Question 1

What is Virginia’s current wealth (equivalently, what is the present value

of her assets)? How much money can she consume today? How much of
the money can she spend and consume one year from today if she
consumes nothing today?

Answer

Virginia has current assets worth $4.83 million at present. This value of her assets
is calculated by adding $2 million she receives today to the present value of $3
million which she will get at the end of one year.

Virginia can spend or consume maximum $4.83 million which is the value of her
total asset at present. Here, she can borrow $2.83 million (present value of $3
million) from bank which she can repay with the money she will be getting after
exactly one year. The rest of the money ($2 million) she has already possessed.
However, if she does not want to borrow money from bank, the maximum amount
she can spend today is $2 million.

If Virginia does not spend any money today, she can spend the at least $5.12
million which is the future value of $2 million plus $3 million which she will get after
one year.

Present Value of
Asset:

Year 0 1 Total
Cash $2,000,000 $3,000,00 $5,000,00
0 0
Present Value $2,000,000 $2,830,18 $4,830,18
9 9

Total PV of the Asset $4,830,1

89

Future
Consumption:

Year 0 1 Total
Cash $2,000,000 $3,000,00 $5,000,00
0 0
Future Value $2,120,000 $3,000,00 $5,120,00

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 0 0

Total Future $5,120,0

Consumption 00

Question 2

How much of the $4 million should Virginia invest in the restaurant? What
happens to Virginia’s wealth when she makes the investment in Ginny’s
Restaurant?

Answer

Here it is assumed that the amount which will not be invested in the restaurant will
be saved in a bank at 6% interest rate. Among the four options, Virginia gets
highest return from the investment option 3 which suggests investing $3 million in
the restaurant and keeping the rest of the money ($1 million) in a bank. Other
options have lower NPV than this option. Therefore, most possibly she will choose
option 3.

Virginia’s wealth will increase 29% if she chooses option 3. The calculation is
showed below.

Option 1 Option 2 Option 3 Option 4

Investment $1,000,000 $2,000,00 $3,000,00 $4,000,00
0 0 0
Remaining Cash $3,000,000 $2,000,00 $1,000,00 $0
0 0
Future Cash Flow $1,800,000 $3,300,00 $4,400,00 $5,400,00
0 0 0
FV of Remaining $3,180,000 $2,120,00 $1,060,00 $0
Cash 0 0

Total FV $4,980,000 $5,420,00 $5,460,0 $5,400,00

0 00 0

PV of Investment $1,698,113 $3,113,20 $4,150,94 $5,094,34

8 3 0
NPV $698,113 $1,113,20 $1,150,94 $1,094,34
8 3 0

Increase in the 17% 28% 29% 27%

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 Asset

Question 3

Suppose that Virginia has a strong preference for current versus future
consumption, and would like to consume at least $3.8 million immediately.
Is this consumption possible, in light of the planned investment in Ginny’s
Restaurant?

Answer

The current consumption of $3.8 million is possible since she has $0.2 million
remaining on her hand and she can invest this amount in the restaurant. After
calculating in Excel, we can observe that if Virginia borrows $2.8 million from bank
and add this to $0.2 million for investing in Ginny’s Restaurant, she can optimize
the return from the investment. After repaying the principal amount with interest
Virginia will still have $1.23 million as profit.

Option Option Option 3 Option

1 2 4
Investment $1,000,0 $2,000,0 $3,000,0 $4,000,0
00 00 00 00
Remaining $200,00 $200,00 $200,000 $200,00
Endowment 0 0 0
Borrow from $800,00 $1,800,0 $2,800,0 $3,800,0
Bank 0 00 00 00
Interest on Loan $48,000 $108,00 $168,000 $228,00
0 0
Repayment to $848,00 $1,908,0 $2,968,0 $4,028,0
Bank 0 00 00 00

Future Cash Flow $1,800,0 $3,300,0 $4,400,0 $5,400,0

00 00 00 00
Total Cash on $752,00 $1,192,0 $1,232, $1,172,0
Hand 0 00 000 00

Question 4

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Assume that Virginia does not have the $4 million endowment to begin
with, but still has the necessary skills to develop and operate Ginny’s
Restaurant. Should she still make the investment in the restaurant, and if
so, how much? Assume that the only source of financing is a bank loan.

Answer

If Virginia has no other option than borrowing from bank, she should borrow the
amount to invest which will optimize the total return. The below stated calculation
articulate that if she invest $3 million in the restaurant, she can get the utmost
return even after repaying the loan.

Option Option Option 3 Option

1 2 4
Loan $1,000,0 $2,000,0 $3,000,0 $4,000,0
00 00 00 00
Interest on Loan $60,000 $120,00 $180,000 $240,00
0 0
Amount to be $1,060,0 $2,120,0 $3,180,0 $4,240,0
paid back 00 00 00 00

Future Cash Flow $1,800,0 $3,300,0 $4,400,0 $5,400,0

00 00 00 00
Cash on Hand $740,00 $1,180,0 $1,220, $1,160,0
0 00 000 00

Question 5

Individuals are of two types, savers and spenders. While all individuals
prefer current consumption to future consumption, all other things equal,
spenders have a relatively higher preference for current consumption.
What if Virginia shares her ownership interest in the Virginia Corporation
(cash of $4 million) with a widely-diffuse group of investors, savers and
spenders? How much of the $4 million will the savers want to invest in the
restaurant, and how much will the spenders want to invest (assume
whatever is not invested will be paid out as dividend to investors). Will
they reach a compromise, and if so what will it be?

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Answer

Generally the savers prefer future consumption to current consumption and the
spenders are of opposite nature. Because of their nature savers will choose the
investment option which has the highest future value. In this case, investing $3
million has the highest PV; therefore this investment option will attract savers
investors more. On the other hand, spenders will look for those options which will
maximize present value of the investment. Here again the $3 million invest option
has the highest present value. So, most of the investors will agree on the $3 million
investment option. The detail calculation is given on the next page.

Option 1 Option 2 Option 3 Option 4

Investment $1,000,000 $2,000,00 $3,000,00 $4,000,00
0 0 0
Remaining Cash $3,000,000 $2,000,00 $1,000,00 $0
0 0
Interest on Remaining $180,000 $120,000 $60,000 $0
Cash
Future Cash Flow of $1,800,000 $3,300,00 $4,400,00 $5,400,00
Investment 0 0 0

PV of Investment $4,698,113 $5,113,20 $5,150,9 $5,094,34

8 43 0

FV of Investment $4,980,000 $5,420,00 $5,460,0 $5,400,00

0 00 0

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