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	Investment (millions)	End of Year 1 CFs (millions)	End of Year 2 CFs (millions)
1	2	1.8	1.8
2	3	4.3	1.0
3	4	5.4	1.4
4	5	5.2	1.6

1. List 4 perfect capital market assumptions.

1.   ______________________________      2.   ______________________________

3.   ______________________________ 4.   _______________________________

2. Which investment option should Ginny choose?

3. 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.

4. What is the NPV of the Ticket Brokering venture?

5. What is the new value of Ginny’s Corporation?

6. Suppose Ginny does not have the $2 million 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

Answer:-

i)

The 4 perfect capital market assumptions are:-

1) There are no transaction costs
2) There are no taxes under consideration.
3) The market information available is for no cost and is every market participant has same information
4) There are no costs for financial distress
5) Due to large number of market participants that are buying and selling the stocks, no one buyer or seller can effect the price of the stock.

ii) Which investment option should Ginny choose?

We will calculate the NPV of all the 4 projects

Given the interest rate (r) = 6% and the total endowed fund =$ 8

# investment 1 option
Investment = $ 2 millions and CF1 = $ 1.8m and CF 2 =$ 1,8m
NPV = -$ 2 m + $ 1.8 m / 1.06 + $ 1.8 m / 1.06²
NPV = - $ 2 m + $ 1.698 m + $ 1.61 m
NPV = $ 1.308

# investment 2 option
Investment $3 millions and CF1 = $ 4.3 m and CF 2 =$ 1 m
NPV = - $ 3 m + $ 4.3 m / 1.06 + $ 1 m / 1.06²
NPV = -$3 m + 4.06 m + 0.89 m
NPV = $ 1.95 m

# investment 3 option
Investment = $ 4 millions and CF1 = $ 5.4 m and CF 2 =$ 1.4 m
NPV = - $ 4 m + $ 5.4 / 1.06 + $ 1.4 / 1.06²
NPV = - $ 4 m + $ 5.09 m + $ 1.25 m
NPV = $ 2.34

# investment 4 option

Investment = $ 5 millions and CF1 = $ 5.2 m and CF 2 =$ 1.6 m
NPV = -$ 5 m + $ 5.2 m / 1.06 + $ 1.6 m / 1.06³
NPV = -$ 5 m + $ 4.9 m + 1.32 m
NPV = $ 1.22 m

Since the endowed find is only $ 8 million therefore Ginny should choose the investment options which will maximize the NPV.

Investment # 2 and # 3 should be chosen as the total outlay is $ 3 and $ 4  
Total investment = $ 7 million
The total NPV = $ 1.95 + $ 2.34 = $ 4.29 m

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

Investment # 4 should be eliminated from consideration as it has an investment of $ 5 million which is the highest investment and the NPV of this project is least $ 1.22 among all the investment options. Therefore investment option 4 should not be considered.

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

Given the investment is $ 2 million and the realized cash flows inn exactly two years ie. Ginny will get $ 6 million t the end of two years and there will be no cash flow realized after 1 year and interest rate will be 6%.
NPV = - $ 2 m + ($ 6 m / 1.06)
NPV = - $ 2 m + $ 5.66
NPV = $ 3.66

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