FIN 254

Case 1

1. Assume that your father is now 50 years old, that he plans to retire in 10 years, and that he
expects to live for 25 years after he retires, that is, until he is 85. He wants a fixed re- tirement
income that has the same purchasing power at the time he retires as $40,000 has today (he
realizes that the real value of his retirement income will decline year by year after he retires). His
retirement income will begin the day he retires, 10 years from today, and he will then get 24
additional annual payments. Inflation is expected to be 5 percent per year from today forward; he
currently has $100,000 saved up; and he expects to earn a return on his savings of 8 percent per
year, annual compounding. To the nearest dollar, how much must he save during each of the next
10 years (with deposits being made at the end of each year) to meet his retirement goal?

2. You are serving on a jury. A plaintiff is suing the city for injuries sustained after falling down an
uncovered manhole. In the trial, doctors testified that it will be 5 years before the plaintiff is able to
return to work. The jury has already decided in favor of the plain- tiff, and has decided to grant the
plaintiff an award to cover the following items:
(1) Recovery of 2 years of back-pay ($34,000 in 2000, and $36,000 in 2001). Assume that it is
December 31, 2001, and that all salary is received at year end. This recov- ery should include
the time value of money.
(2) The present value of 5 years of future salary (2002–2006). Assume that the plaintiff’s salary
would increase at a rate of 3 percent a year.
(3) $100,000 for pain and suffering.
(4) $20,000 for court costs.
Assume an interest rate of 7 percent. What should be the size of the settlement?

3. a. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the
end of each of the next 5 years. The interest rate is 10 percent, compounded annually.
b. How large must each annual payment be if the loan is for $50,000? Assume that the interest rate
remains at 10 percent, compounded annually, and that the loan is paid off over 5 years.
c. How large must each payment be if the loan is for $50,000, the interest rate is 10 percent,
compounded annually, and the loan is paid off in equal installments at the end of each of the next
10 years? This loan is for the same amount as the loan in part b, but the payments are spread out
over twice as many periods. Why are these payments not half as large as the payments on the loan in
part b?

4. Case from Gitman (Chapter 4 p-22) : Funding Jill Morgan’s Retirement Annuity

Good Luck!!!
1)
As the inflation rate is 5% per year after 10 years if I want to buy the same thing that I can buy
with $40000 then I need to have the following amount of money:

FV = PV(1+k)n ,

Here, FV = money I need after 10 years to have the same purchasing power that has today’s
$40000

k= inflation rate, n= years

so, FV = 40000(1+.05)10

= $65155.79

To have this amount after 10 years I need to save the following amount each year:

( )
FVAn = PMT[∑ ( ) ] = PMT[ ]

FVA= 65155.79

n=10, k=8% (as the savings interest rate is 8%)

so, PMT = [ ( ) ] =[ ( )
]

PMT=

PMT = $4497.671

So, My father needs to save $4498 each year to have the same purchasing power that has
today’s $40000
2.)
Future value of year 2000 salary = 34000(1+.07) = $36380
value of year 2001 salary (current time) = $36000
Future Salary of year 2002-2006 (salary increase 3% per year)
2002 37080 36000 (1+.03)
2003 38192.4 37080(1+.03)
2004 39338.172 38192.4(1+.03)
2005 40518.31716 39338.172(1+.03)
2006 41733.86667
40518.31716(1+.03)
Present value of year 2002-2006 salary=
2002 34654.21
2003 33358.72
2004 32111.67
2005 30911.23
2006 29755.67
Total = $160791.5

(we need to use the unequal stream PV formula to find out the PV of this annuity)

PV = PMT + PMT +PMT + PMT + PMT

( ) ( ) ( ) ( ) ( )

PMT=each year’s salary

k= interest rate
so, PV = 160791.4935
So the total settlement amount =36800+36000+160791.5+100000(suffering cost)+20000(court
fee)
= $353171.5
 3-a)

Beginning
Year Amount Payment Interest Repayment of Principal Remaining Balance
Column Column
Column 1 2 3 Column 4 (column2-column3) Column 5 (column1-column4)
2012 25000 6594.937 2500 4094.937 20905.063
2013 20905.063 6594.937 2090.506 4504.4307 16400.6323
2014 16400.6323 6594.937 1640.063 4954.87377 11445.75853
2015 11445.75853 6594.937 1144.576 5450.361147 5995.397383
2016 5995.397383 6594.937 599.5397 5995.397262 0.0001213

Interest = 25000*0.1=2500, 20905.063*0.1=2090.506, 16400.6323*0.1=1640.063,

11445.75853*0.1=1144.576, 5995.397383*0.1=599.5397

PV of Annuity = PMT [ ( )
]
PV of annuity = 25000, k = 10%=0.1, n= 5, PMT=payment=?

So, payment = = $6594.937

( ) ( )

3-b)

Payment = payment = = $13189.87404

( ) ( )

PV of annuity = 50000, k = 10%=0.1, n= 5, PMT=payment=?

3-c) Payment = payment = = $8137.269744
( ) ( )

Here, PV of annuity = 50000 and n=10

The amount is not as half as part “b” because of the present value interest factor

4)

To answer this question I must find the present value of the annuity for next 25 years.

So,

PVAn = PMT[∑ ( )
] = PMT [ ( )
]
= PMT [ ( )
]
Here, PVAn= present value of the annuity = amount I am willing to pay for this retirement plan

k= interest rate = 9%, n=25 years, PMT=$12000

so, PVAn= 12000 [ ( )

]
= 12000* 9.82258

= $117870.9553

So, I would like to pay $117870.9553 for this retirement plan.