Tutorial 1: Time value of money

Q. You invest Rs. 100 at a 10% annual rate with monthly compounding for two years.
What is the EAR? What is the amount that you will receive after two years?

Ans: EAR = 10.47%,

Amount after two years = 122.039

Q. I don't know what is the interest rate, but I assume that it should be positive (Fair
assumption)
In this case, what would you prefer
A) Receive INR 2 at year 1 OR Receive INR 1 at year 1 and year 2

Ans: Receive INR 2 at year 1.

B) Receive INR 500 for 4 years, starting one year from now OR Receive INR 400 for
5 years, starting one year from now.

Ans: Receive INR 500 for 4 years

Q. You are offered a deal by a bank where you get 1000 at the end of odd years
(starting at the end of year 1) and pay 1000 at the end of even years (starting at the
end of year 2). If the opportunity cost is 8% per annum, what is the present value of
this deal to you?

Ans: 480.77

Q. Suppose you are exactly 30 years old. You believe that you will be able to save for
the next 20 years, until you are 50. For 10 years following that, and till your retirement
at age 60, you will have a spike in your expenses due to your kids’ college education
expenses, weddings etc, and you will not be able to save. If you want to guarantee
yourself 100,000 per year starting on your 61st birthday, how much should you save
each year, for the next 20 years, starting at the end of this year. Assume that your
investments are expected to yield 8% and you are likely to live till 80.

Ans: 9,937.73

Q. Aman has been approached by a bank to invest in one of their schemes. The
scheme promises to give Aman INR 5000 at the end of every year forever. Aman
expects that the effective annual rate will be 10% for the next 8 years and will reduce
to a daily compounded rate of 8% thereafter. How much should he be willing to pay
for this promised cash-flow stream?

Ans: EAR after 8 years = 8.33%.

PV at year 8 = 60040.18.
Discount PV(t=8) to year 0, PV at t=0: 28009.187
PV at t=0 of the first eight years annuity = 26674.63

Total PV at (t = 0)= 28009.18+26674.63 = 54683.33

Practice questions:

Q. Aneya is in the market for a new bike. She has narrowed her search down to 2
models. Model A costs 33000 and Model B costs 28000. With both bikes, she plans
to pay cash and own them for 3 years before trading in for a new bike. Her research
indicates that the trade in value for Model A after 3 years is 56% of the initial purchase
price, while the trade in value for Model B is 45%. The interest rate is 4%. For
simplicity, assume zero operating and maintenance costs. Which model is the better
decision and how much ``cheaper’’ is it than the alternative?

Ans: Model A cheaper by 227.30

Q. Which security would you choose if annual interest rate is 10%?

a) An annuity that pays INR 10,000 at the end of each of the next 6 years
OR
b) A perpetuity that pays INR 10,000 forever but the first cash payment is 11 years
from today

Ans: PV of annuity = 43552.61

PV of perpetuity = 38554.32

Q. Ira has savings of Rs.2,50,000 in his savings account that she intends to use
towards buying a house. In addition, she can get a 20 year loan @ 7.2% compounded
monthly. After reviewing her finances, she figures out that she can pay an installment
of Rs.12,000 per month. What is the most expensive house she can buy? Assume
payments are made at the end of the month.

Ans: 177,401

Q. You have an expected liability of Rs.500,000 in 10 years, use 10% as discount rate
to predict how much would need right now as savings to cover this? How much do you
need to set aside each year for next ten years to cover this liability ?

Ans: PV = 192,750; Installment = 31,372

Q. Monish wants to save for his son’s college education. He estimates that the college
education expense will be Rs. 10 lakhs per year for four years – the expenses will be
payable at the beginning of each year. He expects the annual interest rate of 8% over
the next two decades. How much money should he deposit in the bank for the next 15
years (assume deposit at the end of each year) to take care of his son’s college
education?

Ans: 121,980

Q. On 31st December 2017, Bre-X declared that it has discovered world’s largest
deposit of gold at one of its mines in Busang, Indonesia. Bre-X estimates that starting
from 2018, the mine can produce 1000 tonnes of gold every year for the next 20 years.
Bre-X expects that it will generate after-tax cash-flows of $1000/ton of gold produced
in 2018, and these cash-flows will grow by 4% for every subsequent year because of
expected appreciation in gold prices. You can assume that these cash-flows occur at
the end of the year, so for instance, the first cash-flow occurs at 31st December 2018,
the next one occurs at 31st December 2019, and so on, until the last cash-flow is
received on 31st December 2037. You are looking to buy this goldmine from Bre-X. If
you feel that the appropriate annual discount rate is 10%, what is the maximum amount
that you would be willing to pay to buy this goldmine on 31st December 2017?

Ans: 11,238,391.78