1.

Mutual Fund Fees and Retirement Savings

Prof. Finance moves to a new university and has $100,000 in retirement savings to invest
(rollover) into a new retirement account. Prof. Finance wants to invest this money for 25
years into one of the following two stock mutual funds.

– Vanguard Total Equity Fund with an expected annual return of 10% before a 0.3% annual
expense fee.

– Super Stock Selector Fund with an expected annual return of 11% before a 2.2% annual
expense fee.

What is the difference in Prof. Finance’s expected future retirement savings between the two
funds?

Vanguard: N: 25 Super Stock Selector: N: 25

I/Y: 10 – 0.3 I/Y: 11 – 2.2 = 8.8
PV: 100,000 PV: 100,000
PMT: 0 PMT: 0
=> FV = $1,011,965.46 => FV = $823,611.47

2. Paying for Baby’s MBA

Just had a baby. You think the baby will take after you and earn academic scholarships to
attend college to earn a Bachelor’s degree. However, you want send your baby to a top-notch
2-year MBA program when baby is 25. You have estimated the future cost of the MBA at
$90,000 for year 1 and $95,000 for year 2. • Today, you want to finance both years of baby’s
MBA program with one payment (deposit) into an account paying 8%
interest compounded annually.• How large must this deposit be?

There are 2 ways of doing this.

(1) Treat each cost separately, calculate PV’s separately and them add them up

year 1: year 2:
FV: 90,000 FV: 95,000
N: 25 N: 26
I/Y(or r): 8 I/Y(or r): 8
PMT: 0 PMT: 0
=> PV = 13,141.61 => PV = 12,844.17

answer: 13,141.61 + 12,844.17 = $25,985.78

(2) Alternatively, translate year 2’s cost as of year 1, and year 2’s cost to year 1’s cost, then
discount the combined cost as of year 1.

year 2’s cost as of year 1: 95,000/(1.08) = 87,962.96

FV: 90,000 + 87,962.96 = 177,962.96
I/Y(or r): 8

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 N: 25
PMT: 0

=> answer: PV = 25,985.78

3. The current required rate of return on a bond issued by Who with a par value $1,000 is 11
percent. “Who” has a bond issue outstanding that pays interest semiannually, is selling for
$845 and matures in 8 years. What is the coupon rate on the outstanding bond?

N = 16 I/Y = 11 / 2 = 5.5 PV = -845 FV = 1,000 PMT = 40.1847

Annual payment = 40.18 x 2 = 80.3694
coupon rate = 8.037%

4. What is the yield to maturity of a RJR bond with 10 years to maturity, a par value of $1,000
and a coupon of 15%? The current price of this bond is $1,109. Assume interest is paid
annually.

N = 10 PMT= (1,000) x (15% ) = 150 FV= 1,000 PV= -1,109 I/Y=12.99%~=13%

5. WXAM has an outstanding bond issue with a coupon rate of 6 1/8 %, a par value of $1,000.
The yield to maturity on this bond is 7 5/8%. What is the market price of this bond if it pays
interest semi-annually and has 12 years to maturity?

N =12 x 2 = 24 I/Y=7.625 / 2 = 3.8/25 PMT= [(1,000) x (6.125%)]/ 2 = 30.625 FV=

1,000 PV = 883.42

6. Krustyburger has $1,000 par value bonds outstanding that make annual coupon payments.
These bonds have an 7% annual coupon rate and 20 years left to maturity. What’s the most
that each of the following investors will be willing to pay for a Krustyburger bond given their
required return? N = 20 PMT = 70, FV = 1,000

- Homer Simpson requires a 5% return: I/Y = 5 => PV = 1,249.24

- Bart Simpson requires a 7% return: I/Y = 7 => PV = 1,000.00

- Mr. Burns requires a 9% return: I/Y = 9 => PV = 817.43

Recall from previous Krustyburger example, the 20-year, 7% annual coupon bond has the
following values at r = 5%, 7%, & 9%. Let’s compare with a 2-yr, 7% annual coupon bond.

20-year bond 2-year bond

r=5%: PV = $1,249.24 PV = 1,037.19
r=7%: PV = $1,000 PV = 1,000.00
r=9%: PV = $817.43 PV = 964.82

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7. Recall from previous Krustyburger example, the 20-year, 7% annual coupon bond has the
following values at r = 5%. PV = $1,249.24. What is bond value one year later when N= 19 if r
is still = 5%? PV = 1,241

8. A Duff’s Beer $1000 par value bond with an annual coupon rate of 6% pays coupons
semiannually with 15 years left to maturity. What is the most you would be willing to pay for
this bond if your required return is 7.4% APR?

FV = 1,000 PMT = 30 N = 30 I/Y = 7.4/2 = 3.7 => PV = 874.42

9. Eastern Electric currently pays a dividend of about $1.64 per share and sells for $27 a share.

a. If investors believe the growth rate of dividends is 3% per year, what rate of
return do they expect to earn on the stock?

[1.64/27](1.03) + 0.03 = 9.26%

b. If investors’ required rate of returns is 10 %, what must be the growth rate

they expect of the firm?

[0.1 – (1.64/27)]/ [1 + (1.64/27)] = 3.70%

c. If the sustainable growth rate is 5 percent, and the plowback ratio is 0.4, what
must be the rate of return earned by the firm on its new investments?

0.05/0.4 = 12.5%

10. Here are data on 2 stocks, both of which have discount rates of 15%.

Stock A Stock B
Return on equity 15% 10%
Earning per share $2.00 $1.50
Dividends per share $1.00 $1.00

a. What are the dividend payout ratios for each firm? ½ = 0.5, 1/1.5 =
0.667

b. What are the expected dividend growth rates for each firm?

15%*0.5 = 7.5%, 10%*(0.5/1.5) = 3.33%

c. What is the proper stock price for each firm?

1(1.075)/[0.15 – 0.075] = $14.33 1(1.0333)/[0.15-0.0333] = $8.86

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11. Fincorp will pay a year-end dividend of $2.4 per share, which is expected to grow at a 4 %
rate for the indefinite future. The discount rate is 12 percent.

a. What is the stock selling for? 2.4/[0.12-0.04] = $30.00

b. If earnings are $3.10 a share, what is the implied value of the firm’s growth
opportunities?

No growth(Div = Earnings) => E/r = 3.1/0.12 = $25.83

PVGO = P – no growth value = $30 - $25.83 = $4.17

12. Tattletale News Corp. has been growing at a rate of 20 % per year, and you expect this
growth rate in earnings and dividends to continue for another 3 years.

a. If the last dividend paid was $2, what will the next dividend be? 2*1.2 = $2.4

b. If the discount rate is 15% and the steady growth rate after 3 years is 4 percent,
what should the stock price be today?

Div1 = 2.4 Div2 = 2.4*1.2 = 2.88 Div3= 2.88*1.2 = 3.456

P3 = 3.456(1.04)/[0.15 – 0.04] = 32.675

P0 = (2.4/1.15) + (2.88/1.152) + ([3.456+32.675]/1.153)= $28.021

13. Here are the cash flow forecasts for two mutually exclusive projects.

Cash flows, dollars

Year Project A Project B
0 -100 -100
1 30 49
2 50 49
3 70 49
a. Which project would you choose if the opportunity cost of capital is 2 percent?

A: For uneven cashflows, you need to use CF function in your calculator!

CF, 2nd, CE/C, CF0 = -100, enter(see that ‘=’ sign) , down arrow, C01=30, enter, down
arrow, F01= leave it for now, down arrow, C02 = 50, enter, down arrow, F02 = leave
it, down arrow, C03 = 70, then you can use up arrows to check if your inputs are
correct.
Then press NPV, I = 2, enter, down arrow, compute => NPV(A) = 43.43

B: PV of cashflow: N = 3, PMT = 49, I/Y = 2, FV = 0, CPT PV = (-) 141.31

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 Don’t forget that your PV is actually (+)! Even though you have a (-) in your
calculator.

NPV(B) = -100 + 141.31 = 41.31

Which would you choose if the opportunity cost of capital is 12 percent?

A: Do the same thing as above, except use I = 12 => NPV(A) = 16.47

B: likewise…………….. NPV(B) = 17.69
Why does your answer change? Larger CF3, smaller CF1
What are the IRR’s of each project?
A: Input your numbers as above. After finishing the input, press IR(instead of NPV),
compute => IRR(A) = 20.13

B: N = 3, PMT = 49, FV = 0, PV = - 100, CPT I/Y => IRR(B) = 22.05

Draw NPV profiles for each project.

43.43
41.31
17.69
16.47

2 12 20.13 22.05
Calculate crossover rate.(crossover rate:= the rate that equates the NPV of 2 projects, i.e. the
rate where the two NPV profiles cross)

CF, 2nd, CE/C, CF0 = 0 , down arrow, C01=19, enter, down arrow, F01= leave it for
now, down arrow, C02 = -1, enter, down arrow, F02 = leave it, down arrow, C03 = -21,
press IRR, compute => crossover rate = 7.8

14. You are a manager with an investment budget of $8 million. You may invest in the

following projects. Investment and cash-flow figures are in millions of dollars.

Project Discount rate Investment Annual cash flow Project Life

A 10 3 1 5
B 12 4 1 8
C 8 5 2 4
D 8 3 1.5 3
E 12 3 1 6

a. Why might these projects have different discount rates? Less risky, lower rates

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 b. Which should the manager choose?

Project PV of cashflow Investment NPV PI

A 3.79 3 0.79 0.26
B 4.97 4 0.97 0.24
C 6.62 5 1.62 0.32
D 3.87 3 0.87 0.29
E 4.11 3 1.11 0.37

Therefore, choose ( C ) and ( E )

c. Which projects will be chosen if there is no capital rationing? Choose all

15. Consider the two projects

Project C0 C1 C2 C3
A -36 20 20 20
B -50 25 25 25

a. Which project has the higher NPV if the discount rate is 10 percent?
NPV(A) = 13.74
NPV(B) = 12.17

b. Which has the higher profitability index?

Project PV of cashflow Investment NPV PI
A 49.74 36 13.74 0.38
B 62.17 50 12.17 0.24

c. Which project is most attractive to a firm that can raise an unlimited amount of funds to
pay for its investment projects? Both
Which project is most attractive to a firm that is limited in the funds it can raise?A

16. Consider the following project

Year CF
0 +$100
1 -60
2 -60

a. What is this project’s IRR? 13.1%

b. If the discount rate is 12%, should you accept the project? No, since NPV = -1.403

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17. A firm can lease a truck for 4 years at a cost of $30,000 annually. It can instead buy a
truck at a cost $80,000, with annual maintenance expenses of $10,000. The truck will be sold
at the end of 4 years for $20,000. Which is the better option if the discount rate is 10%?
Buy: NPV = - 80,000 - 31,698.65 + 13,660.27 = -98,038.38
Lease: NPV = - 95,095.96 => lease is cheaper

Two projects being considered are mutually exclusive and have the following projected cash
flows:

Year Project A Project B

0 -50,000 -50,000
1 15,990 0
2 15,990 0
3 15,990 0
4 15,990 0
5 15,990 100,560

At what rate (approximately) do the NPV profiles of Projects A and B cross?

PV = 0, PMT = 15,990, FV = – 100,560, N = 5 =>I/Y=IRR = 11.49%

18. Talia’s Tutus bought a new sewing machine for $40,000 that will be depreciated using the
MACRS(modified accelerated cost recovery system) depreciation schedule for a 5 year
recovery period.

a. Find the depreciation change each year

Year MACRS(%) Depreciation Book Value

1 20.00 8,000 32,000
2 32.00 12,800 19,200
3 19.20 7,680 11,520
4 11.52 4,608 6,912
5 11.52 4,608 2,304
6 5.76 2,304 0

b. If the sewing machine is sold after 3 years for $22,000, what will be the after-tax proceeds
on the sale if the firm’s tax bracket is 35%?

Sales price – book value = ( 22,000 ) – ( 11,520 ) = ( 10,480 )

After tax proceeds = ( 22,000 ) – ( 10,480 )*( 0.35 ) = ( 18,332 )

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19. Revenues generated by a new fad product are forecast as follows

Year Revenues
1 $40,000
2 30,000
3 20,000
4 10,000
Thereafter 0

Expenses are expected to be 40% of revenues, and working capital required in each year is
expected to be 20% of revenues in the following year. The product requires an immediate
investment of $45,000 in plant and equipment

a. What is the initial investment in the product? Remember working capital.

Working capital = ( 20 )% * ( 40,000 ) = ( 8,000 )

Initial Investment = ( 45,000 ) + ( 8,000 ) = ( 53,000 )

b. If the plant and equipment are depreciated over 4 years to a salvage value of zero using
straight line depreciation and the firm’s tax rate is 40%, what are the project cash flows
in each year?
c.
Year Revenues Expenses Working capital Depreciation Cash flow
1 40 16 6 11.25 20.9
2 30 12 4 11.25 17.3
3 20 8 2 11.25 13.7
4 10 4 0 11.25 10.1

Cash flow = (R – C) – (R-C-Dep)*t - increase(or + decrease) in working capital

d. If the opportunity cost of capital is 12 %, what is project NPV?

CF, CLR WORK, CF0 = ( -53,000 ), C01 = ( 20,900 ), C02 = (17,300)
C03 = ( 13,700 ), C04 = ( 10,100 ), NPV, I = ( 12 ), down arrow,
CPT, NPV = -$4,377.71

e. What is project IRR?

Just press IRR, CPT: 7.5

20. A drill press costs $30,000 and is expected to have a 10 year life. The drill press will be
depreciated on a straight line basis over 10 years to a zero estimated salvage value. This
machine is expected to reduce the firm’s cash operating costs by $4,500 per year. If the firm
is in the 40% marginal tax bracket, determine the annual net cash flows generated by the drill
press.

Since +4,500 – (+4,500 – 3,000)*0.4 = 3,900

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21. Consider the following scenario analysis
Scenario Probability Rate of Return
Stocks Bonds
Recession 0.2 -5% +14%
Normal Economy 0.6 +15% +8%
Boom 0.2 +25% +4%

a. Calculate the expected return and standard deviation for each investment
ER(stock) = -5*0.2 + 15*-.6 + 25*0.2 = -1.0 + 9.0 + 0.5 = 13.0%
V(stock) = (-5-13)2*0.2 + (15-13) 2*0.6 + (25-13) 2*0.2 = 64.8 + 2.4 + 28.8 = 96
SD(stock) = 96 = 9.8%
ER(bond)= 14*0.2 + 8*0.6 + 4*0.2 = 2.8 + 4.8 + 0.8 = 8.4%
V(bond)= (14-8.4) 2*0.2 + (8-8.4) 2*0.6 + (4-8.4) 2 * 0.2 = 10.24
SD(bond)= 10 .24 = 3.2%

b. Which investment would you prefer? Depends on your risk aversion: higher risk
aversion => ( bonds )

22. Use the data in the previous problem and consider a portfolio with weights of 0.6 in stocks
and 0.4 in bonds

a. What is the rate of return on the portfolio in each scenario?

Recession: 0.6(-5) + 0.4(14) = -3.0 + 5.6 = 2.6%
Normal Economy: 0.6(15) + 0.4(8) = 9.0 + 3.2 = 12.2%
Boom: 0.6(25) + 0.4(4) = 15.0 + 1.6 = 16.6%

b. What is the expected rate of return and standard deviation of the portfolio?
ER(portfolio) = 2.6*0.2 + 12.2*0.6 + 16.6*0.2 = 0.52+7.32+3.32 = 11.16%
V(portfolio) = (2.6-11.16) 2*0.2 + (12.2-11.16) 2*0.6 + (16.6-11.16) 2*0.2
= 14.655 + 0.649 + 5.92 = 21.22
SD(portfolio) = 21 .22 = 4.61 %

c. Would you prefer to invest in the portfolio, in stocks only or in bonds only?

ER SD
Stocks 13% 9.8%
Bonds 8.4% 3.2%
Portfolio 11.16% 4.61%

Would depend on risk aversion, but probably portfolio…..

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 23. A share of stock with a beta of 0.75 now sells for $50. Investors expect the stock to pay a
year-end dividend of $2. The T-bill rate is 4 percent, and the market risk premium is 8 %.
If the stock is perceived to be fairly priced today, what must be investors’ expectation of
the price of the stock at the end of the year?

ri= rf + βi(rm-rf) => ri = 4+0.75*8 = 4+6 = 10%

D1 + P1 − P0
r= = > P0 (1 + r ) = D1 + P1 = > P1 = P0 (1 + r ) − D1 = 50 (1 + 0.1) − 2 = $53
P0
24. Reconsider the stock in the preceding problem. Suppose investors actually believe the
stock will sell for $52 at year-end. IS the stock a good buy or bad buy? What will the
investors do? At what point will the stock reach an “equilibrium” at which it again is
perceived as fairly priced?

Fair price(CAPM) => P0 = (D1+P1)/(1+r) = (2+52)/1.1 = 49.01<50 => overpriced

25. Stock A has a beta of 0.5 and investors expect it to return 5 percent. Stock B has a beta of
1.5 and investor expect it to return 13 percent. Use the CAPM to find the market risk
premium and the expected rate of return on the market.

5= rf + 0.5(rm-rf)
13= rf + 1.5(rm-rf)

=> rf = 1%, rm = 9%

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