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 $3,000,000 $5,000,000
Present Value $2,000,000 $2,830,189 $4,830,189

Total PV of the Asset $4,830,189

Future Consumption:

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

Total Future Consumption $5,120,000

Question 2

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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 $2,000,000 $3,000,000 $4,000,000
Remaining Cash $3,000,000 $2,000,000 $1,000,000 $0
Future Cash Flow $1,800,000 $3,300,000 $4,400,000 $5,400,000
FV of Remaining Cash $3,180,000 $2,120,000 $1,060,000 $0
 
Total FV $4,980,000 $5,420,000 $5,460,000 $5,400,000
 
PV of Investment $1,698,113 $3,113,208 $4,150,943 $5,094,340
NPV $698,113 $1,113,208 $1,150,943 $1,094,340
 
Increase in the Asset 17% 28% 29% 27%

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

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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 1 Option 2 Option 3 Option 4

Investment $1,000,000 $2,000,000 $3,000,000 $4,000,000
Remaining $200,000 $200,000 $200,000 $200,000
Endowment
Borrow from Bank $800,000 $1,800,000 $2,800,000 $3,800,000
Interest on Loan $48,000 $108,000 $168,000 $228,000
Repayment to Bank $848,000 $1,908,000 $2,968,000 $4,028,000
 
Future Cash Flow $1,800,000 $3,300,000 $4,400,000 $5,400,000
Total Cash on Hand $752,000 $1,192,000 $1,232,000 $1,172,000

Question 4

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 1 Option 2 Option 3 Option 4

Loan $1,000,000 $2,000,000 $3,000,000 $4,000,000

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 Interest on Loan $60,000 $120,000 $180,000 $240,000
Amount to be paid $1,060,000 $2,120,000 $3,180,000 $4,240,000
back
 
Future Cash Flow $1,800,000 $3,300,000 $4,400,000 $5,400,000
Cash on Hand $740,000 $1,180,000 $1,220,000 $1,160,000

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?

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 $2,000,000 $3,000,000 $4,000,000
Remaining Cash $3,000,000 $2,000,000 $1,000,000 $0

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Interest on Remaining Cash $180,000 $120,000 $60,000 $0
Future Cash Flow of Investment $1,800,000 $3,300,000 $4,400,000 $5,400,000
 
PV of Investment $4,698,113 $5,113,208 $5,150,943 $5,094,340
 
FV of Investment $4,980,000 $5,420,000 $5,460,000 $5,400,000

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