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TVM Review Lecture (DOC)

VIEWS: 130 PAGES: 19

  • pg 1
									                                    Time Value of Money Problems

1.       What is the PV of $100 received in:
         a.       Year 10 at a discount rate of 1 percent.
         b.       Year 10 at a discount rate of 13 percent.
         c.       Year 15 at a discount rate of 25 percent.
         d.       Each of years 1 through 3 at a discount rate of 12 percent.


               a. PV = $100/1.0110 = $90.53

               b. PV = $100/1.1310 = $29.46

               c. PV = $100/1.2515 = $ 3.52
               d. PV = $100/1.12 + $100/1.122 + $100/1.123 = $240.18


                 a                  b                   c             d
          N = 10                    10                  15            3
           I= 1                     13                  25            12
     Cpt. PV = 90.53                29.46               3.52          240.18
        Pmt = 0                     0                   0             100
         FV = 100                   100                 100           0


2.       For each of the following, compute the future value:
               Present Value                Years              Interest Rate    Future Value
                  $1,000                     4                     10%
                  $2,500                     6                    12.25%


                     N= 4                    6
                     I = 10%                 12.25%
                  PV = 1,000                 2,500
                 Pmt = 0                     0
              Cpt. FV = 1,464.10             5,001.01




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                               Page 1
3.     For each of the following, compute the interest rate:
           Present Value                   Years               Interest Rate   Future Value
               $5,500                       8                                    $12,000
               $7,500                       15                                   $60,000


                N= 8                        15
            Cpt. I = 10.2433%               14.8698%
              PV = -5,500                   -7,500
              Pmt = 0                       0
              FV = $12,000                  $60,000


4.     For each of the following, compute the number of years:
           Present Value                   Years               Interest Rate   Future Value
                $300                                               5%              450
              $27,500                                           10.125%          $60,000


           Cpt. N = 8.3104                  8.0891
                 I= 5                       10.125
              PV = -300                     -27,500
              Pmt = 0                       0
              FV = 450                      60,000




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                 Page 2
5.     A factory costs $800,000. You believe that it will produce a cash flow of $170,000 a year
       for 10 years. If the opportunity cost of capital is 14 percent, what is the NPV of the factory?
       What will the factory be worth at the end of five years?
               The present value of the 10-year stream of cash inflows is:
                                 1            1        
               PV  $170,000                      10 
                                                           $886,739.66
                                 0.14 0.14 (1.14) 
               Thus:
               NPV = –$800,000 + $886,739.66 = +$86,739.66


                CF0 = -800,000                  I = 14
                CF1 = 170,000        F1= 10     Cpt NPV = 86,739.66

       At the end of five years, the factory’s value will be the present value of the five remaining
       $170,000 cash flows:
                                1          1        
               PV  $170,000                    5 
                                                        $583,623.76
                                0.14 0.14  (1.14) 
                         N= 5
                          I = 14
                  Cpt. PV = 583,623.76
                      Pmt = 170,000
                       FV = 0




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                      Page 3
6.      A machine costs $380,000 and it is expected to produce the following cash flows.
Year             1         2         3      4       5       6    7    8    9     10
CF ($000S)       50        57        75     80      85      92   92   80   68    50

If the cost of capital is 12 percent, what is the machine’s NPV?
         10
                 Ct                  $50,000 $57,000 $75,000 $80,000 $85,000
NPV                t
                         $380,000                             
        t 0   (1.12)                 1.12    1.122   1.123   1.124   1.125


                           $92,000 $92,000 $80,000 $68,000 $50,000
                                                               $23,696.15
                            1.126   1.127   1.128   1.129   1.1210
Or
 CF0            -380            I=               12%
 CF1            50              Cpt NPV =        23.69615
 CF2            57
 CF3            75
 CF4            80
 CF5            85
 CF6            92
 CF7            92
 CF8            80
 CF9            68
 CF10           50




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                   Page 4
7.     Mike Polanski is 30 years of age and his salary next year will be $40,000. Mike forecasts
       that his salary will increase at a steady rate of 5 percent per year until his retirement at age
       60.
       a.      If the discount rate is 8 percent, what is the PV of these future salary payments?
       b.      If Mike saves 5 percent of his salary each year and invests these savings at an
               interest rate of 8 percent, how much will he have saved by age 60?
       c.      If Mike plans to spend these savings in even amounts over the subsequent 20 years,
               how much can he spend each year?
               a.      Let St = salary in year t
                      30
                               St     30
                                           40,000 (1.05)t 1 30 (40,000/1.    05) 30 38,095.24
               PV                                                           
                      t 1   (1.08)t  t 1     (1.08)t       t  1 (1.08 / 1.05)
                                                                                t
                                                                                   t 1 (1.0286)
                                                                                                t


                                   1              1          
                     38,095.24                         30 
                                                                 $760,379.21
                                   0.0286 0.0286 (1.0286) 


               PV(salary) x 0.05 = $38,018.96
               Future value = $38,018.96 x (1.08)30 = $382,571.75


                                1       1      
                       PV  C              t 
                                 r r  (1 r) 

                                           1           1        
                        $382,571.75  C                    20 
                                           0.08 0.08  (1.08) 

                                                 1           1        
                        C  $382,571.75                                $38,965.78
                                                 0.08 0.08  (1.08)20 
                                                                      
               Or
                               a            b                                  c
                       N = 30               30                                 20
                        I = 2.86            8                                  8
                Cpt. PV = 760,379.21 (0.05)(760,379.21) = 38,018.96 382,571.75
                    Pmt = 38,095.24         0                                  Cpt Pmt = 38,965.78
                     FV = 0                 Cpt FV = 382,571.75




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                        Page 5
8.     A factory costs $400,000. It will produce a cash inflow of $100,000 in year 1, $200,000 in
       year 2, and $300,000 in year 3. The opportunity cost of capital is 12 percent. Calculate the
       NPV

           Period                               Present Value

               0                                400,000.00
               1         +100,000/1.12 =        + 89,285.71
                                           2
               2         +200,000/1.12 =        +159,438.78
                                           3
               3         +300,000/1.12 =        +213,534.07
                         Total = NPV = $62,258.56

         CF0           -400,000                I = 12%
         CF1           100,000        Cpt NPV = $62,258.56
         CF2           200,000
         CF3           300,000




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                   Page 6
9.     Halcyon Lines is considering the purchase of new bulk carrier for $8 million. The
       forecasted revenues are $5 million a year and operating costs are $4 million. A major refit
       costing $2 million will be required after both the fifth and tenth years. After 15 years, the
       ship is expected to be sold for scrap at $1.5 million. If the discount rate is 8 percent, what is
       the ship’s NPV?
       We can break this down into several different cash flows, such that the sum of these separate
       cash flows is the total cash flow. Then, the sum of the present values of the separate cash
       flows is the present value of the entire project. (All dollar figures are in millions.)
              Cost of the ship is $8 million
               PV = $8 million
              Revenue is $5 million per year, operating expenses are $4 million. Thus, operating
               cash flow is $1 million per year for 15 years.
                                    1              1         
               PV  $1million                          15 
                                                                 $8.559 million
                                    0.08 0.08  (1.08) 
              Major refits cost $2 million each, and will occur at times t = 5 and t = 10.
               PV = ($2 million)/1.085 + ($2 million)/1.0810 = $2.288 million
              Sale for scrap brings in revenue of $1.5 million at t = 15.
               PV = $1.5 million/1.0815 = $0.473 million
       Adding these present values gives the present value of the entire project:
               NPV = $8 million + $8.559 million  $2.288 million + $0.473 million
               NPV = $1.256 million
        CF0 = -8                            I=8
        CF1 = 1                  F1= 4      Cpt NPV =-1.2552
        CF2 = 1 – 2 = -1         F2 = 1
        CF3 = 1                  F3= 4
        CF4 = 1 – 2 = -1         F4 = 1
        CF5 = 1                  F5= 4
        CF6 = 1 + 1.5 = 2.5 F6 = 1




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                       Page 7
10.    As winner of a breakfast cereal competition, you can choose one of the following prizes:
       a.       $100,000 now.
       b.       $180,000 at the end of 5 years.
       c.       $11,400 a year forever.
       d.       $19,000 for each of 10 years.
       e.       $6,500 next year and increasing thereafter by 5 percent a year forever.
       If the interest rate is 12 percent, which is the most valuable prize?
                a.      PV = $100,000
                b.      PV = $180,000/1.125 = $102,137
                c.      PV = $11,400/0.12 = $95,000
                                       1           1        
               d.      PV  $19,000                    10 
                                                                $107,354
                                       0.12 0.12  (1.12) 
               e.      PV = $6,500/(0.12  0.05) = $92,857
               Prize (d) is the most valuable because it has the highest present value.


                             a             b      c                       d
                       N= 0                5                              10
                        I = 12             12                             12
                Cpt. PV = 100,000 102,137 11,400/0.12 = 95,000 107,354
                    Pmt = 0                0                              19,000
                     FV = 100,000 180,000                                 0




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                  Page 8
11.    Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to
       invest $20,000 in an annuity that will make a level payment at the end of each year until his
       death. If the interest rate is 8 percent, what income can Mr. Basset expect to receive each
       year?
       Mr. Basset is buying a security worth $20,000 now. That is its present value. The unknown
       is the annual payment. Using the present value of an annuity formula, we have:
                        1       1      
               PV  C              t 
                         r r  (1 r) 

                              1           1        
               $20,000  C                    12 
                              0.08 0.08  (1.08) 

                            1           1        
               C  $20,000                        $2,653.90
                            0.08 0.08  (1.08)12 
                                                 


                        N = 12
                         I= 8
                      PV = 20,000
                Cpt. Pmt = 2,653.90
                      FV = 0




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                   Page 9
12.    David and Helen Zhang are saving to buy a boat at the end of five years. If the boat costs
       $20,000 and they can earn 10 percent a year on their savings, how much do they need to put
       aside at the end of years 1 through 5?
               Assume the Zhangs will put aside the same amount each year. One approach to
               solving this problem is to find the present value of the cost of the boat and then
               equate that to the present value of the money saved. From this equation, we can
               solve for the amount to be put aside each year.
               PV(boat) = $20,000/(1.10)5 = $12,418
                                               1          1        
               PV(savings) = Annual savings                    5 
                                               0.10 0.10  (1.10) 
               Because PV(savings) must equal PV(boat):
                                 1          1        
               Annual savings                    5 
                                                         $12,418
                                 0.10 0.10  (1.10) 
                                              1              1       
               Annual savings  $12,418                           5 
                                                                         $3,276
                                              0.10 0.10  (1.10) 
               Another approach is to find the value of the savings at the time the boat is purchased.
               Because the amount in the savings account at the end of five years must be the price
               of the boat, or $20,000, we can solve for the amount to be put aside each year. If x is
               the amount to be put aside each year, then:
                            x(1.10)4 + x(1.10)3 + x(1.10)2 + x(1.10)1 + x = $20,000
                                     x(1.464 + 1.331 + 1.210 + 1.10 + 1) = $20,000
                                                                x(6.105) = $20,000
                                                                       x = $ 3,276
       Or
                        N= 5
                         I = 10
                      PV = 0
                Cpt. Pmt = 3,275.95
                      FV = 20,000




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                    Page 10
13.    Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and
       then $300 a month for the next 30 months. Turtle Motors next door does not offer free
       credit but will give you $1,000 off the list price. If the rate of interest is 10 percent a year,
       which company is offering the better deal?
               The fact that Kangaroo Autos is offering “free credit” tells us what the cash
               payments are; it does not change the fact that money has time value. A 10 percent
               annual rate of interest is equivalent to a monthly rate of 0.83 percent:
               rmonthly = rannual /12 = 0.10/12 = 0.0083 = 0.83%
               The present value of the payments to Kangaroo Autos is:
                                      1                   1          
               $1,000  $300                                    30 
                                                                         $8,938
                                      0.0083 0.0083 (1.0083) 
               A car from Turtle Motors costs $9,000 cash. Therefore, Kangaroo Autos offers the
               better deal, i.e., the lower present value of cost.
               Or
                       N = 30
                        I = 10/12 = 0.8333
                Cpt. PV = 7,934.11  7,934.11 + 1,000 = 8,934.11
                    Pmt = 300
                     FV = 0




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                        Page 11
14.    You are building an office building and construction will require two years. The contractor
       requires a $120,000 down payment now and commitment of the land with a market value of
       $50,000. The contractor will be paid $100,000 in 1 year and a final payment of $100,000 at
       the completion of construction in 2 years. Your real estate advisor estimates the office
       building will be worth $420,000 when completed. What is the NPV if the cost of capital is 5
       percent, 10 percent, and 15 percent? Draw a NPV profile. At what rate would the NPV be
       zero? Check your answer.
                  Time     T=0        T=1        T=2
                  Land     -50,000
         Construction -120,000 -100,000 -100,000
                Payoff                        420,000
          Total CFs -170,000 -100,000         320,000
       The NPVs are:
                                                 $100,000   $320,000
       at 5 percent       NPV  $170,000                           $25,011
                                                   1.05      (1.05) 2
                                                 $100,000   320,000
       at 10 percent  NPV  $170,000                              $3,554
                                                   1.10     (1.10) 2
                                                 $100,000   320,000
       at 15 percent  NPV  $170,000                              $14,991
                                                   1.15     (1.15) 2
       The figure below shows that the project has zero NPV at about 11 percent.
       As a check, NPV at 11 percent is:
                            $100,000       320,000
       NPV  $170,000                              $371
                               1.11        (1.11) 2
          CF0            -170,000    I=           5%          10%          15%
          CF1            -100,000    Cpt NPV =    $25,011.34 $3,553.72     -$14,990.55
          CF2            320,000



         30
   NPV
         20


         10


          0


         -10


         -20

                0.05                   0.10                0.15 Rate of Interest




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                 Page 12
15.    You have just read an advertisement stating, “Pay us $100 a year for ten years and we will
       pay you $100 a year thereafter in perpetuity.” If this is a fair deal, what is the rate of
       interest?
               One way to approach this problem is to solve for the present value of:
               (1)      $100 per year for 10 years, and
               (2)      $100 per year in perpetuity, with the first cash flow at year 11.
               If this is a fair deal, these present values must be equal, and thus we can solve for the
                        interest rate (r).
               The present value of $100 per year for 10 years is:
                              1         1       
               PV  $100                   10 
                               r (r) (1 r) 
               The present value, as of year 10, of $100 per year forever, with the first payment in
                       year 11, is: PV10 = $100/r
               At t = 0, the present value of PV10 is:
                     1   $100
               PV             
                            10       
                     (1 r)   r 
               Equating these two expressions for present value, we have:
                       1         1         1   $100
               $100                     
                                       10  
                                                        
                                                    10         
                        r (r) (1 r)   (1 r)   r 
               Using trial and error or algebraic solution, we find that r = 7.18%.




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                      Page 13
16.    Which would you prefer?
       a.         An investment paying interest of 12 percent compounded annually.
       b.         An investment paying interest of 11.7 percent compounded semiannually.
       c.         An investment paying 11.5 percent compounded continuously.

       Assume the amount invested is one dollar.

       Let A represent the investment at 12 percent, compounded annually.
       Let B represent the investment at 11.7 percent, compounded semiannually.
       Let C represent the investment at 11.5 percent, compounded continuously.
       After one year:
               FVA = $1  (1 + 0.12)1         = $1.1200
               FVB = $1  (1 + 0.0585)   2
                                              = $1.1204
                           (0.115  1)
               FVC = $1  e            = $1.1219
       After five years:
               FVA = $1  (1 + 0.12)5         = $1.7623
               FVB = $1  (1 + 0.0585)   10
                                              = $1.7657
                           (0.115  5)
               FVC = $1  e            = $1.7771
       After twenty years:
              FVA = $1  (1 + 0.12)20         = $9.6463
              FVB = $1  (1 + 0.0585)    40
                                              = $9.7193
              FVC = $1  e(0.115  20) = $9.9742
       The preferred investment is C.
            b                        c                      c
            Nom             11.7     Nom           11.5     Nom            11.5
            Cpt. Eff. 12.0422%       Cpt. Eff. 12.185%      Cpt. Eff. 12.186%
            C/Y                2     C/Y            365     C/Y             730




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                   Page 14
17.    Fill in the blanks in the following table:
            Nominal
                                Inflation Rate         Real Interest Rate
          Interest Rate
              6.00%                  1.00%
                                    10.00%                   12.00%
              9.00%                                          3.00%


               1 + rnominal = (1 + rreal)  (1 + inflation rate)


            Nominal
                                Inflation Rate         Real Interest Rate
          Interest Rate
              6.00%                 1.00%                     4.95%
             23.20%                10.00%                    12.00%
              9.00%                 5.83%                     3.00%

               1.06 = (1 + rreal)(1.01)  rreal = .0495
               1 + rnominal = (1.1)(1.12)  rnominal = 0.2320
               1.09 = (1.03) (1 + inflation rate)  inflation rate = 0.0583

18.    A leasing contract calls for an immediate payment of $100,000 and nine subsequent
       $100,000 semiannual payments at six-month intervals. What is the PV of these payments if
       the discount rate is 8 percent?
       Because the cash flows occur every six months, we use a six-month discount rate, here
       8%/2, or 4%. Thus:
                                         1          1        
               PV  $100,000 $100,000                   9 
                                                                 $843,533
                                         0.04 0.04  (1.04) 
               N= 9
                I = 8/2 = 4
        Cpt. PV = 743,533  743,533 + 100,000 =843,533
             Pmt = 100,000
              FV = 0




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                Page 15
19.    You estimate that by the time you retire in 35 years, you will have accumulated savings of
       $2 million. If the interest rate is 8 percent and you live 15 years after retirement, what
       annual level of expenditure will these savings support?
       Unfortunately, inflation will eat into the value of your retirement income. Assume a 4
       percent inflation rate and work out a spending program for your retirement that will allow
       you to maintain a level real expenditure during retirement.
       This is an annuity problem with the present value of the annuity equal to $2 million (as of
       your retirement date), and the interest rate equal to 8 percent, with 15 time periods. Thus,
       your annual level of expenditure (C) is determined as follows:
                 1       1      
        PV  C              t 
                                                                                         N = 15
                  r r  (1 r)                                                          I= 8
                                                                                       PV = 2,000,000
                          1           1        
        $2,000,000  C                    15 
                                                                          or     Cpt. Pmt = 233,659
                          0.08 0.08  (1.08) 
                                                                                       FV = 0

                        1           1        
        C  $2,000,000                        $233,659
                        0.08 0.08  (1.08)15 
                                             
       With an inflation rate of 4 percent per year, we will still accumulate $2 million as of our
       retirement date. However, because we want to spend a constant amount per year in real
       terms (R, constant for all t), the nominal amount (C t ) must increase each year. For each
       year t:
               R = C t /(1 + inflation rate)t
               Therefore:
               PV [all C t ] = PV [all R  (1 + inflation rate)t] = $2,000,000
                   (1  0.04)1 (1  0.04)2          (1  0.04)15 
               R                         . . .                 $2,000,000
                   (1 0.08) (1  0.08)             (1 0.08)15 
                              1           2


               R  [0.9630 + 0.9273 + . . . + 0.5677] = $2,000,000
               R  11.2390 = $2,000,000
               R = $177,952
               Thus C1 = ($177,952  1.04) = $185,070, C2 = $192,473, etc.


                N = 15                     Remember:
                 I = 3.8462                1 + rnominal = (1 + rreal)  (1 + inflation rate)
              PV = 2,000,000               1.08 = (1 + rreal)(1.04)  rreal = .038462
        Cpt. Pmt = 177,952
              FV = 0


b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                          Page 16
20.    You are considering the purchase of an apartment complex that currently generates a net
       cash flow of $400,000 per year. You normally demand a 10 percent rate of return on such
       investments. Future cash flows are expected to grow with inflation at 4 percent year from
       today’s level. How much would you be willing to pay for the complex if it:
       a.      Will produce cash flows forever?
       b.      Will have to be torn down in 20 years? Assume that the site will be worth $5 million
               at the time of demolition costs. (The $5 million includes 20 years’ inflation.)
       Now calculate the real discount rate corresponding to the 10 percent nominal rate. Redo the
       calculations for part (a) and (b) using real cash flows. (Your answers should not change.)
               First, with nominal cash flows:
       a.      The nominal cash flows form a growing perpetuity at the rate of inflation, 4%. Thus,
               the cash flow in one year will be $416,000 and:
               PV = $416,000/(0.10 – 0.04) = $6,933,333
       b.      The nominal cash flows form a growing annuity for 20 years, with an additional
               payment of $5 million at year 20:
                         1        1     ( 1  g)t  $5,000,000
                PV  C1                        t 
                                                      
                         (r-g) (r  g) ( 1  r)       ( 1  r)t
                                       1             1        ( 1.04 )20  $5,000,000
                     $ 416,000                                     20 
                                                                            
                                 ( 0.10-0.04 ) ( 0.10-0.04 ) ( 1.10 )       ( 1.10 )20
                     $5,418,389
               Second, with real cash flows:
       a.      Here, the real cash flows are $400,000 per year in perpetuity, and we can find the
               real rate (r) by solving the following equation:
               (1 + 0.10) = (1 + r)(1 + 0.04)  r = 0.05769 = 5.769%
               PV = $400,000/0.057692 = $6,933,333
       b.      Now, the real cash flows are $400,000 per year for 20 years and $5 million (nominal)
               in 20 years. In real terms, the $5 million dollar payment is:
               $5,000,000/(1.04)20 = $2,281,935
               Thus, the present value of the project is:
                               1                 1             $ 2,281,935
        PV  $ 400,000                                   20 
                                                                          20
                                                                               $5,418,510
                          ( 0.05769 ) ( 0.05769 )(1.05769 )  ( 1.05769 )
       [As noted in the statement of the problem, the answers agree, to within rounding errors.]
                       N = 20
                        I = 5.7692
                Cpt. PV = 5,418,389
                    Pmt = 400,000
                     FV = 2,281,935

b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                   Page 17
21.    Vernal Pool, a self-employed herpetologist, wants to put aside a fixed fraction of her annual
       income as savings for retirement. Ms. Pool is now 40 years old and makes $40,000 a year.
       She expects her income to increase by 2 percentage points over inflation (e. g., 4 percent
       inflation means a 6 percent increase in income). She wants to accumulate $500,000 in real
       terms to retire at age 70. What fraction of her income does she need to set aside? Assume
       her retirement funds are conservatively invested at an expected real rate of return of 5
       percent a year. Ignore taxes.
       Let x be the fraction of Ms. Pool’s salary to be set aside each year. At any point in the
       future, t, her real income will be:
               ($40,000)(1 + 0.02) t
               The real amount saved each year will be:
               (x)($40,000)(1 + 0.02) t
               The present value of this amount is:
                x $40,0001  0.02t
                       1  0.05t
       Ms. Pool wants to have $500,000, in real terms, 30 years from now. The present value of
       this amount (at a real rate of 5 percent) is:
               $500,000/(1 + 0.05)30
               Thus:
                $500,000 30 x $40,0001.02
                                                  t


                 1.0530 
                          
                            t 1   1.05t
               $500,000
                          x 
                                30
                                    $40,0001.02
                                                  t


                1.0530
                               t 1      1.05t
               $115,688.72 = (x)($790,012.82)
               x = 0.146




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                    Page 18
22.    You own a pipeline which will generate a $2 million cash flow over the coming year. The
       pipeline’s operating costs are negligible, and it is expected to last for a very long time.
       Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline
       by 4 percent per year. The discount rate is 10 percent.
       a.      What is the PV of the pipeline’s cash flows if its cash flows are assumed to last
               forever?
       b.      What is the PV of the cash flows if the pipeline is scrapped after 20 years?

               a.     This calls for the growing perpetuity formula with a negative growth rate
                      (g = –0.04):
                        $ 2 million      $ 2 million
                PV                                  $14 .29 million
                     0.10  (  0.04 )       0.14
               b.        The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash flows last
                         forever, is:
                          C21  C ( 1  g)20
                PV20          1
                         rg      rg
               With C1 = $2 million, g = –0.04, and r = 0.10:
                      ($2 million)  ( 1  0.04 )20 $0.884 million
                PV20                                                 $6.314 million
                                  0.14                      0.14
               Next, we convert this amount to PV today, and subtract it from the answer to Part
                      (a):
                                       $ 6.314 million
               PV  $14 .29 million                     $13.35 million
                                           ( 1.10 )20




       Most of these problems and part of the solutions are from Chapter 3 in Principles of
       Corporate Finance by Brealey, Myers, and Allen 8th edition. Part of the solutions were
       generated by Danny Ervin




b0deb235-ce52-462e-bbba-a3a1066034ce.doc                                                         Page 19

								
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