Applied Corporate Finance

Assignment 2: TVM
Due Date: September 21, 2018
Submit to Secretary, Management Sc. by 4:00 PM sharp

Please show calculations, where necessary.

1. A mother will make her son’s first $100,000 college tuition payment 12 years from now.
How much will she need to invest today to meet her first tuition goal, if the investment is
expected to earn 10% pa.

2. A client can choose between receiving 10 annual $100,000 retirement payments, starting
one year from today, or receiving a lump sum today. Knowing that he can invest at a rate
of 5% pa., he has decided to take the lump sum. What lump sum today will be equivalent
to the future annual payments?

3. For liquidity purposes, a client keeps $100,000 in a bank account. The bank quotes a
stated annual interest rate of 7% pa. The bank’s service representative explains that the
stated rate is the rate one would earn if one were to cash out rather than invest the interest
payments.

a. With quarterly compounding, how much will you client have in his account at
the end of one year, assuming no additions or withdrawals?
b. With monthly compounding, how much will he have in his account at the end of
one year, assuming no additions or withdrawals?
c. With continuous compounding, how much will he have in his account at the end
of one year, assuming no additions or withdrawals?

4. Two years from now, a client will receive the first of three annual payments of $20,000
from a small business project. If she can earn 9% pa on her investments and she plans to
retire in six years, how much will the three business project payments be worth at the
time of her retirement?

5. You are analyzing the last five years of earnings per share for a company. The figures are
$4.00; $4.50, $5.00, $6.00, and $7.00. At what annual average compound rate did the
earnings per share grow over these years?

6. You will probably want to give something back to FAST at some point in your life.
Assuming that this is money and not a less-than-flattering hand gesture, you could
endow a scholarship when you retire. Assume that, 40 years from now, tuition fee at
FAST will be $18000 per year. How much would it cost today to endow a scholarship
that paid $18000 per year forever starting 40 years from now? Assume a discount rate
of 6.91% per year, compounded annually.

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7. "Invest early and often." You often hear that, but why does it make sense? Consider two
outcomes of your life: (1) you invest $5000 per year in the stock market, starting when
you’re 25, or (2) you invest $10,000 per year in the stock market starting when you’re
35. The average annual return on the stock market is 12%. How much more or less will
you have when you're 65 with the second path vs. the first path?

8. Assume you need $10,000 four years from now. Your bank compounds interest at 10
percent annually.

a) If only one deposit is made, how much must you place in your account today to
have a balance of $10,000 in 4 years?
b) If you deposit equal beginning-of-the-year payments into your account every
year for four years, how large must each of the four payments be to accumulate
the $10,000 you need in 4 years?
c) If your father offered either to make the payments calculated in part b or to give
you a lump sum of $7,500 today, which option would you choose?

9. John funded the construction of his house by borrowing Pak Rupees 1,500,000 at 10%
annual rate of interest to be repaid over 10 years in equal, end-of-year instalments.
Calculate:
(i) the yearly installment;
(ii) Find out the amount of loan outstanding at the end of the 5th year.

10. A company is considering the possibility of acquiring new manufacturing unit for
$6,000,000 cash. The scrap value is estimated to be $500,000 at the end of the 10-year
life of the equipment. The firm could lease the equipment for $1,000,000 per year,
payable at the start of each year. The equipment will be returned to the lessor at the expiry
of the lease. If the firm can earn 15% pa on its capital, advise whether it should buy or
lease.

11. You plan to retire in 25 years. You estimate that you would need Pak Rupees 5 million
by then to provide for the retired life. You plan to make equal annual beginning-of-the-
year deposits into an account paying 8% per annum return. How large must the annual
deposit be to accumulate Pak Rupees 5 million by the end of 25 years?

12. As an investment manager of an insurance fund, you have been advised the following
scenario by your actuary:

 the fund currently has Rs. 250 million invested across different assets;
 insurance premium income inflow is expected to be Rs. 100 million a year for the
next five years approaching zero thereafter. Assume these inflows are received
and invested at the end of each year;
 compensation for liabilities is expected to drain out some Rs. 150 million a year
beginning the end of year 6 out to the end of year 10.
 Investments earn 8% pa.

Find out:

a) How much money will be left in the fund at the end of the 10th year?
b) If you were required to pay a perpetuity out of the money left in the fund at the
end of the 10th year, how much could you afford to pay?

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13. You inherit rights to a gold mine for the next 10 years during which you plan to extract
5,000 ounces of gold every year. The current price per ounce of gold is $1300 and it is
expected to stay at that level throughout the investment horizon. What is the present value
of these rights? Assume all cashflows are received at the end of the year and the
opportunity cost of capital is 20% pa.

14. If the inflation rate is expected to be 20% pa. and the nominal interest rate is 30% pa. ,
calculate the corresponding real interest rate.

15. You are presented with an investment opportunity that returns 15% per annum for the
next 5 years. You expect inflation to average 5% per annum over the investment
horizon. Calculate:

a) In nominal terms, what would be the terminal value of Rs. 100/- invested in this
opportunity?
b) In real terms, what would be the terminal value of Rs. 100/- invested in this
opportunity?

i = (1+i*) (1+p) – 1

i* = (1+i)/ (1+p) - 1

i= nominal interest rate

i*= (required) real interest rate
p= expected inflation rate

16. A state has a pension fund liability of $25 billion, due in 10 years. Each year the
legislature is supposed to set aside an annuity to arrive at this future value. The annuity
is based on the rate of return estimates.

a. Estimate the annuity needed each year for the next 10 years, assuming that the
interest rate that can be earned on the money is 6%.
b. Assume the investment rate is revised to 8%. Recalculate the annuity needed to
arrive at the future value.
c. Can the state take the difference between the two amounts as budget savings
this year?