Module 2 Case Assignment

FIN301 - Principles of Finance

Dr. Alan Harper

March 5, 2011

Part I:

A. Suppose your bank account will be worth $15,000.00 in one year. The interest rate (discount rate) that the bank pays is 7%. What is the present value of your bank account today? What would the present value of the account be if the discount rate is only 4%?

Present Value at 7%

$15,000/1.07=$14,018.69

Present Value at 4%

$15,000/1.07=$14,423.08

B. Suppose you have two bank accounts, one called Account A and another Account B. Account A will be worth $6,500.00 in one year. Account B will be worth $12,600.00 in two years. Both accounts earn 6% interest. What is the present value of each of these accounts?

Account A

$6,500.00 /1.06=$6,132.08

Account B

$12,600.00 /1.062=$11,886.79

C. Suppose you just inherited an gold mine. This gold mine is believed to have three years worth of gold deposit. Here is how much income this gold mine is projected to bring you each year for the next three years: Year 1: $49,000,000

Year 2: $61,000,000

Year 3: $85,000,000

Compute the present value of this stream of income at a discount rate of 7%. Remember, you are calculating the present value for a whole stream of income, i.e. the total value of receiving all three payments (how much you would pay right now to receive these three payments in the future). Your answer should be one number - the present value for this gold mine at a 7% discount rate but you have to show how you got to this number.

At 7% discount rate

$49,000,000/(1.07)+ $61,000,000/(1.07)2+$85,000,000/(1.07)3=$168,459,474.48 $45,794,392.52 + $53,279,762.42 + $69,385,319.54

Now compute the present value of the income stream from the gold mine at a discount rate of 5%, and at a discount rate of 3%. Compare the present values of the income stream under the three discount rates and write a short paragraph with conclusions from the computations.

At %5 discount rate

$49,000,000/(1.05)+$61,000,000/(1.05)2+$85,000,000/(1.05)3=$175,421,660.73 $46,666,666.67 + $55,328,798.19 + $73,426,195.88

At %3 discount rate

$49,000,000/(1.03)+$61,000,000/(1.03)2+$85,000,000/(1.03)3=$182,858,207.04 $47,572,815.53 + $57,498,350.46 + $77,787,041.05

It is evident that the risk is higher at the higher discount rate, vice that of the lowest discount rate, whereas the risk is lowest. The present value of the gold mined is worth more today at the lowest discount rate, than that of the highest discount rate, in order to maintain the same stream of income from the gold each year.

Part II:

In my best intuition of evaluating each of the three business plans, I believe the risk to investors can be calculated as: * Ice Dreams Shaved Ice Beverage Business at low risk, providing for a low discount rate, * RJ Wagner and Assoc. Realty Real Estate Brokerage Business at high risk with a high discount rate, and * Interstate Travel Center Truck Stop Business at medium risk with a moderate discount rate Ice Dreams Shaved Ice Beverage Business

Though this business has a solid marketing analysis and plan, I feel it provides for a low discount rate as a low risk business. The owner's chance for success is high, based on relatively low cost for material, salary of employee (one), and advertising, thus, a low-cost product can be sold at a reasonable fee, while the profit margin is higher. Such example is the $1.00 for flavored shave ice, which only costs 19 cents to produce. This low cost product should remain stable in sales as economy relatively less affects sales of comfort foods (snacks, candy, ice cream, etc.). People need things that make them feel good in tough times, as these shave ice products are relatively inexpensive. The stress of being in debt leads people to overeat, rely on comfort foods and buy junk food because it's cheaper (Rose, 2009).

Though this business will have low...