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Fundamentals of Corporate Finance PDF

Added on - 07 Oct 2021

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Question 1
1) Based on the given data, it is apparent that the liquidity is low for Investment 2 while it is
high for Investment 1. As a result, the liquidity risk premium would be higher for investment
2 when compared to investment 1. One of the determinants of interest rate on a given
investment is the liquidity risk premium. Since this is higher for Investment 2, hence interest
rate is also higher than investment 1 (Parrino and Kidwell, 2014).
2) In order to estimate the default rate premium consideration would be given to Investment 4
and Investment 5 which have the same maturity but different default risk. The difference in
the interest rates on these two investments should give a value of the default risk premium.
However, adjustment would need to be made for difference in liquidity and hence 0.5%
liquidity premium would be considered (Damodaran, 2015).
Hence, default risk premium = (6.5-4) -0.5 = 2%
3) The lower limit for r3 would be 2.5% since the liquidity and default risk of Investment 3 is
similar to Investment 2. However, investment 3 has a higher maturity compared to
investment 2 and hence the interest rate would be higher than 2.5% (Brealey, Myers and
Allen, 2014). The interest rate on investment 4 would become 4.5 % if the liquidity is made
low. After making this change, all the parameters of investment 4 would match with
investment 3 except the maturity. The maturity of investment 3 is lower than that of
investment 4 and hence the upper limit is 4.5 % and r3 would be lower than this (Petty et. al.,
Question 2
Based on the information provided, the payments of $ 20,000 each would be received at t=2,
t=3 and t=4. The objective is to find the cumulative value of the above cash flows at t=6
when the client would retire.
Amount at the time for retirement for payment received at t=2 is 20000*1.094= $ 28,231.63
Amount at the time for retirement for payment received at t=3 is 20000*1.093= $ 25,900.58
Amount at the time for retirement for payment received at t=4 is 20000*1.092= $23,762
Total amount at retirement = 28,231.63 + 25,900.58 + 23,762 = $77,894.21
Question 3
The formula for present value of annuity is indicated below (Damodaran, 2015).
Based on the given information, P = $100,000, r=5%, n=10
PV of annuity = 100000*(1-1.05-10)/0.05 = $ 772,173.5
Hence, the lump sum payment which must be accepted for forgoing the annuity is $
Question 4
The first step is to estimate the size of corpus that would be required when the child’s college
would begin. The relevant formula for estimating the present value of annuity due would be
used considering that the college expenses would be borne at the beginning of the year. This
formula is indicated below (Petty et. al., 2015).
Based on the given information, P = $20,000, n=4 years, r=5%
Hence, amount of funds required by the age of 18 = 20000 + 20000(1-1.05-4+1)/0.05 =
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