Corporate Finance: Practice Exercises

Solutions

Part 1: The Time Value of Money

1. You are offered a 30-year annuity investment that will pay you €500 per
month, starting at the end next month (t = 1). What is the value of this
investment today if the monthly interest rate is 0.6%?
PV=?
Annuity Cashflow=500 €
m= 30 years * 12 months per year= 360 months
rm=0.6%

C
(
PV = ∗ 1−
r
1
( 1+r )n )
PV =
500
0.6 % (
∗ 1−
1
(1+ 0.6 % )360 )
=73,360.68 €

will be the present value of the annuity

2. Mr Smith is thinking about buying a perpetual preferred stock that

pays dividends worth $300 per year indefinitely. The first payment Mr.
Smith will receive would be at t = 4. Given that the required rate of
return is 8% per annum, compounded annually, how much should Mr.
Smith pay today?

( )
3
300 1
PV = =2,967.87
8 % 1+ 8 %

3. I plan to invest in a company that is expected to right now (t=0) have a

cash flow of €10,000 that will continue forever and that we are
assuming it will experiment a growth at a constant rate of 4%. The
opportunity cost of capital is 8%. I am short of liquidity right now so I
would be doing my investment at the end of year 3. What is the
present value of the investment?

1
 ❑

( )
2
10,000(1+ 4 %) 1+ 4 %
PV = =241,097.39
8 %−4 % 1+8 %

2
4. Assume you won a 4-million-euro lottery. Due to tax reasons, you hope the
lottery issuer could pay your bonus MONTHLY during the next 30 years.
How much money would you receive per month if the annual interest rate
promised by the lottery issuer were 5%?

5%
FindingC for an annuity with PV =4,000,000 ; r= ; n=360
12

PV =
C
r [
1−
1
(1+r )
n
]
[ ]
C 1
4,000,000= 1−
( )
5% 5% 360
1+
12 12

C=21,473
5. You go to a TV show contest and you are offered the following prizes. If
the annual interest rate is 8%, which one is the most valuable prize?
Show your working for each alternative.

 $150,000 now.

Because is PV, you don´t have to do anything so 150,000

 $170,000 at the end of 6 years.

Here we are discounting a single CF

170,000
PV = =107,128.8 $
( 1+8 % )6

 $10,000 a year forever, the first payment starts today.

This is a perpetuity with no growth

10,000
PV =10,000+ =135,000 $
8%

 $9,000 a year forever (starting at the end of this year) that will grow
forever at a 2% rate.

Growing perpetuity
3
 9,000
PV = =150,000 $
8 %−2 %

 $800,000 at the end of 20 years.

Single CF in the future

800,000
PV = =171.638 .6 $
( 1+8 % )20

 8 semi-annual payments of $14,000 where the first payment starts at

the end of the first semester.

Ordinary Annuity

PV =
14,000
4%
∗ 1−
( 1
( 1+ 4 % )8 )
=94,258 $

 $14,000 a year, starting this year for 12 payments.

Ordinary Annuity

PV =
14,000
8% (
∗ 1−
1
( 1+ 8 % )12)=105,505.4 $

 $70,000 in year 2 and $50,000 in year 4.

Series of Cashflows

70,000 50,000
PV = 2
+¿ 4
=96,765.5 $ ¿
(1+8 % ) (1+8 % )

6. Suppose that your firm is considering divesting (i.e., selling) one of its
product lines. You have been approached by a prospective buyer that is
willing to pay as much as €25 million for it. The product line is expected
to generate a cash flow of €2 million during the next year of operations.
Thereafter, annual cash flows are expected to grow at a rate of 3% in
perpetuity. The risk of the product line is comparable to that of the
overall stock market, whose annual rate of return is estimated to be
10%. On the other hand, risk-free investment opportunities currently
yield a 2% annual rate of return. Should you accept the offer of the
prospective buyer?
4
Accepting the project means obtaining an immediate cash flow of €25M but
also giving up all the cash flows that the project line will generate in the
future. The future cash flows are as risky as the overall stock market so should
be discounted at the same rate. The NPV of the transaction is therefore

€ 2.0 M
NPV =€ 25.0 M − =€ 25 M −€ 28.6 M =−€ 3.6
10 %−3 %

The transaction has a negative NPV so it lowers the value of the firm and
should not be accepted.

7. You have a salad & juice shop. You are trying to improve efficiency, so
you are looking at three different projects:

A. Cold press juice machine.

B. Two-year automatic invoice system.
C. Customized machine for sandwiches and muffins.

The cost of capital for all alternatives is 8%. Compute the NPV of the three
projects, whose cash flows are described in the table below. What project do
you think will be the most profitable option for your business? (Remember the
NPV rule).

PROJECT T =0 T=1 T=2 T=3 T=4 T= NPV

S 5
A -1.000 500 200 200 200 200 76.32
B -1.500 1.20 400 0 0 0 -45-
0 95
C -3.000 1.00 1.00 1.50 500 500 681.8
0 0 0 2

First you calculate the NPV for each project with a 8% cost of capital.
Remember that when you see a negative cashflow it means an outflow.
Usually conventional projects have an outflow at time 0 (buying the machine,
doing the plant expansion…).

500 200 200 200 200

NPV A =−1,000+ + + + + =76.32
( 1+8 % ) ( 1+8 % ) ( 1+ 8 % ) ( 1+ 8 % ) ( 1+8 % )5
1 2 3 4

1200 400
NPV B=−1,500+ + =−45.95
( 1+8 % ) ( 1+8 % )2
1

1,000 1,000 1,500 500 500

NPV C =−3,000+ + + + + =681.82
( 1+ 8 % ) (1+ 8 % ) ( 1+8 % ) ( 1+8 % ) ( 1+ 8 % )5
1 2 3 4

According to the NPV rule you would choose the NPV of the Project with the
5
highest NPV which is Project C.

6
 Part 2: Interest Rate problems
1. Your bank (A) offers you an automobile loan of €20.000 at 13% APR, but
the interest rate is going to be compounded monthly. What is the EAR
that you will be paying? If another bank (B) offers you an APR of 13.1%
compounded quarterly, which of the options will you choose?

OPTION A:

( ) ( ) −1=13.8 %
m 12
APR 13 %
EAR= 1+ −1= 1+
m 12

OPTION B:

( ) ( )
m 4
APR 13.1 %
EAR= 1+ −1= 1+ −1=13.76 %
m 4

So, you will choose option B because its EAR is lower.

2. Suppose you have a credit card that charges you 18% annual rate that
is compounded monthly. What will be the equivalent EAR for that
year? Imagine you have a balance of €1.000, what will be your ending
balance at the end of the year if you did not make any payments
during the year?
Method 1: compute directly the ending balance:

( ) ( ) =1,195.62
m 12
APR 18 %
FV =1000 1+ =1,000 1+
m 12
Method 2: compute the EAR first and then the ending balance:

( ) ( ) −1=19.562 %
m 12
APR 18 %
EAR= 1+ −1= 1+
m 12
1
FV =1,000 ( 1+19.562 % ) =1,195.62

Both methods lead to the same result. Remember the higher the
compounding periods, the bigger the benefit for the Credit Card
company and the worst for you because your payments are going to be
higher.
7
3. You win a €5.000 award for your excellent grades. You want to use this
money at the end of the year to do a trip around Europe. Your bank
offers you these options:

• Option 1: an annual percentage return of 10.1%.

1
FV =5,000 ( 1+10.1 % ) =5,505

• Option 2: an annual percentage return of 10% compounded quarterly.

( )
4
10 %
FV =5,000 1+ =5,519
4

• Option 3: an annual percentage return of 9.95% compounded daily.

( )
365
9.95 %
FV =5,000 1+ =5,523
365

Which one is the best option?

It is Option 3, because it gives the highest return.

Part 3: Bond problems

1. Boeing has just issued a 10-year bond to finance investments in a new

airline model. The face value of the bond is 1,000$. The bond is based in the
USA and pays coupon semi-annually; being the annualized coupon yield
3.5%. The current interest rate is 1.49% in semi-annual terms. Please
calculate:

Typical mistakes:

First, because this is a semi-annual bond, it is necessary to adjust the

number of periods, the coupon rate, and the interest rate accordingly.
Another common mistake consists in confusing Coupon Yield (which is
used for the calculation of the coupon payments–cash flows) and Current
Market Yield (which represents the rate of discount of the bond “r”).

(a) PV of the bond. If the bond is quoted in the market at 1.020$, will
you recommend the purchase?
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 Remember that the formula used for the valuation of a Coupon
Bond is a combination of: a) the annuity formula for the coupon
payments and b) PV of a single future cash flow for the face value.

In this case, the periodicity of payments is m = 2, meaning that there

are 2 semiannual payments in one year. The total number of periods
(N) must reflect the periodicity of the coupon payments:

N = (maturity of the bond in years) × m = 10 × 2 = 20.

Other inputs are as follows. The face value is F=$1,000. The Annual
Coupon Yield is 3.5%, so the coupon payment is

(Face Value) × (Coupon Yield)/(Periodicity)=$1,000 × 3.5%/2= $17.5.

Finally, the current interest rate on a semi-annual basis is 1.49%. So

we get:

PV of the Coupon Bond=

17.5
1.49 %[1−
1
(1+1.49 % )
20
]+
1,000
(1+1.49 %)
20
=1,044.68 .

The market price is below our PV (fair price), so I would recommend

purchasing the bond because it is cheaper that what I think i t is
worth according to the PV calculation. Remember: the Fair Price
is the result of the PV calculation, the Face Value is also called the
nominal value of the bond and is used to compute Coupon
Payments; and t h e Market Price is the price at which the bond is
selling in the market.

(b) You decide to buy the bond at the current market price of 1,020$.
Suddenly, the market crashes and you decide to sell the bond at the
new market price of $990. What is your capital gain/loss?
The Capital gain/loss is simply given by the difference
Sale Price – Purchase Price = 990-1020= -30.
Because the result is negative, you have a capital loss.