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.)