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UVic Econ 103C with Peter Bell

Technical Practice Exam #4 Discounting
Assigned: Thursday, 3 July 2014; Due: 5PM Wednesday, 16 July 2014

Section 1: Discounting Cash Flows
Suppose there a contract that offers a lump sum payment (F) due at maturity (T time steps in the
future). The discount rate is r per time step.
(1) State the formula for the Present Value (PV) of the payment.

(2) State and discuss the sign of the derivative for the PV in terms of the discount rate. Repeat for
the maturity time.
In both cases, the sign of the derivative will be negative. This is due to the fact that the
lump sum payment, F, is a constant. This can be seen by examining the quotient rule for
derivatives. The quotient rule,

, clearly shows that the first term of the

numerator will go to zero when f is a constant.

Suppose there is another lump sum payment (F), but the discount rate changes before maturity. Let
0<t
1
<t
2
<T and T=t
1
+t
2
. From 0 to t
1
, the rate is r
1
. From t
1
to t
2
the rate is r
2
.
(3) State the formula for the PV in this case.
For 0 to t
1
:

For t
1
to t
2
:

(4) Let F =100, t
1
=50, t
2
=50, r
1
=0.05, r
2
=0.10. Calculate the PV.
Suppose there is another lump sum payment with a random component (F + e, where e~N(0,s)). The
payment is due after T time steps and the discount rate constant (r).
(5) State the PV for the random payment. What is the average PV?
(6) Let F =100, s=10, T=100, r=0.01. Estimate the distribution for the PV using simulation.
Suppose there is contract that provides an annuity payment (A). The payment is made once each time
step, for N time steps into the future. The discount rate is r per time step.
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(7) State the formula for the Present Value (PV) of the annuity payment.
(8) State and discuss the sign of the derivative for the PV in terms of the discount rate. Repeat for
the maturity time and the annuity amount.
Suppose you face the same annuity contract as above, but your discount rate changes before maturity.
As before, let 0<n
1
<n
2
<N and N=n
1
+n
2
. From 0 to n
1
, the rate is r
1
. From n
1
to n
2
the rate is r
2
.
(9) State the PV for the payment as a series.
(10) Let A =100, n
1
=50,n
2
=50, r
1
=0.05, r
2
=0.10. Calculate the PV.
Suppose the annual payments are random (A + e, where e~N(0,s)). The contract still specifies N
payments and you use a constant discount rate (r) to calculate PV.
(11) State the PV for the random payment as a series. What is the average PV?
(12) Let A =100, s=10, N=100, r=0.01. Estimate the distribution for the PV using simulation.

Section 2: Accounting for Depreciation
There are two broad ways to recognize the cost of an investment: as an expense or as a capitalized cost.
(13) Define both term and discuss differences.
Suppose a company has an expense of $1M. They can treat this expense in two ways, as described in
the table below (entries represent the amount of investment counted as expenses each year):
Time 0 1 2 3 4 5
Expense 1.0 0 0 0 0 0
Cap. Cost 0 0.2 0.2 0.2 0.2 0.2
(14) Calculate the PV of the cost under the two accounting treatments with a general interest rate
(r). Which one is better for the company as a tax-payer? For the government?
Suppose an investment costs $100 and has a 10 year life. The asset is sold at $10 after 10 years. The
company can control the rate that they depreciate the asset and the salvage value, but they do not
control the market price: the difference between the accounting and market price is taxable. The
annual discount rate is 15% and tax rate is 20%.
Case 1: the company depreciate 95% of the asset value, leaving B=$5 after 10 years.
Case 2: the company depreciate 90% of the asset value, leaving B=$10 after 10 years.
Case 3: the company depreciate 85% of the asset value, leaving B=$15 after 10 years.
(15) For case 1, solve the PV of the annual depreciation charges and the tax implications for the sale.
(16) For case 2, solve the PV of the annual depreciation charges and the tax implications for the sale.
(17) For case 3, solve the PV of the annual depreciation charges and the tax implications for the sale.
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(18) Which case is best based solely on the tax implications?
(19) How do the results in Question (13) and (14) compare with the results in Question (18)?
In general, companies do not expense the entire value of the investment because they plan to sell the
asset for a salvage value. The company may control the salvage value based on their accounting rules,
but they do not generally control the market price. The difference between the accounting and market
price is taxable; taxes due if market price is larger than salvage, or a tax credit if smaller.
(20) Fill in the blanks with the following terms: larger, smaller, tax rebate, taxes due.
If the company depreciates the asset faster, then they get ______________ expenses during the
asset life and get ___________ at expiry.
If the company depreciates the asset slower, then they get ______________ expenses during
the asset life and get ___________ at expiry.



Section 3: Word Problems
Newton-Bell Research is considering buying equipment that costs $100. The equipment will be used for
five years at zero cost each year and zero net benefit at expiry. Without the equipment, the company
will spend $25 on operations each year, and earn total cash flow of $45 and total profits of $20 per year.
With the equipment, the company will have total cash flow of $70 and total profits of $40 each year.
The company faces zero taxes.
(21) State the relevant figures for assessment of the project. Calculate the NPV at 10%. Determine
whether to invest in the project or not.
(22) Explain why you calculated the results this way.
Newton-Bell Research is considering an investment that costs $55. It will depreciate over ten years to
book value of $5 and will be sold for $6. The cash flow will be $15 per year for ten years. There are
startup costs of $6, where $5 of the startup costs will be capitalized and $1 will be expensed. The
company faces $5 for clean-up costs in the tenth year. The company faces zero taxes.
(23) State the relevant figures for the initial cost of the project and calculate it.
(24) State the relevant figures for the annual cash flow after tax and calculate it.
(25) State the relevant figures for the cash flow at termination and calculate it.
(26) Report the time series of cash flow.
CF(0) =_____ CF(t)=______ for t in [1,9] CF(10) =______
(27) Calculate the NPV at 0%, 5%, and 10%.

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Comment on Grading
I will grade each question as 0, 1, or 2. I will assign 0 if you do not try the question or make incorrect
statements. I will assign 1 if you try the question but make significant mistakes in content or formatting.
I will assign 2 if you correctly address the question in a professional manner.
There is a maximum of 54 points on the exam. However, I will calculate your score on the exam as
follows. If your score is greater than 45 points, then you get 5% credit for this Practice Exam towards
your final grade. If you get less than 45, then you get X/9 towards this portion of your final grade, where
X is the number of points you get.