UNIVERSITY
OF MISSOURI-COLUMBIA April
14, 2003[1]
CHARLIE’S MAGAZINE
Evaluating
Investment Opportunities
Charlie has just
inherited some money. He will receive $2
million net after taxes today and $3 million net after taxes one year from
today. Charlie does not have any other
assets. For the purpose of this case, you are to assume that all future cash flows
are known with certainty (no risk whatsoever) as is an interest rate of 6
percent.
1. What is Charlie’s current wealth today? (Hint:
Do a Present Value calculation on his future payment, but not on the $2 million
he receives today.)
2. If he wanted to, how much could he spend
today? (Hint: Assume he can borrow at
6%.)
3. How much money can he spend one year from
today if he spends nothing today? (Hint: Assume he can invest at 6%.)
Suppose
that instead of having an inheritance in two stages, Charlie has an initial
inheritance of $4 million. He decides to
invest some the $4 million in Charlie
Magazine, which he will design, create, edit, and manage. The data below indicates the future cash
flows at the end of the year for Charlie
Magazine.
|
Current
Investment |
Future
Cash Flow (Year End) |
|
$1.0 million |
$1.8 million |
|
2.0
million |
3.3
million |
|
3.0
million |
4.4
million |
|
4.0
million |
5.4
million |
4. What is the optimal amount of the $4 million
should Charlie invest in his magazine? (Hint: Do Net Present Value calculations for each level of
investment and look for diminishing marginal returns.)
5. Suppose that Charlie has a strong preference
for spending his money now, and would like to spend $3.8 million immediately
(he has his eye on a yacht)?
a.
Can he
buy the yacht in light of the planned investment in Charlie Magazine?
b.
If so, what
is his best borrowing strategy?
6. Assume that Charlie does not have the $4
million inheritance, but still has the necessary skills to create, develop,
edit, and manage Charlie Magazine.
a.
Should
he still make an investment in the magazine, assuming that the only source of
financing is a bank loan, and how much should he borrow from the bank?
b.
If he
borrows the optimal amount, how much will his profit be?
7. Charlie forms a corporation at the end of the
magazine’s first year, the Charlie Corporation, and issues 200,000 shares of
stock in the corporation.
a.
Assuming
no inheritance, the optimal loan amount, and that his profit in #6b to be his
cash, what are the Charlie Corporation’s assets at the end of the year? (Hint:
Cash plus present value of the magazine).
b.
Assume
that Charlie is considering another investment, selling yachts on the
Internet. This project will require a
$2.5 million investment and will yield a future cash flow of $3.4 million (no
risk involved). Should Charlie make this
investment?
c.
Assume
that he does not want to use the corporation’s cash to finance the investment
and does not want to use debt (borrow money) to finance the project. Charlie wants to finance the Internet project
by issuing more stock. What is a share
of stock in the Charlie Corporation worth if he goes ahead with the Internet project?
(Hint: The current value of Charlie Corporation is cash plus the Present Value
of Charlie Magazine plus the Net
Present Value of the Internet project. Add
these three items and divide by 200,000 to get a share price.)
d.
How many
shares of stock will Charlie have to issue to raise $2.5 million to finance the
Internet project? (Hint: Divide the
share price into $2.5 million.)
8. If Charlie Corporation makes the investment
in the Internet project, what would the total assets of the Charlie Corporation
be? (Hint: Cash plus the Present Value
of Charlie Magazine plus the Present
Value of the Internet operation.)