Ginny's Restaurant

Ginny's Restaurant

SCENARIO 1

Assuming that Virginia will receive $2 million today and $3 million one year from today and she doesn't have any other assets. There are no transaction costs and taxes and all potential creditors and investors have all relevant information about investment payoffs. In addition, investment is made in a "perfect" capital market with interest rate of 6 percent. Virginia's current wealth would be worth of $4.83 million approximately. In order to get Virginia's current wealth, the net present value (NPV) of her assets has to be sought. This value was calculated from summing the $2 million that she receives today and the present value (PV) of the $3 million that she will receive one year from now. She can spend and consume approximately $4.83M today (see exhibit A).

If she consumes nothing today, she would be able to spend and consume more than $4.83 million. If Virginia invests her money at the 6 percent interest rate, the future value of her original assets will be between $2.12 million and $2.124 million depending on the types of compounding interest. By adding $3 million that she will receive one year from today, the maximum amount of money Virginia would be able to spend and consume one year from today would be between $5.12 million and $5.124 million (see exhibit A).

SCENARIO 2

Suppose that instead of having a two-endowment, Virginia has an initial endowment of $4 million and decides to invest part of the $4 million in Ginny's Restaurant. After making the analysis of the four investment strategies, investing $3 million in Ginny's restaurant is the optimal investment decision for Virginia. NPVs are calculated by discounting the future cash flow to the present value and subtracting the initial investment amount. If she invests $3 million and save $1 million today, she will get the highest NPV of approximately $1.15 million in one year from today. Although the rate of return of the $1 million investment is the highest among four alternatives, it doesn't give the highest NPV. By investing $3 million, Virginia increases her current wealth and the present value of her assets by $1.15 million approximately. Her total wealth would be $5.15 million approximately.

Exhibit-B: Finding the best investment alternative

Investment

$ in Million C0

=-Investment

(today) C1

= Future payoff (one year) Rate of return

= (C1-C0)/C1 Net Present Value at 6%

= C0 + (C1/1.06) Virginia's wealth after investment

= NPV + $4M

1 -1 1.8 80% 0.698 4.689

2 -2 3.3 65% 1.113 5.113

3 -3 4.4 46.47% 1.151 5.151

4 -4 5.4 35% 1.094 5.094

SCENARIO 3

If Virginia has a strong preference for current versus future consumption, and would like to consume at least $3.8 million immediately, she is still able to consume this amount and to process the planned investment in scenario 2 as well. If she wants to consume $3.8 million now, she will have left $0.2 million from her endowment for the investment. So, she needs to borrow $2.8 million from creditors in order to invest $3 million in Ginny's Restaurant. She still makes profit from the investment after paying back the loan even though her wealth decreases from $5.151 million to 1.351 million due to her preference of current consumption (see exhibit C).

Exhibit-C: Virginia's wealth which reflects from the current consumption.

SCENARIO 4

Virginia has the necessary

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