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ACST152 2015 Week 9 Leverage

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Present Values and Fixed Term Annuities

Q1. Sam is now age 65 and wishes to have a retirement

income of $30,000 per annum. He will withdraw

$25,000 at the START of each year for the next 30

years (30 payments in all). If he can earn 5% p.a.

interest, how much does he need to have in his account

on the date of retirement, in order to provide these

payments?

Q1. Sam is now age 65 and wishes to have a retirement income of $30,000 per

annum. He will withdraw $30,000 at the START of each year for the next 30 years

(30 payments in all). If he can earn 4% p.a. interest, how much does he need to

have in his account on the date of retirement, in order to provide these

payments?

Solution: using the formula for payments in advance

PV = 30000 * 1.04 * (1-1.04^-30) / 0.04

= 539,511.44

Q2. (Increasing annuity) Sam's friend has pointed out that he should allow for

the cost of living, which is expected to increase at 3% per annum. Suppose he

withdraws $30,000 at the start of the first year, $30,000*1.03 at the start of the

second year, $30,000 * 1.03^2 at the start of the third year, and so on. If he can

earn 4% p.a. interest, how much does he need to have in his account on the date

of retirement, in order to provide these payments? {You should be able to do this

by summing a GP but you can check your answer using a spreadsheet}

Solution:

The Pv of the first payment is 30000

The PV of the second payment is 30000 * 1.03 / 1.04

The PV of the third payment is 30000 * 1.03^2 / 1.04^2

and so on

This is a GP where the first term is $30000, the constant ratio is 1.03/1.04, and

the number of terms is 30.

Answer = 30000 * [(1.03/1.04)^30-1]/(1.03/1.04-1)

= 785,084.56

Q3. (Deferred annuity) Maryann is now age 50 exactly. She has $Y in her

superannuation account and it is earning 4% per annum interest . Ignore taxes

fees and charges for this question. She does not intend to make any more

contributions. She intends to retire at age 65 exactly. She has calculated that by

the time she retires, the superannuation account will have enough to pay a

retirement income of $10,000 p.a. for 40 years (with the first payment occurring

on the day she retires). What is $Y?

First find the PV at age 65 of the benefit.

PV at age 65 = 10000 * 1.04 * [1-1.04^-40]/0.04

= 205,844.85

If she has $Y now, it must accumulate up to 205,844.85 by the time she

reaches age 65.

S o Y * 1.04^15 = 205844.85

Y = 114,298.34

Q4. (Decreasing annuity). You work for an oil company. The company sells its

output each year on 31 December. In 2013, the output was worth $100 million.

However the oil well is slowly being depleted and you expect that the output will

decrease by 10% p.a. compound each year (i.e. $90 million in 2014, $81 million

in 2015, $72.9 million in the 2016, and so on). If it is now 1 January 2014,

calculate the present value of the future income from the oil well for the next 20

years, using 8% p.a. interest. {You should be able to do this by summing a GP

but you can check your answer using a spreadsheet}

Solution:

The PV of the first payment is 90 * 1.08^-1

The PV of the second payment is 90 * 0.90 * 1.08^-2

The PV of the third payment is 90*0.90^2 * 1.08^-3

and so on.

This is a GP with 20 terms, where the first term is 90/1.08 and the constant ratio

is 0.90/1.08

PV = 90 / 1.08 * [(0.90/1.08)^20-1] /(0.90/1.08-1]

= 486.96 million

needy students. He intends to put $X in a bank account on 1 January 2014. The

account will earn interest at 4% p.a. Each year, starting on 1 January 2015 and

every year thereafter for 50 years, the Smith Scholarship will be awarded to one

student. The Scholarship is $1000 in every year. What is the value of $X which is

necessary to meet this requirement?

Solution

PV = 1000 * [1-1.04^-50]/0.04 = 21,482.18

Q6. (Perpetuity) Repeat Q5, but this time assume that Mr Smith wants the prize

to be a perpetuity, i.e. the prize will be awarded every year, forever. What is the

value of $X which is necessary to meet this requirement?

Solution

PV = 1000 / 0.04 = 25,000

Note that the sum of 25000 invested at 4% will produce an income of

$1000 in interest per

year. The scholarship simply pays the interest and the

account balance remains the same at the start of each year.

to calculate the present value of a series of unequal payments. The calculations

have been done using an interest rate of 4%. The spreadsheet calculates the

present value of each individual payment and then sums the individual values.

The present value was calculated as $11,211.48

Interest rate

Total present

value

4% p.a

$

11,211.48

Time of

payment

1

2

3

4

5

6

7

8

9

10

Payme

nt

1800

1700

1600

1500

1400

1300

1200

1100

1000

900

PV of payment

$

1,730.77

$

1,571.75

$

1,422.39

$

1,282.21

$

1,150.70

$

1,027.41

$

911.90

$

803.76

$

702.59

$

608.01

One of your colleagues has calculated the present value of these payments using

a different interest rate, which was determined by finding the average interest

rate earned on accounts. His answer was $10,253.53. What interest rate did he

use? Use Solver to find the answer, as a percentage accurate to 2 decimal places

(e.g. 3,76% or 9.88%)

Interest rate

Total present

value

6.08%

p.a

$

10,253.53

Time of

payment

1

2

3

4

5

6

7

8

9

10

Payme

nt

1800

1700

1600

1500

1400

1300

1200

1100

1000

900

$

$

$

$

$

$

$

$

$

$

PV of payment

1,696.83

1,510.71

1,340.35

1,184.56

1,042.22

912.31

793.87

686.00

587.89

498.78

company. The company is particularly concerned about losing customers and

they have decided to give discounts to selected customers.

Customers who are under age 30 will get no discount

Customers who are over age 30 and spend less than $50 per month will

get 5% discounts

Customers who are over age 30 and spend more than $50 per month will

get 10% discounts.

Column E shows the level of discount. What Excel command should be in cell E5?

[Note that there might be more than 1 correct answer. This will be a multiple

choice question in the quiz]

A

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

B

Custom

er

Id

Numbe

r

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

....

20000

Age

Avera

ge

Discou

nt

Monthl

y

Spend

84

19

62

52

61

59

20

73

86

20

34

52

68

100

80

92

58

80

....

56

0%

0%

10%

10%

10%

10%

0%

10%

10%

0%

5%

0%

10%

10%

10%

0%

0%

10%

...

10%

25

23

52

44

48

44

27

42

45

21

36

29

43

42

40

23

28

54

....

57

ANSWER: IF (c5<30,0,IF(d5<50,5%,10%))

"shadow shopping" exercise to see whether financial advisors give good financial

advice. Look up ASIC's Media Release MR-55 dated 27 March 2012, and then

decide whether the following statements are True or False. (1/2 mark each)

Q9. More than two-thirds of the clients received excellent advice.

FALSE

Q10. More than two-thirds of the plans included an estimate of how long the

client's retirement savings would last.

FALSE ONLY 56% HAD AN ESTIMATE OF THIS TIMESPAN

Q11. When clients received poor advice, they were usually annoyed because

they felt that they had wasted money paying fees for poor advice.

FALSE - THEY WERE UNAWARE OF THE FACT THAT THEY HAD RECEIVED

POOR ADVICE

Q12. Some financial planners recommended investments which would pay high

commission to the financial planner, even if it was not very good for the client.

TRUE

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