MT 1 solution

# MT 1 solution - MGCR 341 Finance 1 Summer 2010 Vadim di...

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For 12% APR, monthly compounding: 1+ EAR = (1+ APR/12) 12 = 1.1268 For 12.1% APR, annual compounding: 1+ EAR = (1+ APR) 12 = 1.121 Thus you prefer the 12% APR, monthly compounding option. 2) (5 points, 5 mins) If the risk free rate is 8%, and the inflation rate is 3%, by how much does the purchasing power of an investment in the risk free asset grow each year? [(1 + 0.08) / (1 + 0.03)] -1 = 4.85% 3) (10 points, 20 mins) You are considering starting a business that sells novelty t-shirts. There is an initial startup cost of \$X at t = 0. Your first cash inflow will be \$10M at t = 4 (on sales of 1M t-shirts, priced at \$10 each; ignore the cost of producing the t- shirts). Subsequently, each year forever, you will increase the sale price of a t-shirt by the inflation rate of 2%, and each year you will sell 1% more t-shirts. If the project is risk free and the risk free rate is 5%, what is the most you would be willing to pay in startup costs, X, for this business? You can solve this using either the nominal or real approach. Nominal approach: The revenues are a forward starting growing perpetuity, where g = (1.02)(1.01) - 1= 0.0302 PV (revenues) = 10M/(0.05 – 0.0302) / (1.05^3) = \$436.28M. The most you would be willing to pay is \$436.28M as a startup cost for this business.
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MT 1 solution - MGCR 341 Finance 1 Summer 2010 Vadim di...

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