Solution to homework 2

FV of a single payment

1. Bradley Snapp has deposited $7,000 in a guaranteed investment account with a promised rate of 6%
compounded annually. He plans to leave it there for 4 full years when he will make a down payment on
a car after graduation. How much of a down payment will he be able to make?
A. $1,960.00
B. $2,175.57
C. $8,960.00
D. $8,837.34
E. $9,175.57

$7,000 (1.06)4 = $8,837.34

Entering data into calculator: PV=-7,000; I/Y=6(%); N=4; Compute FV

2. You deposit $100 in an account that pays 6 percent annual interest, compounded quarterly. What will
your deposit grow to in 3 years?
A. $119.56
B. $134.69
C. $ 170.91
D. $ 192.53
E. $ 216.89

PV= -100; N=12 (quarters); I/Y=1.5(%) (per quarter); Compute FV

Growth rate

3. In 1990 the average tuition for one year at a 4-year institution was $3,500. Twenty years later, in
2010, it had risen to $21,200. What was the growth rate in tuition over this 20-year period?
A. 13.73%
B. 11.92%
C. 10.52%
D. 9.42%
E. 8.53%

PV= -3,500; N=20; FV= 21,200; Compute rate (which is I/Y)

Annuity payment

4. If you buy a store worth $250,000 with 14 percent down. The balance is to be paid off with equal
annual payments at the end of each year over 30 years at a 12 percent rate of interest. What is the
amount of the annual payment?
A. $ 27,312
B. $ 26,691
C. $ 26,070
D. $ 25,449
E. $ 24,829

PV of remaining payment = 250,000 – (250,000 x 14%) = 215,000

PV= -215,000; I/Y=12(%); N=30; Compute PMT

PV of annuity

5. You are the beneficiary of a life insurance policy. The insurance company informs you that you have
two options for receiving the insurance proceeds. You can receive a lump sum of $50,000 today or
receive payments of $641 a month for ten years. You can earn 6.5% on your money. Which option
should you take and why?
A. You should accept the payments because they are worth $56,451.91 today.
B. You should accept the payments because they are worth $56,523.74 today.
C. You should accept the payments because they are worth $56,737.08 today.
D. You should accept the $50,000 because the payments are only worth $47,757.69 today.
E. You should accept the $50,000 because the payments are only worth $47,808.17 today.

You need to compare the PV of the two options.

PV of the second option: PMT=641; N=120 (months); I/Y= 6.5%/12 (which is monthly rate); Compute PV

6. The Ajax Co. just decided to save $1,500 a month for the next five years as a safety net for
recessionary periods. The money will be set aside in a separate savings account which pays 3.25%
interest compounded monthly. It deposits the first $1,500 today. If the company had wanted to deposit
an equivalent lump sum today, how much would it have had to deposit? (Note that this is annuity due)
A. $82,964.59
B. $83,189.29
C. $83,428.87
D. $83,687.23
E. $84,998.01

Note that this is annuity due because payment is made at the beginning of each period. To find the PV of
annuity due, you can find the PV of ordinary annuity, then multiply the PV of ordinary annuity by
(1+interest rate).
PMT=1,500; N=60 (months); I/Y=3.25(%)/12 (monthly rate); Compute PV (which is PV of ordinary
annuity, =82,964.59).
PV of annuity = PV ordinary annuity*(1+month rate) = 82,964.59*(1+3.25%/12) = 83,189.29.

Calculate annuity payment

7. The Great Giant Corp. has a management contract with its newly hired president. The contract
requires a lump sum payment of $25 million be paid to the president upon the completion of her first
ten years of service. The company wants to set aside an equal amount of funds each year to cover this
anticipated cash outflow. The company can earn 6.5% on these funds. How much must the company set
aside each year for this purpose?
A. $1,775,042.93
B. $1,798,346.17
C. $1,801,033.67
D. $1,852,617.25
E. $1,938,018.22

FV=25,000,000; N=10; I/Y=6.5(%); Compute PMT

Time period of annuity

8. You are considering an annuity which costs $100,000 today. The annuity pays $6,000 a year. The rate
of return is 4.5%. What is the length of the annuity time period?
A. 24.96 years
B. 29.48 years
C. 31.49 years
D. 33.08 years
E. 38.00 years

PV= -100,000; PMT=6,000; I/Y=4.5(%); Compute N

Rate of return
9. The Robertson Firm is considering a project which costs $123,900 to undertake. The project will yield
cash flows of $4,894.35 monthly for 30 months. What is the rate of return on this project?
A. 12.53%
B. 13.44%
C. 13.59%
D. 14.02%
E. 14.59%

PV= -123,900; PMT=4,894.35; N=30 (months); Compute I/Y.

Note that since the payment is per month and the number of periods is in month, the interest rate that
you found above is monthly rate. You still need to multiply monthly rate by 12 to get the (nominal)
annual interest rate.

PV of multiple cash flows

10. Marko, Inc. is considering the purchase of ABC Co. Marko believes that ABC Co. can generate cash
flows of $5,000, $9,000, and $15,000 over the next three years, respectively. After that time, Marko
feels ABC will be worthless. Marko has determined that a 14% rate of return is applicable to this
potential purchase. What is Marko willing to pay today to buy ABC Co.?
A. $19,201.76
B. $21,435.74
C. $23,457.96
D. $27,808.17
E. $31,758.00
You need to find the PV of uneven cash flows in this problem.

CFo=0;

CF1=5,000, F01=1;

CF2= 9,000; F02=1;

CF3=15,000; F03=1;

Compute NPV given I/Y=14(%).

Alternatively, you can find the PV of each cash flow then sum them up.

FV of multiple cash flows

11. What is the future value of the following cash flows at the end of year 3 if the interest rate is 6%?
The cash flows occur at the end of each year.

Year 1 Year 2 Year 3

$5,180 $9,600 $2,250

A. $15,916.78
B. $18,109.08
C. $18,246.25
D. $19,341.02
E. $19,608.07

You need to find the FV (at t=3) for each cash flow then sum them up:
FV = 5,180(1+6%)2 + 9,600(1+6%) + 2,250

PV of perpetuity
12. You would like to establish a trust fund that will provide $50,000 a year forever for your heirs. The
trust fund is going to be invested very conservatively so the expected rate of return is only 2.75%. How
much money must you deposit today to fund this gift for your heirs?
A. $1,333,333.33
B. $1,375,000.00
C. $1,425,000.00
D. $1,666,666.67
E. $1,818,181.82

PV= C/r = 5000/2.75%

Mortgage

13. A mortgage instrument pays $1.5 million at the end of each of the next two years. An
investor has an alternative investment with the same amount of risk that will pay interest at 8%
compounded semiannually. Which of the following amounts is closest to what the investor
should pay for the mortgage instrument? (Note that when investments have the same amount of
risk, they should have the same effective annual rates).
A. $1,386,834
B. $1,388,889
C. $2,674,897
D. $2,669,041
E. $3,854,512

First find effective annual rate, EAR = (1 + r/m)m-1 = (1 + 0.08/2)2-1 = 0.0816

PV = $1.5/(1.0816)1 + $1.5/(1.0816)2 = $2,669,041

Growing perpetuity

14. Aunt Clarisse has promised to leave you an annuity that will pay $60 next year and grow at an annual
rate of 4%. The payments are expected to go on indefinitely and the interest rate is 9%. What is the
value of the growing perpetuity?
A. $667
B. $693
C. $1,200
D. $1,248
E. None of the above

PVgrowing perpetuity = C1/(r - g) = $60/(.09 - .04) = $1,200

Others

15. What’s the present value of a 6-year ordinary annuity of $1,000 per year plus an additional
$1,500 at the end of Year 6 if the interest rate is 6%?
A. $6,250.49
B. $6,300.15
C. $4,982.67
D. $5,574.28
E. $5,974.77

N=6; PMT=1000; FV=1500; I/Y=6(%); Compute PV

16. You plan to borrow $35,000 at a 7.5% annual interest rate. The terms require you to amortize the
loan with 7 equal end-of-year payments. How much interest would you be paying in Year 2?
A. $1,994.49
B. $2,099.46
C. $2,209.96
D. $2,326.27
E. $2,442.59

Find the required payment:

N 7

I 7.5%

PV $35,000

FV $0

PMT $6,608.01 Found with a calculator.

Amortization schedule (first 2 years)

Year Beg. Balance Payment Interest Principal End. Balance

1 35,000.00 6,608.01 2,625.00 3,983.01 31,016.99

2 31,016.99 6,608.01 2,326.27 4,281.74 26,735.25

17. You just deposited $2,500 in a bank account that pays a 4.0% nominal interest rate, compounded
quarterly. If you also add another $5,000 to the account one year (4 quarters) from now and another
$7,500 to the account two years (8 quarters) from now, how much will be in the account three years (12
quarters) from now?
A. $15,234.08
B. $16,035.87
C. $16,837.67
D. $17,679.55
E. $18,563.53

Interest rate 4.0%

Periods/year 4 Years on Quarters Ending

Quarterly rate 1.0% Deposit on Deposit Amount

1st deposit $2,500 3 12 $ 2,817.06

2nd deposit $5,000 2 8 5,414.28

 3rd deposit $7,500 1 4 7,804.53

Total $16,035.87

18. Suppose you borrowed $15,000 at a rate of 8.5% and must repay it in 5 equal installments at the
end of each of the next 5 years. By how much would you reduce the amount you owe in the first year?
A. $2,404.91
B. $2,531.49
C. $2,658.06
D. $2,790.96
E. $2,930.51

Interest rate 8.5%

Years 5

Amount borrowed $15,000

Step 1: Find the PMT 3,806.49

Step 2: Find the 1st year's interest 1,275.00

Step 3: Subtract the interest from the payment; this is repayment of principal 2,531.49

19. Your bank is offering a CD that pays a nominal rate of 8.25 percent with interest compounded
monthly. What is the effective rate of interest on this CD?
A. 8.30%
B. 8.57%
C. 9.11%
D. 9.38%
E. 9.65%

EAR = (1+8.25%/2)2 – 1 = 8.57%

20. John and Daphne are saving for their daughter Ellen's college education. Ellen just turned 10 (at t =
0), and she will be entering college 8 years from now (at t = 8). College tuition and expenses at State U.
are currently $14,500 a year, but they are expected to increase at a rate of 3.5% a year. Ellen should
graduate in 4 years--if she takes longer or wants to go to graduate school, she will be on her own.
Tuition and other costs will be due at the beginning of each school year (at t = 8, 9, 10, and 11).

So far, John and Daphne have accumulated $15,000 in their college savings account (at t = 0). Their
long-run financial plan is to add an additional $5,000 in each of the next 4 years (at t = 1, 2, 3, and 4).
Then they plan to make 3 equal annual contributions in each of the following years, t = 5, 6, and 7. They
expect their investment account to earn 9%. How large must the annual payments at t = 5, 6, and 7 be
to cover Ellen's anticipated college costs?
A. $1,965.21
B. $2,068.64
C. $2,177.51
D. $2,292.12
E. $2,412.76

Current college cost/year $14,500

College cost inflation 3.5%

Return on investment account 9.0%

Payments at t = 1, 2, 3, and 4 $5,000

Account balance at t = 0 $15,000

1. Determine the cost of each year during college and its PV at t = 8, discounted at the return on
investment.

Cost PV at t=8

Year 1 (t = 8) = Current cost × (1+infl)8 = -19,093.73 -19,093.73

Year 2 (t = 9) = Prior year × (1+infl) = -19,762.01 -18,130.29

Year 3 (t = 10) = Prior year × (1+infl) = -20,453.68 -17,215.45

Year 4 (t = 11) = Prior year × (1+infl) = -21,169.56 -16,346.79

Find PV (at t = 8) of all college costs =amount needed at t = 8: -70,786.26

2. Create a time line with those cash flows, plus the known initial CFs, as shown below. Put X in
for the unknown values for t = 5-7. We show the time line on two sets of rows. Ours now has the
solution value, but it didn't originally.

0 1 2 3 4 5

Known values; X for unknown: $15,000.00 $5,000.00 $5,000.00 $5,000.00 $5,000.00 X

Solution value for X: $2,412.76

Cash flows: $15,000.00 $5,000.00 $5,000.00 $5,000.00 $5,000.00 $2,412.76

6 7 8 9 10 11
 X X -$19,093.73 -$19,762.01 -$20,453.68 -$21,169.56

$2,412.76 $2,412.76

Cash flows, continued: $2,412.76 $2,412.76 -$19,093.73 -$19,762.01 -$20,453.68 -$21,169.56

3. We found the PV of the college costs (t = 8-11) at t = 8 above.

Their sum is shown to the right. -70,786.26

4. Find the FV of t = 0 & 4 positive CFs at t = 8 0 $15,000.00 $29,888.44

1 $5,000.00 $9,140.20

2 $5,000.00 $8,385.50

3 $5,000.00 $7,693.12

4 $5,000.00 $7,057.91

$62,165.16

5. Find the difference between the positive and negative t = 8 values: -$8,621.09

6. Find PMT for a 3-year annuity due whose FV is equal to this difference:

$2,412.76