EXERCISE THREE – Corporate Finance 101

In this exercise we will use some of the principles of corporate finance to evaluate an investment in a four year university degree – and the decision by a small business to develop or outsource financial, tax and accounting talent.

PART 1

EVALUATING THE FUTURE VALUE OF AN INVESTMENT IN A FOUR YEAR UNIVERSITY DEGREE

In Canada we have invested in post-secondary education on an industrial scale. In fact we lead the world in terms of the percent of adults with tertiary education.

So how much does it cost to invest in a university degree?

For the purposes of this exercise we’re going to use some of the principles of corporate finance to look at the “cost” of this investment and compare that “value” with an investment in the stock market. If you invested the cost of a university degree in the stock market at the age of 25, what would it be worth at your retirement age?

There are a lot of uncertainties incorporated into that question – but we’re going to try and deal with these using reasonable assumptions and a corporate finance concept called the “time value of money”….

 

Using the concepts described in the article from WIKIPEDIA, we will build a model to determine the “future value” of an investment in a four year bachelor’s degree.

WHAT DOES IT COST TO PURCHASE A UNIVERSITY DEGREE TODAY?

The short answer is that if you are buying a degree from an accredited Canadian university, you can’t actually buy it today. Instead you have to earn it over a four year period.

So we will have to determine the “present value” of the cost of the degree as though we were able to purchase it today. When modelling a set of facts using these techniques, we will inevitably simplify the reality, since there is no such thing as a perfect model. Trying to perfect the model will be much more time-consuming and will not be much more helpful in understanding the results.

For this exercise we will assume that the cost of each can be determined at the beginning of the year – as though there was no impact in terms of time value of money in wages foregone at the beginning of the school year compared with the end of the year.

WHAT IS THE ANNUAL COST OF A YEAR IN UNIVERSITY?

There are number of considerations in determining that cost:

  1. tuition cost
  2. after tax wages foregone – presumably you would work if you weren’t going to university

WHAT IS THE PRESENT VALUE OF THE COST OF THE SUBSEQUENT YEARS?

Presumably the cost of the subsequent years is the same as the cost of the first year – each is just happening a year later than the previous year.  At least we will make that assumption for the purposes of this exercise.

Other assumptions:

  1. the “discount rate” used will be the same rate used to calculate the future value of an investment in the stock market
  2. there are no earnings from summer jobs in any of the four years of university
  3. rather than look at inflation of individual costs, we will assume that the inflation-adjusted discount rate deals adequately with inflation

WHAT IS THE FUTURE VALUE OF AN EQUIVALENT INVESTMENT IN THE STOCK MARKET?

Once we determine the present value of an investment in a four year degree program, we will look at the future value of an investment in the stock market using the following assumptions:

  1. historical average returns equal to the S&P 500 INDEX
  2. adjusted for inflation using the Canadian Consumer Price Index (over the last 20 years)
  3. no adjustment for investment broker commissions

S&P 500 INDEX – HISTORICAL RETURNS

CANADIAN CONSUMER PRICE INDEX – LAST 20 YEARS – OECD

CALCULATE THE FV OF THE INVESTMENT IN A 4-YEAR DEGREE

Use the formula to see how the calculations were made in the workbook. You will need to download the spreadsheet to your PC first.

QUESTION ONE: This model only looks at the projected future value of the investment at retirement. The model is missing assumptions about additional earnings throughout the student’s lifetime resulting from that investment in education and experience.
How might someone go about modelling the future value of those additional earnings?

(Hint: Consider using the FUTURE VALUE of an ANNUITY – MICROSOFT EXCEL has a formula built-in)

QUESTION TWO: How likely is it that the assumptions used in modelling the bump in salary arising from:
  1. education
  2. experience
  3. ownership interests
are correct?

 

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