ST-1 Key terms sT-2 ST-3 PcidadiidaE Selenkel aR fall achilles flee Ll darresereseesisacn eS Define each of the following terms: a. PV; i; INT; FV,5 0; PVA,; FVA,; PMT; m; inom ‘ : "VAsi FVAss Ph c. Annuity; lump sum payment; cash flow; uneven cash flow stream d. Ordinary (deferred) annuity; annuity due e. Perpetuity; £ Outflow; inflow; time line g. Compounding; discounting h. Annual, semiannual, quarterly, monthly, and daily compounding i. Effective (equivalent) annual rate (EAR); nominal (quoted) interest rate; Annual Percentage Rate (APR); postedioaee i. : amortived-loon k, Terminalvalue I, Passinkamosisesion-balloompeymont Assume that it is now January 1, 2003. On January 1, 2004, you will deposit $1,000 into a say- ings account that pays 8 percent. a. If the bank compounds interest annually, how much will you have in your account on Jan- ary 1, 2007? b. What would your January 1, 2007, balance be if the bank used quarterly compounding rather than annual compounding? c. Suppose you deposited the $1,000 in 4 payments of $250 each on January 1 of 2004, 2005, 2006, and 2007, How much would you have in your account on January 1, 2007, based on 8 percent annual compounding? 4. Suppose you deposited 4 equal payments in your account on January 1 of 2004, 2005, 2006, and 2007. Assuming an 8 percent interest rate, how large would cach of your payments have to be for you to obtain the same ending balance as you calculated in part a? Assume that it is now January 1, 2003, and you will need $1,000 on January 1, 2007. Your bank compounds interest at an 8 percent anmual rave. 2. How much must you deposit on January 1, 2004, to have a balance of $1,000 on January 1, 2007? b. If you want to make equal payments on each January 1 from 2004 through 2007 to accu- ‘alate the $1,000, how large must each of the 4 payments be? c. Ifyour father were to offer either to make the payments calculated in part b ($221.92) or to give you a hump sum of $750 on January 1, 2004, which would you choose? 4. Ifyou have only $750 on January 1, 2004, what interest rate, compounded annvally, would you have to earn to have the necessary $1,000 on January 1, 2007? e. Suppose you can deposit only $186.29 each January I from 2004 through 2007 but you still need $1,000 on January 1,°2007. What interest rate, with annual compounding, must you scck out to achieve your goal? £. Tohelp you reach your $1,000 goal, your father offers to give you $400 on January 1, 2004, You will get a part-time job and make 6 additional payments of equal amounts each 6 months thereafter. If all of this money is deposited in a bank that pays 8 percent, con pounded semiannually, how large must each of the 6 payments be? ig. What is the effective anmual rate being paid by the bank in part £2 hh Reinvestment rate risk was defined in Chapter 4 as being the risk that maturing securities {Gnd coapon payments on bonds) will have to be reinvested at a lower rate of interest than they were previously carning. Is there a reinvestment rate risk involved in the preceding analysis? If so, how might this risk be eliminated? Bank A pays 8 percent interest, compounded quarterly, on its money market account. The managers of Bank B want its money market zecount to equal Banks AS effective annual rate, but interest isco be compounded on a monthly basis. What nominal, or quoted, or APR rate must ank B sew? 5were —0.9, the risk reduction would be much larger. In fact, the correlation coefficietifl tween Stocks A and B is 0.92. . If more ran gay selected stocks were added to a portfolio, 6» would be in the vicinigy only if the correlation coil were added to the portfolio, r3 a. Y) + (O.1XL.30) + (0.05)(1.50) b. ce =f55)(0.70) + (0.25)(0.90) Pe + (0.15)(1.50) 0.35 + 0.225 + 0.13 + 0.225 0.93. . 6% + (5%)(0.93) = 10.65%. CHAPTER 6 111103 gy 1/1104 1W1)08 +VI08 41107 ST-20 a. ee 1,000 FV=2 q $1,000 is being compounded for 3years, so your balance on January 1, 2007, is $1,259.71 FV, = PV(L + i)" = $1,000(1 + 0.08)° = $1,259.71. ‘Alternatively, using a financial calculator, input N = 3,1 = 8, PV = — 1000, PMT = 0, and ? Solve for FV = $1,259.71. 11003 411106 1108 1108 107 b. 2% 53 FR eet ie eee ~1,000 FV=2 FV, = = Pv(1 + ia)" = FV, = $1,000(1.02)" = $1,268.24. Altematively, using a financial calculator, input N = 12, I = 2, PV = ~1000, PMT = 0, and EV = ? Solve for FV = $1,268.24. 41103 gy VWilo4 1S 106 AI07 ppp a 250 250 250 250 Fv=? Using a financial calculator, input N = 4,1 250, and FV = ? Solve for FV = $1,126.53. AS gy W104 110808407 PF a + ; A-14 | _aprenorx # » soLutioNs To SELF-TEST PROBLEMS‘Using’ « financial calculator, input N = 4, I = 8, PV = 0, FV = 1259.71, and PMT. Solve for PMT = $279.56. Therefore, you would have to make 4 payments of $279.56 each to have a balance of $1,259.71 on January 1, 2007. Set up 2 time line like the one in the preceding problem: W103 gy 1/1/04 = 18106 1/07 1 —_+—__1 Pv=? 1,000 Note that your deposit will grow for 3 years at 8 percent. The fact that it is now Janvary 1, 2003, is irrelevant. The deposit on January 1, 2004, is the PV, and the FV is $1,000. Using a financial calculator, input N = 3, 1 = 8, PMT = 0, FV = 1000, and PV = ? Solve for PV = $793.83, $1,000 PV= = $793.83. “a+ (1.08) 11108 gy 1104 05S AMN/07 Pt FV = 1,000 Here we are dealing with a 4-year annuity whose first payment occurs 1 year from today, on 1/1/04, and whose future value must equal $1,000. You should modify the time line to help visualize the situation. Using a financial calculator, input N = 4,1 = 8, PV = 0, FV = 1000, and PMT = ? Solve for PMT = $221.92 ‘This problem can be approached in several ways. Peshaps the simplest is to ask this ques tion: “If I received $750 on 1/1/04 and deposited it to earn 8 percent, would I have the required $1,000 on 1/1/072” ‘The answer is no, W103 gy 1104 1105S NOT a 750 2 2 FV EV, = $750(1.08)(1.08)(1.08) = $944.78. ‘This indicates that you should let your father make the payments rather than accept the Jump sum of $750. You could also compare the $750 with the PV of the payments as shown below: 1103 gy, 1/104 105 NOB 4/07 re tt 221.92 221,92 221.92 221.92 PV=? ‘Using a financial calculator, input N = 4,1 = 8, PMT = -221.92, FV = 0, and PV =? Solve for PV = $735.03. This is less than the $750 lump sum offer, so your initial reaction might be to accept the | lump sum of $750, However, this would be a mistake. The problem is that when you found the $735.03 PV of the annuity, you were finding the value of the annuity zeday, on January 1, 2003. You were comparing $735.03 today with the lump sum of $750 1 year from now. This is, of course, invalid. What you should have done was take the $735.03, recognize that this is the PV of an annuity as of January 1, 2003, multiply $735.03 by 1.08 to get $793.83, andcompare $793.83 with the Imp sum of $750. You would then take your father’s offer to make the payments rather than take the lump sum on January 1, 2004. wi0s j= 7 11041105 10811807. a tt —— 750 4,000 Using a financial calculator, input N = 3, PV = —750, PMT = 0, FV = 1000, and I Solve for I = 10.0642%. 103 j=7 V4 105 tos 07 a_i 18629 © 186.29 “186.29 (186.29 FV = 1,000 Using a financial calculator, input N = 4, PV = 0, PMT = ~186.29, FV = 1000, and T Solve for 1 = 19.9997%, You might be able to find a borrower willing to offer you a 20 percent interest rate, but there would be some risk involved—he or she might not actually pay you your $1,000! 11103 4% W104 1105110811107 Pt tt 40 7 2 7 «2 1,000 Find the future value of the original $400 deposit: EV, = PVUL.04)* = $400(1.2653) = $506.13. ‘This means that on January 1, 2007, you need an additional sum of $493.87: $1,000.00 ~ $506.13 = $493.87. ‘This will be accumulated by making 6 equal payments chat earn 8 percent compounded semiannually, or 4 percent each 6 months. Using a financial calculator, input N = 6,1 = 4, PV = 0, FV = 493.87, and PMT =? Solve for PMT = $74.46. Alternatively, input N = 6,1 = 4, PV = -400, FV = 1000, and PMT = ? Solve for PMT = 1.0816 = 1 = 0.0816 = 8.16%. . There is a reinvestment rate risk here because we assumed that funds will earn an 8 percent return in the bank. In fact, if interest rates in the economy fall, the bank will lower its de- posit rate because it will be earning less when it lends out the funds you deposited with it. If you buy certificates of deposit (CDs) thet mature on the date you need the money 1/1/07), you will avoid the reinvestment risk, but that would work only if you were mak- ing the deposit today. Other ways of reducing reinvestment rate risk will be discussed later in the text. ST-4 Bank A’s effective annual rate is 8.24 percent: Effective annual rate = ( + 208) 10 = (1.02) ~ 1 = 1.0824 ~ 1 = 0.0824 = 8.24%.Now Bank B must have the same effective annual rate: 0.0824 = 1.0824 = (1.0824)? 1+ 75 = 1.00662 77 = 0.00662 i = 0.07944 = 7.94%. Thus, the two banks have different quoted rates—Bank Ab quoted rate is 8 percent, while Bank BS quoted rate is 7.94 percent; however, both banks have the same effective annual rate of 8.24 percent The difference in their quoted rates is due tothe difference in compounding frequency. CHAPTER 7 a. Pennington’ bonds were sold at par; therefore, che original YIM equaled of 12 percent. 1¢ coupon rate With a financl| calculator, input the following: N 5/50, I = 5, PMT = 60, FV = 1000, and PV = ? Solve for PV = $1,182.56. foral yield — Current yield Ne — 10.15% = ~0.15%. N= 13, PV = -916.42, PMT = 60, FV lator solution \ky/2 = 7.00%; therefore, ky = 14.00%, $120/3946.42 1000, and ky/2 = 1 = > Calpa e ‘Current yie pital gains yield = 14% — 1 Ke £. The following upfe line illustrates the years to maturity'of the bond: Am2 7102 wos 7403 ta 42/81/08 Fp tN ania ‘ ‘Ths, on March 1, 2002, there were 13% periods left before the bond matured. Bond ‘faders actually use the following procedure to determine the price of the bond: /AQ) Find the price of the bond on the next coupon date, July 1, 2002. Using a financial calcu- Jator, input N = 13,1= 7.75, PMT = 60, FV = 1000, and PV =? Solve for PV = $859.76,