Annuities, Perpetuities

1. You are thinking of purchasing a house. The house costs $ 3,500,000. You have $500,000 in cash
that you can use as a down payment on the house, but you need to borrow the rest of the purchase
price. The bank is offering a 20-year mortgage that requires annual payments and has an interest
rate of 5% per year. What will your annual payment be if you sign up for this mortgage?

2. Your parents have made you an offer you cannot refuse. They are planning to give you part of
your inheritance early. They have given you a choice: they will pay you $10,000 per year for
seven years (beginning today) or they’ll give you their 2015 BMW M5 Convertible, which you
can sell for $61,000 (guaranteed) today. If you can earn 7% annually on your investments, which
should you choose?

3. Ellen is 35 years old and she has decided it is time to plan seriously for her retirement. At the end
of each year until she is 65, she will save $10,000 in a retirement account. If the account earns
10% per year, how much will Ellen have in her account at age 65?

4. Adam is 25 years old, and he has decided it is time to plan seriously for his retirement. He will
save $10,000 in a retirement account at the end of each year until he is 45. At that time, he will
stop paying into the account, though he does not plan to retire until he is 65. If the account earns
10% per year, how much will Adam have saved at age 65?

5. Consider a growing perpetuity that will pay $100 in one year. Each year after that, you will
receive a payment on the anniversary of the last payment that is 6% larger than the last payment.
This pattern of payments will continue forever. If the interest rate is 11%, then what will be the
value of this perpetuity?

Capital Budgeting

1. The Sisyphean Corporation is considering investing in a new cane manufacturing machine that has
an estimated life of three years. The cost of the machine is $30,000 and the machine will be
depreciated straight line over its three-year life to a residual value of $0.

The cane manufacturing machine will result in sales of 2,000 canes in year 1. Sales are
estimated to grow by 10% per year each year through year three. The price per cane that
Sisyphean will charge its customers is $18 each and is to remain constant. The canes have a cost
per unit to manufacture of $9 each.

Installation of the machine and the resulting increase in manufacturing capacity will not require
any increase in net working capital accounts. The firm is in the 35% tax bracket, and has a cost
of capital of 10%.

 Compute the project's NPV, IRR and PI

2. ABC, a company involved in the production of industrial hardware, is considering purchasing a

new generation hydraulic press for $4 million. The machinery will be depreciated using the
 straight line method to a zero salvage value over 4 years which will be the end of the lifetime of
the project. The company expects to sell the machine at $0.5 million at the end of year 4. This new
process is expected to generate additional revenues of $2.5 million during the 4 years. Operating
expenses (without Depreciation and Amortization) are expected to be $1 million in year 1 and 2, it
will decrease to $0.75 million for the last two years (year 3 and 4). The marginal tax rate is 40%
and the discount rate is 9%.

 Compute the cash flow for years 0-4.

 What will be the project's NPV, PI & IRR?
 Estimate the discounted payback.

Cost of Capital
1. Pony Corporation is undertaking a capital budgeting analysis. The firm’s beta is 1,5 . The
rate on 10-year U.S. treasury bonds 5% and the return on the stock market is 12%. What is the
cost of Pony’s common equity?
a. 17,7%
b. 19,9%
c. 13,3%
d. 15,5%

2. Based on current market values, Shawhan Supply’s capital structure is 30% debt, 20% preferred
shares and 50% common stock. The required return on each component is debt 10%; preferred
stock 11% and common stock 18%. What return must Shawhan earn on its investments if the
value of the firm is to remain unchanged?
a. 18,0%
b. 13,0%
c. 14,2%
d. 10,0%

3. Metals Corp. has $ 2.575.000 of debt, $ 550.000 of preferred stock and $ 18.125.000 of common
equity. Metals Corp.’s after-tax cost of debt is 5,25%, preferred stock has a cost of 6,35% and
newly issued common stock has a cost of 14,05%. What is Metals Corp.’s weighted average cost
of capital?
a. 10,84%
b. 6,56%
c. 8,32%
d. 12,78%

4. Assume the following facts about a firm’s financing in the next year, and calculate the component
cost of debt:
Weighted average cost of capital 11,
3%
Proportion debt financing 45
%
Proportion internal financing 55
%
Cost of internal equity 14,
0%
Cost of after-tax debt ?
 %
a. 8%
b. 7%
c. 10%
d. 9%