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EC140 Chapter Notes - Chapter 28: Demand For Money, Yield Curve, Money Supply

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oliveoyster27
13 Apr 2016
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WLU
Department
Economics
Course
EC140
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All

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EC140 Full Course Notes
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Chapter 28: money, interest rates, and economic acivity. If there are a sequence of future payments: pv = [r1 / (1 + i)] + [r2 / (1 + i)2] + . The higher interest rate implies that any future payments are discounted at a higher rate and thus have a lower present value. The pv of any bond that promises a future payment or sequence of future payments is negaively related to the market interest rate. The pv of a bond is the most someone would be willing to pay now to own the bond"s future stream of payments. If market price is greater than pv quanity demanded will be very low causing the price to fall. If market price is less than pv quanity demanded will be high causing the price to rise. Equilibrium market price of any bond is the pv of the income stream that it produces.

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Related Questions

Dr. Harold Wolf of Medical Research Corporation (MRC) was thrilledwith the response he had received from drug companies for hislatest discovery, a unique electronic stimulator that reduces thepain from arthritis. The process had yet to pass rigorous FederalDrug Administration (FDA) testing and was still in the early stagesof development, but the interest was intense. He received the threeoffers described below this paragraph. (A 10 percent interest rateshould be used throughout this analysis unless otherwisespecified.)

Offer I $1,000,000 now plus $200,000 from year 6 through 15. Alsoif the product did over $100 million in cumulative sales by the endof year 15, he would receive an additional $3,000,000. Dr. Wolfthought there was a 70 percent probability this would happen.

Offer II Thirty percent of the buyer’s gross profit on the productfor the next four years. The buyer in this case was ZbayPharmaceutical. Zbay’s gross profit margin was 60 percent. Sales inyear one were projected to be $2 million and then expected to growby 40 percent per year.

Offer III A trust fund would be set up for the next 8 years. At theend of that period, Dr. Wolf would receive the proceeds (anddiscount them back to the present at 10 percent). The trust fundcalled for semiannual payments for the next 8 years of $200,000 (atotal of $400,000 per year).

The payments would start immediately. Since the payments are comingat the beginning of each period instead of the end, this is anannuity due. To look up the future value of an annuity due in thetables, add 1 to n (16 + 1) and subtract 1 from the value in thetable. Assume the annual interest rate on this annuity is 10percent annually (5 percent semiannually). Determine the presentvalue of the trust fund’s final value.

Required: Find the present value of each of the three offers andindicate which one has the highest present value.


d. TTC recently introduced a new line of products that has been wildly successful. On the basis of this          
success and anticipated future success, the following free cash flows were projected:              
                         
Year FCF (in millions)                      
1 $5.5                      
2 $12.1                      
3 $23.8                      
4 $44.1                      
5 $69.0                      
6 $88.8                      
7 $107.5                      
8 $128.9                      
9 $147.1                      
10 $161.3                      
                         
After the 10th year, TTC's financial planners anticipate that its free cash flow will grow at a constant rate          
of 6%. Also, the firm concluded that the new product caused the WACC to fall to 9%. The market value          
of TTC's debt is $1,200 million, it uses no preferred stock, and there are 20 million shares of common          
stock outstanding. Use the corporate valuation model approach to value the stock.              
                         
INPUT DATA: (Dollars in Millions)                      
WACC   9%                    
gn   6%                    
Millions of shares 20                    
MV of debt   $1,200                    
 
                       
Year                        
0 1 2 3 4 5 6 7 8 9 10 11  
FCF's $5.5 $12.1 $23.8 $44.1 $69.0 $88.8 $107.5 $128.9 $147.1 $161.3    
PV of FCF's
                   
     
   
 
 
     
     
     
 
 
                     
                         
PV of FCF1-10 =                        
HV at Year 10 of FCF after Year 10 = FCF11/(WACC – gn):                  
PV of HV at Year 0 = HV/(1+WACC)10:                    
                         
Sum = Value of the Total Corporation                      
Less: MV of Debt and Preferred                      
Value of Common Equity                      
                         
Number of Shares (in Millions) to Divide By:                    
                         
Value per Share = Value of Common Equity/No. Shares:     versus   using the discounted      
                dividend model      
                         
The price as estimated by the corporate valuation method differs from the discounted dividends method because          
different assumptions are built into the two situations. If we had projected financial statements, found both          
dividends and free cash flow from those projected statements, and applied the two methods, then the            
prices produced would have been identical. As it stands, though, the two prices were based on somewhat          
different assumptions, hence different prices were obtained. Note especially that in the FCF model we          
assumed a WACC of 9% versus a cost of equity of 10% for the discounted dividend model. That would obviously tend to        
raise the price.                        

I am having problems with this problem from my Econcoursework. Iunderstand how to do parts 1 and 2, but amhaving trouble with parts3 and 4. For part 3, how do I dothe calculation for an infiniteperiod? As the time becomeslonger the present value goes to zero,so do i assume a period, oris there an actual method for infiniteperiods? For part 4,do I simply do the sum for the future value andplug it into thePresent value equation? Not really looking for thesolutionhere, but I need some help getting the third and fourthpartssolved.

Congratulations! You just won the lottery! You can elect toreceiveyour prize in one of four
payment streams:
(i) $1,000,000 now
(ii) $1,500,000 at the end of five years
(iii) $60,000 per year in perpetuity (for ever), with paymentsmadeat the end of each year (so your
first payment comes one year from today)
(iv) $150,000 per year for the next ten years, with payments madeatthe end of each year (so your
first payment comes one year from today)

Suppose the annual interest rate is 5% with certainty andinperpetuity. Calculate the present value of
each of the four payment options (i.e., in today’s dollars).Rankfor four options from most to least
valuable. You can use Excel or a calculator to solve this, butyoumust show the formulas you use.