Coursera Wharton Foundation Series Introduction to Corporate Finance Professor Franklin Allen Problem Set 1 Solutions 1.

. Michael owns two things today: $10,000 and the NPV (net present value) of the investment opportunity, conditional on the investment opportunity having NPV > 0. Therefore, the most he can consume in Old Age (one period from now) is the FV (future value) of $10,000 + the NPV of the project, if it is NPV positive. First, calculate the NPV of the investment project: 8,000/1.2 6,000 = 666.67 > 0. This tells us we should take the project. So Michaels total wealth in his Youth is: 10,000 + 666.67 = 10,666.67 The FV of this combined amount is 10,666.67 x 1.2 = 12800. 2. Sunita owns two things today: $5,000 and the NPV of the investment opportunity, conditional on the investment opportunity having NPV > 0. First, calculate the NPV of the investment project: 3550/1.25 3000 = -160 < 0. This tells us that we should NOT take the project. So Sunitas total wealth in her Youth is only 5,000. The FV of this is 5,000 x 1.25 = 6250. 3. The correct answer here is A only. We need all of the firms shareholders to be able to borrow and lend at the same rate, for them to agree on the capital budgeting decisions of the firm. This is because the rate at which they can lend and borrow affects their own opportunity costs of capital, which determines whether projects are worthwhile for them individually. B is incorrect, since agreement on capital budgeting does not depend on market impact. C is also incorrect, since if shareholders have different information about project outcomes, they will likely NOT agree on capital budgeting decisions (in this case, rather than discount rates being different, the expected cash flows in the numerators are different). D is incorrect because A is a necessary condition. 4. 524/495 1 = 0.059. This is the discount rate. 5. 195/262 = 0.744. This is the discount factor. 6. To get a net lending exposure from year 2 to year 3, we need to take a long-term lending position today. To do this, we lend at the 3 year rate, for 3 years. For every dollar lent out today, we receive 1.073 in 3 years. To net out this position so it does not lead to a cash flow

today, we borrow for two years at the 2 year rate. For every dollar we borrow today, we pay 1.052 in 2 years. Therefore, the one year lending rate we can lock in two years from now, which is the reinvestment rate r2,3 that firms can lock in today for lending in the third year between year 2 and year 3 is (1.073)/(1.052) 1 = 0.111. This is also known as the forward rate. 7. Michikos mortgage has 25 equal payments. Let the equal payment she makes every year be S. We have: S x [1/(1+r) + 1/(1+r)2 + + 1/(1+r)25] = 265,000, where r = 9%. Therefore, solving for S we have that S = 26978.66. There was a technical error which caused students with the correct answer to this question to not receive credit. We have since updated our solutions, and Coursera Support has assured us that their team is looking into what happened. 8. We want a rate r such that er = 1.07. Taking the natural logarithm (ln) on both sides, we have ln(1.07) = 0.068. 9. The value of the first perpetuity is 125/0.05 = 2500. The value of the second (growing) perpetuity is 75/(0.05-0.03) = 3750. So, Miguel chooses the second perpetuity, which has a value of 3750. Questions 10 through 13 are parts of the same question. This is an [Exam-Type] question. 10. The NPVs of the projects are: Project I Project II Project III 1,930,000/1.12-1,500,000 = 223214 1,420,000/1.12-1,260,000 = 7857 777,000/1.12 700,000 = -6250

11. We would take the NPV > 0 projects, which are Projects I and II. 12. The future value of Mohans inheritance, after he consumes 2.4 million today is: FV = (10,000,000-2,400,000) x 1.12 = 8512000 The FV of the two projects he chooses is:

FV = (223,214 + 7,857) x 1.12 = 258800 Putting these two together, the most Mohan can consume at time t1 is equal to: 8,512,000+258,800 = 8770800. 13. Mohan is a net lender (he has so much initial wealth that after consumption and all possible investments, he would still have money left over, which he lends to the bank), so he cares about the lending rate of 10% when making his NPV calculations. Using a discount rate of 10%, we calculate: NPV of Project I is 1,930,000/1.1 1,500,000 = 254545 NPV of Project II is 1,420,000/1.1 1,260,000 = 30909 NPV of Project III is 777000/1.1 700,000 = 6364 Now, all of the projects are NPV positive, so he should take Projects I, II, and III.