Problems

Problem 4-23
Problem 4-24
Problem 4-25
Problem 4-37
Problem 4-39
Problem 4-41
Problem 4-42
Problem 4-23

Assume that Social Security promises you $40,000 per year starting when you retire
45 years from today (the first $40,000 will be paid 45 years from now). If your
discount
rate is 7%, compounded annually, and you plan to live for 15 years after retiring (so
that you will receive a total of 16 payments including the first one), what is the value
today of Social Security’s promise?

Payment $40,000.00
Number of Payments 16
Number of Years Until
First Payment 45
Rate 7.00%
PV of Payments in 44
Years
PV of Payments Today
tarting when you retire
ars from now). If your

years after retiring (so

one), what is the value
Problem 4-24

When Alex Rodriguez moved to the Texas Rangers, he received a lot of attention for his "$252 million" contract (the total of the payments promised was
$252 million). Assume the following:

Rodriguez earns $16 million in the first year, $17 million in years 2 through 4, $19 million in years 5 and 6, $23 million in year 7 and $27 million in
years 8 through 10. He would also receive his $10 million signing bonus spread equally over the first 5 years ($2 million per year). His deferred
payments will begin in 2011. The deferred payments amounts total $33 million and are $5 million, then $4 million, then 8 amounts of $3 million (ending
in 2020). However, the actual payouts will be different. All of the deferred payments will earn 3% per year until they are paid. For example, the $5
million is deferred from 2001 to 2011, or 10 years, meaning that it will actually be $6.1796 million when paid. Assume that the $4 million payment
deferred to 2012 is deferred from 2002 (each payment is deferred 10 years).

The contract is a 10-year contract, but each year has a deferred component so that cash flows are paid out over a total of 20 years. The contractual
payments, signing bonus, and deferred components are given below. Note that, by contract, the deferred components are not paid in the year they are
earned, but instead are paid (plus interest) 10 years later.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
16,000,000 17,000,000 17,000,000 17,000,000 19,000,000 19,000,000 23,000,000 27,000,000 27,000,000 27,000,000
2,000,000 2,000,000 2,000,000 2,000,000 2,000,000

Deferred
5,000,000 4,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000

Assume that an appropriate discount rate for A-Rod to apply to the contract payments is 7% per year.

a. Calculate the true payments under this contract, including the deferred payments with interest.
b. Draw a timeline of all of the payments
c. Calculate the present value of the contract.
d. Compare the present value of the contract to the quoted value of $252 million. What explains the difference?

Deferred
Interest rate: 7.00% 3.00%
interest rate:

a and b.
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

c. using Excel
d.
 Problem 4-25

You are trying to decide how much to save for retirement. Assume you plan to
save $5000 per year with the first investment made one year from now. You think
you can earn 10% per year on your investments and you plan to retire in 43 years,
immediately after making you last $5000 investment.

a. How much will you have in your retirement account on the day you retire?
b. If, instead of investing $5000 per year, you wanted to make one lump-sum
investment today for your retirement that will result in the same etirement saving,
how much would that lump sum need to be?
c. If you hope to live for 20 years in retirement, how much can you withdraw every
year in retirement (starting one year after retirement) so that you will just exhaust
your savings with the 20th withdrawal (assume your savings will continue to earn
10% in retirement)?
d. If, instead, you decide to withdraw $300,000 per year in retirement (again with
the first withdrawal one year after retiring), how many years will it take until you
exhaust your savings? (Use trial-and-error, a financial calculator: solve for “N”, or
Excel: function NPER)
e.
Assuming the most you can afford to save is $1000 per year, but you want to retire
with $1 million in your investment account, how high of a return do you need to
earn on your investments? (Use trial-and-error, a financial calculator: solve for the
interest rate, or Excel: function RATE)

Annual Savings $5,000.00

Investment Return 10.0%
Retirement in 43
Retirement Horizon 20

a. Account ValueSum
Todays Lump
b. Needed
c. Retirement Annual
Withdrawal
d. Years of retirement
e. Rate required
t. Assume you plan to
ar from now. You think
an to retire in 43 years,

day you retire?

o make one lump-sum
same etirement saving,

an you withdraw every

at you will just exhaust
gs will continue to earn

rement (again with

s will it take until you
ulator: solve for “N”, or

r, but you want to retire

a return do you need to
calculator: solve for the
Problem 4-37

You would like to buy the house and take the mortgage described in Problem 4.28.
You can afford to pay only $23,500 per year. The bank agrees to allow you to pay
this amount each year, yet still borrow $300,000. At the end of the mortgage (in 30
years), you must make a balloon payment; that is, you must repay the remaining
balance on the mortgage. How much will this balloon payment be?

Payment $23,500.00
Loan $300,000.00
Term 30
Rate 7.00%
Balloon
- OR -
PV of Payments
PV of difference
FV of difference
 cribed in Problem 4.28.
ees to allow you to pay
d of the mortgage (in 30
ust repay the remaining
ent be?
Problem 4-39

You graduate and get a $10,000 check from your grandparents. You decide to save it tow
payment on a house. You invest it earning 10% per year and you think you will need to h
saved for the down payment. How long will it be before the $10,000 has grown to $20,00

The question is, how

to equal
long will it take for
$10,000.00 $20,000.00

Using Excel:
s. You decide to save it toward a down
you think you will need to have $20,000
10,000 has grown to $20,000?

if it grows
per year?
at
10.00%
Problem 4-41

You are thinking of making an investment in a new plant. The plant will generate revenues of $1 million per year for as long
as you maintain it. You expect that the maintenance cost will start at $50,000 per year and will increase 5% per year
thereafter. Assume that all revenue and maintenance costs occur at the end of the year. You intend to run the plant as long as
it continues to make a positive cash flow (as long as the cash generated by the plant exceeds the maintenance costs). The
plant can be built and become operational immediately. If the plant costs $10 million to build, and the interest rate is 6% per
year, should you invest in the plant?

The question is, how long will it take

for $50,000.00 to equal $1,000,000.00 if it grows at 5.00% per year?

Using Excel:

Is it worth the original investment?

Interest rate: 6%
Plant operates for years
Annual revenues $1,000,000
Initial operating costs $50,000
operating costs annual growth rate 5%
Initial investment: $10,000,000

PV of revenues:
PV of operating costs:
PV of initial investment:
NPV:
Problem 4-42

You have just turned 22 years old, received your bachelor’s degree, and accepted
your
first job. Now you must decide how much money to put into your retirement plan.
The plan works as follows: Every dollar in the plan earns 7% per year. You cannot
make withdrawals until you retire on your 65th birthday. After that, you can make
withdrawals as you see fit. You decide that you will plan to live to 100 and work
until you turn 65. You estimate that to live comfortably in retirement, you will need
$100,000 per year, starting at the end of the first year of retirement and ending on
your 100th birthday. You will contribute the same amount to the plan at the end of
every year that you work. How much do you need to contribute each year to fund
your
retirement?

Starting Age 22
Investment Return 7.0%
Retirement Age 65
Planned Lifespan 100
Retirement Income $ 100,000

Needed Retirement
Savings
Required Annual
Contribution
’s degree, and accepted

o your retirement plan.

% per year. You cannot
ter that, you can make
live to 100 and work
tirement, you will need
rement and ending on
o the plan at the end of
ibute each year to fund