CHAPTER REVIEW PROBLEMS AND SELF-TEST

5.1 Calculating future values

Assume that you deposit $1,000 today in an account that pays 8 per cent interest.
a) How much will you have in four years?
PV = $1,000, I = 8%, n = 4
 FV = $1,360.49
b) How much will you have if the 8 per cent is compounded quarterly?
PV = $1,000, I = 8% / 4 = 2%, n = 4 x 4 = 16
 FV = $1,372.79
c) How much will you have in four-and-a-half years in this case?

5.2 Calculating present values

Suppose that you have just celebrated your 19 th birthday. A rich uncle set up a trust fund
for you that will pay you $100,000 when you turn 25. If the relevant discount rate is 11 per
cent, how much is this fund worth today?
FV = $100,000, I = 11%, n = 6
 PV = $53,464

5.3 More present values

The Australian rugby league halfback has been signed to a three-year, $1.5 million
contract. The details provide for an immediate cash bonus of $400,000. The player is to
receive $300,000 in salary at the end of the first year, $300,000 the next, and $500,000 at the
end of the last year. Assuming a 10 per cent discount rate, is this package worth $1.5
million? How much is it worth?
Obviously, the package is not worth $1.5 million because payments are spread out over three
years. The bonus is paid today, so it is worth $400,000.
I = 10%
1=0
2 = 300,000
3 = 300,000
4 = 500,000
The present values for the three subsequent salary payments are $896,319.
 Hence, the package is worth $1,296,319, including the $400,000 bonus.
5.4 Future value with multiple cash flows
You plan to make a series of deposits in an interest-bearing account. You will deposit
$1,000 today, $2,000 in two years and $8,000 in five years. If you withdraw $3,000 in three
years and $5,000 in seven years, how much will you have after eight years if the interest
rate is 9 per cent? What is the future value of these cash flows?
Note that we treat the withdrawals as negative cash flows:
FV0 = $1,000 x (1.09)8 = $1,992.56
FV2 = $2,000 x (1.09)6 = $3,354.20
FV3 = - $3,000 x (1.09)5 = - $4,615.87
FV5 = $8,000 x (1.09)3 = $10,360.23
FV7 = - $5,000 x (1.09)1 = - $5,450
 Total FV = $5,643.12

5.5 Annuity present value

You are looking into an investment that will pay you $12,000 per year for the next 10 years.
If you require a 5 per cent return, what is the most you would pay for this investment?
PMT = 12,000, n =10, I = 5%
 PV = $92,660.82

5.6 NIR versus EAR

The going rate on student loans is quoted as 9 per cent NIR. The terms of the loan call for
monthly payments. What is the effective annual rate (EAR) on such a student loan?
I = 9%, n = 12
 EAR = 9.38%

5.8 Just a little bit each month

You’ve recently finished your MBA. Naturally, you must purchase a second-hand BMW
immediately. The car costs about $21,000. The bank quotes an interest rate of 12 per cent
NIR for a 72-month loan with a 10 per cent deposit. You plan on trading the car in for a
new one in two years.
a) What will your monthly payment be?
Deposit = $21,000 x 0.1 = $2,100
PV = $21,000 – $2,100 = $18,900, n = 72, I = 12%/12 = 1%
 PMT = $369.50
b) What is the effective interest rate on the loan?
I = 12%, n = 72/12 = 6
  EAR = 12.62%
c) What will the loan balance be when you trade the car in?
To calculate the present value of the remaining payments after two years:
I = 12% / 12 = 1%, n = 72 – 24 = 48, PMT = $369.50
 PV = $14,031.38

QUESTIONS AND PROBLEMS

1) Calculating present values
For each of the following, compute the present value:
Future Value Years Interest Rate Present Value
4995 13 4% 2,999.87
4782 8 6% 3,000.29
8277 15 7% 2,999.97
14,305 7 25% 2,999.98

2) Calculating future values

For each of the following, compute the present value:
Present Value Years Interest Rate Future Value
20,000 8 10% 42,871.78
40,000 8 10% 85,743.55
20,000 8 20% 85,996.34
20,000 16 10% 91,899.46

3) Calculating interest rate

Assume that the cost of a university education will be $80,000 when your children enter
university in 15 years’ time. You presently have $27,000 to invest. What rate of interest
must be earned on your investment to cover the cost of a university education 15 years
from now?
FV = $80,000, PV = $27,000, n = 15
 I = 7.51%

4) Present value with multiple cash flows

You are considering an investment that has the following cash flows.
Year Cash Flows
1 $200
2 $400
3 $800
 a) If the discount rate is 8 per cent, what is the present value of these flows?
I = 8%
1=0
2 = 200
3 = 400
4 = 800
 Total PV = $1,163.19

b) What is the present value at 10 per cent?

I = 10%
1=0
2 = 200
3 = 400
4 = 800
 Total PV = $1,113.45

c) What is the present value if the interest rate is zero?

I = 0%
1=0
2 = 200
3 = 400
4 = 800
 Total PV = $1,400

5) Calculating future values

What is the future value of $6,000 in 15 years, assuming a rate of 12 per cent
compounded monthly?
PV = $6,000, n = 15 x 12 = 180, I = 12% / 12 = 1%
 FV = $35,974.81

6) Calculating future values

A local bank in Bryon Bay is offering 4.75 per cent compounded daily on savings
accounts.
a) If you deposit $2,000 today, how much will you have in two years?
PV = $2,000, n = 2 x 365 = 730, I = 4.75% / 365
 FV = $2,199.30
b) How much will you have in 4 years?
PV = $2,000, n = 4 x 365 = 730, I = 4.75% / 365
  FV = $2,418.47

7) Present value and multiple cash flows

You have just joined the investment advisory firm, Vulture Fund. They have offered
you two very different salary arrangements. You can have $200000 per year for the
next five years; or $100000 per year for the next five years, along with $400000 signing
bonus today. If the interest rate is 6 per cent compounded quarterly, which do you
prefer? For simplicity, assume the salaries are to be paid at the end of each year.
I = 6%, n = 4,  EAR = 6.136355062%
Option A: $200000 per year for the next 5 years
I = 6.136355062%
1=0
2 = 200000
3 = 200000
4 = 200000
5 = 200000
6 = 200000
Total PV = $839356.85

Option B: $100000 per year for the next 5 years, along with 400000 bonus paid today
I = 6.136355062%
1=0
2 = 100000
3 = 100000
4 = 100000
5 = 100000
6 = 100000
Total PV = $419678.42 + $400000 (bonus) = $819678.42
 Prefer option A

8) Calculating EAR
Recently the ANZ bank offered the following rates for term deposits: (a) 6 per cent per
annum paid annually, (b) 5.91 per cent per annum paid half yearly, (c) 5.87 per cent
per annum paid quarterly and (d) 5.84% per cent per annum paid monthly. What is the
EAR for each of these rates?
a) I = 6%, n = 1
 EAR = 6%
 b) I = 5.91%, n = 2
 EAR = 5.997%
c) I = 5.87%, n = 4
 EAR = 6%
d) I = 5.84%, n = 12
 EAR = 5.999%

9) Calculating NIR
Find the NIR or stated rate in each of the cases below:
Stated Rate (NIR) When Compounded Effective Rate (EAR)
4.94% Semi-annually 5%
5.87% Quarterly 6%
6.78% Monthly 6.99%
7.70% Daily 8%

11) Present value with multiple cash flows

Investment A pays $2000 per year for three years. Investment B pays $1600 per year
for four years. Which of these cash flow streams has the higher PV if the discount rate
is:
a) 10 per cent?
Investment A Investment B
I = 10% I = 10%
1=0 1=0
2 = $2000 2 = $1600
3 = $2000 3 = $1600
4 = $2000 4 = $1600
 Total PV = $4973.70 5 = $1600
 Total PV = $5071.78
b) 40 per cent?
Investment A Investment B
I = 40% I = 40%
1=0 1=0
2 = $2000 2 = $1600
3 = $2000 3 = $1600
4 = $2000 4 = $1600
 Total PV = $3177.84 5 = $1600
  Total PV = $2958.77

12) Calculating the number of periods

At 5 per cent per annum interest, how many years does it take for your money to
double? To triple?
PV = $1, FV = $2, I = 5% PV = $1, FV = $3, I = 5%
 n = 14.21 years  n =22.52 years

15) Calculating interest rates

You are considering buying a Greek investment that requires you to invest $7000 today
in exchange for $12533.71 in 2 years. What is the rate of return of this investment?
PV = $7000, FV = $12533.71, n = 2
 I = 33.81%

16) Calculating interest rates

You are comparing two investments. Both requires a $2500 initial investment.
Investment A returns $4700 in eight years. Investment B pays $5650 in 12 years. Which
of these investments has the higher return?
Investment A Investment B
PV = $2500, FV = $4700, n = 8 PV = $2500, FV = $5650, n = 12
 I = 8.21% (higher return)  I = 7.03%

17) Calculating the number of periods

Solve for the unknown number of years in each of the following cases:
Present Value Future Value Interest Rate Time (Years)
100 305 7% 16.5
123 218 6% 9.8
4100 6700 5% 10
10543 16500 6% 7.7
20000 23750 3% 5.8

18) EAR versus NIR

A credit card rate is 1.5 per cent per month. Credit cards are legally required to report
interest rates.
 a) If this was the NIR, what rate should they report?
NIR = APR = 1.5% x 12 = 18% p.a.
b) What is the effective annual rate?
I = 1.5% x 12 = 18%, n = 12
 EAR = 19.56%

24) Loan payments and EAR

If you borrow $120000 at 6 per cent NIR for 60 months,
a) what will your monthly payment be?
PV = 120000, n = 60, I = 6% / 12 = 0.5%
 PMT = $2319.94
b) What is the effective interest rate on this loan?
I = 6%, n = 12
 EAR = 6.17%

26) Calculating number of periods

One of your customers is having trouble paying her bills. You agree to a repayment
schedule of $3000 per month. You charge 1 per cent per month interest on late
accounts. If the current account balance is $200000, how long will it take until the debt
is fully paid?
PMT = $3000, PV = $200000, I = 1%
 n = 110 months

30) Calculating number of periods

You think that the value of a piece of beach real estate you just purchased will increase
by 5 per cent per year. You paid $950000 for the property and plan to sell when you can
make a $200000 profit. How long will you wait if the value does increase by 5 per cent
per year?
I = 5%, PV = $950000, FV = 1150000
 n = 4 years

31) EAR versus NIR

If a loan has an NIR of 14 per cent, what is the effective annual rate (EAR) assuming
the loan
a) calls for semi-annual payments?
I = 14%, n = 2
  EAR = 14%
b) calls for monthly payments?
I = 14%, n = 12
 EAR = 14.93%

35) Present value and multiple cash flows

You have won the lottery with the number 8888887. Lottery officials offer you the
decide of the following alternative pay-outs:

Alternative 1: $500000 one year from now

Alter native 2: $960000 five years from now

Which should you choose if the discount rate is:

a) 0 per cent?
Alternative 1: Alternative 2:
I = 0% I = 0%
1=0 1=0
2 = $500000 2=0
 Total PV = $500000 3=0
4=0
5=0
6 = $960000
 Total PV = $960000 (chosen)
b) 10 per cent?
Alternative 1: Alternative 2:
I = 10% I = 10%
1=0 1=0
2 = $500000 2=0
 Total PV = $454545.45 3=0
4=0
5=0
6 = $960000
 Total PV = $596084.47 (chosen)

c) 20 per cent?
Alternative 1: Alternative 2:
I = 20% I = 20%
1=0 1=0
2 = $500000 2=0
 Total PV = $416666.67 (chosen) 3=0
4=0
 5=0
6 = $960000
 Total PV = $385802.47

47) Calculating annuity payments

This is a classic ‘retirement’ problem. A timeline will help in solving it. Your friend is
celebrating her 35th birthday today and wants to start saving for her anticipated
retirement at age 65. She wants to be able to withdraw $10000 from her savings
account on each birthday for 10 years following her retirement; the first withdrawal
will be on her 66th birthday. Your friend intends to invest her money in the local
savings bank, which offers 7 per cent interest per year. She wants to make equal,
annual payments on each birthday in a new savings account she will establish for her
retirement fund.
a) If she starts making these deposits on her 36 th birthday and continues to make
deposits until she is 65 (the last deposit will be on her 65 th birthday), what amount
must she deposit annually to be able to make the desired withdrawals on
retirement?
To find the present value at the age of 65
PMT = $10,000, I = 7%, n =10
 PV65 = $70235.81

To find the present value at the age of 36

FV65 = $70235.81, I = 7%, n = 30
 PMT = $743.54

b) Suppose your friend has just inherited a large sum of money. Rather than making
equal payments, she has decided to make one lump-sum payment on her 36 th
birthday to cover her retirement needs. What amount would she have to deposit?
To find the present value at the age of 65
PMT = $10,000, I = 7%, n = 10
 PV65 = $70235.81

To find the present value at the age of 36

FV65 = $70235.81, I = 7%, n = 30
 PV = $9226.68