# Lecture 1 Additional Q2 1 Essay

Submitted By thuanbau
Words: 457
Pages: 2

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