Fundamentals of Corporate Finance

Third European Edition

Solutions Manual
Chapter 4

BASIC

1. Simple Interest versus Compound Interest First City Bank pays 8 per cent simple
interest on its savings account balances, whereas Second City Bank pays 8 per cent
interest compounded annually. If you made a £10,000 deposit in each bank, how much
more money would you earn from your Second City Bank account at the end of 10
years?
Answer: The simple interest per year is:

£10,000 × 0.08 = £800

So after 10 years you will have:

£800 × 10 = £8,000 in interest.

The total balance will be £10,000 + £8,000 = £18,000

With compound interest we use the future value formula:

FV = PV(1 +r)t
FV = £10,000(1.08)10 = £21,589.25

The difference is:

£21,589.25 – £18,000 = £3,589.25

2. Calculating Future Values Calculate the future value of a £100 cash flow for the
following combinations of rates and times.
a) r = 8%; t = 10 years
£ 215.89
b) r = 8%; t = 20 years
£ 466.10
c) r = 4%; t = 10 years
£ 148.02
d) r = 4%; t = 20 years
£ 219.11

Answer:

a) FV = PV (1 + r)t = 100 x (1.08)10 = £215.89

b) FV = PV (1 + r)t = 100 x (1.08)20 = £466.10
c) FV = PV (1 + r)t = 100 x (1.04)10 =£148.02

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

d) FV = PV (1 + r)t = 100 x (1.04)20 = £219.11

3. Calculating Present Values Calculate the present value of a £100 cash flow for the
following combinations of rates and times.
a) r = 8%; t = 10 years
£ 46.32
b) r = 8%; t = 20 years
£ 21.45
c) r = 4%; t = 10 years
£ 67.56
d) r = 4%; t = 20 years
£ 45.64

Answer:

a) PV = FV / (1 + r)t = 100 / (1.08)10 = £46.32

b) PV=FV / (1 + r)t = 100 / (1.08)20 = £21.45
c) PV=FV / (1 + r)t = 100 / (1.04)10 = £67.56
d) PV=FV / (1 + r)t = 100 / (1.04)20 = £45.64

4. Calculating Interest Rates Solve for the unknown interest rate in each of the following:

Present value (£) Years Interest rate (%) Future value (£)
240 3 297
360 11 1,080
39,000 12 185,382
38,261 50 531,618

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1

FV = £297 = £240(1 + r)3; r = (£297 / £240)1/3 – 1 = 7.36%

FV = £1,080 = £360(1 + r)11; r = (£1,080 / £360)1/11 – 1 = 10.50%
FV = £185,382 = £39,000(1 + r)12; r = (£185,382 / £39,000)1/12 – 1 = 13.87%
FV = £531,618 = £38,261(1 + r)50; r = (£531,618 / £38,261)1/50 – 1 = 5.40%

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

5. Calculating the Number of Periods Solve for the unknown number of years in each of
the following:

Present value (NKr) Years Interest rate (%) Future value (NKr)
560 10 1,284
810 7 4,341
18,400 15 364,518
21,500 12 173,439

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

FV = Nkr1,284 = Nkr560(1.10)t; t = ln(Nkr1,284/ Nkr560) / ln 1.10 = 8.71 years

t
FV = Nkr4,341 = Nkr810(1.07) ; t = ln(Nkr4,341/ Nkr810) / ln 1.07 = 24.81 years
FV = Nkr364,518 = Nkr18,400(1.15)t; t = ln(Nkr364,518 / Nkr18,400) / ln 1.15 = 21.37 years
FV = Nkr173,439 = Nkr21,500(1.12)t; t = ln(Nkr173,439 / Nkr21,500) / ln 1.12 = 18.42 years

6. Calculating Interest Rates Assume the total cost of a university education will be
€290,000 when your child enters college in 18 years. You currently have €40,000 to
invest. What annual rate of interest must you earn on your investment to cover the
cost of your child’s university education?

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = (€290,000 / €40,000)1/18 – 1 = .1163 or 11.63%

7. Calculating the Number of Periods At 6 per cent interest, how long does it take to
double your money? To quadruple it?

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

Answer: To find the length of time for money to double, triple, etc., the present value and
future value are irrelevant as long as the future value is twice the present value for doubling,
three times as large for tripling, etc. To answer this question, we can use either the FV or the PV
formula. Both will give the same answer since they are the inverse of each other. We will use
the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

The length of time to double your money is:

FV = £2 = £1(1.06)t
t = ln 2 / ln 1.06 = 11.90 years

The length of time to quadruple your money is:

FV = £4 = £1(1.06)t
t = ln 4 / ln 1.06 = 23.79 years

Notice that the length of time to quadruple your money is twice as long as the time needed to
double your money (the difference in these answers is due to rounding). This is an important
concept of time value of money.

8. Calculating Interest Rates In 2017 the average price per metre for owner-occupied
flats in Copenhagen was about 23,000 Danish kroner. In 1998 the average price was
around 6,000 Danish kroner. What was the annual increase in selling price?
Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = (Dkr23,000 / Dkr6,000)1/19 – 1 = .0733 or 7.33%

9. Calculating the Number of Periods You’re trying to save to buy a new €170,000
Ferrari. You have €40,000 today that can be invested at your bank. The bank pays 5 per
cent annual interest on its accounts. How long will it be before you have enough to buy
the car?

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

t = ln (€170,000 / €40,000) / ln 1.05 = 29.66 years

10. Calculating Present Values Imprudential plc has an unfunded pension liability of £800
million that must be paid in 20 years. To assess the value of the firm’s equity, financial
analysts want to discount this liability back to the present. If the relevant discount rate
is 7 per cent, what is the present value of this liability?

Answer: To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = £800,000,000 / (1.07)20 = £206,735,202

11. Calculating Present Values You have just received notification that you have won the
€1 million first prize in the Euro Lottery. However, the prize will be awarded on your
100th birthday (assuming you’re around to collect), 80 years from now. What is the
present value of your windfall if the appropriate discount rate is 12 per cent?
Answer: To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = €1,000,000 / (1.12)80 = €115.49

12. Calculating Future Values Your coin collection contains fifty 1952 silver dollars. If your
grandparents purchased them for their face value when they were new, how much will
your collection be worth when you retire in 2057, assuming they appreciate at a 4.5
per cent annual rate?
Answer: To find the FV of a lump sum, we use:

FV = PV(1 + r)t
FV = $50(1.045)105 = $5,083.71

13. Calculating Interest Rates and Future Values In 1968 prize money for the Wimbledon
Tennis Championships was first awarded. The winner of the men’s singles was £2,000
and for the ladies’ singles it was £750. In 2016 both winners received £850,000. What
was the percentage increase per year in the winner’s cheque for men and women over
this period? If the winner’s prize increases at the same rate, what will the men’s and
ladies’ singles tournament winners receive in 2040?

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, for men we get:

r = (FV / PV)1 / t – 1
r = (£850,000 / £2,000)1/41 – 1 = .1591 or 15.91%

Solving for r, for women we get:

r = (FV / PV)1 / t – 1
r = (£850,000 / £750)1/41 – 1 = .1871 or 18.71%

To find the FV of the men’s prize, we use:

FV = PV(1 + r)t
FV = £850,000(1.1591)31 = £82,553,860 (based on unrounded values)

To find the FV of the women’s prize, we use:

FV = PV(1 + r)t
FV = £850,000(1.1871)31 = £173,305,085 (based on unrounded values)

14. Calculating Interest Rates In 2017 a gold Morgan dollar minted in 1895 sold for
$28,786. For this to have been true, what rate of return did this coin return for the
lucky numismatist? Assume interest is calculated annually.

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t
T = 2013 – 1895 = 118 years

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($28,786 / $1)1/118 – 1 = .0909 or 9.09%

15. Calculating Rates of Return On 8 February 2009 John Madejski, chairman of Reading
Football Club, sold the Edgar Degas bronze sculpture Petite Danseuse de Quatorze Ans
at auction for a world record price of £13.3 million. He bought the statue in 2004 for £5
million. What was his annual rate of return on this sculpture?

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = (£13,300,000 / £5,000,000)1/5 – 1 = 21.6%

INTERMEDIATE

16. Calculating Rates of Return Consider again the security issue by Spanish Word Ltd that
in return for receiving £24,099 today from investors, they will pay back £100,000 in 30
years.
(a) Based on the £24,099 price, what rate was Spanish Word paying to borrow
money?
(b) Suppose that in 2020 this security’s price is £38,260. If an investor had purchased
it for £24,099 in 2014 and sold it in 2020, what annual rate of return would she
have earned?
(c) If an investor had purchased the security at market in 2020, and held it until it
matured, what annual rate of return would she have earned?

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1

a. PV = £100,000 / (1 + r)30 = £24,099

r = (£100,000 / £24,099)1/30 – 1 = .0486 or 4.86%

b. PV = £38,260 / (1 + r)6 = £24,099

r = (£38,260 / £24,099)1/6 – 1 = .0801 or 8.01%

c. PV = £100,000 / (1 + r)18 = £38,260

r = (£100,000 / £38,260)1/18 – 1 = .0548 or 5.48%

17. Calculating Present Values Suppose you are still committed to owning a €170,000
Ferrari (see Problem 21). If you believe your mutual fund can achieve a 12 per cent
annual rate of return and you want to buy the car in 9 years on the day you turn 30,

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

how much must you invest today?

Answer: To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = €170,000 / (1.12)9 = €61,303.70

18. Calculating Future Values You have just made your first £4,000 contribution to your
retirement account. Assuming you earn a 10 per cent rate of return and make no
additional contributions, what will your account be worth when you retire in 45 years?
What if you wait 10 years before contributing? (Does this suggest an investment
strategy?)

Answer: To find the FV of a lump sum, we use:

FV = PV(1 + r)t

FV = £4,000(1.10)45 = £291,561.93

FV = £4,000(1.10)35 = £112,409.75

The calculations show that one should start investment early.

19. Calculating Future Values You are scheduled to receive £30,000 in two years. When
you receive it, you will invest it for six more years at 8.4 per cent per year. How much
will you have in eight years?
Answer: We need to find the FV of a lump sum. However, the money will only be invested for
six years, so the number of periods is six.

FV = PV(1 + r)t
FV = £30,000(1.084)6 = £48,673.99

20. Calculating the Number of Periods You expect to receive €10,000 at graduation in two
years. You plan on investing it at 10 per cent until you have €75,000. How long will you
have to wait from now?

Answer: To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

t = ln(€75,000 / €10,000) / ln(1.10) = 21.14

So, the money must be invested for 21.14 years. However, you will not receive the money for
another two years. From now, you’ll wait:

2 years + 21.14 years = 23.14 years

CHALLENGE

21. Balloon Payments On 1 September 2012, Susan Chao bought a motorcycle for
£15,000. She paid £1,000 down and financed the balance with a 5-year loan at a stated
annual interest rate of 9.6 per cent, compounded monthly. She started the monthly
payments exactly one month after the purchase (i.e., 1 October 2012). Two years later,
at the end of October 2014, Susan got a new job and decided to pay off the loan. If the
bank charges her a 1 per cent prepayment penalty based on the loan balance, how
much must she pay the bank on 1 November 2014?

Answer: Since she put £1,000 down, the amount borrowed will be:

Amount borrowed = £15,000 – £1,000 = £14,000

So, the monthly payments will be:

PVA = C({1 – [1/(1 + r)]t } / r )

£14,000 = C[{1 – [1/(1 + .096/12)]60 } / (.096/12)]

C = £294.71

The amount remaining on the loan is the present value of the remaining payments.
Since the first payment was made on October 1, 2012, and she made a payment on
October 1, 2014, there are 35 payments remaining, with the first payment due
immediately. So, we can find the present value of the remaining 34 payments after
November 1, 2014, and add the payment made on this date. So the remaining
principal owed on the loan is:

PV = C({1 – [1/(1 + r)]t } / r ) + C0

PV = £294.71[{1 – [1/(1 + .096/12)]34 } / (.096/12)] + £294.71
C = £9,037.33

She must also pay a one per cent prepayment penalty, so the total amount of the
payment is:

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

Total payment = Amount due(1 + Prepayment penalty)

Total payment = £9,037.33(1 + .01)
Total payment = £9,127.71

22. Interest You receive a credit card application from Shady Banks plc offering an
introductory rate of 1.90 per cent per year, compounded monthly for the first six
months, increasing thereafter to 16 per cent per year compounded monthly. Assuming
you transfer the £4,000 balance from your existing credit card and make no
subsequent payments, how much interest will you owe at the end of the first year?

Answer: Here, we need to find the FV of a lump sum, with a changing interest rate. We must
do this problem in two parts. After the first six months, the balance will be:
FV = £4,000 [1 + (.019/12)]6 = £4,038.15
This is the balance in six months. The FV in another six months will be:
FV = £4,038.15 [1 + (.16/12)]6 = £4,372.16
The problem asks for the interest accrued, so, to find the interest, we subtract the beginning
balance from the FV. The interest accrued is:
Interest = £4,372.16 – 4,000.00 = £372.16

23. Future Values Your job pays you only once a year for all the work you did over the
previous 12 months. Today, December 31, you just received your salary of £100,000,
and plan to spend all of it. However, you have also decided to join the company’s
employee pension scheme. Under the very generous scheme, your company
contributes £2 for every £1 that you pay into the pension. You have decided that one
year from today you will begin paying 2 per cent of your annual salary into the pension
in which you are guaranteed to earn 8 per cent per year. How much money will you
have on the date of your retirement 40 years from today?

Answer:
Step 1: Determine the total contribution
2% of annual salary = £100,000 x 0.02 = £2,000
Company contribution (£2 for every £1) = 2 x £2,000 = £4,000
Total contribution = £6,000
The question indicates there is 0% salary increase per year, the total contribution one year
hence:
= £6,000 x 1 = £6,000

Step 2: Determine the PV of Growing Annuity:

1 1 1+g
PV = C × – ×
r–g r–g 1+r

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

PV = £6,000 x [1/(0.08-0)) – ((1/0.08-0))*((1+0)/(1+0.08))40]

PV = £6,000 x 11.92461333
PV = £71,547.68

Step 3: Determine the amount on retirement 40 years from today

FV = £71,547.68 (1+0.08)40 = £1,554,339.11

24. Present Values A 3-year annuity of six £5,000 semiannual payments will begin 10 years
from now, with the first payment coming 10.5 years from now. If the discount rate is
10 per cent compounded monthly, what is the current value of the annuity?

Answer: The cash flows in this problem are semi-annual, so we need the effective semi-annual
rate. The interest rate given is the stated rate, so the monthly interest rate is:
Monthly rate = .10 / 12 = .008333
To get the semi-annual interest rate, we can use the EAR equation, but instead of using 12
months as the exponent, we will use 6 months. The effective semi-annual rate is:

Semi-annual rate = (1.008333)6 – 1 = 5.11%

We can now use this rate to find the PV of the annuity. The PV of the annuity is:

PVA @ t = 10:

Note, that this is the value one period (six months) before the first payment, so it is the value at
t = 10. So, the value today is: PV @ t = 0: £25,289.43 / 1.051120 = £9.333.80

Mini-Case

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

Questions 1 - 3
Hreon SA is an online technology company that provides services in outdated programming
languages. As software upgrades, older languages such as VAX become obsolete. However,
many organizations still have systems that use these languages and can’t afford to purchase
completely new systems. This emerging sector is entering the growth phase of development
and so Hreon is considering an increase in its capability effectiveness.
Since the firm has little free cash, it will need to borrow funds to support its investment. The
problem facing Hreon is how much to borrow. The company has decided that an appropriate
discount rate for its investment is 15 per cent and it wishes to increase its annual cash flows
beginning one year from now by €250,000. Because of competition, it is not anticipated that
the increased cash flows will last beyond ten years.

1. Hreon SA assumes that they will achieve an increase in cash flow of €250,000 for 10
years. Why is €250,000 in year 10 actually worth less than €250,000 in year 1?

 Because of the time value of money

 Because of exchange rate risk
 It is not worth less

Explanation:

The €250,000 in year 10 is worth less than €250,000 in year 1 because of the time value of
money. As a result, the present value of the cash flow in year 10 will be less than the present
value of the cash flow in year 1:
Year 1 = €250,000/1.151 = €217,391.30
Year 10 = €250,000/1.1510 = €61,796.17

2. Hreon SA is assuming a discount rate of 15%. If they reassessed this and discovered that
the discount rate should be 10%, what would this mean for the profitability of the investment?

 It is worth more
 The value won’t change
 It is worth less

Explanation:

If the discount rate was to be reduced to 10% then the present value of the project would
increase because: PV = CFt/(1+r)t
PV = €250,000/1.151 = €217,391.30
PV = €250,000/1.101 = €227,272.72

3. Aside from the time value of money effect, what other factor influences how future
cash flows are viewed?

 Nothing, all cash flows are equal

© McGraw-Hill Education 2017

Fundamentals of Corporate Finance
Third European Edition

 Risk and uncertainty

 Marketing
 Credit

Explanation:

Aside from the time value of money, cash flows that occur further into the future are subject to
a much higher degree of risk and uncertainty. It is very difficult, if not impossible, to accurately
predict the future and so it is only a very rough approximation that the cash flow in year 10 for
Hreon SA will actually come into the business.

© McGraw-Hill Education 2017