Guiding solution, Finance, tutorial 1

Spring 2018

Ch. 4, problem 10

Your grandfather put some money in an account for you on the day you were born. You are now 18 years old and are allowed to withdraw the money for the first
time. The account currently has $4200 in it and pays a 12% interest rate.

Question 1: How much money would be in the account if you left the money there until your 25th birthday?

The exercise is to calculate the future value of the money. Hence, we use equation 4.1 (page 133 in Berk & DeMarzo).

Amount in account 4,200

Interest rate 12%
Number of years 7 = 25-18 years
Future value (FV) 9,285 = 4,200*(1+12%)^7

Hence there is USD 9,285 in the account if we wait until the 25th birthday. The effect of earning "interest on interest" is known as compound interest and is
the second rule of "time travel" in Berk & DeMarzo.

Question 2: What if you left the money until your 65th birthday?

Amount in account 4,200

Interest 12%
Number of years 47 = 65-18 years
Future value (FV) 863,965 = 4,200*(1+12%)^47

Hence there is USD 863,965 in the account if we wait until the 65th birthday.

Question 3: How much money did your grandfather originally put in the account?

Instead of calculating future values, we discount back the current amount in the account after 18 years. This is the third rule of "time travel" in Berk &
DeMarzo and we use equation 4.2 (page 136 in Berk & DeMarzo).

Amount in account 4,200

Interest 12%
Number of years 18
Present value (PV) 546 = 4,200/(1+12%)^18

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Guiding solution, Finance, tutorial 1
Spring 2018

Ch. 4, problem 14

You have been offered a unique investment opportunity. If you invest $20,000 today, you will receive $1,000 one year from now, $3,000 two years from now, and
$20,000 ten years from now.

Question 1: What is the NPV of the opportunity if the interest rate is 12% per year? Should you take the opportunity?

We use equation 4.6 in Berk & DeMarzo (page 141) to find the NPV. To find the present value of the inflows and outflows we use equation 4.4 in Berk &
DeMarzo (page 139).

Discount rate 12%

Year 0 1 2 3 4 5 6 7 8 9 10
Cash outflow -20,000 0 0 0 0 0 0 0 0 0 0
Cash inflow 0 1,000 3,000 0 0 0 0 0 0 0 20,000
Net cashflow -20,000 1,000 3,000 0 0 0 0 0 0 0 20,000
Present value -20,000 893 2,392 0 0 0 0 0 0 0 6,439 = CF/(1+r)^n
NPV -10,276

NPV is less than 0, hence we should not accept the project (page 101 in Berk & DeMarzo explains the NPV decision rule).

Question 2: What is the NPV of the opportunity if the interest rate is 2% per year? Should you take it now?

Discount rate 2%

Year 0 1 2 3 4 5 6 7 8 9 10
Cash outflow -20,000 0 0 0 0 0 0 0 0 0 0
Cash inflow 0 1,000 3,000 0 0 0 0 0 0 0 20,000
Net cashflow -20,000 1,000 3,000 0 0 0 0 0 0 0 20,000
Present value -20,000 980 2,884 0 0 0 0 0 0 0 16,407
NPV 271

The discount rate is less than before, hence the value is larger (the discount rate reflects the opportunity cost of capital). We now accept the project since
NPV > 0.

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We can illustrate the relationsship between discount rate and NPV:

271
0.50% 2,992.2
1.00% 2,036.7 4,000.0
1.50% 1,130.6
2.00% 270.9 2,000.0
2.50% -545.0

NPV
3.00% -1,319.5 0.0
3.50% -2,054.9 0% 2% 4% 6% 8% 10% 12%
4.00% -2,753.5 -2,000.0
4.50% -3,417.3
-4,000.0
5.00% -4,048.3
5.50% -4,648.2 -6,000.0
6.00% -5,218.7
6.50% -5,761.5 -8,000.0
7.00% -6,278.1
7.50% -6,769.9 -10,000.0
Discount rate
8.00% -7,238.2
8.50% -7,684.3
9.00% -8,109.3
9.50% -8,514.4
10.00% -8,900.7
IRR 2.16%
Excel trick: The What if-analysis "Data table" can be
used to construct the data used in the graph.

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Guiding solution, Finance, tutorial 1
Spring 2018

Ch. 4, problem 18

The British government has a consol bond outstanding paying £200 per year forever. Assume the current interest rate is 12% per year.

Question 1: What is the value of the bond immediately after a payment is made?

Normally we find the present value using the following equation:

PV = CF(t)/(1+r)^t

However, when it is a perpetuity, we can use a shortcut. When valuing a perpetuity, we use equation 4.7 in Berk & DeMarzo (page 145). Note that the
perpetuity isn't growing.

CF 200
Discount rate 12%
Value 1,666.7 = 200/12%

The value of the bond is USD 1,666. This is known as the no-arbitrage price of the security (equation 3.3 in Berk & DeMarzo, page 108).

Question 2: What is the value of the bond immediately before a payment is made?

The difference in the timeline of the cash flows between question 1 and 2 can be illustrated:

Year 0 1 2 3 4 5 6 … ∞
Question 1 0 200 200 200 200 200 200 200 200
Question 2 200 200 200 200 200 200 200 200 200

We use the following procedure as in question 1, but adds one payment as the timeline shows:

CF 200
Discount rate 12%
Present value 1,666.7 = 200/12%
Value 1,866.7 = 1.666 + 200

The value of the bond is USD 1,866. This is known as the no-arbitrage price of the security (equation 3.3 in Berk & DeMarzo, page 108).

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Ch. 4, problem 29

Question: You are running a hot Internet company. Analysts predict that its earnings will grow at 40% per year for the next five years. After that, as
competition increases, earnings growth is expected to slow to 3% per year and continue at that level forever. Your company has just announced earnings of
$5 million. What is the present value of all future earnings if the interest rate is 7%? (Assume all cash flows occur at the end of the year.)

As stated in problem 18, we normally value a cashflow using the following equation:

PV = CF(t)/(1+r)^t

However, we have 2 different kinds of cashflows: A growing annuity (first 5 years) followed by a growing perpetuity. We can use shortcuts:

PV growing annuity = (CF*/(r-g))*(1-((1+g)/(1+r))^n)

PV growing perpetuity = CF/(r-g)

This corresponds to equation (4.11) and (4.12) in chapter 4 in Berk & DeMarzo (page 151 and 152).

The annuity
CF year 1 7.0 = 5*(1+40%)
Years 5
Discount rate 7%
Growth 40%
Value 60.13 = 7/(0,07-0,4)*(1-((1+0,4)/(1+0,07))^5)

The perpetuity
CF year 6 27.70 = 5*(1+40%)^5*(1+3%)
Discount rate 7%
Growth 3%
Value year 5 692.45 = 27,7/(7%-3%)
Value year 0 493.71 = 692,45/(1+7%)^5

Total value 553.83 = 60,13 + 493,71

Hence the present value of future earnings is USD 553 mio.

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Spring 2018

Ch. 7, problem 1

Assume that you are offered a deal leading to the following cash flow:

Year 0 1 2 3 4
Cash flow 5,000 -2,500 -2,000 -1,000 -1,000

Question a: What is the IRR of this deal?

The IRR is the discountrate resulting in NVP = 0. In other words: It's the average return on the investment opportunity. The easiest way to solve this problem is to
use the Excel function IA:

IRR = 13.99% = IA(5,000 -2,500 -2,000 -1,000 -1,000)

The internal rate of return is 13.99 %. Note that you can use the Excel tool Solver as well.

Question b: If the appropriate discount rate is 10 per cent, should you accept this offer?

Normally, the IRR investment rule states: "Take any investment opportunity where the IRR exceeds the opportunity cost of capital..." since the average rate of return
on the investment opportunity is greater than the return on other alternatives in the market with equivalent risk and maturity (page 248 in Berk & DeMarzo).
However, this is only valid if it's an investing-type project where it's negative cash flows precede its postive cash flows. The cash flow indicate that this is a
financing-type project (initial cash flow is positive and all future cash flow are negative). For financing situations the rule of thumb is to accept the project when the
IRR is less than the discount rate and reject the project when the IRR is greater than the discount rate. The intuition is, that the IRR is the "average borrowing rate"
and should be less than the "borrowing rate" in the market. The conclusion is, that we should not accept this offer.

Question c: If the appropriate discount rate is 20 per cent, should you accept this offer?

We should accept the deal according to the argument in question b.

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Question d: What is the NPV of the offer if the appropriate discount rate is 10 per cent? 20 per cent?

Discount rate = 10.00%

Year 0 1 2 3 4
Future value 5,000 -2,500 -2,000 -1,000 -1,000
Present value 5,000 -2,273 -1,653 -751 -683 = CF(t)/(1+10 %)^t

Net present value = -359.95 = sum(present values)

When the discount rate is 10 percent, the NPV of the offer is –£359.95, hence reject the offer.
When the discount rate is 20 percent, the NPV of the offer is £466.82, hence accept the offer.

Question e: Are the decisions under the NPV rule in part (d) consistent with those of the IRR rule?

Yes, the decisions under the NPV rule are consistent with the choices made under the IRR rule since the signs of the cash flows change only once.

-359.95 NPV 1,000.0

2.00% -1,239.5
4.00% -996.8
6.00% -770.2 500.0
NPV

8.00% -558.4
10.00% -359.9 0.0
12.00% -173.8 0% 5% 10% 15% 20% 25% 30%
14.00% 1.0
16.00% 165.6 -500.0
18.00% 320.6
20.00% 466.8 -1,000.0
22.00% 605.0
24.00% 735.7
26.00% 859.5 -1,500.0
Discount rate

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Spring 2018

Ch. 7, problem 2

Consider the following cash flows on two mutually exclusive projects for Tomatina, Recreation SA. Both projects require an annual return of 15 per cent.

Year 0 1 2 3
Deepwater Fishing CF -600,000 270,000 350,000 300,000
New Submarine Ride CF -1,800,000 1,000,000 700,000 900,000

Cost of capital = 15.00%

Question a: If your decision rule is to accept the project with the greater IRR, which project should you choose?

We use the IA function:

Deepwater Fishing = 24.30% = IA(cash flows)

New Submarine Ride = 21.46% = IA(cash flows)

Based on the IRR rule, the deepwater fishing project should be chosen because it has the higher IRR - however this decsion is flawed, due to the scale problem as
we will se in question b) .

Question b: Because you are fully aware of the IRR rule's scale problem, you calculate the incremental IRR for the cash flows. Based on your
computation, which project should you choose?

To calculate the incremental IRR, we subtract the smaller project’s cash flows from the larger project’s cash flows (page 256 in Berk & DeMarzo):

Year 0 1 2 3
Deepwater Fishing CF -600,000 270,000 350,000 300,000
New Submarine Ride CF -1,800,000 1,000,000 700,000 900,000
Incremental CF -1,200,000 730,000 350,000 600,000 = NSR - DF

IRR = 19.92% = IA(Incremental cash flows)

Hence, the incremental IRR for the project is 19.92%. Incremental IRR is the IRR on the incremental investment from choosing the large project instead of the
small project. For investing-type projects, accept the larger project when the incremental IRR is greater than the discount rate. We choose NSR

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Question c: To be prudent, you compute the NPV for both projects. Which project should you choose? Is it consistent with the incremental IRR rule?

Deepwater Fishing:

Year 0 1 2 3
CF -600,000 270,000 350,000 300,000
PV -600,000 234,783 264,650 197,255 = CF(t)/(1+15%)^t

Net present value = 96,688 = sum(present values)

New Submarine Ride:

Year 0 1 2 3
CF -1,800,000 1,000,000 700,000 900,000
PV -1,800,000 869,565 529,301 591,765 = CF(t)/(1+15%)^t

Net present value = 190,630 = sum(present values)

According to the NPV rule, we choose NSR. Hence, the NPV rule is consistent with the incremental IRR rule, and can always be used (page 254 in Berk
& DeMarzo).

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Ch. 7, problem 3

Consider the following cash flows:

Year 0 1 2 3 4
Cash flow -504 2,862 -6,070 5,700 -2,000

Question a: How many different IRRs are there?

From first observation, we should notice that some cash flow after first are positive and some cash flows after first are negative. This implies that there might be
more than one IRR (page 249-250 in Berk & DeMarzo). We should accept this project if the NPV > 0 and reject if NPV < 0, but we can't use any IRR criterion.

Using Descartes rule of signs, from looking at the cash flows we know there are four IRRs for this project. To find the IRRs, we need some qualified guesses
and if we plot NPV as a function of the discount rates, we obtain the following (see plot in the end):

Guess 20.00% 30.00% 40.00% 60.00%

IRR = 25.00% 33.33% 42.86% 66.67% = IA(cash flows; "Guess")

For the multiple IRRs, we should have a good sense of what the "correct" IRR is (from a finance perspective), but mathematically they are "all" correct. The IRR is
simply a non-linear solution to a specific mathematical equation. The polynomial that results from the data has multiple zeroes, so all our answers are technically
right. It is the interpretation in finance/capital budgeting which gives rise to these issues. Mathematically, there is no way to say which of the IRRs is better. Ones
again this illustrates that IRR is a flawed concept (pitfall #2 in Berk & DeMarzo page 249-250).

To further investigate, we should plot NPV as function of discount rate and accept the project when the NPV is greater than zero:

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Discount rate NPV

20.00% -0.173 = -504 + NUTIDSVÆRDI(20%;CF from year 1-4)
22.50% -0.055
25.00% 0.000 <-- Approx. calculated IRR. £0.100000
27.50% 0.017
30.00% 0.014 £0.050000
32.50% 0.004 <-- Approx. calculated IRR.
35.00% -0.006 £0.000000
25.00% 33.33% 42.86%
37.50% -0.011 66.67%
40.00% -0.010

NPV
-£0.050000
42.50% -0.002
45.00% 0.012 <-- Approx. calculated IRR.
47.50% 0.030 -£0.100000
50.00% 0.049
52.50% 0.067 -£0.150000
55.00% 0.080
57.50% 0.086
-£0.200000
60.00% 0.082 20.00% 25.00% 30.00% 35.00% 40.00% 45.00% 50.00% 55.00% 60.00% 65.00% 70.00%
62.50% 0.065
Discount Rate
65.00% 0.032
67.50% -0.019 <-- Approx. calculated IRR.
70.00% -0.090

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