Lecture 1 Additional Q2 1 Essay

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Lecture 1 Additional Q2 (a) From the market line, we can see that $4m in Period 1 becomes $5m in Period 2. This tells us that the market interest rate is (5-4)/4 = 25%. (b) The firm should invest $2.6m (the total amount available to the firm for either investment or a dividend payout) less $1.6m (from the optimal investment point - this is the amount to pay as a dividend) which gives $1 million. (c) This investment will be worth $3 million in Period 2, since this is the y-value of the optimal investment point (read this from the graph). (d) The average rate of return on this investment is $3m (total return - from (c)) less $1m (initial investment - from (b)) divided by $1m (initial investment). This gives $2m divided by $1m, which is 200%. (e) Marginal rate of return is equal to the market rate of return - this is where the firm is indifferent to whether it invests itself or gives the funds to shareholders for their own investment. In this case, it is 25% (from (a)). (f) PV of the investment can be calculated by taking the FV of the investment ($3m - from (c)) and discounting by the marginal rate of return (25% - from (e)). This is $3m/1.25 = $2.4m. Alternatively, you can calculate this by the limit on consumption (this is where the market line cuts the x-axis - $4m) less the amount of the dividend paid out ($1.6m - from the optimal investment point and needed to be identified in (b)). Therefore, $4m - $1.6m = $2.4m. (g) NPV is the PV of the investment less the initial investment. This is $2.4m (from (f)) less $1m (from (b), which gives $1.4m. Alternatively, it is also the difference between the limit of consumption (refer (f)) less the total amount available for
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