The exam is in two parts. The first, in-class, part is closed-book. The second, take-home, part consists of the Extended case study, `Welcome to the Real World', on pp. 255-260 of Fraser, Bernhardt, Jewkes and Tajima, and is due on Monday, February 28. The in-class exam is worth a total of 40 points, and the take-home is worth 60 points.
It's the ratio of debt to equity. If you expect the company to increase in value, high leverage will increase your personal gains; on the other hand, it will also increase your losses if the company loses value.
Questions 2-5 are about inflation. The inflation rate is f%, and on January 1, 2000, a real dollar and an actual dollar are worth exactly the same amount. (You'll need to know the difference between real and actual dollars in each question; since the two words are easily confused, it may help to remember that real dollars are also known as `constant dollars' or `now dollars', while actual dollars are also known as `then-current dollars' or `then dollars'.)
An actual dollar
100 real dollars
d
b
In 1981, the rules changed so that only 50% of the cost of an item bought in any given year could be included in the depreciation calculation for that year, the other 50% being included in the depreciation calculation for the subsequent year. This increased the tax burden on all companies affected.
See notes, ``The Company".
This can be solved using the (P/F,i,N) formula, but it's quicker and easier to use the Rule of 72: an investment doubles in 72/i years, where i is the interest rate.
This is the most important question on the quiz, and you should make sure you have a firm grasp of the principle involved. The principle is that as the interest rate grows, future cashflows become less and less visible. (You could envisage the interest rate as a kind of fog that obscures your view of the future.) So if at the poor visibility of 25% interest, the ten-years-distant payback from X looks as big as the next-eight-years payback from Y, then when the visibility improves to 20% interest, the payback from X will loom larger still.
It's definitely bad news for the retired CEO, unless her pension is inflation-linked.
I had been thinking of the insurance company as a life insurance company, in which case inflation is good news, since life insurance companies usually promise a fixed sum on death, and that sum can now be paid out in inflated dollars. But the question leaves open the possibility that the company insures against fire or theft; in which case, if the amount to be paid out is set at replacement cost, the news is nether good nor bad. (Since the replacement cost in real dollars will be constant.)
For the mortgage company, it's bad news: they've lent a sum of money in the past, and they're now going to get paid back in deflated dollars. (If the mortgages are variable-rate, they may be able to put the rates up to cushion the effect.)
A nominal annual rate of 12% compounded monthly is an effective monthly rate of 1%, compounded monthly. So the equivalent effective annual rate is (1.01)12-1.
Suppose the amount is x, then equate present worths:
x(P/F,0.07,5)=1000(P/A,0.07,12)
This is an effective interest rate of 4% per six months, so the accumulated amount will be 4000(F/P,0.04,40).
(d)
If the proposals being considered are the ONLY ones available, you need to consider which makes the best use of your TOTAl investment funds. It's better to get a medium rate of return on a large sum than an excellent rate of return on a small sum, if the latter choice leaves a lot of funds uninvested. To take this into account, you should do an incremental analysis.
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The present cost of the purchase is 800,000*CCTF. The value of the CCTF factor depends on the depreciation rate, according to the formula provided in the cribsheet. So you need to calculate 800,000(CCTF(20%)-CCTF(30%)).
Design A has an initial cost of $1,500,000, and will need to be overhauled every ten years at a cost of $200,000. Design B has an initial cost of $500,000, and requires $5,000 of maintenance at the end of evey year. Every fifth year it will require an additional major overhaul, costing $100,000, and every fifteenth year it will require an even more major overhaul, costing $150,000.
If the city's MARR is 5%, which design should they go with?
Just compare present worths over a suitable time frame. Thirty years is a good choice, since it's a multiple of the overhaul periods. Remember not to include the cost of overhauls in the thirtieth year, since these would cover a period beyond the time horizon.