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BUSN9119 - Financial Management

Tutorial Question 2 - Semester 1, 2020

Student : PHUONG GIANG NGUYEN – ID: 2225141

Question 1
What are the differences/similarities between an ordinary annuity, annuity due and
deferred annuity?
Similarities: they are all A stream of equal periodic cash flows, over a specified time period.
These cash flows can be inflows of returns earned on investments or outflows of funds
invested to earn future returns.
Differences:
- Ordinary annuity: the cash flow occurs at the end of each period.
- Annuity Due: the cash flow occurs at the beginning of each period.
- Deferred annuity: A deferred annuity is a contract with an insurance company that
promises to pay the owner a regular income, or a lump sum, at some future date.
Question 2 - Future Value Of A Single Amount
You have $1,500 to invest today at 7% p.a. compounded annually.
(a) What will be the value of your investment at the end of the following number of years?
1. 3 years
FV3 = PV x (1 + i)n = $ 1,500 * (1 + 7%)3 = 1,838
2. 6 years
FV6 = PV x (1 + i)n = $ 1,500 * (1 + 7%)6 = 2,251
3. 9 years
FV9 = PV x (1 + i)n = $ 1,500 * (1 + 7%)9 = 2,758

(b) Use your findings in part (a) to calculate the amount of interest earned in:
1. years 1 to 3
The amount of interest earned in years 1 to 3 = FV3 – PV = 1,838 - 1,500 = $338
2. years 4 to 6
The amount of interest earned in years 4 to 6 = FV6 – FV3 = 2,251 - 1,838 = $413
3. years 7 to 9
The amount of interest earned in years 7 to 9 = FV9 – FV6 = 2,758 – 2,251 = $507
(c) Compare and contrast your findings in part (b). Explain why the amount of interest
earned increases in each successive three-year period.
Amount of interest earned increases in each successive three-year period because the
interest is compound interest to indicate that the amount of interest earned on a given
deposit has become part of the principal at the end of a specified period.

Question 3
Robert Williams is considering an offer to sell his medical practice, allowing him to retire five
years early. He has been offered $500,000 for his practice and can invest this amount in an
account earning 10% per year. If the practice is expected to generate the cash flows listed
below, should Robert accept this offer and retire now? Each cash flow occurs at year end.
Answer:
Year Cash Flow PVIF PV
1 150,000 0.9 136,363.64
2 150,000 0.826 123,966.94
3 125,000 0.751 93,914.35
4 125,000 0.683 85,376.68
5 100,000 0.62 62,092.13
Total PV 501,713.74

The present value of practice is $501,713.74 higher than the offer  Robert should not
accept that offer.

Question 4
What is the difference between compound interest and simple interest?

Compound interest is the interest that is earned on a given deposit and has become part of
the principal at the end of a specified period. With simple interest, the principal amount of a
loan or deposit does not change during the period.

Question 5
Simon’s employer offers its workers a two-month paid sabbatical every seven years. Simon,
who just started working for the company, plans to spend his sabbatical touring Europe at
an estimated cost of $25,000. To finance his trip, Simon plans to make six annual end-of-
year deposits of $2,500 each, starting this year, into an investment account earning 8%
interest. Will Simon’s account balance at the end of seven years be enough to pay for his
trip?

Simon’s account balance at the end of seven years:

FVA6 = PMT x FVIFA8,6 = 2,500 * 7.336 = 18,339.82
Where:
FVAn = Future value of an annuity at the end of period n
FVIFAi,n = Future value interest factor – annuity

Will Simon’s account balance at the end of seven years is just 18,339 which is not enough to
pay for his trip’s expense ($25,000)
Question 6
Sam wishes to find the present value of $100 received at six years from now at 8% annual
oppurtunity cost.

PV = $100 / (1+8%)6 = $63.02

Question 7
Melissa wants to invest today to assure adequate funds for her son’s university education.
She estimates that her son will need $20,000 in 18 years, $25,000 in 19 years, $30,000 in 20
years and $40,000 in 21 years. How much does Melissa need to invest in a fund today – if
the fund earns the following interest rates?
a. 6% per year with annual compounding
Year (n) Cash Flow (FV) PVIF (6%) PV
18 $20,000 0.35 7,006.88
19 $25,000 0.331 8,262.83
20 $30,000 0.332 9,354.14
21 $40,000 0.294 11,766.22
Total PV 36,450.07

b. 6% per year with quarterly compounding

Period (n) Cash Flow (FV) PVIF (1.5%) PV
18 * 4 = 72 $20,000 0.342 6,846.60
19 * 4 = 76 $25,000 0.323 8,063.45
20 * 4 = 80 $30,000 0.304 9,116.70
21 * 4 = 84 $40,000 0.286 11,452.82
Total PV 35,479.57