Autumn 2005- TBS 907- Tutorial 1 with solutions - NPV Analysis

Autumn 2005- TBS 907- Tutorial 1 with solutions - NPV Analysis

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TBS 907- AUTUMN 2005 TUTORIAL 1- NPV ANALYSIS Question 1 As 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 per year forever. If the interest rate is 12 percent, which is the most valuable prize? Answer: a. PV = $100,000 b. PV = $180,000/1.12 5 = $102,137 c. PV = $11,400/0.12 = $95,000 d. PV = $19,000 × [Annuity factor, 12%, t = 10] PV = $19,000 × 5.650 = $107,350 e. PV = $6,500/(0.12 - 0.05) = $92,857 Prize (d) is the most valuable because it has the highest present value Question 2 Consider the following three stocks: a. Stock A is expected to provide a dividend of $10 per share forever. b. Stock B is expected to pay a dividend of $5 next year. Thereafter, dividend growth is expected to be 4 percent per year forever. c. Stock C is expected to pay a dividend of $5 next year. Thereafter dividend growth is expected to be 20 percent a year for 5 years (i.e. until year 6) and zero thereafter. Assume cost of capital is 10%. Answer: $100.00 0.10 $10 r DIV P 1 A = = = $83.33 .04 0 0.10 5 g r DIV P 1 B = - = - = × + + + + + + = 6 7 6 6 5 5 4 4 3 3 2 2 1 1 C 1.10 1 0.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV 1.10 DIV P $104.50 1.10 1 0.10 12.44 1.10 12.44 1.10 10.37 1.10 8.64 1.10 7.20 1.10 6.00 1.10 5.00 P 6 6 5 4 3 2 1 C = × + + + + + + = TBS 907- S UMMER 2005- T UTORIAL 2- NPV A NALYSIS P AGE 1 OF 5
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At a capitalization rate of 10 percent, Stock C is the most valuable. Question 3 The furniture division of Playfurn Ltd., a profitable, diversified company, purchased a machine 5 years ago for $7,500. When it was purchased the machine had an expected useful life of 15 years and an estimated value of zero at the end of its life. The machine currently has a market value of $1000. the division manager reports that he can buy a new machine for $16,000
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Autumn 2005- TBS 907- Tutorial 1 with solutions - NPV Analysis

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