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END OF CHAPTER EXERCISES - ANSWERS

Chapter 6 : Valuation Techniques

Q1 What is the relationship between ‘compounding’ and ‘discounting’?

A1
Compound interest is ‘interest-on-interest’.

The terminal value TV1 after 1 year of $100 invested today at t = 0 with interest paid quarterly
at R/4 is determined by interest-on-interest and TV1 = 100 (1 + R/4)4. Discounting is the
mirror image of compounding. So, if you were offered $TV1 in one year’s time then you would
be willing to give up $100 today. Hence $TV1 and $100 are equivalent amounts (but
measured at different dates).

Q2 Intuitively, why should you invest in a project if its NPV is positive?

A2
If the NPV of a project is positive, it implies that you can borrow the funds today, invest in the
project and the cash flows from the project will more than pay-off
• the interest payments at the end of each year and
• the capital cost of the project

Q3 What is the internal rate of return (IRR) of an investment project ? Can you discover
what assumptions IRR makes about the reinvestment rate for cash flows from the
project? (Hint: use a two period investment project).

A3
The IRR of a project attempts to measure “the percent return” on the project. The IRR is the
solution for y from:

V1 V2
[1.] KC = +
(1 + y ) (1 + y ) 2

where KC = capital cost, Vi (i = 1,2) = cash flows from the project at the end of years
1 and 2. Multiplying equation [1] by (1+y)2 gives :

[2.] KC (1+y)2 = V1 (1+y) + V2

The left hand side of equation [2] is the terminal value (at t = 2) of the capital cost. V1(1+y) is
the value of year-1 cash flows at t = 2 and V2 is simply the cash flows at t = 2. Hence the IRR
implicitly assumes that the cash flows in year-1 can be reinvested at the end of year-1 at the
rate y%. But y% is the yield calculated at t = 0 and there is no guarantee that at t = 1, the rate
at which you can reinvest V1 will still be equal to y (since interest rates may have risen or
fallen between t = 0 and t = 1).

Q4 What are the ‘payback period’ and the discounted ‘payback period’? Why are they a
poor guide to investment decisions?

A4

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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The payback period is the number of years over which the cash flows from the project are just
sufficient to cover the initial capital cost. The discounted payback period is similar but the
cash flows are discounted before adding up the number of years to pay off the loan. The
main defect of these methods is that in comparing two projects, you ignore any cash flows
which accrue after the payback period cut off point, of say 4 years. Hence an investment in
biotechnology which did not payback for 10 years would probably rank behind many other
projects, even though the biotechnology project may have very large cash flows many years
after the R&D period of 5-10 years.

Q5 You have won the National Lottery. Lottery officials now offer you the choice of the
following alternative pay-outs :

Alternative 1 : £160,000 1 year from now

Alternative 2 : £200,000 5 years from now

Which should you choose if the discount rate is 0%, 5% or 10% ?

A5
Discount Alternative I Alternative II Decision
rate
£160,000 £200,000
0% PV = PV = Alternative II
(1.00)1 (1.00) 5
= £ 160,000 = £ 200,000
£160,000 £200,000
5% PV = PV = Alternative II
(1.05)1 (1.05) 5
= £ 152,230.95 = £ 156,705.23
£160,000 £200,000
10 % PV = PV = Alternative I
(1.10)1 (1.10) 5
= £ 145,454.54 = £ 124,184.26

Q6 Suppose you are considering an investment in which you pay £5000 one year from
today and receive an annual income of £1500, £2000 and £2500 in the three years
that follow. Assume that the discount rate is 10% p.a. What is the Net Present Value,
(NPV) ?

Assume now that the first payment of £ 5000 is due today and you will receive £ 1500
in 1 years time, £2000 in 2 years time and £2500 in 3 years time. The discount rate is
still 10%. How would this change your answer ?

A6
NPV = -5000/(1.10)1 + 1500/(1.10)2 + 2000/(1.10)3 + 2500/(1.10)4
= -5000(0.9091) + 1500 (0.8264) + 2000 (0.7513) + 2500 (0.6830)
= -95.62

As the NPV is negative, the investment should not go ahead.

NPV = -5000 + 1500/(1.10)1 + 2000/(1.10)2 + 2500/(1.10)3

= -5000 + 1500(0.9091) + 2000 (0.8264) + 2500(0.6830)
= -105.18

The NPV is still negative, hence the investment should be rejected.

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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Q7 An investment project earns £110m at the end of the first year and £121m at the end
of the second year. The capital cost (today) is £200m. What is the internal rate of
return (IRR) of the project ?

If the cost of capital (i.e. cost of borrowing or hurdle rate for the project) is 12% should
you invest in the project ? Briefly explain the intuition behind your answer.

A7
The IRR is the discount rate which makes the NPV equal to zero.
NPV = 0 = -200 + 110/(1 + IRR)1 + 121/(1 + IRR)2

Here IRR = 10 %.
If the cost of capital is 12% and IRR = 10%, then you should not invest in this project. The
latter applies because the NPV would be negative and you could not pay off your interest on
the loan (at 12%) and the initial capital cost of 200.

Q8 PENSIONS AND VALUING BONDS

Your own personal pension fund has a capital value of £50,000 on your retirement
day and the fund is offering you the following deal. You receive a pension of £5000 at
the end of every year for the next 25 years, if you live that long. (This is your
guaranteed annuity, expressed in £’s p.a.) The current interest rate on ‘25-year
money’ is 8 % p.a. (This would be the yield on 25-year government bonds.) Your
pension must be in the form of an annuity payment and the pension fund cannot
invest your £50,000 in the stock market.

(a.) Is your pension fund offering you a good deal, if you live 25 years?
(b.) Assume your £5000 p.a. guaranteed pension, will ‘just cover’ the £50,000 you
have in your pension fund today, and therefore the pension fund will just break
even. Show that if your pension fund is to remain viable it expects you to die
after about 21 years.
(c.) If the yield (to maturity) on government bonds is 8%, what would be the price of a
government bond today, which pays out £5,000 p.a. in each of the next 21 years
(starting in 1-year’s time) ? In practice, how does your pension fund guarantee it
will be able to pay you £5,000 p.a. for the next 21 years?

A8
PV of pension annuity receipts:

25

∑ (1. 08 )
5000
i
= 5000 A (n, r)= £5,000( 10.6748) = £53,374
i=1

Value of money in your accumulated pension fund = £50,000 only.

This is a good deal for you, if you do live for 25 years. You get more (in PV terms) from your
pension annuity than the capital sum of £50,000 you provide to purchase the annuity.
However, if on average, your cohort of pensioners does live for 25 years, the pension
fund/insurance company will go into liquidation.

Hence, the pension fund believes you will really live to year ‘n’ where your capital sum of
£50,000 just matches the amount it expects to give to you over the next ‘n’ years, that is
where:

-£50,000 + 5000 A (n, 0.08) = 0

A (n,0.08) = 50,000/5,000 = 10

From ‘PV of annuity’ tables we see that A (21, 0.08) = 10.0168, so your pension fund sales-
person is a ‘shark’ and thinks you will be ‘actuarially dead’ and ‘in the box’ after only 21 years.
Tough. Or he could be incompetent and giving you a good deal, actuarially. But someone

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition

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else who has invested in the pension company will have to cross-subsidise you, if the pension
fund is not to collapse (Equitable Life, again).

If interest rates are 8%, then the price of a government bond with 21 years to maturity and
paying £5000 pa each year (starting at the end of the 1st year) would be £50,000 today. (i.e.
the DPV of the £5,000 p.a. discounted at 8%, i.e. P(bond) = A (n=21,r=0.08) x 5,000 =
£50,000). This is the bond the pension company would purchase on your behalf today, with
your £50,000 in your pension fund and this ensures it can provide you with your £5,000 pa for
the next 21 years (This is called ‘cash flow matching’).

© K. Cuthbertson and D. Nitzsche (2008) ‘Investments’, J. Wiley, 2nd edition