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10TH Edition

Robert C. Higgins

Additional Problems

Chapter 7

**A brief tutorial on Excel financial functions (problems to follow)
**

You may find the following Excel, built-in financial functions helpful when analyzing the problems below. (To

access these functions, select Insert, Functions, and choose Financial.)

=PV(rate, nper, pmt, fv, type) returns the present value of a series of cash flows.

=FV(rate, nper, pmt, pv, type) returns the future value of a series of cash flows.

=PMT(rate, nper, pv, fv, type) calculates the periodic payment for a loan based on constant payments and a

constant interest rate.

=NPER(rate, pmt, pv, fv, type) returns the number of periods for an investment based on periodic, constant

payments and a constant interest rate.

=NPV(rate, range) returns the net present value of an investment based on a discount rate and a series of

future payments (negative values) and income (positive values). (Warning: By convention, NPV

calculates the net present value one period before the first cash flow.)

=IRR(range, guess) returns the internal rate of return for a series of cash flows.

In these functions,

rate = the discount, or interest rate.

nper = number of periods.

pmt = annual uniform payment.

fv = future value, or future cash flow.

type is a logical value allowing you to specify if cash flows occur at the end or the beginning of the period. A

value of 1 indicates beginning of period, 0 or omitted indicates end of period.

pv = present value.

range = the cells on your spreadsheet containing the cash flows you want to analyze. For example, if the cash

flows are in the first 10 rows of column A, the entry for range would be a1:a10.

guess = your guess as to the internal rate of return. This helps the computer get started and may be left blank.

An example Suppose you want to know the present value of $100 per year for 19 years and $500 at the end of the

19th year when the interest rate is 13 percent.

Select a spreadsheet cell and enter =PV(0.13,19,100,500). Excel will return ($742.83). This is the amount one

should be willing to pay today to receive the indicated stream of cash flows when the interest rate is 13 percent.

1

was reported to be buying stock from some of these disgruntled stockholders at $750 a share. Find the investment's accounting rate of return and its payback period.40.000. To finance construction members of the council organized the Patterson Hotel Corporation. b. During the last 20 years of the lease. What was your rate of return on Trublock stock? 4) Having heard of your knowledge of present value techniques. Conrad Billings. Find the investment's net present value at a 15 percent discount rate.000 per year for 6 years. One man was said to have declined Billings’ offer of $750 a share and to have commented publicly that nobody was going to get his stock unless they paid what it was worth. You sold the shares recently for $2. what is the yield to maturity on the bond? Assume interest is paid annually. He got the loan 10 years ago and has been making equal annual payments of $14.80.Problems 1) An investment costing $50.000 promises an after tax cash flow of $18. the operating company agreed to make payments sufficient to permit annual dividends of $400 per share.000. The lease ran for 30 years and contained a clause permitting the lessee to purchase the hotel for $10 million at the end of the 30-year period. 3) Ten years ago you invested $1.296. fixed rate loan at 6 percent interest for $200. Do you agree? Why. There were remarks regarding the "fat dividends" he would be receiving after the mortgage was paid off. c. If the price of the bond is $1.000 par value. Upon completion. This was the most favorable operating contract that Patterson Hotel Company was able to negotiate. many of whom had bought stock under considerable pressure. While you owned the stock it paid $10. Find the investment's internal rate of return. When stockholders. 14 percent mortgage that called for uniform annual payments sufficient to pay interest and to extinguish the debt at the end of 10 years. a local businessmen in the original group that promoted the hotel.000 shares of stock at $1. Find the investment's profitability index at a 15 percent discount rate. He presents this as obvious proof of "gouging on the part of the money changers". Some locals were heard to comment that Conrad Billings was a "clever old bastard" who was taking advantage of his public-spirited neighbors.345. a. and a number of them were anxious to sell their stock.000 per share. the Patterson Hotel Corporation leased the hotel to a national company that operated a chain of hotels. d. learned that there was no prospect of dividends for 10 years. They secured the other $10 million necessary to build the hotel as a loan provided by a local bank on a 10 year.60 ever since. and was to meet the interest and repayment obligations on the mortgage during the first 10 years of the lease.00 yet his payment book indicates that the principal due on the loan has only declined by $33. they were quite upset.08 per share annual dividends. Make whatever assumptions and calculations you find necessary to estimate the fair value of the stock.000 for 10 shares of Trublock common stock. Through strenuous promotion they raised $15 million by selling 15. the city council of the town of Patterson agreed that their community badly in need of a modern hotel that would cost approximately $25 million. you have been asked to testify as an expert witness in the following lawsuit. He observes that he has paid the lending company $145. Assuming the required rate of return on the investment is 15 percent.529. e.196. Several homeowners in a nearby community have organized to protest against alleged gouging on the part of a local lending institution. No payments at all were to be made to the stockholders during the first 10 years. why not? 5) In 1984. which of the above figures of merit indicate the investment is attractive? Which indicate it is unattractive? 2) A $1. The lessee agreed to furnish the hotel and pay all taxes (including income taxes) and operating expenses. One resident presents his payment book as evidence. Was $750 a share really too low a price? 2 . 10 percent coupon bond matures in 20 years. The resident has a 30-year.

Again assuming no capital rationing. Calculate the benefit cost ratio for each alternative. Calculate the net present value of each alternative.000 34% What is the rate of return on this investment? Assuming the investor wants to earn at least 12 percent. Which alternative should the company select? Why? f. If the company is experiencing severe capital rationing.000. If the company's tax rate is 50 percent.000 miles or you can spend $40 per tire and replace them every 40. its cost of capital is 12 percent.000 Expected life 4 yrs 6 yrs Salvage value 0 0 At the end of the useful life of whatever equipment is chosen the product will be discontinued. If the company is not under capital rationing which alternative should be chosen? Why? e. is this investment an attractive one? 8) Management has decided to construct a new building. c. suppose the company plans to produce the product indefinitely rather than quit when the equipment wears out. 9) Sanderson Electronics has made a long-run commitment to produce semi-conductor chips of a specific type.000. how many miles must you drive annually to warrant the more expensive tires? 7) Consider the following investment opportunity. Assuming zero salvage value and straight-line depreciation. Two designs are to be evaluated for their production. exclusive of depreciation Expected life Salvage value after taxes Annual depreciation for tax purposes Tax rate $850. Calculate the internal rate of return for each alternative. A frame structure will cost $800.000 Annual disbursements $20. If money has an opportunity cost of 10 percent to you. Initial cost Annual revenues Annual operating costs.000 annually to maintain.000 $60.000 Annual receipts $50. would any of your answers above change? 3 .000. will have an expected life of 40 years and will cost $100.6) You need four new tires for your car. what recommendation would you give the company when the discount rate is 12 percent? 10) A company is considering two alternative methods of producing a new product.000 $120. The relevant data concerning the alternatives are presented below. You can buy cheap retread tires for $25 a piece and replace them every 20.000 20 years $40. Design Y involves a present investment of $60.000 annually before tax to maintain. A concrete structure will cost $2 million. The company's tax rate is 50 percent and it cost of capital is 10 percent. Estimated annual profits after tax for 20 years are $22. and both structures will be depreciated on a straight-line basis. b. and plans to terminate production when the equipment wears out.000 $25. which alternative is financially superior? Assume the company expects to be profitable in future years.000 $20. Alternative Alternative I II Initial investment $64.000 $12.000 $500.000. Design Z involves a present investment of $120. You may ignore inflation.000 $200. a.000 miles. d. Estimated annual profits after tax for 15 years are $10.000.000 Annual depreciation $16. will have an expected life of 20 years and will cost $250.

126. Consider a $100.000 6% 20 yrs. Clearly. 12) Given the following information about three bonds.01)12 = $1. b. interest on corporate bonds usually is payable every six months. Initial cost Expected life Salvage value Annual depreciation Incremental annual sales Incremental annual production costs Incremental annual selling and administrative costs Tax rate Expected inventory turnover (production cost/end.68 percent is referred to as the effective interest rate. sensitive to interest rate changes as time to maturity increase? Does this suggest short-term bonds are more. The monthly interest rate on the mortgage is 11%/12 months = . Sometimes such a transaction is described as having an interest rate of 12 percent per annum.000 is borrowed with interest at 1 percent per month compounded monthly. a.000 $200. if interest is compounded m times a year at an interest rate of r/m per compounding period. Bond Par value Coupon rate Time to maturity A $1. What is the annual nominal interest rate on the mortgage? 4 .11) Given the following information about a possible average-risk. a.000 10 yrs 0 $20. Do bond prices become more. new product investment.1. the monthly compounding has the same effect on the year-end amount due as the charging of a rate of 12. 11 percent. Assume interest is paid annually and calculate the prices of the bonds at an 11 percent interest rate. To generalize.68 percent compounded annually. 12. fixed-rate.000 $20.000 $110.) Expected collection period Cost of capital Borrowing rate Target debt-to-equity ratio $200.000 50% 4 times 45 days 8% 7% 130% The following problems are best analyzed using a business calculator or a computer. calculate the investment's net present value. Consider a loan transaction in which interest is charged at the rate of 1 percent per month.80 Hence.1268) = $1.000 6% 5 yrs. The effective interest rate per annum = (1+r/m)m . it is desirable to recognize the difference between 1 percent per month compounded monthly and 12 percent per annum compounded annually.000(1. B $1. the amount due in one year is: F = $1.000(1.000 6% 1 yr.91666%. risky than long-term bonds? 13) In many financial transactions. or less. If $1. inv. this rate should be described as a nominal 12 percent per annum coumpounded monthly. The nominal interest rate per annum = m(r/m) = r. home mortgage requiring monthly payments. 30 year.000. Then. For example. answer the questions below. interest is computed and charged more than once a year. Do bond prices vary directly or inversely with interest rates? c. or less. C $1. More precisely.

After paying on this mortgage for 15 years.000 Monthly payment Interest due Principal payment Outstandin g balance end of Month d.1]/i(1+i) n where i is the interest rate per period and n is the number of periods. What is the annual effective interest rate on the mortgage? c. what will be the remaining principal outstanding? You may find it useful to know that the present value of an annuity paying $A per period equals: $A[(1+i)n . If the borrower plans to live in the house for 15 more years. does it make economic sense to refinance? Does your answer change if the borrower only intends to live in the house for 3 more years and will pay off any loans outstanding at that time? You may ignore taxes and may assume there are no prepayment penalties on either mortgage.b. Date Outstanding balance beginning of month 1/31 $100. Suppose after 15 years the borrower has the opportunity to refinance the remaining principal on the mortgage with a new 15-year mortgage carrying an interest rate of 8 5/8%. The borrower's payment book will look something like the following. Complete the entries for the first 6 months. Refinancing will involve $300 in costs and "points" equal to 2 percent of the amount borrowed. e. 5 .

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