Economics 173 – Corporate Finance
Winter 2006-07
Prof. Garey Ramey
Lecture Examples - Revised
1.
Present Value Analysis
Example 1.1.a.
(PQ 2.2, p. 31)
A parcel of land costs $500,000.
For an additional
$800,000 you can build a motel on the property.
The land and property should be
worth $1,500,000 next year.
Suppose that common stocks with the same risk as this
investment offer a 10 percent expected return.
Would you construct the motel?
Why
or why not?
b.
Suppose that real estate investments are substantially riskier than common stocks.
The expected return on real estate investments is 17 percent.
Is the motel still worth
constructing?
c.
Suppose the motel takes an additional year to complete.
Let the expected annual
return for real estate investments be 10 percent, whether they are held one year or two
years.
Is the motel still worth constructing?
Example 1.2.a.
(PQ 3.6, p. 53)
A factory costs $400,000.
It will produce an inflow
after operating cost of $100,000 in year 1, $200,000 in year 2, and $300,000 in year 3.
The opportunity cost of capital is 12 percent.
Calculate the NPV.
b.
Suppose the cash flows from the factory are delayed by two years.
Example 1.3.a.
(PQ 3.4, p. 53)
A factory costs $800,000.
You reckon that it will
produce an inflow after operating costs of $170,000 a year for 10 years.
If the
opportunity cost of capital is 14 percent, what is the net present value of the factory?
b.
Suppose the cash flows from the factory are delayed by three years.
What is the
NPV in this case?
c.
What will the factory be worth at the end of five years?
d.
Suppose cash flows from the factory are received semiannually, starting six months
from now.
What is the NPV in this case?
e.
Suppose cash flows from the factory are received in a continuous stream.
What is
the NPV in this case?
Example 1.4.
(PQ 3.8, p. 53)
As the winner of a breakfast cereal competition, you can
choose one of the following prizes:
a.
$100,000 now.
b.
$180,000 at the end of five years.
c.
$11,400 a year forever.
d.
$19,000 for each of 10 years.
e.
$6,500 next year, and increasing thereafter by 5 percent a year forever.
If the interest rate is 12 percent, which is the most valuable prize?
Example 1.5.
A new product requires an up front investment of $650,000.
Starting at the
end of the year, the product will generate cash flows of $150,000 per year for eight