Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

CHAPTER 3
DISCOUNTED CASH FLOW VALUATION
Exercises
1. Simple Interest versus Compound Interest First City Bank pays 7.5 percent simple
interest on its savings account balances, whereas Second City Bank pays 7.5 percent interest
compounded annually. If you made a $7,000 deposit in each bank, how much more money
would you earn from your Second City Bank account at the end of 10 years?
 Deposit in First City Bank:
Interest = 7,000 x 7.5% x 10 = $5,250
 Total amount received = 5,250 + 7,000 = $12,250
 Deposit in Second City Bank:
Future value = 7,000 x (1 + 7.5%)10 = $14,427.22
 Money earn more from Second City Bank = 14,427.22 – 12,250 = $2,177.22
2. Calculating Future Values Compute the future value of $1,000 compounded annually for
a. 10 years at 6 percent.
FV = 1,000 x (1 + 6%)10 = $1,790.85
b. 10 years at 12 percent.
FV= 1,000 x (1 +12%)10 = $3,105.85
c. 20 years at 6 percent.
FV = 1,000 x (1 + 6%)20 = $3,207.14
d. Why is the interest earned in part (c) not twice the amount earned in part (a)?
3. Calculating Present Values For each of the following, compute the present value:

FV
FV = PV x (1+i)n => PV =
( 1+i )n
FV 13,827
a. PV =
( 1+i )n
= ( 1+7 % )8
= $8,047.44
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

FV 43,852
b. PV =
( 1+i )n
= ( 1+15 % )13
= $7,127.18
FV 725,380
c. PV =
( 1+i )n
= ( 1+11 % )17
= $123,048.11
FV 590,710
d. PV =
( 1+i )n
= ( 1+18 % )26
= $7,988.07
4. Calculating Interest Rates Solve for the unknown interest rate in each of the following:

FV = PV x (1+i)n
a. 345 = 242 x (1 + i)4 => i = 9,3%
b. 927 = 410 x (1 + i)8 => i= 10,7%
c. 152,184 = 51,700 x (1 + i)16 => i= 6.98%
d. 538,600 = 18,750 x (1 + i)27 => i= 13,2%
5. Calculating the Number of Periods Solve for the unknown number of years in each of the
following:

FV = PV x (1+i)n
a. 1,284 = 625 x (1+ 7%)n => n= 10.64
b. 4,341 = 810 x (1+ 12%)n => n= 14.81
c. 402,662 = 16,500 x (1+ 17%)n => n= 20.35
d. 147,350 = 21,500 x (1+ 8%)n => n= 25.01
6. Calculating the Number of Periods At 6.5 percent interest, how long does it take to double
your money? To quadruple it?
FV = PV x (1 + r)t
- Double:
FV = 2PV = PV x (1 + r)t => 2 = (1 + 6.5%)t => t = 11.01
It takes 11.01 years to double your money
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

- Quadruple:
FV = 4PV = PV x (1 + r)t => 4 = (1 + 6.5%)t => t = 22.01
It takes 22.01 years to quadruple your money
7. Calculating Present Values Imprudential, Inc., has an unfunded pension liability of $550
million that must be paid in 20 years. To assess the value of the firm’s stock, financial analysts
want to discount this liability back to the present. If the relevant discount rate is 6.4 percent,
what is the present value of this liability?
550
PV = = $159.05
( 1+ 6.4 % )20
8. Calculating Rates of Return Although appealing to more refined tastes, art as a collectible
has not always performed so profitably. During 2010, Deutscher-Menzies sold Arkie under the
Shower, a painting by renowned Australian painter Brett Whiteley, at auction for a price of
$1,100,000. Unfortunately for the previous owner, he had purchased it three years earlier at a
price of $1,680,000. What was his annual rate of return on this painting?

( ) = ( 1,680,000 ) −1 = -13,17%
1 1
FV 1,100,00
FV = PV x (1+r)t => r = t
−1 3
PV

9. Perpetuities An investor purchasing a British consol is entitled to receive annual payments

10. Simple Interest versus Compound Interest First Simple Bank pays 4.1 percent simple
interest on its investment accounts. If First Complex Bank pays interest on its accounts
compounded annually, what rate should the bank set if it wants to match First Simple Bank
over an investment horizon of 10 years?
 Total money received in First Simple Bank = P + P x i x n = P x (1 + i x n) = P x (1
+4.1% x 10)
 In First Complex Bank: FV = P x (1 + r)n = P x (1 + r)10
 If First Complex Bank wants to match First Simple Bank, we will have:
P x (1 +4.1% x 10) = P x (1 + r)10 => 1,41 = (1 + r)10 => r = 3,49%
11. Calculating Annuities You are planning to save for retirement over the next 30 years. To
do this, you will invest $750 per month in a stock account and $250 per month in a bond
account. The return of the stock account is expected to be 11 percent per year, and the bond
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

account will earn 6 percent per year. When you retire, you will combine your money into an
account with an annual return of 8 percent. How much can you withdraw each month from
your account assuming a 25-year withdrawal period?
Our retirement savings ends at the same time the retirement withdrawals begin, so the PV of the
retirement withdrawals will be the FV of the retirement savings

We have the formula for future value of an annuity: FV= CF [ ( 1+r )T −1

[ ( )
]
11% 30 ×12
1+ −1
[ ]
T
( 1+r ) −1 12
- Stock account: FV = CF =750 = $2,103,389.8
r 11%
12

[ ( )
]
30× 12
6%
1+ −1
- Bond account: FV = CF
r [
( 1+r )T −1
=250 ] 12
6%
= $251,128.76
12

=> Total = 2,103,389.8 + 251,128.76= $2,354,518.56

PV =
CF
r [
1−
1
(1+r )
T
]
[ ]
CF 1
1−
=> 2,354,518.56 = 8% 25 ×12
(1+
8%
)
=> CF = $18,172.56
12 12

12. Growing Perpetuities Mark Weinstein has been working on an advanced technology in
laser eye surgery. His technology will be available in the near term. He anticipates his first
annual cash flow from the technology to be $215,000, received two years from today.
Subsequent annual cash flows will grow at 3.8 percent in perpetuity. What is the present value
of the technology if the discount rate is 10 percent?
CF 215,000
PV = r−g = 10 %−3.8 % = $3,467,741.94
Discount the present value of the growing perpetuity back to Year 0:
FV 3,467,741.94
1 = $3,152,492.673
PV = t
=
(1+r ) (1+10 %)
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

13. Perpetuities A prestigious investment bank designed a new security that pays a quarterly
dividend of $2.75 in perpetuity. The first dividend occurs one quarter from today. What is the
price of the security if the APR is 5.3 percent, compounded quarterly?
CF 2.75
=
PV = r 5.3 % = $207.54
4

14. Annuity Present Values What is the present value of an annuity of $5,500 per year, with
the first cash flow received three years from today and the last one received 25 years from
today? Use a discount rate of 8 percent.

The annuity has 23 payments. Since there is a payment made in Year 3, the annuity actually
begins in Year 2. So, the value of the annuity in Year 2 is:
CF
PV = r 1− [
(1+r )T
1
=
8% ]
1−
5,500
(1+8 %)23 [ 1
] = $57,040.82
Discount the present value of the annuity back to Year 0:
FV 57,040.82
2 = $48,903.31
PV = t
=
(1+r ) (1+8 %)

15. Growing Annuity Southern California Publishing Company is trying to decide whether to
revise its popular textbook, Financial Psychoanalysis Made Simple. The company has estimated
that the revision will cost $135,000. Cash flows from increased sales will be $48,000 the first
year. These cash flows will increase by 4 percent per year. The book will go out of print five
years from now. Assume that the initial cost is paid now and revenues are received at the end
of each year. If the company requires a return of 10 percent for such an investment, should it
undertake the revision?
CF = $48,000 g= 4% T= 5 r= 10%

[ ( )] [ ( ) ]=¿$195,643.42
T 5
CF 1+ g 48,000 1+ 4 %
PV = 1− = 1−
r−g 1+r 10 %−4 % 1+ 10 %
Concept Questions and Exercises VLKH CORPORATE FINANCE 11e by Ross, Westerfield, Jaffe

16. Calculating Loan Payments You need a 30-year, fixed-rate mortgage to buy a new home
for $250,000. Your mortgage bank will lend you the money at an APR of 4.5 percent for this
360-month loan. However, you can only afford monthly payments of $950, so you offer to pay
off any remaining loan balance at the end of the loan in the form of a single balloon payment.
How large will this balloon payment have to be for you to keep your monthly payments at
$950?

The amount of principal paid on the loan is the PV of the monthly payments we make. So, the
present value of the $950 monthly payments is:

[ ] [ ]
CF 1 950 1
1− = 1−
PV = r (1+r )T
4.5 %
(1+
4.5 % 360
)
= $187,493.1
12 12

The monthly payments of $950 will amount to a principal payment of $171,077.26. The amount
of principal we will still owe is:
Remaining principal = $250,000 - $187,493.1 = $62,506.9
 The balloon payment which is the FV of the remaining principal will be:
4.5 % 360
Balloon payment = PV x (1 + r)t = 62,506.9 x (1 + ) = $240,507.68
12

17. EAR versus APR You have just purchased a new warehouse. To finance the purchase,
you’ve arranged for a 30-year mortgage for 80 percent of the $5,200,000 purchase price. The
monthly payment on this loan will be $27,500. What is the APR on this loan? The EAR?
The loan = 80% x 5,200,000 = $4,160,000
 We have:
CF
PV = r 1− [1
(1+r )
T
]
=> 4,160,000 = ¿
27,500
r
1−
[ 1
(1+ r)
360
]
=> r = 0.578%
=> APR = 12 x 0.578% = 6.94%

[ ( )] [ ( )] −1 = 7,16%
m 12
r 6.94 %
- EAR = 1+ −1= 1+
m 12