As part of my continuous commitment to develop in-depth knowledge I started going through “Principles of Corporate Finance” by Brealey Myers and Allen 11th edition (ISBN-13 978-0-0771-5156-0).
This will take a while as the book is over 800 pages long and has plenty of problems sets, at the end of every chapter, which I am committed to solve. The interesting questions, worth discussion or an additional attention will be posted here.
To check myself I also bought Solutions Manual for Principles of Corporate Finance (Eleventh edition) prepared by Peter Crabb (ISBN 978-0-07-750247-8).
All solutions described here are by no means complete or correct. So any use will be at your own risk, although I would appreciate alternative solutions or discussion on the subject.
Chapter 1, page 17 (Appendix question):
Maximising shareholder value. Peter Cormack has $200,000 available to support consumption in periods 0 (now) and 1 (next year). Peter wants to consume exactly the same amount in each period. The interest rate is 8%. There is no risk.
a. How much should Peter invest, and how much can he consume in each period?
b. Suppose Peter is given opportunity to invest up to $200,000 at 10% risk free. The interest rate stays at 8%. What should he do, and how much can he consume in each period?
Answers and thoughts
a. Peter should invest it all. If he invest 8%, he can either consume $200,000 now or $216,000 a year from now. To calculate equal consumption (C) in both year, we need to use formula C=(200,000-C)*1.08, which will gives us C=103,846.
Note: remaining money (200,000-103,856) invested at 8% will generate 103,846 at the end of the first year.
b. Investing it all at 10% will generate 220,000 at the end of the year. If Peter decides to consume all now, he could consume 200,000*1.10/1.08=$203,703.7
Note: This has very important assumption, that we are in well functioning capital markets in which you can borrow and lend at the same rate. As interest rate is 8%, it is assumed that you could easily sell your $220,000 at its present value, which at 8% interest is $203,703.7
To calculate equal consumption C =(203,703.7-C)*1.08 C=105,769.23 (There is small discrepancy between the solution manual and this number).
(203,703.7-105,769.23)*1.08=105,769.23 at the end of the first year.
Calculate present value of financial independence nest egg. Historical market rate over the long (long) period of time was 7%, while inflation is 4%. This leaves at real growth of about 3% a year.
Should I retire in 30 years and have no further investment in my portfolio, how much money will have for my retirements? 482,000*(1+.03)30=482,000*2.42=$1,169 in the current money. This should give $47,000 a year for 25 years.