FIN 612 Managerial Finance

Week Four Assignment

Your assignment for this week is to complete the following questions and problems from Chapter 4.
Please submit your complete assignment in the course room by the due date.

Chapter 4 Questions

(4-2) What is an opportunity cost rate? How is this rate used in discounted cash flow analysis,
and where is it shown on a time line? Is the opportunity rate a single number that is used
to evaluate all potential investments?

Opportunity cost rate is rate of return that investor could earned on an alternative investment of similar risk.
An opportunity cost is the difference in return between an investment that has chosen for investment and one that is
inevitably gave up. For example, if a person invests in equity and get 3% return over a period of time then by
investing his/her money on stock that person gave up the opportunity of another investment. Let’s assume a treasury
bond yielding 5%. In the above situation that person’s opportunity costs are 2% (5% - 3%) (Tatum, September
2010).
Opportunity cost rate is used as an interest rate (discounting factor) to calculate present value of future cash flow. To
compute present value, future value is divided by (1 + r) in each year. Therefore, in time line opportunity cost is
shown in between two cash flows.
No the opportunity cost is not the single number that is used in all situation. As per the risk associated with
investment the alternatives as well as opportunity cost will be different.

(4-5) Would you rather have a savings account that pays 5% interest compounded semiannually or
one that pays 5% interest compounded daily? Explain.

I would rather have a saving account that pays 5% interest compounded daily than compounded semiannually
because effective rate of semiannual interest rate is 5.063% while effective rate of daily compounding is 5.13%.
Calculation of interest compounded semiannually
= (1+ Inom )M - 1.0

M
= (1 + 0.05/2)2 - 1
= (1.025)2 - 1
= 1.050625 - 1
= 5.063%
Calculation of interest compounded daily
= (1+ Inom )M - 1.0

M
= (1 + 0.05/365)365 - 1
= (1.0001369)365 - 1
= 1.05126 - 1
= 5.13%

Chapter 4 Problems

(4-1) If you deposit $10,000 in a bank account that pays 10% interest annually, how much will
be in your account after 5 years?

10000*(1.1)^5 = 16105.1
(4-2) What is the present value of a security that will pay $5,000 in 20 years if securities of equal
risk pay 7% annually?

Future Value = $5,000

Years = 20
Discount % = 7%

Use the following equation to calculate present value:

Present Value = Future Value X (Present Value Interest Factor (PVIF) )

= $5,000 X (1/1.07) ^ 20 years
= $5,000 X 0.258
= $1,290

(4-6) What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year? If this
were an annuity due, what would its future value be?

Annuity: $1725.22 Annuity Due: $ 1845.99

the formula of the future value of a ordinary annuity is here -
http://www.getobjects.com/Components/Finance/TVM/fva.html
You may use table - http://www.principlesofaccounting.com/ART/fv.pv.tables/fvofordinaryannuity.htm
$300*5.75074 = $1725

S = R(((1 + i)n - 1) / i) *(1 + i)

S = $1725 * 1.07
S = $1846

(4-7) An investment will pay $100 at tvvhe end of each of the next 3 years, $200 at the end of Year
4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of equal
risk earn 8% annually, what is this investment’s present value? Its future value?

Here's the Present Value Calculation:

Year 1 $100 / (1.0 + .08) = $ 92.59

Year 2 $100 / (1.0 + .08)^2 = $ 85.73
Year 3 $100 / (1.0 + .08)^3 = $ 79.38
Year 4 $200 / (1.0 + .08)^4 = $147.01
Year 5 $300 / (1.0 + .08)^5 = $204.17
Year 6 $500 / (1.0 + .08)^6 = $315.08

Total PV = $923.98

Here's the Future Value calculation:

(Note: since the payment is at the end of each year, the payment for year 1 will compound for only 5 years, the
payment for year 2 will compound for 4 years, and so on)

Year 1 $100 X (1.0 + .08)^5 = $146.93

Year 2 $100 X (1.0 + .08)^4 = $136.05
Year 3 $100 X (1.0 + .08)^3 = $125.97
Year 4 $200 X (1.0 + .08)^2 = $233.28
Year 5 $300 X (1.0 + .08)^1 = $324.00
Year 6 $500 X (1.0 + .08)^0 = $500.00

Total FV = $1,466.23
(4-8) You want to buy a car, and a local bank will lend you $20,000. The loan would be fully
amortized over 5 years (60 months), and the nominal interest rate would be 12%, with
interest paid monthly. What is the monthly loan payment? What is the loan’s EFF%?

PMT = $444.89 
EAR = (1 + .01)12 -1 = 12.68%

(4-16) Find the amount to which $500 will grow under each of the following conditions.
a. N = 5 I = 12 PV = -500 PMT = 0 FV = ?
FV = $881.17

b. N = 10 I = 6 PV = -500 PMT = 0 FV = ?
FV = $895.42

c. N = 20 I = 3 PV = -500 PMT = 0 FV = ?
FV = $903.06

d. N = 60 I = 1 PV = -500 PMT = 0 FV = ?
FV = $908.35

(4-17) Find the present value of $500 due in the future under each of the following conditions.

The nominal rate is the APR

This means that the semiannual rate is 6%
The quarterly rate is 3%
And the monthly rate is 1%
The differences occur because under these conditions the EAR (the effective annual rate) is going to be different for
each case.
Semi annual compounding: EAR = 1.06^2 - 1 = 12.36%
Quarterly compounding EAR = 1.03^4 - 1 = 12.55%
Monthly compounding EAR = 1.01^12 - 1 = 12.6825%

(4-18) Find the future values of the following ordinary annuities.

a. N = 10 I = 6 PV = 0 PMT = -400 FV = $5272.32


b. a. N = 20 I = 3 PV = 0 PMT = -400 FV = $5374.07

c. The annuity in part b earns more because the money is on deposit for a longer period of time and so earns more
interest. Also, because compounding is more frequent, more interest is earned on interest.

(4-19) Universal Bank pays 7% interest, compounded annually, on time deposits. Regional Bank
pays 6% interest, compounded quarterly.

a. Assuming $100 Deposit:

Universal Bank: N = 1; I1YR = 7; PV = -100; FV = 107
Effective Rate = ((107-100))/100) = .07 or 7%
Regional Bank: N = 4; I1YR = 6/4 = 1.5; PV = -100; FV = 106.136
Effective Rate = 6.136%
You would invest in Universal because the effective rate is higher.

b. If funds must be left on deposit until the end of the compounding period (1 year for Universal and
1 quarter for Regional) and you think there is a high probability that you will make a withdrawal during
the year, the Regional account might be preferable. If you withdraw 364 days after depositing money in
Universal you would receive no interest, however if you were to have deposited with Regional you
would have received 3 quarterly interest payments.
(4-22) Washington-Pacific invested $4 million to buy a tract of land and plant some young pine
trees. The trees can be harvested in 10 years, at which time W-P plans to sell the forest at
an expected price of $8 million. What is W-P’s expected rate of return?

(Final value – Initial investment)/Initial investment

(8-4)/4
4/4
1 = 100%

(4-25) While Mary Corens was a student at the University of Tennessee, she borrowed $12,000
in student loans at an annual interest rate of 9%. If Mary repays $1,500 per year, then how
long (to the nearest year) will it take her to repay the loan?

Amount of loan = $12,000

I1YR = 9
PV = -12,000
PMT = 1,500
N = 14.77 years or about 15 years (unless she has a rich uncle).

(4-28) Assume that you inherited some money. A friend of yours is working as an unpaid intern at a
local brokerage firm, and her boss is selling securities that call for 4 payments of $50 (1
payment at the end of each of the next 4 years) plus an extra payment of $1,000 at the end of
Year 4. Your friend says she can get you some of these securities at a cost of $900 each. Your
money is now invested in a bank that pays an 8% nominal (quoted) interest rate but with
quarterly compounding. You regard the securities as being just as safe, and as liquid, as your
bank deposit, so your required effective annual rate of return on the securities is the same as
that on your bank deposit. You must calculate the value of the securities to decide whether
they are a good investment. What is their present value to you?

With I=8% => EFF%= (1+8%/4)^4 – 1 = 8.24%

8.24%

| | | | |

0 1 2 3 4

50 50 50 1050

PV1,2,3= 50* (1-(1.0824)^-3)/.0824 = 128.29

PV4=1050/(1+.0824)^4=764.87

=> PV=128.29+764.87=$893.16