CHAPTER 2
Present Values, The Objectives of the Firm,
and Corporate Governance
Answers to Practice Questions
1.
The face value of the treasury security is $1,000.
If this security earns 5%, then
in one year we will receive $1,050.
Thus:
NPV = C
0
+ [C
1
/(1 + r)] =

$1000 + ($1050/1.05) = 0
This is not a surprising result because 5 percent is the opportunity cost of capital,
i.e., 5 percent is the return available in the capital market.
If any investment
earns a rate of return equal to the opportunity cost of capital, the NPV of that
investment is zero.
2.
NPV =

$1,300,000 + ($1,500,000/1.10) = +$63,636
Since the NPV is positive, you would construct the motel.
Alternatively, we can compute r as follows:
r = ($1,500,000/$1,300,000) – 1 = 0.1539 = 15.39%
Since the rate of return is greater than the cost of capital, you would construct the
motel.
3.
Investment
NPV
Return
(1)
$5,000
1.20
18,000
10,000
=
+

80.0%
0.80
10,000
10,000
18,000
=
=

(2)
$2,500
1.20
9,000
5,000
=
+

80.0%
0.80
5,000
5,000
9,000
=
=

(3)
$250
1.20
5,700
5,000

=
+

14.0%
0.14
5,000
5,000
5,700
=
=

(4)
$1,333.33
1.20
4,000
2,000
=
+

100.0%
1.00
2,000
2,000
4,000
=
=

a.
Investment 1, because it has the highest NPV.
b.
Investment 1, because it maximizes shareholders’ wealth.
1
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4.
a.
NPV = (

$50,000 + $20,000) + ($38,000/1.05) = $6,190.48
b.
NPV = (

$50,000 + $20,000) + ($38,000/1.10) = $4,545.45
In Part (a), the NPV is higher than the NPV of the office building ($5,000);
therefore, we should accept E. Coli’s offer.
In Part (b), the NPV is less than the
NPV of the office building, so we should not accept the offer.
You can also think of this in another way.
The true opportunity cost of the land is
what you could sell it for, i.e., $56,190 (or $54,545).
At $56,190, the office
building has a negative NPV.
At $54,545, the office building has a positive NPV.
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