PAK Study Manual

Foundations of CFE (CFE) Exam

Fall 2018 Edition

CTE
Hull-White
Ito’s Lemma
Agency Theory
Reinsurance
Risk Neutral
Corporate Finance
Stochastic Simulation
Efficient Market Hypothesis
Regime Switching Lognormal
Dynamic Hedging
Economic Capital
Behavioral Finance
Martingale
Value at Risk
Dividend
WACC
Delta
 PAK Study Manual
for CFE Fall 2018

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 PAK STUDY MANUAL A printed copy of the manual can
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1. Summary
The PAK Study Manual covers the entire Foundations of CFE (CFE) syllabus. Not only
does it give you the detailed explanations on conceptual, calculation, and exam materials,
but it also fills in the gaps among the topics that are not covered in the source readings. It
helps you better understand and master the confusing logics and difficult materials.
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PAK Study Manual for CFE Fall 2018

Frequent Answer Questions

Do You Need to Read the Source Readings?

Unlike the preliminary exams, reading the source readings (textbooks, SOA study notes, and online readings) is a
must in the FSA exams. PAK Study Manual can help you understand the materials faster and memorize them
quickly so that in the time-limited environment, you can be well-prepared for the exam.

How Much Time is Needed to Study for This Exam?

This varies by person. Usually it will take one 350-400 hours to study for a FSA exam (5-hour). Please expect to
spend the same amount of time for the CFE exam.

Study Schedule

From the date the SOA release the new syllabus to the exam date, there are around 4 months to study. How to
plan your study schedule?
T=0 T=2.5 months T=3.5 months T=4 months

Read the Source Readings Review Again Practice

Read the Source Readings

Assume you take the CFE exam in this exam sitting. In general, it will take one 2 to 2.5 months to finish them. To
study more efficiently, we highly suggest you following the steps below:

Step 1: Define Your Own Study Schedule

- Use the suggested study schedule as a reference
- Prepare your own study schedule (Target 20-30 pages @weekday and 50-60 pages @weekend)
- Expect to read the whole syllabus and the past exams 2 or 3 times before the exam

Step 2: Read the Source Readings Together with the PAK Study Manual
- Write down your notes in the study manual
- Highlight all the key points there (Will be used for memorization later)
- Label any calculations that you will go over again later
- Go over the related past exam questions once you finish that reading

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- Practice them once you finish your first-round of readings (use the PAK Exam Aid)
- Understand how the topics were tested and how the questions were answered

Review Again
After completing the three steps above, you probably have a general idea about how the exam looks like. Now
you should review the source readings again but this time focus more on the key topics, clarify the confusing
concepts/calculations, think of what can be tested and read them carefully (use our mock exam questions)

Practice
The last month is the most critical month. Here are the steps:
- Practice the past exams and my mock questions to identify what you still do not know
- Go back to the readings and find your answers (or send us an email if you need help)
- Start memorizing the key points (use the PAK Flash Cards)
- Use the PAK Test Aid to test your knowledge (Send us your answers and we will give you detailed
feedbacks on how to improve your score in the exams)
More Information
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PAK Study Manual for CFE Fall 2018

F-107-13: A Market Cost of Capital Approach to Market Value Margins (by CFO Forum)

Key Points

Key Points in This Reading

1. Understand the economic balance sheet structure
SAMPLE
2. Understand how to use the market cost of capital approach to calculate the market value margin

1. Executive Summary

Two Common Approaches to Calculate the Market Value Margins (MVMs)

1. Percentile approach
2. Market cost of capital (MCoC) approach

Market Cost of Capital (MCoC) Appaoch

- The CRO Forum prefers the MCoC approach
- This approach works for both life and non-life business

Main Reasons for the CRO Forum’s Preference

1. Support appropriate risk management actions
2. Appropriate reflection of risk
3. Better response to a potential crisis
4. Easy to implement
5. Transparent, easily verifiable and understandable
6. Pass the “use test”

Figure 2: Economic Balance Sheet

Components of Market Consistent Value of Liabilities (MVL)

1. Expected PV of future LCFs
2. MVM for non-hedgeable risks (An explicit cost of risk for non-hedgeable risk)

Memorization: Definition
MVL
- It represents the market consistent value at which the liabilities could be transferred to a willing,
rational, diversified counterparty in an arms’ length transaction under normal business conditions

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PAK Study Manual for CFE Fall 2018

Note
“Arms’ Length Transaction” means the transaction made by two totally independent parties.

Memorization: Definition
MVM
- It is the cost of risk (risk margin) in addition to the expected PV of future LCFs required to manage
the business on an ongoing basis
- It is estimated by the PV of the cost of future capital requirements for non-hedgeable risks
- Calculation of MVMs using a MCoC approach is straightforward given that the majority of the calculation
is prescribed under the standard SCR

2. Introduction

The Purpose of This Paper

- The MCoC approach to MVMs is the CFO Forum’s preferred method

Calculate the Liability Value

- The assets and liabilities should be measured on a consistent basis for solvency purposes
o This basis should be market value

- In order to determine the MVL, a MVM is added to the expected PV of future LCFs
o The CRO Forum does not agree with using the percentile method to calculate the MVM since it is
not consistent with the aim of introducing a risk based solvency assessment
o The MCoC approach to MVMs is the CFO Forum’s preferred method

3. Why Take a MCoC Approach to MVMs?

Two Common Approaches to Calculate the Market Value Margins (MVMs) for Non-Hedgeable Risks
Approach Description
1. Market cost of capital
o Sufficient capital is needed to be able to run-off the business
(MCoC) approach

o Sufficient capital is needed to ensure that the liabilities can be met with a
2. Percentile approach
predefined confidence level

Main Reasons for the CRO Forum’s Preference

1. Support appropriate risk management actions
2. Appropriate reflection of risk
3. Better response to a potential crisis
4. Easy to implement
5. Transparent, easily verifiable and understandable
6. Pass the “use test”

Supports Appropriate Risk Management Actions

Approach Description

o It more appropriately differentiates between risks similar to the way in which capital markets
differentiate between risks (equity investment vs. equity option)
o It ensures that the cost of risk is measured purely based on the economic cost of holding
Market cost of capital capital to support non-hedgeable risks
(MCoC) approach  The cost of risk and any allowance for prudence are clearly separated
 The reserve reflects the best estimate of the cost of managing risk
 Margins for prudence should only be reflected in the capital held (SCR) and not in the
technical provision (MVL)

o Prudence may be incorporated in both the reserves and capital which can lead to inefficient
Percentile approach
management of risks and double counting of risks

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PAK Study Manual for CFE Fall 2018

Appropriate Reflection of Risk

Approach Description
Market cost of capital
o The MVMs will always reflect the risk inherent in the product
(MCoC) approach

o The MVMs will not always reflect the risk inherent in the product because there is no link
Percentile approach between the arbitrary percentile value chosen and the market price
o Also, the percentile approach does not refer to each risk type separately

Figure 1: Percentile vs. MCoC

Figure 1
- For the long tailed gamma distribution (“more-severity” risks: catastrophic risk, terrorist risk, etc)
o The percentile approach underestimates the price of non-hedgeable risk

- For the normal distribution (regular insurance risks: mortality risk, etc)
o The percentile approach greatly overestimates the market price of risk

- The MCoC approach ensures that insurers consider the tails of the distributions
o No consideration is given to the shape of the distribution using the percentile approach

Experiences of the Australian and the Swiss Regulators

- Australian regulators
o It is difficult to reasonably explain the spread of risk margins using the percentile approach

- Swiss Regulators
o The MVMs under a MCoC approach appropriately reflect the risk inherent in the business
 The calculation is stable from period to period
 Life insurers writing mainly savings products have relatively small MVM since insurance
risk is small
 Life insurers writing risk products have relatively large MVM since they have a large
exposure to biometric risk and a long duration of the run-off portfolio

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PAK Study Manual for CFE Fall 2018

Response to a Potential Crisis

Approach Description
o It ensures that after a stressed event, the company will be able to appropriately remunerate
either a third party accepting the liability or new capital providers
Market cost of capital
o It achieves this through the SCR for non-hedgeable risks needed to support the liability in
(MCoC) approach
future years and hence the MVM, which represents a provision for the cost of holding this
capital

o It implicitly forces the insurer to hold part of the capital needed to support the business in
future years in the form of a prudence margin
o This prudence margin will not suffice to run-off the liabilities with the level of confidence
Percentile approach implied by the SCR
o It does not ensure that there will be sufficient financial resources to cover future capital
costs needed to remunerate either a third party accepting this liability or new capital
providers

Ease of Implementation
Approach Description

Market cost of capital o It is easier to implement since there is only one unknown item (the SCR for non-hedgeable
(MCoC) approach risks) and this can be calculated with ease using the standard SCR

o It is complex (for small entities) to implement since it requires stochastic calculations over
Percentile approach the whole run-off period to determine the appropriate percentile on the distribution of
liability values

Transparent, Verifiable and Comprehensible

Approach Description

Market cost of capital o Supervisors can easily replicate and verify the MVM calculation (using standard SCR and
(MCoC) approach internal model)

o It is not so easily verified because it is not possible for the regulator to use the standard
SCR to benchmark the internal models used to determine the percentile value
Percentile approach
o Australian regulators experienced a wide variation in the results from insurer to insurer ,
when adopting a percentile approach

The “Use Test”

- The MCoC approach has been used for some 20 years
- It already passes the “use test” envisioned in the Solvency II framework

Testable Topic: Evaluate the two approaches based on the following topics:

Topic MCoC Percentile

Support appropriate risk management actions ? ?

Appropriate reflection of risk ? ?

Better response to a potential crisis ? ?

Easy to implement ? ?

Transparent, easily verifiable and understandable ? ?

Pass the “use test” ? ?

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PAK Study Manual for CFE Fall 2018

4. Theory Underpinning the MCoC Approach: The Economic (Solvency) Balance Sheet

Figure 2: Economic (Solvency) Balance Sheet

Note
In the general accounting framework, we know that assets = liabilities + equities.
Assume that assets = MVA and liabilities = MVL. Then equities = SCR + Excess capital.

Economic (Solvency) Balance Sheet

- It distinguishes between the asset and liability values and the capital required for solvency purposes
- Capital requirements consider risks emanating from both sides of the balance sheet
- It does not explicitly identify the cost of capital

Market Value of Assets (MVA)

- The capital markets provide the MVA

Market Consistent Value of Liabilities (MVL)

- It is derived from the cost of managing the risks underlying the business on an ongoing basis
- It represents the market consistent value at which the liabilities could be transferred to a willing, rational,
diversified counterparty in an arms’ length transaction under normal business conditions
- Market values should be used where available to value the MVL
- Where market values are not available, the MVL must be explicitly calculated using market consistent
valuation techniques

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PAK Study Manual for CFE Fall 2018

Figure 3: Components Parts of the MVL Calculation

Expected Present Value of Future Liability Cash Flows

- It includes premiums, fees, policyholder claims, expenses and commissions
- The market consistent value of these future CFs may be determined as the cost of setting up a replicating
portfolio

Replicating (Hedge) Portfolio

- The portfolio of assets that most closely matches the corresponding liability CFs
- In the absence of arbitrage, and if the liability CFs could be matched exactly, the market consistent value
of the liabilities will exactly equal the market value of the replicating portfolio

Note
To the simplest form, the expected PV of future LCFs is the same as the reserve that we learnt in FAP. Remember the
formula?  Reserve = PV(Expenses/Claims) – PV(Premiums)

Figure 4: Replicating Portfolio

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MVM for Non-Hedgeable Risk

- The MVM is defined as the cost of risk (risk margin) in addition to the expected PV of future LCFs
required to manage the business on an ongoing basis
- It is only necessary to calculate an explicit MVM for non-hedgeable risks

Figure 5: Types of Risk Affecting the Liability Cash Flow

Hedgeable Risks
- A hedgeable risk is a risk which can be pooled or hedged using a replicating portfolio
o Hedging costs are implicit in the observed market price of those instruments
o Thus, it is not necessary to calculate an explicit MVM for hedgeable risks

Non-Hedgeable Risks
- Risks for which a deep and liquid market is not available are referred to as non-hedgeable
o They are risks for which a market price cannot be observed

- To compensate an investor for the cost of taking non-hedgeable risks, an explicit MVM is demanded
o Under the MCoC approach, the MVM is the compensation required for the cost of holding capital
against non-hedgeable risks over the life of the policy

Figure 6: Flowchart for Determining the Appropriate Method for Calculating the MVL

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Solvency Capital Requirement (SCR)

- It can be determined by the Standard Approach or the Internal Model Approach under Solvency II
- The projection of what the SCR is for non-hedgeable risk is needed to calculate the MVM

Cost of Capital (CoC)

- It refers to the capital charge on fully diversified capital held to cover non-hedgeable risks only
o This should not be seen as a total company CoC

Note
In the embedded value framework, the CoC means the cost of holding the capital needed to support the businesses of the
whole company. In the MVM calculation here, we just focus on the capital held to cover non-hedgeable risks only.

5. The MCoC Approach to MVMs

MCoC Approach to MVMs

- The MVM for non-hedgeable risk is calculated as the PV of the cost of future capital requirements for
non-hedgeable risks

Steps to Calculate the MVM for Non-Hedgeable Risks

Step Description
o Using the standard model or internal models, the projected SCR can be determined via an
underlying driver that is indicative of the risk level (e.g. PV of benefit) (See Appendix C)
1. Project the SCR for
o The required SCR at time 0 for non-hedgeable risk types would be set at 99.5% Value at
non-hedgeable risks
Risk for a holding period of one year and calculated net of full diversification effects (see
Appendix B)

o The capital charge for non-hedgeable risks can be explicitly calculated by multiplying the
2. Calculate the capital
future SCR at each point in time by the CoC for non-hedgeable risk
charge
o This cost of capital charge only applies to capital that is required for the non-hedgeable risk

3. Discount the
o The projected capital charge stream is then discounted at the risk free rate (swap rate) to
projected capital
get the MVM
charge

Figure 7: Calculating the MVM for Non-Hedgeable Risk

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Illustrative Example

Data and Assumptions

- An insurer has sold 500 term policies and the premium on each policy is €50
- If the policyholder dies within a 5 year period, then a benefit of €1000 is paid
- The probability of dying within any one year is 1%
- The swap rate is 5% (yield curve is assumed to be flat) (it is assumed to be the risk-free rate)
- The CoC for non-hedgeable risks used to illustrate the approach in this example is 4%

Step 1: Project the SCR for Non-Hedgeable Risks

Time 0 1 2 3 4 5
No. of policies (start of year) 500 495 490 485 480 0
Premium (beginning of year) 25,000
Claims 5,000 4,950 4,901 4,851 4,803
PV Claims (Discounted at mid-year) 21,764 17,729 13,543 9,199 4,687
2,176 1,773 1,354 920 469
SCR = 10% x 21,764 = 10% x 17,729 = 10% x 13,543 = 10% x 9,199 = 10% x 4,687
SCR as % of PV of benefits 10%

Claimst PV (Claimst +1 ) mid − year

PV (Claimst ) mid − year = + SCRt = ( SCR rate) × PV (Claimst ) mid − year
(1 + r )0.5 (1 + r )1

Claims4 PV (Claims5 ) mid − year

PV (Claims4 )mid − year = +
(1 + r )0.5 (1 + r )1
SCR4 = (10%) × 4687 = 469
4803 0
= + = 4687
(1 + 0.05) 0.5
(1 + 0.05)1

Claims3 PV (Claims4 ) mid − year

PV (Claims3 ) mid − year = +
(1 + r )0.5 (1 + r )1
SCR3 = (10%) × 9199 = 920
4851 4687
= + = 9199
(1 + 0.05)0.5 (1 + 0.05)1

Step 2: Calculate the Capital Charge

Time 0 1 2 3 4 5
SCR 2,176 1,773 1,354 920 469
87 71 54 37 19
Capital Charge = 4% x 2,176 = 4% x 1,773 = 4% x 1,354 = 4% x 920 = 4% x 469
Capital Charge / SCR 4%

Capital charget ,mid − year = (CoC ) × SCRt

Capital charge4,mid − year = (4%) × 469 = 19
Capital charge3,mid − year = (4%) × 920 = 37

Step 3: Discount the Capital Charge

Time 0 1 2 3 4 5
SCR 2,176 1,773 1,354 920 469
Capital Charge (mid-year) 87 71 54 37 19
85 66 48 31 15
Discounted Capital Charge = 87/1.05^0.5 = 71/1.05^1.5 = 54/1.05^2.5 = 37/1.05^3.5 = 19/1.05^4.5
Total MVM 245
PV Liabilities 21,764
MVL 22,009

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n Capital charget ,mid − year

MVM =  PVL = PV (Claims0 ) mid − year
t =0 (1 + r )t + 0.5
87 71 54 37 19
MVM = + + + + = 245 PVL = 21764
1.050+ 0.5 1.051+ 0.5 1.052 + 0.5 1.053+ 0.5 1.054 + 0.5

MVL = PVL + MVM

MVL = 21764 + 245 = 22009

6. Frequently Asked Questions

Frequently Asked Questions (The Considerations of Calculating the MVM)

1. Circularity 7. Total Portfolio vs. Different Business Line
2. Asset Liability Mismatching 8. Non-Life Business
3. Level of Risk Margin Relative to Overall Liability 9. Small Entities
4. Tax 10. Variation in CoC
5. Operational risk 11. Time Horizon
6. Harmonization

Circularity
- The issue of circularity in the calculation arises because the MVM is calculated directly from the SCR
o But it also makes up part of the MVL and is assumed to be included in the SCR calculation

- The relative size of the MVM in comparison to the total MVL is small so the impact of including the MVM
in the SCR calculation would be insignificant
o Thus, it is assumed that the MVM will have little or no effect on the SCR

Asset Liability Mismatching

- The acquiring insurer should not be compensated for any avoidable asset liability mismatch (ALM) taken
by the defaulting insurer
o ALM risk is a hedgeable risk so it is assumed that the acquiring insurer can swap back to the
replicating portfolio instantaneously and hedge any ALM taken by the defaulting insurer

Level of Risk Margin Relative to Overall Liability

- Some regulators and supervisors are concerned about the relatively low level of MVMs
- The explicit MVM only corresponds to the MVM charged for non-hedgeable risks
o Low margins are also observed using a percentile approach so this is not purely a MCoC issue

Tax
- The liabilities and the MVM should be set on a pre-tax basis since this is analogous to how market values
are set for assets

Operational risk
- Since operational risk is a non-hedgeable risk, it should be included in the calculation of the MVM

Harmonization
- The MVM calculation is based on the projected capitals but various insurers have various internal models
o The CRO Forum has also formulated recommended approaches of benchmarking internal
models to address these concerns
o The proportion of the MVL that corresponds to the explicit MVM is relatively small so any
discrepancies will have a relatively small impact on the results

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Total Portfolio vs. Different Business Line

- The MVM is calculated for each LoB for each risk type and then added to the best estimate liability value
o This will improve transparency and facilitate companies’ analysis of the risks they take
o The MVL is then aggregated to a company level

Non-Life Business
- The MCoC approach applies for non-life business
o For in-force business, a SCR for non-hedgeable risk will be set up for the current year to support
the insured risk
o In addition to this, SCR for the non-hedgeable reserve risks will be held after the expiration of the
contract
o This capital is held to cover the risk that reserves may not be sufficient to cover claims either
because ultimate claims or the pay out pattern had been incorrectly estimated

Small Entities
- The Swiss Solvency Field Test showed that this MCoC approach works well in smaller entities due to its
simplifying assumptions
- The standard SCR approach can be adopted to determine the SCR for non-hedgeable risks

Variation in CoC
- The CoC for non-hedgeable risks reflects the excess return over risk free rates that an acquiring company
would require to compensate them for the cost of holding capital to run-off the business

- The CRO Forum suggests that the risk margin (MCoC) should not vary by risk type or business
o Since the SCR for non-hedgeable risk will differ between risk types, the MVM will automatically
differ under the MCoC approach thereby better reflecting risk

- With regard to the reference market in which the products are sold, it is possible that the price of risk may
vary between countries due to uncertainty in the market
o Most of this uncertainty is due to the difficulties in hedging unwanted risk and will already be
factored into the SCR and MVM, as these risks are not hedgeable

Time Horizon
- One common misconception regarding the MCoC approach
o The MVM only considers one year worth of risk and everything after the first year is ignored
because the SCR is measured using a one-year shock approach
o This is incorrect

- The SCR calculation does consider the expected LCFs over periods
o The SCR represents the change in liability value between expected future liability cash flows and
worst-case (99.5% percentile) cash flows
o These worst-case cash flows reflect not what we can observe in any one year but rather how far
off we can be in estimating our expected liability cash flows over their entire life

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Appendix A. Expected Present Value of Future Cash Flows

Products without Optionality

- All cash flows that occur with certainty are totally risk free and can be replicated with risk-free assets of a
similar term

Diversifiable Risk
- The market consistent framework assumes that there is no reward for holding diversifiable risk
o This assumption implies that any cash flows that are not risk free but where risk is diversifiable
should be treated as risk free and hence discounted at the swap rate
o This assumption flows through to the treatment of the MVM for non-hedgeable risks

Non-Diversifiable Risk
- This assumption also implies that expected cash flows that are subject to non-diversifiable risk should be
discounted at a rate that reflects the risk inherent in the cash flow
o The risk-adjusted rate contains a risk premium that investors would demand for
o The greater the expected return driving such a risky cash flow, the greater the discount rate
applied to the cash flow

Certainty Equivalent Approach

- This is a form of risk-neutral valuation where the risky cash flows are adjusted and projected assuming
that all underlying assets earn the risk-free rate

Note
CFrisky ,t
1. Discount risky cash flows using risk-adjusted rate: V0 = 
(1 + rf + rp )t
CFrisk free,t
2. Discount risk-free cash flows using risk-free rate: V0 = 
(1 + rf )t
CFrisky ,t − Z t
3. Adjust risky cash flows and discount at risk-free rate: V0 = 
(1 + rf )t

Products with Embedded Options or Guarantees

- For products with options/guarantees, using the certainty equivalent approach becomes a very complex
process due to the non-linear, asymmetric relationships with market returns that exist in these products
o It is necessary to determine the liability value using option pricing or Monte Carlo simulation
o In order to achieve market-consistency, both methods should be calibrated to reproduce the
prices of traded assets that best reflect the characteristics of the liabilities being valued

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Appendix B. Diversification

Four Levels of Diversification

Diversification Levels
Level 1
(Within risk types)
Level 2
(Across risk types)
Level 3
(Across entities, within a given geography)
Level 4
(Across geographies or regulatory jurisdictions)
Example
Adding more unrelated risks to the portfolio
Combining two classes of insurance
Two or more insurance companies in the same geography within an
insurance Group
Two or more insurance companies in different geographies within an
insurance Group

Appendix C: Proxy Measures for Projecting Capital

Products
Non-Hedgeable Risk Type Death Protection Survivorship Protection Savings Accident & Health
Mortality Net amount at risk PV of benefits Economic liability Net amount at risk
Life
Morbidity N/A N/A N/A Net amount at risk
Insurance
Persistency Economic liability Economic liability Economic liability Economic liability

Note
There is a long list in the reading. You should read it once. I personally think the life insurance line is more important so I put it
here.

Past CFE/FETE SOA Questions Related To This Reading

2016 Fall CFE Q12a-c (Must Read)

2016 Spring CFE Q11a (Must Read)
2015 Spring CFE Q13 (Must Read)
2013 Fall CFE Q8 (Must Read)

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PAK Study Manual (Practice Questions)

for CFE Fall 2018

(Sample)

Note
1. 400+ Practice Questions/Solutions are included in the PAK
Study Manual.

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Textbook Reading: Corporate Finance Ch.8

Data for Q1
Suppose XYZ has an investment opportunity. It requires an initial investment of $120 today. XYZ's tax rate is
25%. The investment will generate the following cash flows one year later. Calculate the unlevered net income at
time 1.
Sales 200
Cost of Goods Sold 60
Selling, Gen, & Admin 25
R&D 20
Depreciation 15

Q2: Describe opportunity costs.

Q3: Describe cannibalization.

Data for Q4
Continue from the data for Q1. Opportunity costs increase the selling, general, and administrative expenses by
$13. Cannibalization reduces the sales of existing products by $20 and the cost of goods sold $9. Calculate the
new unlevered net income at time 1.

Q5: Describe sunk costs.

Q6: Explain why it is difficult to estimate revenues and costs in the real world.

Data for Q7-Q8

Continue from the data for Q1. Suppose the investment will generate the cash flows at the end of each year for
three years. This requires an additional investment on net working capital of $15 at year 1 and 2.
Q7: Calculate the free cash flow each year.
Q8: Calculate the tax shield each year.

Data for Q9-Q10

Continue from the data for Q7. The free cash flow of the investment beyond year 3 is expected to grow at a rate
of 4% per year. Assume the cost of capital is 9%.
Q9: Calculate the continuation value at year 3.
Q10: Calculate the NPV at year 0.

Data for Q11-Q15

ABC Bicycle Inc. creates a new program to sell bicycles through local shopping mall. The program generates a
sales of $60,000 each year for five years. Its annual cost of goods sold is 20,000. 10% of the sales will be paid in
credit and 20% of the cost of goods sold will be paid in credit. An account receivable and an account payable are
established to record these items. The marketing cost of this program is $5,000 annually. It needs to hire one
additional staff to administrate the program and the annual salary of this position is $10,000. All these cash flows
incurs at the end of the year.

The initial capital expenditure is $10,000 at time 0. The $10,000 is used to purchase display equipment and
computer system. Those items will be depreciated at MACRS depreciation rates (20% at time 0, 32% at time 1,
19.2% at time 2, 11.52% at time 3, 11.52% at time 4, 5.76% at time 5). It also sets aside a cash of $2000 at time
0 to pay for unexpected set-up expenses. The after-tax salvage value of the equipment and computer system
after 5 year is $2,000. Its tax rate is 25%. The discount rate to discount this program is 10%.

Q11: Calculate the unlevered net income each year.

Q12-Q15 are not shown in this sample.

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Textbook Reading: Corporate Finance Ch.8

Q1-Q6 are not shown in this sample.

S7:
FCF = ( Revenus - Costs - Depreciation ) × (1 − τ c ) + Depreciation - CapEx - ΔNWC
= ( Revenus - Costs ) × (1 − τ c ) - CapEx - ΔNWC + Depreciation × τ c

Year 0 Year 1 Year 2 Year 3

(+) Unlevered Net Income 0 60 60 60
(+) Depreciation 15 15 15
(−) Capital Expenditures 120
(−) Increases in NWC 15 15
(=) FCF -120 60 60 75

S8:
Year 0 Year 1 Year 2 Year 3
(+) Depreciation 15 15 15
(x) Tax rate at 25% x 25% x 25% x 25%
(=) Tax Shield 0 3.75 3.75 3.75

S9:
FCF3 × (1 + g ) 1.04
Continuation Value at Year 3 = = $75 × = $1560
r−g 0.09 − 0.04

S10:
Year 0 Year 1 Year 2 Year 3
(=) FCF -120 60 60 75
(+) Continuation Value 1560
(=) FCF -120 60 60 1635
(=) NPV @9% 1248.07

S11:
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
(+) Sales - 60,000 60,000 60,000 60,000 60,000 -
(−) COGS - 20,000 20,000 20,000 20,000 20,000 -
(=) Gross Profit - 40,000 40,000 40,000 40,000 40,000 -
(−) Selling, Gen, & Admin - 15,000 15,000 15,000 15,000 15,000 -
(−) R&D - - - - - - -
(−) Depreciation 2,000 3,200 1,920 1,152 1,152 576 -
(=) EBIT (2,000) 21,800 23,080 23,848 23,848 24,424 -
(−) Income Tax @ 25% (500) 5,450 5,770 5,962 5,962 6,106 -
(=) Unlevered Net Income (1,500) 16,350 17,310 17,886 17,886 18,318 -

Q12-Q15 are not shown in this sample.

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