Assignment

On

Chapter 8: Risk and Return

Exercises 1 to 6
Problems 1 to 31

Prepared for:

Yousuf Harun Fuad

Assistant Professor
Course Teacher
Course Title: Corporate Finance
Course Code: FNB 208

Prepared by:

Shahriar Mridha
Student Id. 1664
7th Batch
BBA Program
Department of Finance & Banking
Faculty of Business Studies
Jahangirnagar University
Savar, Dhaka- 1342

May 16, 2018

The MBA Decision

Ben Bates graduated from college six years ago with a finance undergraduate degree. Although
he is satisfied with his current job, his goal is to become an investment banker. He feels that an
MBA degree would allow him to achieve his goal. After examining schools, he has narrowed his
choice to either Wilton University or Mount Perry College. Although internships are encouraged
by both schools, to get class credit for the internship, no salary can be paid. Other than
internships, neither school will allow its students to work while enrolled in its MBA program.

Ben currently works at the money management firm of Dewey and Louis. His annual salary at
the firm is $55,000 per year, and his salary expected to increase at 3 % per year until retirement.
He is currently 28 years old and expects to work for 38 more years. His current job includes a
fully paid health insurance plan, and his current average tax rate is 26 %. Ben has savings
account with enough money to cover the entire cost of his MBA program.
The Ritter College of Business at Wilton University is one of the top MBA programs in the
country. The MBA degree requires two years of full time enrollment at the university. The
annual tuition is $63,000, payable at the beginning of each school year. Books and other supplies
are estimated to cost $2500 per year. Ben expects that after graduation from Wilton, he will
receive a job offer for about $98,000 per year, with a $15,000 signing bonus. The salary at this
job will increase at 4 % per year. Because of the higher salary, his average income tax rate will
increase to 31 %.
The Bradley School of Business at Mount Perry College began its MBA program 16 years ago.
The Bradley School is smaller and less well known than the Ritter College. Bradley offers an
accelerated, one – year program, with a tuition cost of $80,000 to be paid upon matriculation.
Books and other supplies for the program are expected to cost $3,500. Ben thinks that he will
receive an offer of $81,000 per year upon the graduation, with an $10,000 signing bonus. The
salary at this job will increase at 3.5 % per year. His average tax rate at this level of income will
be 29 %.
Both schools offer a health insurance plan that will cost $3,000 per year, payable at the
beginning of the year. Ben also estimates that room and board expenses will cost $20,000
moreper year at both schools than his current expenses, payable at the beginning of each year.
The appropriate discount rate is 6.5 percent.
Questions:

1. How does Ben’s age affect his decision to get an MBA?

Answer: Ben graduated 6 years ago, as a Finance Major, and has a goal to become an
investment banker. Ben’s age is one of the critical factors affecting his decision to get an MBA,
because of following reasons:
1) His age determines how much longer he can work.
2) Time is a critical factor for him to retire safely at an early age.
3) Lose of opportunity of potentially higher earnings as time passes or age increases.
4) Being away from studies for many years can cause difficulty in getting back into the study
mode, and
5) Adjustments to the rigors of an MBA program increases with age.
Analysis: He graduated from college six years ago at an age of 22 years, and he is now 28 years
old, which is the standard age to get an MBA, and it will help Ben to achieve his goal faster in
short time. Assuming that he wants to work for 38 years more, he must decide to get his MBA as
early as possible, so that within 1 or 2 years (depending on school he chooses), he can graduate
with MBA, and soon start his career of investment banker at age of 29 or 30 years, and then he
can safely retire at age of 69 or 70.
Secondly Ben must evaluate the cost of completing a MBA program against the higher earning
potential after graduating. Working at East Coast Yachts only pays him $55,000/ year, with
expected 3% increases per year until retirement. If he earns his MBA, he would qualify to get job
offer from $78,000 or $90,000 per year (depending on school he chooses), with 4% increases in
salary per year. So, looking to these figures, the earning potential after completing his MBA,
would play an important role for his life, if he completes MBA at early age.
Thirdly, MBA program combines high-quality core curriculum with the finance specialization
curriculum that is consistently updated to ensure real-world relevancy to today global
marketplace. In MBA program, Ben has to face the problems such as dissimilar subject,
communication, and teamwork. So, the willingness of Ben to overcome all these strictness, and
challenges, in this age is important.
Finally, Ben was away from studies for many years, which is an additional and very difficult
point to get him back into the study mode.
2. What other, perhaps no quantifiable factors affect Ben’s decision to get an MBA?
Answer: In case of Ben, there can be perhaps a list of Non-quantifiable factors that can affect
Ben’s decision to get an MBA, such as:
1) Family: Whether or not he is married, and if he has any children. With a spouse and/or child,
he may be less inclined to go for an MBA (especially full-time), since his family may be less
willing to the time, and money, constraints imposed by classes. His family should consider that
increased earning potential associated with MBA can help him to take better care of family.

2) Necessity to alter his attitude and divert it towards education: Since he had a 6-year gap from
university or study, this can be an important factor in his decision to go for study.

3) Necessity of at least two years experiences in respective field of his MBA specialization:
Assuming that Ben has already worked for about six years since graduated from college, he
would be having this job experience.

4) Willingness to continue the study: If he is eager to continue the study, he will continue the
study. But if he has not willingness to study, he could do anything else, for example having jobs
that would pay more or open his own business.

5) The value he attaches to education: Completing a higher degree or a sense of accomplishment

may positively affect his decision. On the other hand, the stress of an MBA program, the time
commitment, or the intellectual challenge may be negative factors in Ben’s decision-making
process.

6) Considering the geographical diversity: He has to consider the location of his preferred
university.8) other factors such as desire to pursue an MBA, job satisfaction, and the prestige of
a job, regardless of the salary, may play role in his decision for MBA studies.
3. Assuming all salaries are paid at the end of each year, what is the best option for Ben –
from a strictly financial standpoint?

Answer: My opinion is there are three options have to be calculated:

Remain at current job:

After-tax salary = $55,000(1 – .26) = $40,700

His salary will grow at 3 percent per year, so the present value of his after-tax salary is:

PV = C {1 – [(1 + g)/ (1 + r)]t} / (r – g)]

PV = $40,700{[1 – [(1 +.065)/ (1 + .03)]38} / (.065 – .03)
PV = $836,227.34

Wilton MBA:

Costs:

Total direct costs = $63,000 + 2,500 + 3,000 = $68,500

PV of direct costs = $68,500 + 68,500 / (1.065) = $132,819.25

PV of indirect costs (lost salary) = $40,700 / (1.065) + $40,700(1 + .03) / (1 + .065)2 =

$75,176.00

Salary:

PV of after-tax bonus paid in 2 years = $15,000(1 – .31) / 1.0652 = $9,125.17

After-tax salary = $98,000(1 – .31) = $67,620

His salary will grow at 4 percent per year. We must also remember that he will now only work for
36 years, so the present value of his after-tax salary is:

PV = C {1 – [(1 + g)/ (1 + r)]t} / (r – g)]

PV = $67,620{[1 – [(1 +.065)/ (1 + .04)]36} / (.065 – .04)
PV = $1,554,663.22

Since the first salary payment will be received three years from today, so we need to discount
this for two years to find the value today, which will be:

PV = $1,544,663.22 / 1.0652
PV = $1,370,683.26

So, the total value of a Wilton MBA is:

Value = –$75,160 – 132,819.25 + 9,125.17 + 1,370,683.26 = $1,171,813.18

Mount Perry MBA:

Costs:

Total direct costs = $78,000 + 3,500 + 3,000 = $86,500. Note, this is also the PV of the direct
costs since they are all paid today.

PV of indirect costs (lost salary) = $40,700 / (1.065) = $38,215.96

Salary:

PV of after-tax bonus paid in 1 year = $10,000(1 – .29) / 1.065 = $6,666.67

After-tax salary = $81,000(1 – .29) = $57,510
His salary will grow at 3.5 percent per year. We must also remember that he will now only work
for 37 years, so the present value of his after-tax salary is:

PV = C {1 – [(1 + g)/ (1 + r)]t} / (r – g)]

PV = $57,510{[1 – [(1 +.065)/ (1 + .035)]37} / (.065 – .035)
PV = $1,250,991.81

Since the first salary payment will be received two years from today, so we need to discount
this for one year to find the value today, which will be:

PV = $1,250,991.81 / 1.065
PV = $1,174,640.20

So, the total value of a Mount Perry MBA is:

Value = –$86,500 – 38,215.96 + 6,666.67 + 1,174,640.20 = $1,056,590.90

Comparing all the results my opinion is for him the best choice is having study at Wilton
University.

4. Ben believes that the appropriate analysis is to calculate the future value of each option.
How would you evaluate this statement?

Answer: Ben is somewhat correct. Calculating the future value of each option will result in an
option with the highest present value, having the highest future value. Thus, a future value
analysis will result in the same decision. But, his statement that a future value analysis is the
correct method is wrong, because net present value analysis will give the correct answer as well.
5. What initial salary would Ben need to receive to make him indifferent between attending
Wilton University and staying in his current position? Assume his tax rate after graduating
from Wilton University will be 31 percent regardless of his income level.

Answer: To find the salary offer he would need to make the Wilton MBA as financially
attractive as the as the current job, we need to take the PV of his current job, add the costs of
attending Wilton, and the PV of the bonus on an after-tax basis. So, the necessary PV to make
the Wilton MBA the same as his current job will be:

PV = $836,227.34 + 132,819.25 + 75,176.00 – 9,125.17 = $1,035,097.42

This PV will make his current job exactly equal to the Wilton MBA on a financial basis.
Since his salary will still be a growing annuity, the after-tax salary needed is:

PV = C {1 – [(1 + g)/ (1 + r)]t} / (r – g)]

$1,035,097.42 = C {[1 – [(1 +.065)/ (1 + .04)]36} / (.065 – .04)

C = $45,021.51

This is the after-tax salary. So, the pretax salary must be:

Pretax salary = $45,021.51 / (1 – .31) = $65,248.57

6. Suppose that instead of being able to pay cash for his MBA, Ben must borrow the
money. The current borrowing rate is 5.4 percent. How would this affect his decision to get
an MBA?
Answer: The cost (interest rate) of the decision depends on the riskiness of the use of funds, not
the source of the funds, means taking a loan increases the risk, and the costs, of pursuing a MBA.
If Ben is not able to find a job after graduating, he will have the loan amount, and interest
expense, to pay off. The borrowing rate of 5.4 also increases his overall costs of getting a MBA.
Once Ben knows the exact loan terms, he could calculate the present values of all interest
expenses and include them in his net present value assessment of the various options. In fact,
whether he can pay cash or must borrow is irrelevant, so I advise that without adding loan
expense to the total coast, and thereby increase risk of using his funds, he should use his savings,
to go to Wilton University to pursue his MBA.