Baggins wants to save money to meet three objectives. First, he
would like to be able to retire 30 years from now with a retirement income of
$17,500 a month for 20 years. Second, he would like to purchase a cabin in
Rivendell in 10 years at an estimated cost of $350,000. Third, after he
passes on at the end of the 20 years of withdrawals, he would like to leave
an inheritance of $1,500,000 to his nephew Frodo. He can afford to save
$1,800 per month for the next 10 years. If he can earn an EAR of 11
percent before he retires and an EAR of 8% after he retires, how much will
he have to save each month in Years 11 through 30?
Answer:
Step 1: Calculate the APR for before he retires.
𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
𝑟 12
0.11 = 1 + −1
12
𝐴𝑃𝑅 = 12 1.111Τ12 − 1 = 0.1048 𝑜𝑟 10.48%
 Chapter 4 Problem 57
Answer:
Step 2: Calculate the APR for after he retires
𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
𝑟 12
0.08 = 1 + −1
12
𝐴𝑃𝑅 = 12 1.081Τ12 − 1 = 0.0772 𝑜𝑟 7.72%
Step 3: Calculate the present value of the annuity payment of $17,500 for
240 months (20 years x 12 months per year)
1 1
𝑃𝑉 = 𝐶 −
𝑟 𝑟 1+𝑟 𝑇
1 1
𝑃𝑉 = $17,500 −
0.0772Τ12 0.0772 0.0772 240
1+
12 12
𝑃𝑉 = $17,500 155.4404145 − 33.35500401 = $2,136,494.684
 Chapter 4 Problem 57
Answer:
Step 4: Calculate the present value of the lump sum that needs to
bequeathed to his nephew Frodo.
𝐹𝑉𝑡
𝑃𝑉 =
1+𝑟 𝑡
$1,500,000
𝑃𝑉 = = $321,822.3111
1 + 0.08 20
Step 5: Calculate the total amount that is needed upon retirement.
$2,136,494.684 + $321,822.3111 = $2,458,316.995
Step 6: Calculate the future value of the amount that can be saved for 10
years.
1+𝑟 𝑡
𝐹𝑉 = 𝐶 −1
𝑟
0.1048 120
1+ −1
𝐹𝑉 = $1,800 12 = $379,029.5552
0.1048Τ12
 Chapter 4 Problem 57
Answer:
Step 7: Calculate the balance of the amount left after buying the cabin.
$379,029.5552 - $350,000 = $29,029.5552
Step 8: Calculate the future value of the balance in Step 7 after 20 years.
𝐹𝑉 = 𝑃𝑉 × 1 + 𝑟 𝑡
240
0.1048
𝐹𝑉 = $29,029.5552 × 1 + = $233,975.14
12
Step 9: Calculate the balance lump sum required to be saved upon
retirement.
$2,458,316.995 - $233,975.1383 = $2,224,341.857
Step 10: Calculate the monthly amount that need to be saved from Year 11
to Year 30 using the future value annuity formula.
1+𝑟 𝑡−1
𝐹𝑉 = 𝐶
𝑟
0.1048 240
1+ −1
$2,224,341.857 = 𝐶 12
0.1048Τ12
 Chapter 4 Problem 57
Answer:
$2,224,341.857 = 808.384812𝐶
$2,224,341.857
𝐶= = $2,751.59
808.384812
The monthly amount that Bilbo Baggins needs to save each month in Years
11 through 30 is $2,751.59.
 Chapter 4 Problem 57
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 1 & 2 is the same for both solutions.
Step 3: Calculate the present value of the annuity payment of $17,500 for
240 months (20 years x 12 months per year)
Keystrokes Display Description

240, N N = 240.00 Stores number of periods

0.6433333333, I/Y I/Y = 0.64 Stores the interest rate

17,500, +/-, PMT PMT = -17,500.00 Stores the periodic payment

0, FV FV = 0.00 Stores the future value

CPT, PV PV = 2,136,494.68 Computes the present value

 Chapter 4 Problem 57
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 4: Calculate the present value of the lump sum that needs to
bequeathed to his nephew Frodo
Keystrokes Display Description

20, N N = 20.00 Stores number of periods

8, I/Y I/Y = 8.00 Stores the interest rate

0, PMT PMT = 0.00 Stores the periodic payment

1,500,000, FV FV = 1,500,000.00 Stores the future value

CPT, PV PV = -321,822.31 Computes the present value

 Chapter 4 Problem 57
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 5: Calculate the total amount that is needed upon retirement.
$2,136,494.684 + $321,822.3111 = $2,458,316.995
Step 6: Calculate the future value of the amount that can be saved for 10
years.
Keystrokes Display Description

120, N N = 120.00 Stores number of periods

0.8733333333, I/Y I/Y = 0.87 Stores the interest rate

0, PV PV = 0.00 Stores the present value

1,800, +/-, PMT PMT = -1,800.00 Stores the periodic payment

CPT, FV FV = 379,029.56 Compute the future value

 Chapter 4 Problem 57
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 7: Calculate the balance of the amount left after buying the cabin.
$379,029.5552 - $350,000 = $29,029.55517
Step 8: Calculate the future value of the balance in Step 7 after 20 years.
Keystrokes Display Description

240, N N = 240.00 Stores number of periods

0.8733333333, I/Y I/Y = 0.87 Stores the interest rate

29,029.5552, +/-, PV PV = -29,029.556 Stores the present value

0, PMT PMT = 0.00 Stores the periodic payment

CPT, FV FV = 233,975.14 Compute the future value

 Chapter 4 Problem 57
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 9: Calculate the balance lump sum required to be saved upon
retirement.
$2,458,316.995 - $233,975.1383 = $2,224,341.857
Step 10: Calculate the monthly amount that need to be saved from Year 11
to Year 30 using the future value annuity formula.
Keystrokes Display Description

240, N N = 240.00 Stores number of periods

0.8733333333, I/Y I/Y = 0.87 Stores the interest rate

0, PV PV = 0.00 Stores the present value

2,224,341.857, FV FV = 2,224,341.857 Stores the future value

CPT, PMT PMT = -2,751.59 Compute the periodic payment

The monthly amount that Bilbo Baggins needs to save each month in Years
11 through 30 is $2,751.59.
 Chapter 4 Problem 61
You are serving on a jury. A plaintiff is suing the city for injuries sustained
after a freak street sweeper accident. In the trial, doctors testified that it will
be five years before the plaintiff is able to return to work. The jury has
decided in favour of the plaintiff. You are the foreperson of the jury and
propose that the jury give the plaintiff an award to cover the following: (1)
The present value of two years’ back pay. The plaintiff’s annual salary for
the last two years would have been $39,000 and $43,000, respectively. (2)
The present value of five years’ future salary. You assume the salary will be
$47,000 per year. (3) $150,000 for pain and suffering. (4) $25,000 for court
costs. Assume that the salary payments are equal amounts paid at the end
of each month. If the appropriate rate you choose in an EAR of 7.4 percent,
what is the size of the settlement? If you were the plaintiff would you like to
see a higher or lower rate?
 Chapter 4 Problem 61
Answer:
Step 1: Calculate the APR.
𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
𝑟 12
0.074 = 1 + −1
12
𝐴𝑃𝑅 = 12 1.0741Τ12 − 1 = 0.0716 𝑜𝑟 7.16%
Step 2: Calculate the future value of the annuity of the second year back
pay.
1+𝑟 𝑡
𝐹𝑉 = 𝐶 −1
𝑟
0.0716 12
$39,000 1 + 12 −1
𝐹𝑉 = = $40,305.65
12 0.0716Τ12
This value is future value for that year. We need to bring this value a further
year forward to the present using the future value of the lump sum
calculated in Step 2.
 Chapter 4 Problem 61
Answer:
Step 3: Calculate the future value of the lump sum to bring the second year
back pay to current period.
𝐹𝑉 = 𝑃𝑉 × 1 + 𝑟
𝐹𝑉 = $40,305.65 × 1 + 0.074 = $43,288.2681
Step 4: Calculate the future value of last year’s back pay to bring it to
current period.
1+𝑟 𝑡
𝐹𝑉 = 𝐶 −1
𝑟
0.0716 12
$43,000 1 + 12 −1
𝐹𝑉 = = $44,439.56261
12 Τ
0.0716 12
Step 5: Calculate the present value of five years’ future salary.
1 1
𝑃𝑉 = 𝐶 −
𝑟 𝑟 1+𝑟 𝑡
$47,000 1 1
𝑃𝑉 = −
12 0.0716Τ12 0.0716Τ12 1 + 0.0716Τ12 60
 Chapter 4 Problem 61
Answer:
𝑃𝑉 = $3,916.66667 167.5977654 − 117.2877901 = $197,047.4034
Step 6: Size of the settlement
Back pay + 5 years future pay + Pain and suffering cost + Court costs
[$43,288.2681 + $44,439.56261] + $197,047.4034 + $150,000 + $25,000 =
$459,775.23
 Chapter 4 Problem 61
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 1 is based on the above way.
Step 2: Calculate the future value of the annuity of the second year back
pay.
Keystrokes Display Description

12, N N = 12.00 Stores number of periods

0.5966666667, I/Y I/Y = 0.60 Stores the interest rate

0,PV PV = 0.0 Stores the present value

3,250, +/-, PMT PMT = -3,250.00 Stores the periodic payment

CPT, FV FV = 40,305.65 Compute the future value

 Chapter 4 Problem 61
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 3: Calculate the future value of the lump sum to bring the second year
back pay to current period.

Keystrokes Display Description

1, N N = 1.00 Stores number of periods

7.4, I/Y I/Y = 7.4 Stores the interest rate

40,305.65, +/-, PV PV = -40,305.65 Stores the present value

0, PMT PMT = 0.00 Stores the periodic payment

CPT, FV FV = 43,288.27 Compute the future value

 Chapter 4 Problem 61
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 4: Calculate the future value of last year’s back pay to bring it to
current period.

Keystrokes Display Description

12, N N = 12.00 Stores number of periods

0.5966666667, I/Y I/Y = 0.60 Stores the interest rate

0,PV PV = 0.0 Stores the present value

3,583.333333, +/-, PMT PMT = -3,583.3333 Stores the periodic payment

CPT, FV FV = 44,439.56 Compute the future value

 Chapter 4 Problem 61
Alternative Answer:
Use financial calculator Texas Instruments BA II Plus
Step 5: Calculate the present value of five years’ future salary.
Keystrokes Display Description

60, N N = 60.00 Stores number of periods

0.5966666667, I/Y I/Y = 0.60 Stores the interest rate

3,916.666667, +/-, PMT PMT = -3,916.6667 Stores the periodic payment

0, FV FV = 0.00 Stores the future value

CPT, PV PV = 197,047.40 Compute the present value

Step 6: Size of the settlement
Back pay + 5 years future pay + Pain and suffering cost + Court costs
[$43,288.27 + $44,439.56] + $197,047.40 + $150,000 + $25,000 =
$459,775.23
 Thank You

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