Hansson

No. 3 (13-Oct @13h30)

Analysis of Financial Statements

Time Value of Money

An Introduction to Capital Investment Valuation

Irene will receive $3 million today and $3 million one year from today. Irene does not have any other assets. There are no transaction costs or taxes, and all potential creditors and investors have all relevant information about investment payoffs. All these assumptions together are sometimes summarized by saying the capital markets are “perfect.” In addition, assume that all future cash flows are known with certainty. For simplicity, assume that Irene lives in a world that lasts only one year, and the rate of interest is 7 percent.

1. 1.What is Irene’s current wealth (equivalently, what is the present value of her assets)? How much money can she spend and consume today? How much of the money can she spend and consume one year from today if she consumes nothing today?

2. Suppose that instead of having a two-period endowment, Irene has an initial endowment of $5 million. She decides to invest part of the $5 million in KoKob Restaurant which she will build and manage. The data below indicates the future cash flows (end of the year) that will result from an investment today. All payoffs are completely certain and known to all.

1. 2.How much of the $5 million should Irene invest in the restaurant? What happens to Irene’s wealth when she makes the investment in KoKob Restaurant?

1. 3.Suppose that Irene has a strong preference for current versus future consumption, and would like to consume at least $4.2 million immediately. Is this consumption possible, in light of the planned investment in KoKob Restaurant?

2. 4.Assume that Irene does not have the $5 million endowment to begin with, but still has the necessary skills to develop and operate KoKob’s Restaurant. Should she still make the investment in the restaurant, and if so, how much? Assume that the only source of financing is a bank loan.