I.

Suggested end-of-chapter problems for Chapter 4:

#3, #6, #7, #12, #14, #18, #21, #22, #24, #26, #37, #48

II. Sample Questions for Chapter 4

Present Value: PV
Future Value: FV
Net Present Value: NPV
Internal Rate of Return: IRR, which is the interest rate that makes NPV = 0.

1) Which of the following statements is false?

A) The process of moving a value or cash flow forward in time is known as compounding.
B) The effect of earning interest on interest is known as compound interest.
C) It is only possible to compare or combine values at the same point in time.
D) A dollar in the future is worth more than a dollar today.
Answer: D
Explanation: A dollar in the future is worth less than a dollar today.

2) At an annual interest rate of 7%, the future value of $5,000 in five years is closest to:
A) $3,565
B) $6,750
C) $7,015
D) $7,035
Answer: C
Explanation: FV = PV(1 + i)^N = 5000(1.07)^5 = 7,012.76

3) At an annual interest rate of 7%, the present value of $5,000 received in five years is closest
to:
A) $3,565
B) $6,750
C) $7,015
D) $7,035
Answer: A
Explanation: PV = FV/(1 + i)^N = 5000(/1.07)^5 = 3,564.93

4) Consider the following timeline:

If the current market rate of interest is 9%, then the present value of this timeline as of year 0 is
closest to:
A) $492
B) $637
C) $600
D) $400
Answer: A
Explanation: PV = FV(1 + r)n
100 / (1.09)1 = 91.74, 200 / (1.09)2 = 168.34, 300 / (1.09)3 = 231.66, the sum = 491.74.

5) Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 8%, then the future value of this stream of cash flows is
closest to:
A) $11,699
B) $10,832
C) $12,635
D) $10,339
Answer: A
Explanation: FV = 1000(1.08)4 + 2000(1.08)3 + 3000(1.08)2 + 4000(1.08)1 = $11,699

6) Which of the following formulas is incorrect?

1   1  r  
N
1  
r  g   (1  g )  
A) PV of a growing annuity = C ×  
 1 
1 1 
 (1  r ) N 
B) PV of an annuity = C × r  
C
C) PV of a growing perpetuity = r  g
C
D) PV of a perpetuity = r
Answer: A
1   1  g  
N
1  
r  g   (1  r )  
Explanation: PV of a growing annuity = C ×  
7) If the current rate of interest is 8%, then the present value of an investment that pays $1000 at
the end of the next 20 years is closest to:
A) $18,519
B) $45,761
C) $9,818
D) $20,000
Answer: C
Explanation: PV = C/r (1 - (1 + r)^ -N)= 1000/.08(1-(1+0.08)^-20)
PV = $9,818

8) If the appropriate interest rate is 8%, then present value of $500 paid at the BEGINNING of
each of the next 40 years is closest to:
A) $23
B) $5,962
C) $6,439
D) $20,0000
Answer: C
Explanation: When the first cash flow occurs at time 0, we call it annuity due, whose value = PV
of ordinary annuity*(1+i). That is, its PV = PMT[1/r - 1/(r(1+r)^n)] * (1+r) = 500[1/.08 -
1/(.08(1.08)^40)]*(1.08) = 6,439.29

9) If the current rate of interest is 8%, then the future value 20 years from now of an investment
that pays $1000 per year and lasts 20 years is closest to:
A) $45,762
B) $36,725
C) $9,818
D) $93,219
Answer: A
Explanation: FV = C/r((1+r)N -1)= 1000/0.08((1+0.08)20 - 1) = $45,762

10) Suppose that a young couple has just had their first baby and they wish to insure that enough
money will be available to pay for their child's college education. They decide to make deposits
into an educational savings account on each of their daughter's birthdays, starting with her first
birthday. Assume that the educational savings account will return a constant 7%. The parents
deposit $2000 on their daughter's first birthday and plan to increase the size of their deposits by
5% each year. The future value of the amount available for the daughter's college expenses on
her 18th birthday is closest to:
A) $42,825
B) $97,331
C) $67,998
D) $103,063
Answer: B
Explanation: FV of a growing annuity
   1  .05 18 
1 1    
  (1  .07)  
$2,000 × .07  .05   (1.07)18= $97,331
11) Consider a growing perpetuity that will pay $100 in one year. Each year after that, you will
receive a payment on the anniversary of the last payment that is 6% larger than the last payment.
This pattern of payments will continue forever. If the interest rate is 11%, then the value of this
perpetuity is closest to:
A) $1,667
B) $588
C) $2,000
D) $909
Answer: C
Explanation: PV growing Perpetuity = C / (r – g) = 100 / (.11 - .06) = $2000

12) You are thinking about investing in a mine that will produce $10,000 worth of ore in the first
year. As the ore closest to the surface is removed it will become more difficult to extract the ore.
Therefore, the value of the ore that you mine will decline at a rate of 8% per year forever. If the
appropriate interest rate is 6%, then the value of this mining operation is closest to:
A) $71,429
B) $500,000
C) $166,667
D) This problem cannot be solved.
Answer: A
Explanation: PV = C / (r – g) = 10,000 / (.06 - -.08) = 10,000 / .14 = $71,429

13) A firm is considering purchasing a parcel of wilderness land near a popular historic site.
Although this land will cost $400,000 today, by renting out wilderness campsites on this land,
the firm expects to make $35,000 at the end of every year forever. If the appropriate discount
rate is 8%, then the NPV of this new wilderness campsite is closest to:
A) -$50,000
B) -$37,500
C) $37,500
D) $50,000
Answer: C
Explanation: NPV = -400,000 + $35,000/.08 = 37,500

14) You are interested in purchasing a new automobile that costs $35,000. The dealership offers
you a special financing rate of 6% annual percentage rate (APR), which corresponds to 0.5% per
month for 48 months. Assuming that you do not make a down payment on the auto and you take
the dealer's financing deal, then your monthly car payments would be closest to:
A) $729
B) $822
C) $842
D) $647
Answer: B
Explanation: PV = 35000, I = .5, N = 48, FV = 0, Compute Payment = $821.98

15) You are considering purchasing a new home. You will need to borrow $250,000 to purchase
the home. A mortgage company offers you a 15 year fixed rate mortgage (180 months) at 9%
APR (0.75% per month). If you borrow the money from this mortgage company, your monthly
mortgage payment will be closest to:
A) $2,585
B) $660
C) $2,535
D) $1,390
Answer: C
Explanation: PV = 250000, I = 0.75, N = 180, FV = 0, Compute PMT = $2535.67

16) You are looking for a new truck and see the following advertisement. "Own a new truck!
No money down. Just five easy annual payments of $8000." You know that you can get the
same truck from the dealer across town for only $31,120. The interest rate for the deal
advertised is closest to:
A) 5%
B) 9%
C) 12%
D) 15%
Answer: B
Explanation: PV = 31120, FV = 0, N = 5, PMT = -8000, Compute I = 8.9965%

17) You have an investment opportunity that will cost you $10,000 today, but return $12,500 to
you in one year. The IRR of this investment opportunity is closest to:
A) 80%
B) 125%
C) 20%
D) 25%
$12,500
Answer: D, Explanation: IRR = $10, 000 - 1 = 0.25 or 25%
18) At an annual interest rate of 6%, about how many years does it take to double your money?
A) 6 years
B) 8 years
C) 12 years
D) 17 years
Answer: C, Explanation: PV = -1, FV = 2, I =6, Compute N = 11.9. Note the rule of 72 will give
you the approximate answer. The rule of 72 is that the number of years to double money is 72/i.