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You have just deposited $15,000 in an account earning 8% APR, compounded annually. If you leave the money in the account for 10 years, how much will you have? Show Solution Step 1) Time Line 0 | $15,000 Step 2) Formula FV = PV (1 + r ) t FV = $15,000(1 + .08)10 FV = $32,383.87 1 | 2 | 9 | 10 | ?

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You have just inherited $25,000. You immediately place $5,000 in a mutual fund earning 12% APR, compounded quarterly. You plan to blow the other $20,000 on a trip to Las Vegas. Much to your chagrin, after 2 years in Vegas, you not only did not manage to blow your inheritance, you actually now have $50,000. You now take $10,000 of the $50,000 and place it in the same mutual fund. Interest rates remain constant. After 10 years and many sad tales, you return home penniless. However, that day you receive your statement from the mutual fund. You quickly tear it open and discover that your deposits are now worth…? Show Solution Step 1) Time Line

26 Part b)FV of $10.000 ??? Note that the time units of the time line are in quarters. that APR = r * #pds/yr Thus.661. 12% = r * 4. Then find the future value of this amount after an addition 10 years (40 quarters).281.000 $10.661. è r = 3% Part a) FV of $5000.0 4 8 48 | | | … | | $5.38 = $53. or 8 quarters. you examine your mutual fund statement 12 years or 48 quarters from the time you deposit the $5.000 has been added to the FV of the $5000 after 2 years.38 Total Value of portfolio = $20. FV = PV (1 + r ) t FV = $5. you could solve this by finding the value of the portfolio at t = 8 after the $10. You will find that the answers are the exact same.03) 48 FV = $20. Thus.620.000.620.03) 40 FV = $32.000 in the account two years. . Also note.000 FV = PV (1 + r ) t FV = $10.64 Also note. you place the $10. from today. Step 2) Formula Note that you will need to use the future value tool two times to answer this question.000(1 + .26 + $32.000(1 + . Finally.

500 ? | $2.500 = 30. we need to determine the monthly rate: APR = r * #pds/yr 15% = r * 12 r = 1. You have just invested $1. You believe that Dell will continue to earn its historical return of 15%.200. Given this information. compounded monthly. since our time periods are in months. how many months must you wait before you can purchase the car? Show Solution Step 1) Time Line 0 | $1.500 in shares of Dell.200 | | … | Step 2) Formula Note that we are moving a single value through time.You would like to save for the down payment for a new car.25%/month Now we need to manipulate the present value formula to the form that we need it: FV = PV(1 + r ) t FV = (1 + r ) t PV FV t ln = ln(1 + r ) = t ln(1 + r ) PV FV ln PV = t ln(1 + r ) $2. The car you wish to purchase will have a required down payment of $2.83months t= ln(1.200 ln $1. . so the appropriate tool is the present/future value tool. However.0125) or about 2 ½ years.

the money was invested for 9 full years.How much must you place in an account today in order to have accumulated $100. at the beginning of 1992.831. his portfolio of assets was worth a mere $25.000 is 15 years? Assume that interest rates are 8%.000 $750.000 (before he lost almost all of it when the market declined!).87 You uncle constantly brags about his outstanding performance in the stock market. Also note that we want to calculate the answer in years in order to have.000 Note that the number of periods (t) is 30 (2 per year times 15 years). well.04) 30 PV = $30.000 Note that since you started at the beginning of 1992 and ended at the end of 2000. The rate/period is APR = r * #pds/yr 8% = r * 2 r = 4% (every 6 months) Step 2) Formula FV = PV(1 + r ) t FV PV = (1 + r ) t $100. an annual rate.000 PV = (1. Indeed. Step 2) Formula . By the end of 2000. his portfolio had appreciated in value to $750. Show Solution Step 1) Time Line 0 1 2 29 30 | | | … | | ? $100. What was his annual rate of return on his portfolio? Show Solution Step 1) Time Line 1992 1993 1994 2000 2001 | | | … | | $25.000. compounded semi-annually.

The money earns 16% interest for the first 20 years and 8% for the last 20 years. Which one of you has the most money after 40 years? Show Solution Step 1) Time Line You: 0 | 16% $1.000 $25.FV = PV(1 + r ) t FV = (1 + r ) t PV FV PV FV PV 1/ t = (1 + r ) −1 = r 1/ 9 1/ t $750. Your sibling invests in a different account that earns 8% for the first 20 years and 16% for the next 20 years.000 Sibling 20 | 40 | ??? 8% .000 in your mutual fund account and plan to keep it in the account for forty (40) years.92%!! You have just deposited $1.000 − 1 = 45.

460.76. FV2 = PV (1+r)t FV2 = $19.0 | 8% $1.705. note that there is a little short-cut. recalling the A * B is the same as B * A. Show Solution .16)20 = $19. So now we can calculate the amount that your sibling will have as: FV = $1000(1.76(1. determine the future value of $19.76(1+. determine the value of your investment after 20 years (FV1) FV1 = PV(1+r)t FV1 = $1000(1. the $19.08)20 = $90.76 Next. the same amount. If lottery officials wanted to pay you at the end of the year rather than at the beginning.460.16)20.705. First.705.76 after 20 years (FV2) at 8%. However.76 You could repeat this procedure for your sibling. how much must they offer you in order for you to be indifferent between the two? Assume the effective annual interest rate is 10%. Annuities You have just won the lottery. paid in equal annual installments over the next 20 years.460.000 20 | 16% 40 | ??? Step 2) Formula Initially we will solve this in two steps.460. we could get to the value at time period 40 by conducting the following calculation: FV = $1000(1.16)20(1. Although this may not be intuitive.76 is really just $1000(1. a record $500 million. you can see that the two answers must be the same. The first payment will be received immediately. Thus.08)20(1.460.16)20 = $19.76. In the equation FV = $19.08)20 = $90.08)20.

123. we treat the $234.002 as the present value of the proposed payment stream. to determine the payment stream based on the next 20 periods. 1 1 PV = $25M − = $209.123. that the annuity tool will work if $234.002 = PMT − . If we can determine the value of the original stream at t = 0.123.1(1 + . Recall the annuity tool: 1 1 PV = PMT − r r (1 + r ) t it is extremely important to note that this tool when applied to the original stream of cash flows will only tell you the value of the cash flows 1-19.002 is the present value.002 . So to the PV of the annuity.1(1 + .500. 1 1 $234.123.123.123. Step 1) Time Line 0 1 2 19 20 | | | … | | Original $25M $25M $25M $25M $0 Proposed $0 PMT PMT PMT PMT Step 2) Formula Note that the best time to solve this question for is at t = 0. NOT the value of the first $25M (recall the picture of how this tool works). you will need to add $25M.1) 20 PMT = $27.Note that since there are 20 equal payments summing to $500 million.000 . Now note.1 .002 + $25. then each payment is $25 million.000 = $234. we can then treat this as the present value of the proposed stream of cash flows to determine the fair PMT.000.1 .002 Next.1)19 So the total present value of the cash flows stream is $209.

04 You are considering the purchase of a Titanic Bond.What is the present value today of a constant stream of $500 payments to be received at the end of the year for the next 10 years. you could individually discount each of the 10 $500 payments back to t = 0 using the present value formula.S. This bond promises the owner a payment of $50/year forever. Interest rates are 8% APR. which we will use. government. Show Solution Step 1) Time Line 0 | 1 | $500 2 | $500 9 | $500 10 | $500 … Note that there are two ways to solve this question. First. If the price of this bond is $850. Step 2) Formula 1 1 PV = PMT − r r (1 + r ) t 1 1 PV = $500 − . compounded annually. issued by the U. what will be your rate of return on this investment? Show Solution Step 1) Time Line . a much shorter way is to simply use the annuity tool.08 .08)10 PV = $3. However.08(1.355.

.000 and will do so again for the next 19 years.000 at the beginning of each year. You estimate that you will require $60.000. compounded annually. Thus.000.000 payments. we will first need to subtract the present value of the 20 $60. how much can you afford to spend on an RV today? Show Solution Step 1) Time Line 0 | $60 RV Value 1 | $60 2 | $60 19 | $60 20 | $0 … To solve this.| Step 2) Formula PMT r PMT r= PV $50 r= $850 r = 5. What is left over can be spent on the RV. Step 2) Formula Present value of twenty $60. with the first to be received today. Your lifelong dream has been to purchase an RV and motor the roads of North and South America for the 20 expected years of your retirement. you will immediately withdraw $60. Assume interest rates are 10% APR.000/year with which to live in retirement and you will withdraw the $60.88% PV = | $50 | $50 | $50 | … You have just retired after a long career with a nest egg of $800.000 payments from your retirement fund of $800.

Given this information. What was your rate of return and the current yield on this bond? Show Solution Step 1: First note that the price of the bond when you purchased it was $1000 because the coupon rate equaled the YTM.12 .895.104.12) 8 Last year.1)19 $800. and had a yield to maturity of 8%. had 12 years to maturity.21 .79 Bonds You have just purchased a bond with an annual coupon of 7%. that is selling at a price such that the yield to maturity is 12%. In order to determine this.12(1.1 1 PV = $60.21 = $238.1 . 8 years remaining until maturity. what is the price that you paid for the bond? Show Solution Time Line 0 | 1 | $70 2 | $70 7 | $70 8 | $1070 … 1 $1000 1 PB = $70 − = $751. The first coupon of $80 has just been paid and current interest rates have changed such that the yield to maturity on the bond is now 4%.000 − = $561.1(1. you purchased a bond issued by IBM that offered 8% annual coupon payments. After the first coupon is paid.000 + $60.12) 8 (1. we need to calculate the ∆Price.62 + .895. Current yield = Coupon/Pbond = $80/$1000 = 8% Coupon + ∆ Pr ice Investment Rate of Return = or coupon plus change in price divided by the initial investment. the bond will be worth: .000 − $561.

67 .04(1.$1.42 + . $80 + $350.04)11 Thus.000 6 PVface = (1 + . 1 $1000 1 PB = $80 − = $1.$666.04% $1000 $1000 So Rate of Return = Der-Bond-Hauffe is a little-known firm that just issued a bond with a maturity of 6 years. 1 1 $238.350. and a price of $904.350.33 1 1 − .42 = = 43.34 Thus.42. $904.67.07) 1 | C 2 | C … 5 | C 6 | C+1000 = $666.42 $430. What must be the coupon rate of this bond? Show Solution Time Line 0 | $904. Next.07) 6 = $50 .67 First. solve for what stream of 6 coupon payments has a present value of $238.07 .07) 6 C= $238.33 = C − .04)11 (1.07(1. a yield to maturity of 7%.000 = $350. $1.42 . we need to determine how much of the current price is due to the payment of the face value.34 = $238.04 .33.07 . ∆Price = $1.33 is the value of the coupon payments.07(1.

indefinitely. The required return on equity is 18%. However. the company will begin to pay dividends on their stock of $2. Show Solution The payments associated with owning this stock are simply a growing perpetuity. Assuming that stocks with similar risks require a rate of return of 20%.50 = $16. you expect that after 5 years. PS = DIV1 $1(1.15 What is the price today of a stock that just paid a dividend of $1 and dividends are expected to grow at a constant rate of 4% per year. Show Solution The promised payments are a simple perpetuity.67 . We can use the Gordon Growth model to value this stream of payments. what is a fair price to have paid for this security? Show Solution Time Line 0 1 2 3 4 5 6 7 .04) = = $7.Stocks What is the price today of a stock that is expected to pay an annual dividend of $2.00 per share.50 each year in perpetuity? The appropriate discount rate for a stock of this risk is 15%. and that this amount will grow at a constant rate of 5% per year thereafter.04) You have just purchased a stock that currently pays no dividends.18 − . Thus.43 r − g (. the value is: PS = $2.

36 We could have achieved that same answer by treating the $2.33 at t = 5 (since we are treating the $2 as the beginning of the perpetuity). finding the value of the growing perpetuity at t = 6. this is a growing perpetuity.2 5 = $5. what is the price of the stock? Show Solution Recall that growth = return on equity * plowback.08 $1.10 … … Once the dividends begin. Given this information.30 − . Thus.2 * . Thus. and that dividends are expected to grow by 8% each year thereafter.08 = = $4. Ps = DIV1 2. The firm just paid a dividend of $1.08.33 1 .22 . We know that the next dividend is expected to be $1(1.08) = $1. g = . the present value (at t = 0) of this cash flow is: V0 = $13.10 payment as the first dividend.08 . and discounting the entire amount back to t = 0. We now have sufficient information with which to value the stock.05 Note that the stock will have a value of $13. the price of the stock is: Ps = $1. We can value the growing stream of dividends using the Gordon Growth model.20 − . A firm has a return on equity of 20% and a plowback ratio of 40%.33 r − g .00 = = $13. The risk of this firm is such that equityholders expect a 30% return.4 = .DIV | 0 | 0 | 0 | 0 | 0 | 0 | 2 | 2. adding $2 to this value.91 .08. Thus.

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