Question

Ginny is endowed with $8million and is deciding whether to invest in a restaurant. Assume perfect capital markets with an interest rate of 6%.

Investment Option: 1, 2, 3, 4

Investment (millions): 2, 3, 4, 5

End of Year 1 Cash Flows (millions): 1.8, 4.3, 5.4, 5.2

End of Year 2 Cash Flows (millions): 1.8, 1.0, 1.4, 1.6

(i) List 4 perfect capital market assumptions.

(ii) Which investment option should Ginny choose? Why?

(iii) Which investment option can be eliminated from consideration? Why?

Ginny is actively pursuing another business venture as a ticket scalper. She estimates that for a $2 million investment in inventory she can resell her tickets for $6 million over the next two years (cash flows realized in exactly two years). Assume the same 6% interest rate.

(iv) What is the NPV of the Ticket Brokering venture?

(v) What is the new value of Ginny's Corporation?

(vi) Suppose Ginny does not have the $2million to start the new venture. Instead, she wants to raise equity capital by issuing 100,000 shares. What price will new investors be willing to pay?

Answer 1

You have asked two unrelated questions in the same post. Further, each of your questions have multiple sub parts. I have addressed all the sub parts of the first question. Please post the second question separately.

(i) List 4 perfect capital market assumptions.

The four assumptions are:

• Rational behavior of the capital market participants, absence of flotation costs on securities, tax-free world;
• No transactions costs on transaction of the securities, securities are infinitely divisible;
• Given investment policy; and,
• Perfect certainty in the capital market

(ii) Which investment option should Ginny choose? Why?

Please see the table below.Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

Ginny should choose investment option 3 as it has the highest NPV.

(iii) Which investment option can be eliminated from consideration? Why?

Please see the table below. This has been obtained by dividing the respective option's cash flow by dividing the amount of initial investment. Say for example, divided all the cash flows of option 1 by its initial investment of 2, that of option 2 by 3 and so on. We now have cash flows corresponding to $ 1 of investment in each of the options.

	1	2	3	4
Year 0	(1.00)	(1.00)	(1.00)	(1.00)
Year 1	0.90	1.43	1.35	1.04
Year 2	0.90	0.33	0.35	0.32

Clearly option 4 is masked by option 2 as it has lower cash flows in year 1 and 2 even though same initial investment. Hence, Investment option 4 can be eliminated.