HDBTY2

Economics and Financial Management

Question Sets

Equations:
FVt = $1 × (1 + r )
Equation 1.1 t

PV = $1 × (1 + r )
−t
Equation 1.2
$1
=
(1 + r )t

Equation 1.3
FV = C ×
[(1 + r ) − 1]t

Equation 1.4
{
1 − 1/ (1 + r )t 
PV = C ×  
}
 r 

Convert 1.3 to be Equation 1.5

𝑟
C = FV x
(1 + 𝑟)𝑡 − 1
Convert 1.4 to be Equation 1.6

𝑟 (1+𝑟)𝑛
C = PV x (1+𝑟)𝑛−1
Example 1: What is the future value six years from now of a $1,000 cash flow that
occurs one year from now using a periodic interest rate 10% compounded annually?

Solution: To solve this problem, a period with a length of one year is used because
interest rate compounds annually. We would also use n equal to 5 periods because the
$1,000 was invested for five years (6 years-1 year).

• Substituting these values into Eq. 1.1 we get the following:

• FV = $1,000(1 + 0.10)5 = $1,610.51

Example 2: What is the future value a year from now of a $1,000 cash flow that occurs
today using a periodic interest rate of 1% compounded monthly?

Solution: To solve this problem, a period with a length of one month is used because the
interest rate compounds monthly. We would also use n equal to 12 periods, the number
of months in a year. Substituting these values into Eq. 1.1 we get the following:

• FV = $1,000 (1 + 0.01 )12 = $1,126.83

Example 3: What is the present value of $1,000 received five years from now using a
periodic interest rate of 10% compounded annually?

Solution: For this problem, the periodic interest rate is 10%, the period is one year, and
the number of periods is 5. Substituting these values into Eq. 1.2 we get the following:

• PV = $1,000/(1 + 0.10)5 = $620.92

Example 4: What is the present value of $1,000 cash flow one year from now and
$1,000 cash flow two years from now using a 10% compounded annually interest rate?

Solution: To solve this example Eq. 1.2 will be used to convert both future cash flows
into their present values. These values are as follows:

• P1 = $1,000/(1 + 0.10)1 = $909.09

• P2 = $1,000/( 1 + 0.10)2 = $826.45
• After finding the present values for these two future cash flows, they
may be added together:
• P = $909.09 + $826.45 = $1,735.54

Example 5: What is the future value ten years from now of ten $500 cash flows using a
periodic interest rate of 9% compounded annually? The cash flows occur at the end of
each year and begin a year from now.

Solution: For this problem, the annual cash flows equal $ 500, the
periodic interest rate equals 9%, and the number of periods is 10.
The future value is calculated as follows using Eq. 1.3):

• FV = $500[( 1 + 0.09)10 – 1]/0.09 = $7,596.46

Comment : The future value of this series of $500 cash flows is $7,596.46. It also means
that $500 invested at the end of the year for the next ten years in a bank account
earning 9% compounded annually would have grown to $7,596.46 at the end of the
tenth year, which is the time of the tenth deposit.

Example 6: What uniform series of cash flows is equivalent to a $100,000 cash flow
twenty years from now if the uniform cash flows occur at the end of the year for the
next twenty years and the periodic interest rate is 10% compounded annually?

Solution: For this problem the number of periods is 20, the periodic interest rate is 10%,
and the future value is $100,000.
By substituting these amounts into Eq. 1.5 we get the following:

• Annuity or Cash Flow (C) = $100,000(0.10)/[ (1 + 0.10)20 – 1] = $1,745.96

Example 7: What is the present value of five $500 cash flows that occur at the end of
each year for the next five years at a periodic interest rate of 6% compounded annually?
The first cash flow occurs a year from now, the second cash flow occurs two years from
now, . . . , and the fifth cash flow occurs five years from now.

Solution: For this problem, the annual cash flow is $ 500, the number of periods is 5, and
the periodic interest rate is 6%.
Substituting these values into Eq. 1.4 we get the following:

PV = $500{[1-[1/(1 + 0.06)5] ]/0.06} = $2,106.18

Comment: We invested $2,106.20 in a bank account earning 6% interest compounded

annually, we could have withdrawn $500 a year for the next five years with the
withdrawals occurring at the end of the first, second, third, fourth, and fifth years.
During the five-year existence of the bank account the original $2,106.18 would have
earned $393.82 (5 x $500.00 - $2,106.18) of interest, allowing annual withdrawals of
$500 each. The interest earned on the money remains in the account each year. The
interest decreases
each year because the amount in the bank account decreases each year as withdrawals
are made. The value of the bank account over time is shown in the next slide.

Example 8: What uniform series of cash flows is equivalent to a $10,000 cash flow
occurring today if the uniform series of cash flows occur at the end of each month for
the next five years and the periodic interest rate is 1% compounded monthly?

Solution: For this problem, the present value is $10,000, the number of periods is sixty
months, and the periodic interest rate is 1%.
Substituting these values into Eq. 1.6 we get the following:

• Annity or C = $10,000 [0.01(1 + 0.01)60]/[ (1 + 0.01)60 - 1] = $222.44

Comment:We borrowed $10,000 today at an interest rate of 1% compounded monthly

and paid it off in sixty monthly cash flows occurring at the end of each month, we would
have paid $13,346.40 (222.40 x 60),
of which $3,346.40 ($13,346.40 - $10,000) was interest.
Example 9: Determine the future value of a $2000 cash flow that occurs today and
an additional $1,000 cash flow that occurs at the end of each of the next ten years
using a periodic interest rate of 7% compounded annually.

Solution: The cash flow for this example is shown in Figure below.
• The future value of today's cash flow is calculated by using Eq. 1.1 as
follows:

• F0 = $2,000 (1 + 0.07)10 = $3,934.30

• The future value of the cash flows for years 1 through 10 is calculated by
using Eq. 1.3 as follows:

• F1-10 = $1,000[(1 + 0.07)10 - 1]/0.07 = $13,816.45

• Summing these two future values we get the following:

• F = $3,934.30 + $13,816.45 = $17,750.75

Comment: This means that if we deposit the cash flows in Figure below in a bank
account earning 7% interest compounded annually, at the end of the tenth year there
would be $17,750.75 in the bank account, which includes the original $12,000.00 of
principal plus $5,750.75 in interest.

Example 10: Determine the future value at the end of August for the following cash
flows using a periodic interest rate of 1.5% compounded monthly. These cash flows
occur at the end of the respective months.

Solution: The cash flows are shown in Figure on right. Using Eq. 1.1 we can calculate the
future values of the money borrowed during each of the months.

These calculations are as follows:

March = $10,000(1 + 0.015)5 = $10,772.84

April = $15,000(1 + 0.015)4 = $15,920.45
May = $25,000(1 + 0.015)3 = $26,141.96
June = $21,000(1 + 0.015)2 = $21,634.72
July = $17,000(1 + 0.015)1 = $17,255.00

 Adding the values together we get:

F = $91,724.97
Example 11: Determine the present value of the cash flow shown in Figure below on left using a
periodic interest rate of 12% compounded annually. Solution: To simplify the calculations, the cash
flow occurring in the third year may be treated as two $1,000 cash flows as shown in Figure below on
right.
• The present value of the five $1,000 cash flows is determined by using Eq. 1.4 as follows:

P1-5 = $1,000{[1-[1/(1 + 0.12)5] ]/0.12} = $3,604.78

• The present value for the additional $1,000 cash flow that occurs in year 3 is calculated by using Eq.
1.2 as follows:

P3 = $1,000/( 1 + 0.12)3 = $711.78

The present value for the entire cash flow is:

P = $3,604.78 + $711.78 = $4,316.56

Example 12: Determine the present value of the cash flow shown in Figure below using
an interest rate of 8% compounded annually. Solution - Method 1: The present value of
each of the cash flows are calculated by using Eq. 1.2 as follows:

• P2 = $1,000/(1 + 0.08)2 = $857.34

• P3 = $1,000/(1 + 0.08)3 = $793.83
• P4 = $1,000/(1 + 0.08)4 = $735.03
• Ps = $1,000/(1 + 0.08)5 = $680.58
• Summing these cash flows we get the following:
• P = $857.34 + $793.83 + $735.03 + $680.58 = $3,066.78

Solution - Method 2: The future value in year 5 of the four $1,000 cash flows may be
determined by using Eq. 1.3, using four periods as follows:

• F5 = $1,000[(1 + 0.08)4 ‐ 1]/0.08 = $4,506.11

• Next, the present value is calculated by taking the present value of the future value in
year 5 using Eq. 1.2 as follows:

• P = $4,506.11/( 1 + 0.08)5 = $3,066.78

Solution - Method 3: The value of the four $1,000 cash flows may be determined by
using Eq. 1.6 Year 1 is regarded as the present time for the purposes of this calculation.

The calculations are as follows:

• P1 = $1,000[(1 + 0.08)4 - 1]/[0.08(1 + 0.08)4] = $3,312.13

• The value of the four $1,000 cash flows in year 1 is still one year into the future and is
treated as a future value when converting the present value in year 1 to the present
value in year 0. The present value is calculated by taking the present value in year 1 and
substituting it into Eq. 1.2 as the future value as follows:

• P = $3,312.13/( 1 + 0.08)1 = $3,066.79

Comment: We see that in all three cases the present value is the same, other than
rounding errors. This is because when the calculations are completed we perform the
same mathematical calculations on the cash flows

Example 13: At what periodic interest rate is a $1,000 cash disbursement occurring two years
ago equivalent to cash receipt of $1,177.22 occurring today? The periodic interest rate is
compounded annually.
Solution: The cash flow for this example is shown in Figure below. Because the interest
compounds annually and the cash disbursement occurs two years before the cash receipt, the
number of periods is two. For the purposes of this example, the time of the cash disbursement
may be regarded as the present time and today may be regarded as the future time. Substituting
the cash disbursement as the present value and the cash receipt as the future value into Eq. 1.2
we get the following:

• $1,177.22 = $1,000.00(1 + i)2, Solving for i we get the following:

• (1 + i)2 = $1,177.22/$1,000.00, » 1 + i = (1.17722)(1/2)
• i = (1.17722)0.5 - 1 = 0.085

• The periodic interest rate at which the cash receipts are equivalent to
the cash disbursements is 8.5% compounded annually.

Example 14: At what periodic interest rate is a $1,000 cash receipt occurring at the
beginning of year 1 equivalent to two $ 550 cash disbursements, one occurring at the
end of year 1 and the second occurring at the end of year 2? The periodic interest rate
is compounded annually.

Solution: The cash flow for the problem is shown in Figure below. Note that the
beginning of year 1 is the same as the end of year 0.

This cash flow corresponds to Eq. 1.4 and is written as follows:

• $1000=$550[1-[1/(1+r)2]/r],

• [1-[1/(1+r)2]/r]=1000/550, solving by trial and error,

• i = 0.0659 or 6.59%

Example 15: At what periodic interest rate is a $1,000 cash receipt occurring at the
beginning of year 1 equivalent to a $500 cash disbursement occurring at the end of year
1 and a $600 cash disbursement occurring at the end of year 2? The periodic interest
rate is compounded annually.
Solution: The cash flow for the problem is shown in Figure below. Note that the
beginning of year 1 is the same as the end of year 0.

• Using Eq. 1.2 the present values for the two cash disbursements may
be expressed algebraically as follows:

• P1 = $500/(1 + i)1 and P2 = $600/(1 + i)2, P1+P2=P,

• $500/(1 + i)1 + $600/(1 + i)2 = $1000

• Excel’s Goal Seek function can be used to find the solution. i=6.39%

Excel’s Goal Seek Initial Application for Example 15

Goal Seek Result Example 15