Section #1 Solutions Time Value Exercises January 23rd, 2013 Copyright 2013 by Rich Curtis

1. Michelle and The Time Value of Money

a. After agents fees and taxes, Michelle will have $5.28 M:

$10 M - Agent's Fees - Tax = $10 M - .04($10 M) = $10 M - .04($10 M)

- .45(Taxable Income) - .45($10 M - .04($10 M))

= [$10 M - .04($10 M)] [1-.45] = [$10 M] [1-.04] [1-.45] = $5.28 M

If Michelle can invest to earn 5.5% annually after-tax for 25 years, the $5.28 million will become $20.13 million:
N FV = PV 1+r 25 = $5.28 M 1.055

= ($5.28 M) (3.81339) = $20.1347 M

Is this consistent with the Rule of 72? Note: 72 = 13.09 5.5

b. If we consider the cash flows at times 0, 1, 2, 3, and 4, her total Time 25 future value could be calculated as follows:

24 + $5.28 M (1.055) + $5.28 M (1.055)

25 $5.28 M (1.055)

23

22 + $5.28 M (1.055) 21 + $5.28 M (1.055)

$90.710 M

$5.28 M

$5.28 M

$5.28 M $5.28 M $5.28 M

Time 0 1 2 3 4 25

Is there a more elegant way to get the same answer?

One could also use the formula for the future value of an annuity to get the Time 4 value of the annuity:

FVt =4 = $5.28 M

1.055 - 1 .055

= $29.4682 M

Remember that the formula for the future value of an annuity gives you the value as of the date of the final cash flow, Time 4. Then use the formula for the future value of a single cash flow to find the Time 25 future value of the annuity:
21 FVt =25 = $29.4682 M 1.055

= $90.710 M

(1.055)21
29.5 M 90.7 M

$5.28 M

$5.28 M

$5.28 M $5.28 M $5.28 M

Time 0 1 2 3 4 25

One could also a) PV the Time 0 cash flow and b) add the PV of the Time 1-4 annuity, if one was very careful:

1 -

PVt =0

= $5.28 M + $5.28 M

(1.055)
.055

= $23.7872 M Then take this Time 0 present value out to Time 25 by using the formula for the future value of a single cash flow:

FVt =25 = PVt =0(1+r)25 = $23.7872 M (1.055)25 = $90.710 M

(1.055)25

$5.28 M

$5.28 M $5.28 M $5.28 M $5.28 M

Time 0 1 2 3 4 25

Lastly, you could use the formula for the PV of an annuity to bring all the cash flows to Time -1 (since the first cash flow is at Time 0):

1 -

PVt =-1 = $5.28 M

(1.055)
.055

= $22.5471 M Then future value the $22,5471 M ahead 26 years, to get the Time 25 value of the annuity: FVt =25 = PVt =-1 (1+r)26 = $22.5471 M (1.055)26 = $90.710 M

(1.055)26

$5.28 M $5.28 M

$5.28 M $5.28 M

$5.28 M

Time -1 0 1 2 3 4 25

2. Sunflowers
We must solve for the discount rate r in the following expression:

PV =

FV N (1+r) $36,000,000 98 (1+r)

$125 =

(1+r)98 = $36,000,000 $125 1+ r =

$36,000,000 $125

1 98

r = .13686 or 13.686%

The equation above could also be solved using logarithms or by trial and error. Note: You may be asked a question like this at Finance interviews.

3. Amerks Dividend Discount Stock Valuation (See RWJ, 2008, Chapter 8)

Time: Cash Flow: 1 D1 2 D1(1+g) 3 D1(1+g)2

D1 D1 (1+g) D1 (1+g)2 P0 = + + + ... (1+ke) (1+ke)2 (1+ke)3

D 1 if ke > g k e -g

a.

D 1 P = 0 ke g = $2 .14 .05

= $22.22

b.

D 1 P = 0 ke g = $2 .12 .05

= $28.57

Stock Prices versus Cost of Equity (D1=$2, g=.05)

Stock Prices
$60.00 $50.00 $40.00 $30.00 $20.00 $10.00 $0.00 0.00

0.05

0.10

0.15

0.20

0.25

Costs of Equity

c.

D1 P0 = ke g D ke g = 1 P 0

D ke - 1 = g P 0 D 1 = .14 - $2 P $15 0

= k g e -

g = .00667 or .667%

Note: g in the formula is the growth rate from Time 1 to Infinity. The growth rate from Time 0 to Time 1, g0,1 , is not explicitly in the formula but defines the magnitude of D1. That is, the D1 we use equals D0(1+g0,1). In fact, in (c) the dividend grows at 5% between Time 0 and Time 1 (since we assumed that the market uses a D1 of $2/share) and the dividend grows at .667% after Time 1.

d.

In parts (a) and (b) the growth rate g was determined as follows: g = b = (.20) (.25) = .05 If internal investments return 30% annually rather than 20% annually, then the growth rate increases to 7.5%: g = b = (.30) (.25) = .075 If the dividends are estimated to grow at 7.5% not only from Time 1 to Infinity, but also from Time 0 to Time 1, we have: D = D (1+g ) = $1.9048 (1.075) = $2.048 1 0 0,1 D1 also equals (1-b) E1.

The stock price is given by:

D 1 P = 0 ke g = $2.048 .14 .075

= $31.51

Note: 1. In (d) the dividends are assumed to grow at 7.5% between Time 0 and Time 1 AND at 7.5% from Time 1 to Infinity. If dividends instead grew at 5% from Time 0 to Time 1 and at 7.5% from Time 1 to Infinity, then: D = D (1+g ) = $1.9048 (1.05) = $2 1 0 0,1

and the estimated Time 0 stock price is: D 1 P = 0 ke g = $2 .14 .075

= $30.77 Note that changing g0,1 , the growth rate from Time 0 to Time 1 only changed D1, not the g in the formula (which holds from Time 1 to Infinity)!!

2. The numbers show how sensitive the stock price is to changes in g. If a firm misses their earnings or sales numbers by a measly penny, analyst may revise their estimates of g downward with a dramatic effect on the theoretical stock price.

Stock Prices
$450.00 $400.00 $350.00 $300.00 $250.00 $200.00 $150.00 $100.00 $50.00 $0.00 0.00

Stock Prices versus Growth Rates (D1=$2, ke=.14)

0.05 Growth Rates

0.10

0.15

4. Multiple and Continuous Compounding

a.

FV = $100(1+.06) = $106
The effective annual interest rate is 6.00%.

One could also use the formula for EAR in the Time Value notes:
p APR EAR = 1 + p - 1 1 .06 = 1 + - 1 1

= .06

b. FV = $100 1+ .06 12

12

= $106.168 The effective annual interest rate is 6.168%. Once again, one could also use the formula for EAR in the Time Value notes: EAR = 1+ APR p

- 1

12 .06 = 1+ - 1 12

= .06168

c. FV = $100eAPR(t) = $100e(.06)(1) = $106.184

The effective annual interest rate is 6.184%.

Once again, one could also use the continuous compounding formula for EAR in the Time Value notes: EAR = eAPR - 1 = e(.06) - 1 = .06184

5. Factoring Accounts Receivable

For every $100 of accounts receivable sold to the factor, the contract would result in a cash flow to your firm of +$97.50 at time 0 an $100 sixty days later. (The negative cash flow is due to the fact that youre selling the accounts receivable and thus are giving up cash you would have received 60 days later.) Time: Cash Flows: 0 +$97.50 60 Days -$100

Whats the interest rate over that 60-day period?

If you borrowed $100 at Time 0 and repaid $110 at Time 1, you would be paying $10 in interest: Time: Cash Flows: 0 +$100 1 -$110

Eyeballing it, its perhaps obvious that the interest rate over that period is 10%. To get .10 you divide the dollar interest cost, $10, by the amount borrowed. Dont divide by the amount repaid. $10 = .10 $100

Since in the factoring problem, you are effectively paying $2.50 in interest for every $97.50 in financing, the effective cost of borrowing over the 60-day period is: $2.50 = .025641 $97.50
Remember to divide the interest paid by the amount borrowed, not the amount repaid!!

Now, lets annualize that 60-day rate Remember that if the monthly rate was 1% (i.e. an APR of 12%), we would calculate the effective annual rate as: 1 + Effective Annual Rate = (1.01)12 = 1.1268 Effective Annual Rate

= .1268 or 12.68%

The calculation on the next slide is the same, except that we use a 60-day interest rate (instead of a monthly interest rate) and we compound 6.0833 times per year (instead of 12 times per year).

Given a 60-day rate of 2.5641%, the effective annual cost of borrowing is given by:

365 1 + Effective Annual Rate = (1.025641) 60 = (1.025641)6.0833 = 1.1665 Effective Annual Rate

= .1665 or 16.65%

Theres also another way to solve for the effective annual cost of the loan:
$97.50 = $100

( ) ( ) ( )
60 1+ r 365

60 1+ r 365

$100 $97.50

60 1+ r 365

= 1.02564

365 1 + r = (1.02564) 60

1 + r = (1.02564)6.08333 r = .1665 or 16.65%

The End