1.

The following cash-flow streams need to be analyzed:

CASH-FLOW END OF YEAR
STREAM 1 2 3 4 5
W $100 $200 $200 $300 1 ,$300
X$ 600 – – – –
Y – – – –1 1,200
Z$ 200 –$ 500 – $0, 300
a. Calculate the future (terminal) value of each stream at the end of year 5 with a
compound annual interest rate of 10 percent.
b. Compute the present value of each stream if the discount rate is 14 percent.

2. Muffin Megabucks is considering two different savings plans. The first plan would have
her deposit $500 every six months, and she would receive interest at a 7 percent annual rate,
compounded semiannually. Under the second plan she would deposit $1,000 every year with a
rate of interest of 7.5 percent, compounded annually. The initial deposit with Plan 1 would be
made six months from now and, with Plan 2, one year hence.
a. What is the future (terminal) value of the first plan at the end of 10 years?

b. What is the future (terminal) value of the second plan at the end of 10 years?
Part 2 Valuation
64
l To compare alternative investments having different
compounding periods, it is often necessary to calculate
their effective annual interest rates. The effective annual
interest rate is the interest rate compounded annually
that provides the same annual interest as the nominal
rate does when compounded m times per year.
l Amortizing a loan involves determining the periodic
payment necessary to reduce the principal amount to
zero at maturity, while providing interest payments on
the unpaid principal balance. The principal amount
owed decreases at an increasing rate as payments are
made.
c. Which plan should Muffin use, assuming that her only concern is with the value of her
savings at the end of 10 years?
d. Would your answer change if the rate of interest on the second plan were 7 percent?
3. On a contract you have a choice of receiving $25,000 six years from now or $50,000 twelve
years from now. At what implied compound annual interest rate should you be indifferent
between the two contracts?
4. Emerson Cammack wishes to purchase an annuity contract that will pay him $7,000 a year
for the rest of his life. The Philo Life Insurance Company figures that his life expectancy is
20 years, based on its actuary tables. The company imputes a compound annual interest
rate of 6 percent in its annuity contracts.
a. How much will Cammack have to pay for the annuity?
b. How much would he have to pay if the interest rate were 8 percent?
5. You borrow $10,000 at 14 percent compound annual interest for four years. The loan is
repayable in four equal annual installments payable at the end of each year.
a. What is the annual payment that will completely amortize the loan over four years?
(You may wish to round to the nearest dollar.)
b. Of each equal payment, what is the amount of interest? The amount of loan principal?
(Hint: In early years, the payment is composed largely of interest, whereas at the end it
is mainly principal.)
6. Your late Uncle Vern’s will entitles you to receive $1,000 at the end of every other year for
the next two decades. The first cash flow is two years from now. At a 10 percent compound
annual interest rate, what is the present value of this unusual cash-flow pattern? (Try to
solve this problem in as few steps as you can.)
7. A bank offers you a seven-month certificate of deposit (CD) at a 7.06 percent annual rate
that would provide a 7.25 percent effective annual yield. For the seven-month CD, is interest
being compounded daily, weekly, monthly, or quarterly? And, by the way, having
invested $10,000 in this CD, how much money would you receive when your CD matures
in seven months? That is, what size check would the bank give you if you closed your
account at the end of seven months?
8. A Dillonvale, Ohio, man saved pennies for 65 years. When he finally decided to cash them
in, he had roughly 8 million of them (or $80,000 worth), filling 40 trash cans. On average,
the man saved $1,230 worth of pennies a year. If he had deposited the pennies saved
each year, at each year’s end, into a savings account earning 5 percent compound annual
interest, how much would he have had in this account after 65 years of saving? How much
more “cents” (sense) would this have meant for our “penny saver” compared with simply
putting his pennies into trash cans?
9. Xu Lin recently obtained a 10-year, $50,000 loan. The loan carries an 8 percent compound
annual interest rate and calls for annual installment payments of $7,451.47 at the end of
each of the next 10 years.
a. How much (in dollars) of the first year’s payment is principal?
b. How much total interest will be paid over the life of the loan? (Hint: You do not need
to construct a loan amortization table to answer this question. Some simple math is all
you need.)