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Case 1 Discounted Cash Flow Analysis Discounted Cash Flow Analysis Davis, Michaels, and


Company 0


Copyright © 1994 The Dryden Press. 1 rights reserved.




1 Part I Fundamental Concepts Tom Davis was born and raised in San Francisco and served as a


Navy lieutenant in Vietnam. After his discharge he used the GI Bill to


attend NYU, where he received his degree in finance and held a


part-time job at Steel, Robbins, Hernandez, and Associates, a


regional brokerage firm headquartered in New York City. After


graduation he was offered a permanent position with Steel, which he


gladly accepted. While at the firm, Tom became friends with Gene


Michaels, a Stanford MBA who had been working as a financial


analyst with the company for just over a year. Although Tom enjoyed


his work, his ultimate goal was to open a financial consulting firm in


his hometown. After five years, Tom managed to save enough


commissions to realize his goal. He convinced Gene to become his


partner and to move to San Francisco to open their own financial


consulting firm, Davis, Michaels, and Company.


Davis, Michaels, and Company provides financial planning


services to upper-middle-class professionals. Basically, the firm


provides consulting services in the areas of income tax planning,


investment planning, insurance planning, estate planning, and


employee benefits planning for small, family-owned businesses. The


firm is heavily involved in the Chinese community where Tom has


close ties. Also, both he and Gene speak fluent Chinese. The firm


does not have a tax lawyer or CPA on its staff, so Tom and Gene hire


outside experts when a problem arises which they cannot handle,


but this is rare.


Business has been good, perhaps too good. Tom and Gene have


been working overtime to handle the load, and no end is in sight. In


fact, Tom recently turned away several potential customers because


he didn?t think that the firm could offer them the high degree of


personal service that it usually gives its customers. As a permanent


solution, he is talking to career resource center personnel at several




He hopes to hire a finance major who can start work


immediately after graduation, but that is still several months away.


In the meantime, Tom believes that Janet Ho, the firm?s top


secretary, can handle various financial analysis duties after turning


over some of her clerical duties to someone else. Janet has been


taking night courses in business at a community college, and she is


convinced that she can handle increased responsibilities. Tom has a


great deal of faith in Janet?she has been with the firm from the very


beginning, and her great personality and sound work ethic have


contributed substantially to the firm?s success. Still, Tom knows that


there is little room for error in this business. Customers must be


confident that their financial plans are soundly conceived and 2 Case 1 Discounted Cash Flow Analysis properly implemented. Any mistakes create instant mistrust, and the


word spreads quickly.


To make sure that Janet has the skills to do the job, Tom plans to


give her a short test. As far as Tom is concerned, the single most


important concept in financial planning, whether it be personal or


corporate, is discounted cash flow (DCF) analysis. He believes that if


Janet has solid skills in this area, then she will be able to succeed in


her expanded role with minimal supervision. The basis for the test is


an actual analysis that Tom is currently working on for one of his


clients. The client has $10,000 to invest with a goal of accumulating


enough money in 5 years to pay for his daughter?s first year of


college at a prestigious Ivy League school. He has directed Tom to


evaluate only fixed interest securities (bonds, bank certificates of


deposit, and the like) since he does not want to put his daughter?s


future at risk.


One alternative is to invest the $10,000 in a bank certificate of


deposit (CD) currently paying about 10 percent interest. CDs are


available in maturities from 6 months to 10 years, and interest can


be handled in one of two ways?the buyer can receive interest


payments every 6 months or reinvest the interest in the CD. In the


latter case, the buyer receives no interest during the life of the CD,


but receives the accumulated interest plus principal amount at


maturity. Since the goal is to accumulate funds over 5 years, all


interest earned would be reinvested.


However, Tom must also evaluate some other alternatives. His


client is considering spending $8,000 on home improvements this


year, and hence he would have only $2,000 to invest. In this


situation, Tom?s client plans to invest an additional $2,000 at the end


of each year for the following 4 years, for a total of 5 payments of


$2,000 each. A final possibility is that the client might spend the


entire $10,000 on home improvements and then borrow funds for his


daughter?s first year of college.


To check your skills at DCF analysis, place yourself in Janet?s


shoes and take the following test. Questions


1. Consider a 1-year, $10,000 CD.


a. What is its value at maturity (future value) if it pays 10.0


percent (annual) interest? 3 Part I Fundamental Concepts b. What would be the future value if the CD pays 5.0 percent?


If it pays 15.0 percent? c. The First National Bank of San Francisco offers CDs with a


10.0 percent nominal (stated) interest rate but compounded


semiannually. What is the effective annual rate on such a


CD? What would its future value be? d. Pacific Trust offers 10.0 percent CDs with daily


compounding. What is such a CD?s effective annual rate and


its value at maturity? e. What nominal rate would the First National Bank have to


offer to make its semiannual compounding CD competitive


with Pacific?s daily-compounding CD? 2. Now consider a 5-year CD. Rework Parts a through d of Question


1 using a 5-year ending date.


3. It is estimated that in 5 years the total cost for one year of


college will be $20,000.


a. How much must be invested today in a CD paying 10.0


percent annual interest in order to accumulate the needed


$20,000? b. If only $10,000 is invested, what annual interest rate is


needed to produce $20,000 after 5 years? c. If only $10,000 is invested, what stated rate must the First


National Bank offer on its semiannual compounding CD to


accumulate the required $20,000? 4 Case 1 Discounted Cash Flow Analysis 4. Now consider the second alternative?5 annual payments of


$2,000 each. Assume that the payments are made at the end of


each year.


a. What type of annuity is this? b. What is the future value of this annuity if the payments are


invested in an account paying 10.0 percent interest


annually? c. What is the future value if the payments are invested with


the First National Bank which offers semiannual


compounding? d. What size payment would be needed to accumulate $20,000


under annual compounding at a 10.0 percent interest rate? e. What lump sum, if deposited today, would produce the same


ending value as in Part b? f. Suppose the payments are only $1,000 each, but are made


every 6 months, starting 6 months from now. What would be


the future value if the 10 payments were invested at 10.0


percent annual interest? If they were invested at the First


National Bank which offers semiannual compounding? 5. Assume now that the payments are made at the beginning of


each period. Repeat the analysis in Question 4.


6. Now consider the following schedule of payments:


End of Year












5 Payment












4,000 a. What is the value of this payment stream at the end of Year


5 if the payments are invested at 10.0 percent annually? b. What payment today (Year 0) would be needed to


accumulate the needed $20,000? (Assume that the


payments for Years 1 through 5 remain the same.) 5 Part I Fundamental Concepts 7. Consider Bay City Savings Bank, which pays 10.0 percent


interest compounded continuously.


a. What is the effective annual rate under these terms? b. What is the future value of a $10,000 lump sum after 5


years? c. What is the future value of a 5-year ordinary annuity with


payments of $2,000 each? 8. The client is also considering borrowing the $20,000 for his


daughter?s first year of college and repaying the loan over a


four-year period. Assuming that he can borrow the funds at a


10 percent interest rate, what amount of interest and principal


will be repaid at the end of each year?


9. Assume that you are given a set of cash flows on a time line and


asked to find their present value. How would you choose the


discount rate to apply to these flows?


10. If you are using the Lotus 1-2-3 model, first examine the model


closely to see how it works and then complete the model. Don?t


hesitate to change input values to obtain a better grasp of the


model. Also, don?t forget to look at the graphs. After you are


thoroughly familiar with the model, write a short summary of


Lotus?s DCF capabilities. Include not only what spreadsheets can


do, but how they can be used in financial management decision


making. 6


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Sep 13, 2020





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