Corporate Finance for BA (2014-2015)

Tutorial - 1
Chapter: 4, 5 And 6

Siraj Zubair_Corporate Finance for BA_2014-2015 1

Ch:4, Question 19
Calculating Annuities: There are four steps;

Step 1 : Find monthly interest rate (share & bond)

Step 2 : Calculate future value in 30 years (share & bond)

Step 3 : Calculate monthly rate on retirement investment

Step 4 : Calculate monthly payment

Siraj Zubair_Corporate Finance for BA_2014-2015 2

1
Ch:4, Question 19
Find out the monthly interest rate:

share:

r = (1+.07)1/12 – 1 = 0.5654%

And bond:

r = (1+.04)1/12 – 1 = 0.3274%

Siraj Zubair_Corporate Finance for BA_2014-2015 3

Ch:4, Question 19
Calculate future value in 30 years:

Bond: T=30 x 12 = 360, C = £500, r = 0.3274%

FV= £342,654.30

Share:
T=30 x 12 = 360, C = £500, r = 0.5654%
FV=£584,706.30

Total Value of the investment in 30 years is:

£584,706.30 + £342,654.30 = £927,360.60
Siraj Zubair_Corporate Finance for BA_2014-2015 4

2
Ch:4, Question 19
Monthly rate on retirement investment:
r = (1+.06)1/12 – 1 = 0.4868%

Monthly payment:
T = 25 x 12 = 300 months,
PV = £927,440.60
r = 0.4868%
C = £5,886.03

Siraj Zubair_Corporate Finance for BA_2014-2015 5

Ch:4, Question 27
The effective semi-annual rate: (using EAR equation)

{1+(10/12)}6 = 1.0083336 – 1 = 5.11%

PV of the annuity is: (Time period – 3 years)

= 25, 289£ (This is the value of one period (six months)

before the first payment i.e. value at t = 10)

Siraj Zubair_Corporate Finance for BA_2014-2015 6

3
Ch:4, Question 27
Thus, PV of that annuity, when time period 5 years
= £25,289.43 / 1.051110
= £15,363.80

PV (3 years from now) : £25,289 / 1.051114

= £12,587.01

PV (now) : £25,289 / 1.051120 = £9.333.80

Siraj Zubair_Corporate Finance for BA_2014-2015 7

Ch:5, Question 19
Non-Constant growth problem

P = D1 / (R – g)

P9 = D10 / (R – g)

= £8.00 / (.13 – .06)

= £114.29

The price of the share today will be:

P0 = £114.29 / 1.139 = £38.04

Siraj Zubair_Corporate Finance for BA_2014-2015 8

4
Ch:5, Question 24
P/E Ratio:

a. P=D/R

P = £1,800,000 / .12

P = £15,000,000

the P/E ratio of each company with no growth is:

P/E = £15,000,000 / £1,800,000 = 8.33 times

Siraj Zubair_Corporate Finance for BA_2014-2015 9

Ch:5, Question 24
b. P = D / R

P = (£1,800,000 + 200,000) / .12

P = £16,666,667

so the P/E with the increased earnings is:

P/E = £16,666,667 / £2,000,000

P/E = 8.33 times

Siraj Zubair_Corporate Finance for BA_2014-2015 10

5
Ch:5, Question 24
c. P = D / R

P = (£1,800,000 + 400,000) / .12

P = £18,333,333

so the P/E with the increased earnings is:

P/E = £18,333,333 / £2,200,000

P/E = 8.33 times

Siraj Zubair_Corporate Finance for BA_2014-2015 11

Ch:5, Question 25
a. P=D/R
P = €4 / .12
P = €33.33

b. NPVGO = C1 / (1 + R) + C2 / (1 + R)2 + C3 / (1 + R)3

NPVGO = –€1 / 1.12 + €1.90 / 1.122 + €2.10 / 1.123

NPVGO = €2.12 and the price is;

P = €33.33 + 2.12 = €35.45

Siraj Zubair_Corporate Finance for BA_2014-2015 12

6
Ch:5, Question 25
C. What will be the share price after 4 years?

After the project is over, and the earnings increase no

longer exists, the share price will revert back to €33.33.

Siraj Zubair_Corporate Finance for BA_2014-2015 13

Ch:6, Question 25
a. Profitability Index

PIA = [70,000 / 1.12 + 70,000 / 1.122] / 100,000 = 1.18

PIB = [130,000 / 1.12 + 130,000 / 1.122] / 200,000 = 1.10

PIC = [75,000 / 1.12 + 60,000 / 1.122] / 100,000 = 1.15

Siraj Zubair_Corporate Finance for BA_2014-2015 14

7
Ch:6, Question 25
b. Calculating NPV:

NPVA = –100,000 + 70,000 / 1.12 + 70,000 / 1.122

= €18,303.57

NPVB = –200,000 + 130,000 / 1.12 + 130,000 / 1.122

= 19,706.63

NPVC = –100,000 + 75,000 / 1.12 + 60,000 / 1.122

= €14,795.92

Siraj Zubair_Corporate Finance for BA_2014-2015 15

Ch:6, Question 25
c. Since the projects are independent accept projects A, B,
and C. because the respective PI of each is greater than 1.

d. Projects A and C have the same initial investment so

based on the profitability index rule, Project C can be
eliminated because its PI of C is less than the PI of Project
A.

Now comparing project A and B, we can calculate the PI

of the incremental cash flows of the two projects.

Siraj Zubair_Corporate Finance for BA_2014-2015 16

8
Ch:6, Question 25
The PI of the incremental cash flows of the two
projects are:

Project C0 C1 C2
B–A –€100,000 €60,000 €60,000
So the PI is:

PI(B – A) = [60,000 / 1.12 + 60,000 / 1.122]/100,000

= 1.014
The company should accept Project B since the PI of the
incremental cash flows is greater than 1.
Siraj Zubair_Corporate Finance for BA_2014-2015 17

Ch:6, Question 25
e. Since we can spend €300,000, we could take two of the
projects. In this case, we should take the two projects
with the highest NPVs, which are Project B and Project A.

Siraj Zubair_Corporate Finance for BA_2014-2015 18

9
Ch:6, Question 26
Comparing investment criteria:

a. Dry Prepreg:

Payback period = 2 years

Solvent Prepreg:
Payback period = 1+ €200,000/€600,000 = 1.333 years

Since the Solvent has a shorter payback period than the

Dry, the company should choose the Solvent.

Siraj Zubair_Corporate Finance for BA_2014-2015 19

Ch:6, Question 26
b. Dry prepreg:

NPV = -800,000 + 500,000 / 1.10 + 300,000 /1.102 +

900,000 / 1.103
= 578,662.6597

Solvent prepreg:

NPV = -600,000 + 400,000/1.10 + 600,000/1.102 +

200,000/1.103
= 409,767.0924

Choose the Dry

Siraj Zubair_Corporate Finance for BA_2014-2015 20

10
Ch:6, Question 26
C. The IRR is the interest rate that makes the NPV of a
project equal to zero
Dry :
NPV = 0 = -800,000 + 500,000 / (1+r) + 300,000 / (1+r)2
+ 900,000 / (1+r)3
= 43.38%

Solvent:
NPV = 0 = - 600,000 + 400,000/ (1+r) + 600,000 / (1+r)2
+ 200,000 / (1+r)3
= 48.88%
Solvent should be taken.
Siraj Zubair_Corporate Finance for BA_2014-2015 21

Ch:6, Question 26
d.
0 1 2 3
Dry CF -€800,000 €500,000 €300,000 €900,000
Solvent CF -€600,000 €400,000 €600,000 €200,000
Incremental CF -€200,000 €100,000 -€300,000 €700,000

Incremental IRR:

NPV = 0 = -200,000 + 100,000 / (1+r) - 300,000 / (1+r)2 +

700,000 / (1+r)3
= 33.67%

Siraj Zubair_Corporate Finance for BA_2014-2015 22

11