Tri Vi Dang Columbia University

Corporate Finance Fall 2012

Answer Key 1

Remark

There are different approaches to solve the questions. Please regard the suggested solution as
one solution approach.

Solution 1(a)

t=1 t=2 t=3

r 1+r A 2 2 10
0,2 1,2 PV(A) 1,67 1,39 5,79 8,84

B 1 4 10
PV(B) 0,83 2,78 5,79 9,40

Solution 1(b)

2 2 10 1 4 10

1 r (1 r ) 2
(1 r ) 3
1 r (1 r ) 2
(1 r ) 3

2 2 1 4

1 r (1 r ) 2
1 r (1 r ) 2

2(1 r ) 2 (1 r ) 4

(1 r ) 2

r 1

For r>1, PVA>PVB.

1
Solution 1 (c)

PV as a function of r

16,00
14,00
Present value PV

12,00
10,00
PV(A)
8,00
PV(B)
6,00
4,00
2,00
0,00
0,0 1,0 2,0 3,0
Interest rate r

Solution 1 (d)

1 x 10
10
1.25 1.25 1.253
2

x=6.375

Solution 1(e)

2 2 10
10.22
1.1 1.1 1.2 1.1 1.2 1.1

2 2 10
10.22
(1 y ) (1 y) 2
(1 y) 3

Use e.g. Excel to find a solution of this cubic equation:

y=0.132

2
Solution 2(a)

Plan A Plan B
t=0 50000,0 50000,0 100000,0
t=1 53000,0 52000,0 102000,0
t=2 56180,0 54080,0 106080,0
t=3 59550,8 56243,2 114566,4
t=4 63123,8 58492,9 126023,0
t=5 66911,3 60247,7 127283,3
t=6 70926,0 62055,1 128556,1
t=7 75181,5 63916,8 129841,7
t=8 79692,4 65834,3 131140,1
t=9 84473,9 67809,3 132451,5
t=10 89542,4 69843,6 133776,0
159386,0 133776,0

Solution 2(b)

1+r Plan B
t=10 159386,0
t=9 1,01 157807,9
t=8 1,01 156245,5
t=7 1,01 154698,5
t=6 1,01 153166,8
t=5 1,01 151650,3
t=4 1,01 150148,8
t=3 1,1 136498,9
t=2 1,08 126387,9
t=1 1,04 121526,8
t=0 1,2153 100000,0

r1=21.53%

Solution 3(a)

t=0 t=1 t=2 t=3

Cash flow 10,00 12,00 40,00

Costs -20 -12,00 -10,00 -3,00
Net CF -2,00 2,00 37,00

NPV 27,63 -1,82 1,65 27,80

7,63

3
Solution 3(b)

The profit the entrepreneur can make has a PV of $7.63 million. He does not accept any price
less than this amount and the private equity firm is not willing to pay more than this amount.

Note, if the PE firm buys the whole project it has to finance all costs (setup cost and operating
costs) itself. Otherwise, the PE firm would just buy future cash flows.

Solution 4(a)

Price t=1 t=2 t=3 t=4

AA Bond 130,46 10,00 10,00 10,00 110,00
r=0,02

B Bond 115,77 10,00 10,00 10,00 110,00

r=0,055

Solution 4(b)

A firm with AA rating raises the total amount of $130.46 million.

A B rated firm raises $115.77 million and thus has to raise $14.69 million or about 126,890
more units of the bonds.