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PRESUMED

KNOWLEDGE
TUTORIAL
Time value of money, debt and equity valuation, capital budgeting
and a little bit of algebra

1
Problem 1
You owe a bank $28,370. You plan to make three equal
annual payments to discharge your debt. The first payment is
in a year’s time. What is the amount of the annuity payment
if the interest rate is?
(a) 6% per annum
(b) 0% per annum

2
Answer
(a) 6% per annum:
■ PV = annuity payment * 3-year annuity factor
■ 28,370 = annuity payment * [(1 – 1.06-3) /0.06]
■ 28,370 = annuity payment * (2.673011949)
■ Annuity payment = 10,613

(b) 0% per annum:


■ $1 in year 1, $1 in year 2 and $1 in year 3 are all
worth the same as $1 today.
■ 28,370 = annuity payment *3
■ Annuity payment = 9,457
3
Problem 2
You have just won a lottery ticket and are offered two
ways to receive your prize money:
(a) $8,000 immediately and $2,388 a year in
perpetuity thereafter; or
(b) $11,000 in year 1 and $2,388 a year in perpetuity
thereafter
Which is the better option if the cost of capital is 6%?
Hint: compare the PV of both options.

4
Answer
(a) $8,000 immediately and $2,388 a year in
perpetuity thereafter:
PV = 8,000 + (2,388/ 0.06) = 47,800

(b) $11,000 in year 1 and $2,388 a year in perpetuity


thereafter:
As the first perpetual payment of $2,388 starts in
year 2, the PV of the perpetuity is calculated as of
year 1. Hence,
PV = 11,000/1.06 + [(2,388/ 0.06) * 1.06-1] =
47,925

Option b is better.
5
Problem 3
■ Calculate the value of a bond that matures in six
years and has a face value of $100,000. The
annual coupon rate is 6% and the markets’
required yield to maturity on a comparable-risk
bond is 9% p.a. compounding semi-annually. What
would be the value of this bond if it paid interest
semi-annually?

Answer
■ Price = {3000 [1- (1 + 0.045)-12 ]/0.045} +
100,000 (1 + 0.045)-12
= 86,322.13

6
Problem 4
The ordinary shares of CFTP Ltd paid $1.45 in dividends last
year. Dividends are expected to grow at an annual rate of 6%
p.a. for an indefinite number of years. What is the value of a
share if your required rate of return is 8.5% p.a.?

Answer
■ D0 = 1.45 g = 0.055 p.a. in perpetuity r = 0.085
D1 = 1.45 (1.06) = 1.537
P0 = 1.537/(0.085 – 0.055)
= 51.23

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Problem 5
It is forecast that TFS Inc. Will pay dividends of $2.30
next year, $2.45 in year 2 and $2.50 in year 3. Thereafter
it is anticipated to grow in perpetuity at a rate of 3% p.a.
What is the value of this share if your required rate of
return is 6% p.a.?

Answer
■ D1 = 2.30 D2 = 2.45 D3 = 2.50 r = 0.06
g = 0.03 p.a. in perpetuity
P2 = 2.50/(0.06 – 0.03) = 83.33
P0 = 2.30/(1.06) + [2.45 + 83.33]/(1.06)-2
= 78.51
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Problem 6
A project, with an initial cost of $100,000, expects to generate
$12,000 p.a. in the first two years and then $10,000 a year
for the next eight years. The cost of capital is 10%p.a. What is
the NPV

Answer
■ NPV = -100,000 + 12,000/(1.1) + 12,000/(1.1)-2 +
{10,000 [1- (1 + 0.1)-8 ]/0.1}
= 10,909 + 9,917 + 77081
= 97,907

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Problem 7
A firm is deciding whether it should sell a machine immediately
for $60,000 or keep using the machine for two more years. If
the machine is kept, it produces annually 100,000 tons of acid
over the next two years. Operating costs are $0.90 a ton. The
salvage value of the machine is expected to be $57,900 in year
2. The cost of capital is 10%. Calculate the selling price per ton
for the next two years such that the firm will be indifferent
between (i) scrapping the machine now and (ii) continue using
the machine for two years and then scrapping it.
60,000 = 100,000*[P – 0.90](1.1)-1 +
100,000*[P – 0.90](1.1)-2 + 57,900(1.1)-2
60,000 = 100,000P(1.1)-1 – 90,000(1.1)-1 + 100,000P(1.1)-2
– 90,000(1.1)-2 + 47,851.24
60,000 = 90,909.09P – 81,818.18 + 82,644.63P –
74,380.17 + 47,851.24
168,347.11 = 173,553.72P
P = 0.97
Problem 8
Given 2N = m*P1
and 54N = (N + m)*P1
Solve for P1

Answer
■ Given 54N = (N + m)*P1
■ 54N = N*P1 + m*P1
■ Substitute 2N = m*P1,
■ 54N = NP1 + 2N
■ 52N = NP1
■ P1 = 52