Business Finance FINS1613: Tutorial Week 3

BUSINESS
FINANCE
FINS1613
Tutorial
Week3
BONUSTimeValueofMoneyQuestions
FINS1613 PeterKjeldAndersen(2012S2)
MULTIPLE CHOICE QUESTION 1
Q. Ifyouhave$200todayandinvestitat5%interest,howmuchwillyouhave
attheendofoneyear?
A. Yourchoices:
a) $210
b) $220
c) $250
d) Noneoftheabove
FV PV(1 r) n
200(1 5%)1 200*1.05
$210
AnswerisB
2
Q. Ifyouhave$100todayandinvestitat7%interestforthreeyears,howmuch
willyouhaveattheend?Assumethatinterestiscompoundedannually.
A. Yourchoices:
a) $122.50
b) $121.00
c) $107.00
d) $93.46
FV PV(1 r) n
100(1 7%) 100 1.07
3 3
$122.50
AnswerisA
3
Q. Youhavedecidedtoinvest$200for4yearsataquotedannualrateof5%.
Howmuchwillyourinvestmentbeworthattheendofthistimeifthe
compoundingperiodismonthly?
A. Yourchoices:
a) $243.10
b) $250.67
c) $244.17
d) $187.55
r nm
FV C(1 )
m
5% 124
) 200 1.004167
48
200(1 $244.17
12
AnswerisC
4
Q. Aninvestmenthasapresentvalueof$150andin6yearstimeitwillbe
worth$215.20.Whatistheinterestrateonthisinvestment?
A. Yourchoices: FV PV(1 r) n
a) 5.32%
FV
b) 6.00% (1 r) n
PV
c) 6.20% 1
d) 7.25% FV n
1 r
e) 43.47% PV
1
FV n
r 1
PV
1
215.20 6
r 1 0.06 6.20%
150
AnswerisC
5
Q. Aninvestmenthasapresentvalueof$225andafuturevalueof$264.67.
Theinterestrateis7%.Howmanyperiodsdoestheinvestmentlast?(Partial
periodsareallowed.
FV
FV PV(1 r) n (1 r) n
A. Yourchoices: PV
a) 1.6 FV
ln ln(1 r) n
b) 1.8 PV
c) 2.0 FV
d) 2.4 ln n ln(1 r)
PV
e) 3.6
FV 264.67
ln ln
n PV
225
2.4years
ln(1 r) ln(1 0.07)
AnswerisD
6
Arealestateinvestmenthasthefollowingexpectedcashflows:
Year 1 2 3 4
CashFlows 10,000 25,000 50,000 35,000
Q. Ifthediscountrateis8%.Whatistheinvestmentspresentvalue?
CF1 CF2 CF3 CF4
PV0
1 r 1 r 1 r 1 r
1 2 3 4
10, 000 25, 000 50, 000 35, 000

PV0
1.08 1.08 1.08 1.08
1 2 3 4
9, 259.26 21, 433.47 39, 691.61 25, 726.04
96,110
7
Afirmhastodecidebetweentwoprojectswiththeseexpectedcashflows:
Year 0 1 2 3
Project A 20,000 10,000 27,000 30,000
ProjectB 30,000 12,000 45,000 30,000
Q. ProjectAshouldbevaluedusinga7%discountrate;ProjectBshouldbe
valuedusinga12%discountrate.Ifthefirmhas$20,000incashavailablefor
theinvestment.Whichprojectshouldthefirmchoose?
10, 000 27, 000 30, 000

A. PVA -20,000 37, 418
1.07 1.07 1.07
1 2 3
12, 000 45, 000 30, 000

PVB -30,000 37,941
1.12 1.12 1.12
1 2 3
ProjectBsNPVishigher,sochooseProjectB.
8
SHORTANSWER QUESTION 1
Q. Whatisthepresentvalueofacashflowof$10,000tobereceivedinfive
yearsgivenaninterestrateof6%p.a.overfiveyears(a)compounded
annually,(b)compoundedmonthly,and(c)continuouslycompounded?
A.
6%p.a.compounded FV 10, 000 10, 000
PV $7, 472.58
1 r 1 0.06
annually n 5 5
1.06
6%p.a.compounded FV 10, 000 10000

monthly
PV n m
512
$7, 413.72
r 0.06 1.00560
1 1
m 12
Notethatastheinterest
FV 10, 000 rateiscompoundedmore
6%p.a.compounded PV rt
0.06 5 $7, 408.18 frequently,thepresent
continuously e e valuedecrease.
9
Q. Aninvestorisearning$15,000thisyearbutexpectstobeearning$60,000
nextyear.Whatisthemaximumamountthattheinvestorcanconsume
todayiftheinterestrateis10%?Iftheinvestordecidestoconsumezerothis
year,howmuchcouldsheconsumenextyear?
A.
???
$15,000 $60,000
10%interest
t=0 t=1
Todayspaycheck Paycheck oneyearfrom
now
Next Year's Pay

PVConsume Today Today's Pay
1 r
n
60, 000
15, 000 15, 000 54,545.45
1 0.10
1
$69,545, 45
10
Q. Aninvestorisearning$15,000thisyearbutexpectstobeearning$60,000
nextyear.Whatisthemaximumamountthattheinvestorcanconsume
todayiftheinterestrateis10%?Iftheinvestordecidestoconsumezerothis
year,howmuchcouldsheconsumenextyear?
A.
???
$15,000 $60,000
10%interest
t=0 t=1
Todayspaycheck Paycheck oneyearfrom
now
FVConsume in 1yr Today's Pay 1 r Next Year's Pay

n
15, 000 1 0.10 60, 000 16,500 60, 000

1
$76,500
11
ANNUITIES
Q. Whatarethekeyfeaturesofanannuity?
A. Anannuityhasthefollowingthreefeatures:
1. Thesamesizedcashfloweveryperiod.
Oracashflowthatgrowsataconstantrate(butwedontneedtoknowthat)
2. Anequalspaceoftimebetweenthearrivalofeachcashflow.
3. Afinitelife.
Q. Whatdowecallanassetthatpaysaconstantcashfloweveryyearforever?
A. Aperpetuity.
Q. Whatisthedifferencebetweenanordinaryannuityandanannuitydue?
A.
3yearordinaryannuity 3yearannuitydue
(cashpaidatendofperiod) (cashpaidatstartofperiod)
$500 $500 $500 $500 $500 $500
t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3

12
ConsiderFigure2.2inthechapter.Giventhecashflowstructureoftheasset
thatis,$2.3millionperyearfromyears1to6 answerthefollowing,assuming
aninterestrateof10%p.a.compoundedannually.
Q. Whatistheaccumulated(future)valueofthisasset?
1 r n 1
A. FV A
r
1.16 1
2.3 $17.75m
0.10
Q. Whatisthepresentvalueofthisasset?
A. 1 1 r n
PV A
r
1 1.16
2.3 $10.02m
0.10
13
Nowassumethattheinterestrateof10%p.a.iscompoundedmonthly.
Q. Whatistheaccumulated(future)valueofthisasset?
A. r
m
0.10
12
Effective Annual Rate 1 nom 1 1 1 10.47%

m 12
1 r n 1 1.10476 1
FV A 2.3 $17.96m
r 0.1047
Q. Whatisthepresentvalueofthisasset?
A. 1 1 r n 1 1.1047 6
PV A 2.3 $9.88m
r 0.1047
14
Q. WhyarethebelowmodifiedannuityformulastheWRONGwaytoworkout
thepreviousquestionwithmonthlycompounding?
r
n12
n12

1 1 r
12 1 1
FV A
PV A 12
r r
12
12
A. BecausetheyassumethattheperiodiccashflowA(or$2.3m)isbeing
received12timesperannum(oratotalof72timesoverthesixyearperiod).
Iftheregularcashflowisarrivingannually,wemustuseaneffectiveannual
ratetofinditspresentvalue.
Butifthecashflowswerearrivingeverymonth,theaboveformulaewouldbe
appropriate.
15
Youwishtoborrow$20,000forfiveyears,andyourbankwillchargeinterestat
10%p.a.compoundedannually.
Q. IfyouweretorepaytheloaninequalANNUALinstalments,whatannual
paymentwouldyoubemakingforthenextfiveyears?
A. PV=amountyou
borrowtoday
1 1 r n
PV A PV
A
r 1 1 r n
A=yourregular

periodicrepayment r
20, 000
$5, 275.95 p.a.
1 1.10
5
0.10

16
Youwishtoborrow$20,000forfiveyears,andyourbankwillchargeinterestat
10%p.a.compoundedannually.
Q. IfyouweretorepaytheloaninequalMONTHLYinstalments,whatmonthly
paymentwouldyoubemakingforthenextfiveyears?
A. First,weneedtoconvertfromthe10%p.a.compoundedannually(an
effectiveannualrate)toaratethatmatchesthefrequencyofourrepayments
(amonthlyrate).
m
r
Effective Annual Rate 1 nom 1
m
12
r
0.10 1 nom 1
12 Oranominalannualratewith
1
monthlycompoundingof:
rnom
1.10 1
12 12x0.79741%=9.569%
12
rnom
Effective Monthly Rate 0.0079741 or 0.79741% per month
12
17
A. Next,applythemonthlyratetotheannuityformulatocalculatethemonthly
cashflowsoverthefiveyearperiod.
PV
A
rnom ( n12)
1 1
12
rnom
12 This is an example of when it IS
appropriate to use a periodic rate
within the annuity formula
20000 (i.e. when you have multiple cash

flows per annum)
1 1.00797 (512)

0.00797
$420.66 interest per month
18
Todayisyour30thbirthday.
Giventherecentchangesinthetaxlawrelatingtoretirement,theearliest
youcanretireisyour60thbirthday.
Youremployercontributionstoyoursuperannuationare$2,500p.a.oneach
birthday,startingimmediately.
Youestimatethatyouwillneed$60,000perannumtoliveonfromyour61st
birthdaytoyour90thbirthday(inclusive).
Youestimatethatyoucanearn12%p.a.betweennowandyour90th
birthday.
Q. Canyouaffordtoretireonyour60thbirthday?Demonstrateyouranswer
withcalculations.
19
withcalculations.
Step1:
HowmuchmoneywillIhaveaccumulatedat
12%interestonmy60th birthdayusingallthe
moneyfrommy31st birthdayonward?
Compoundedforwardat12%interestp.a.
FV=?????
$2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500
t=30 t=31 t=32 t=33 t=57 t=58 t=59 t=60
today 1 r n 1 1.1230 1 retirement

FV A 2,500 $603,331.71
r 0.12
Step2:
Addtothatthefuturevalueofthemoney FV $603,331.71 2500 1 0.12
30
thatIreceivedtoday(onmy30th birthday)
$678, 231.52 in the account on your 60th birthday
20
withcalculations.
A. Answeringhowmuchmoneyyouwillhaveinyourretirementaccountonyour
60th birthdaycouldhavebeenansweredseveralways:
CalculatingtheFVofa30yearordinaryannuityandaddingtheFVofthe
$2,500paymentyoureceivedonyour30thbirthday(asontheslide).
CalculatingtheFVofa30yearannuitydueandthenjustaddingthe$2,500
youwillreceiveonyour60thbirthdaytothat.
CalculatingtheFVofa31yearordinaryannuity.
KeepinmindthatthistechnicallyiscalculatingtheFVofa31yearannuityonyour61st
birthday,butduetothewaythepresentvaluemathematicswork,youwillwindup
withthesameanswerastheprevioustwomethods.
21
withcalculations.
Step3:
Calculatehowmuchyouwillactuallyneedin
youraccountonyour60th birthdaytobeable
towithdraw$60,000perannum
Discountedbackat12%interestp.a.
PV=?????
$60,000 $60,000 $60,000 $60,000 $60,000 $60,000
t=60 t=61 t=62 t=63 t=87 t=88 t=89 t=90
retirement Lastwithdrawalfrom
1 1 r n
1 1.1230 retirementfund
PV A 60, 000 $483,311.04 needed in your account
r 0.12
Step4:
Comparethe$678,232youwillhaveinyourbankaccountonyour
60th birthdaytothe$483,311youwillneedtohave.ANDBEHAPPY!
22
Q. Givenyoursavingsplan,howmuchcanyouexpecttoreceiveasincomeeach
yearwhenyouretire thatis,fromyour61sttoyour90thbirthday?
A. Workouttheannualcashflowthatcouldbetakenoutofyourbankaccount
over30yearsfromyour61st to90th birthdayswhiletheremainingmoney
growsat12%p.a.
PV Discountedbackat12%interestp.a.
$678,231.52
$????? $????? $????? $????? $????? $?????
t=60 t=61 t=62 t=63 t=87 t=88 t=89 t=90
PV 678, 231.52
A $84,198.14 $84,198.14couldbewithdrawneach
1 1 r n
1 1.1230 birthdayfromyour61st untilyour90th
usingthemoneythatyouwillhave
r 0.12
accumulatedbythetimeyouturn60.
23

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BUSINESS

10, 000 25, 000 50, 000 35, 000

9, 259.26 21, 433.47 39, 691.61 25, 726.04

10, 000 27, 000 30, 000

12, 000 45, 000 30, 000

6%p.a.compounded FV 10, 000 10000

Next Year's Pay

FVConsume in 1yr Today's Pay 1 r Next Year's Pay

15, 000 1 0.10 60, 000 16,500 60, 000

t=0 t=1 t=2 t=3 t=0 t=1 t=2 t=3

Effective Annual Rate 1 nom 1 1 1 10.47%

20000 (i.e. when you have multiple cash

$2,500 $2,500 $2,500 $2,500 $2,500 $2,500 $2,500

t=30 t=31 t=32 t=33 t=57 t=58 t=59 t=60

today 1 r n 1 1.1230 1 retirement

$60,000 $60,000 $60,000 $60,000 $60,000 $60,000

t=60 t=61 t=62 t=63 t=87 t=88 t=89 t=90

t=60 t=61 t=62 t=63 t=87 t=88 t=89 t=90

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