1) Evaluating lump sums and annuities.

Crissie just won the lottery, and she must choose

between three award options. She can elect to receive a lump sum today of $61 million, to
receive 10 end-of-year payments of $9.5 million, or 30 end-of-year payments of $5.5 million.

a) If she thinks she can earn 7 percent annually, which should she choose?

1 - $61,000,000

9,500,000 1
2- PV = [1− ]
0.07 ( 1.07 )10

= $66,724,024.64

END
10 7 -9,500,000 0
N I/YR PV PMT FV
66,724,024.64

5,500,000 1
3- PV = [1− ]
0.07 ( 1.07 )30

= $68,249,726.51 **
END
30 7 -5,500,000 0
N I/YR PV PMT FV
68,249,726.51

b) If she expects to earn 8 percent annually, which is the best choice?

1 - $61,000,000

9,500,000 1
2- PV = [1− ]
0.08 ( 1.08 )10

= $63,745,773.29 **
END
10 8 -9,500,000 0
N I/YR PV PMT FV
63,7454,773.29

5,500,000 1
3- PV = [1− ]
0.08 ( 1.08 )30

= $61,917,808.39

END

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 30 8 -5,500,000 0
N I/YR PV PMT FV
61,917,808.39

c) If she expects to earn 9 percent annually, which would you recommend?

1 - $61,000,000 **

9,500,000 1
2- PV = [1− ]
0.09 ( 1.09 )10

= $60,967,748.16

END
10 9 -9,500,000 0
N I/YR PV PMT FV
60,967,748.16

5,500,000 1
3- PV = [1− ]
0.09 ( 1.09 )30

= $56,505,097.24

END
30 9 -5,500,000 0
N I/YR PV PMT FV
56,505,097.24

d) Explain how interest rates influence the optimal choice.

Investment with different compounding intervals provide different effective returns. The higher
the interest rates, the more preferable it is to receive the money now. As such, applying to this
question, when interest rate is higher, Option 1 is the recommended choice. In contrast, when
interest rate is lower, Option 3 will be the recommended choice.

2) Power of compounding. 20-year-old Leia wants to save $3 a day for her retirement. Every
day she places $3 in a drawer. At the end of one year, she invests the accumulated savings
($1,095) in a brokerage account with an expected annual return of 12%. (ordinary annuity)

a) If the last deposit was made when she turns 65, how much money will Leia have when
she is 65 years old?

1- N = 65-20 = 45

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 1+ I
¿
2- FV = ¿
PMT
¿
I

1.12
¿
= ¿
1095
¿
0.12

= $1,487,261.89

END
45 12 0 -1095
N I/YR PV PMT FV
1,487,261.885

b) If Leia doesn’t start saving until she is 40 years old, how much will she have at 65?

1- N = 65-40 = 25

1+ I
¿
2- FV = ¿
PMT
¿
I

1.12
¿
= ¿
1095
¿
0.12

= $ 146,000.59

END
25 12 0 -1095
N I/YR PV PMT FV
146,000.5877

c) If Leia start saving only when she is 40 years old, how much must Leia deposit annually
so that she would have the same retirement amount as she has if she had started saving at
20 years old?

1+ I
¿
FV = ¿
PMT
¿
I

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 1.12
¿
1,487,261.885 = ¿
PMT
¿
0.12

= $11,154.42

END
25 12 0 1,487,261.885
N I/YR PV PMT FV
-11,154.41924

3) Effective versus nominal interest rates. Bank A pays 4% interest compounded annually on
deposits, Bank B pays 3.75% compounded semiannually, and Bank C pays 3.5%
compounded daily.

a) Which bank would you use? Why?

Bank A Bank B Bank C

I NOM =4 % I NOM =3.75 % I NOM =3.5 %

I PER=4 % 0.0375 0.035

I PER= I PER=
2 365
EFF% = 4% = 1.875%
= 0.00959%
M
I NOM
EFF% ¿[1+ ] −1
M I NOM M
EFF% ¿[1+ ] −1
M
2
0.0375 0.035 365
¿[1+ ] −1 ¿[1+ ] −1
2 365

= 3.785% = 3.5617%
= 3.79% = 3.56%

She should choose Bank A, as it has the highest EAR and therefore will give her the
highest effective returns.

b) If you deposited $5,000 in each bank today, how much would you have at the end of 2
years?

Bank A Bank B Bank C

2 2 2
FV A =5000(1+ 4 % ) FV B=5000 (1+ 3.785 %) FV C =5000(1+3.56 %)
= $5408 = $5385.66 = $5362.34

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 END END END
2 4 -5000 0 2 3.785 -5000 0 2 3.56 -5000 0
N I/YR PV PMT FV N I/YR PV PM FV N I/YR PV PMT FV
5408 T 5362.34
5385.66

c) What nominal rate would cause Banks B and C to provide the same effective annual rate
as Bank A?
Bank B Bank C
I NOM M
I M EFF %=(1+ ) −1
EFF %=(1+ NOM ) −1 M
M
I NOM 365
I NOM
2 0.04 = (1+ ) −1
0.04 = (1+ ) −1 365
2
365
I NOM
I 2 (1+ ) = 1.04
(1+ NOM ) = 1.04 365
2
I 365
I NOM 1+ NOM = √ 1.04
1+ =√1.04 365
2
I NOM 365
I NOM = √ 1.04−1
=√ 1.04−1 365
2
I NOM =3.92%
I NOM =3.96 %

d) Suppose you do not have $5000 now but need it at the end of 1 year. You plan to make a
series of deposits, annually for Bank A, semi-annually for Bank B, and daily for Bank C,
with payments beginning today. How large must the payments be to each bank? (annuity
due)

Bank A Bank B Bank C

FV dueA =FV ord (1+ I ) PMT N PMT N

FV dueA= ( [ 1+ I ] −1)(1+ I ) FV dueA = ( [ 1+ I ] −1)(1+ I )
I I
PMT N
= ( [ 1+I ] −1)(1+ I ) 5000 = 5000 =
I 2
PMT 0.0375 0.0375 PMT 365

5000 = 0.0375 [
( 1+
2 ]
−1)(1+
2
)
0.035
( 1+
0.035
365 [ ] −1)(1+
0.035
365
)
PMT 1 2 365
([ 1+ 0.04 ] −1)(1+ 0.04)
0.04
PMT = $2431.19 PMT = $13.46
PMT = $4807.69

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BEGIN BEGIN BEGIN

1 4 0 5000 2 1.875 0 5000 365 0.00959 0 5000

N I/YR PV PMT FV N I/YR PV PMT FV N I/YR PV PMT FV
-4807.69 -2431.19 -13.46

4) Interest portions and remaining balance. The Jackson family is interested in buying a
home. The family is applying for a $125,000, 30-year mortgage. Under the terms of the
mortgage, they will receive $125,000 today to help purchase their home. The loan will be
fully amortized over the next 30 years. Current mortgage rates are 8 percent. Interest is
compounded monthly and all payments are due at the end of the month.

a) What is the monthly mortgage payment?

PMT N = 30
1  12 = 360
PMT 1 125000= (1− ) 0.08
PV = (1− ) 0.08 ( I 360
I/YR0.08 PER ¿ = = 0.66667%
I ( 1+ I ) N 12
1+ (12 ) 12

END
PMT = $917.21 36 0.6666 12500 0
0 7 0
N I/YR PMT PV FV
-917.2057173
b) What will be the remaining balance on the mortgage after the first year?

PMT 1
PV =
I
1−
(
( 1+ I ) N ) N = 360 – 12 = 348
I/YR ( I PER ¿ =
0.08
= 0.66667%
917.2057173 1 12
¿ (1− )
0.08 0.08
348

12
1+ (
12 ) END
34 0.6666 -917.2057173 0
= $123,955.80 8 7
N I/YR PV PMT FV
123955.79

c) What portion of the mortgage payments made during the first year will go toward
interest?

Principal Repaid in Year 1 = $125,000 - $123,955.80

= $1044.20

Interest Paid in Year 1 = Total Payment made in Year 1– Principal Repaid

= ($917.21  12) - $1044.20
= $9962.32

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 $ 9962.32
Portion = 100 %
( $ 917.2112)

= 90.51%

d) What portion of the 25th mortgage payment will go toward interest?

Step 1: Remaining balance on mortgage after 24th payment

PMT 1 N = 360 – 24 = 336

PV =
I
1−
(
( 1+ I ) N ) I/YR ( I PER ¿ =
0.08
= 0.66667%
917.2057173 1 12
¿ (1− )
0.08 0.08
360−24

12
1+ (
12 ) END
33 0.6666 -917.2057173 0
= $122,824.92 6 7
N I/YR PV PMT FV
Step 2: Interest Paid in 25 payment th 122824.921
= Beginning Balance  I PER
0.08
= $122,824.92 
12
=$818.8328
=$818.83

Step 3: Portion

$ 818.83
= 100 %
$ 917.21
= 89.27%

5) Required annuity payments. A father is now planning a savings program to put his
daughter through college. She just celebrated her 13 th birthday, she plans to enroll at the
university in 5 years when she turns 18 years old, and she should graduate in 4 years.
Currently, the annual cost (for everything – food, clothing, tuition, books, transportation, and
so forth) is $15,000, but these costs are expected to increase by 5% annually. The college
requires that this amount be paid at the start of the school year. She now has $7,500 in a
college savings account that pays 6% annually.

a) How large must each payment be if the father makes five equal annual deposits into her
account; the first deposit today and the fifth deposit on the daughter’s 17 th birthday?
[Hint: Calculate the cost (inflated at 5%) for each year of college and find the PV of these
costs, discounted at 6%, as of the day she enters college. Then find the compounded value
of her initial $7,500 on that same day. The difference between the PV costs and the
amount that would be in the savings account must be made up by the father’s deposits].

Step 1: Cost of each of the 4 years of college

N
FV 1 =(1+ I )

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 ¿ 15000(1+0.05)5
¿ $ 19,144.22 (for Year 1 of college)
6
FV 2=15000(1+0.05)
¿ $ 20,101.43 (Year 2 of college)

FV 3 =15000(1+0.05)7
¿ $ 21,106.51 (Year 3 of college)
8
FV 4=15000( 1+ 0.05)
¿ $ 22,161.83 (Year 4 of college)

Step 2: Find PV of cost of college, discounted at 6%, as at the day the daughter enters
college at age 18

FV
PV = N
(1+ I )

19,144.22 20,101.43 21,106.51 22,161.83

¿ 0
+ 1
+ 2
+ 3
(1+0.06) (1+0.06) (1+ 0.06) (1+ 0.06)

= $75,500.05

Step 3: Compounded Value of Savings, as at the day the daughter enters college at age 18

FV =7500(1+0.06)5
¿ $ 10,036.69

Step 4: Amount still lacking, as at the day the daughter enters college at age 18

Difference = $75,500.05 - $10,036.69

= $65,463.36

Step 5: Amount of Each Payment (for annuity due as payment is made at the beginning of each
period) – FV formula, because we are calculating how much he has to pay today at age 13 to get
65.463.36 AKA future value on the day the daughter is age 18, 5 years later

PMT 5
65,463.36= [ ( 1+0.06 ) −1] [1+0.06]
0.06

= $10,955.57

b) If instead, her father makes six equal annual deposits into her account; the first deposit
today and the sixth on the day she starts college. How large must each of the six payments
be?

 Amount needed on the day she starts college = $65,463.36

 The first deposit is made today on her 13 th birthday, and the sixth deposit is made
on her 18th birthday (the day she starts college)

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  The sixth deposit would not earn any interest.
 This connects to: in ordinary annuity, the last payment does not earn interest
 Hence, we treat these series of 6 deposits as a 6-year ordinary annuity, with first
payment made at the end of period t=1
 Treat age 13 as t=1, not t=0

Sample of FV of ORDINARY ANNUITY:

APPLYING TO THIS QUESTION,

Change the mindset: the first deposit at age 13 is made at t=1
Age 13 Age 18

0 1 2 3 45
6

65,463.36

PMT 6
65,463.36= [ ( 1+0.06 ) −1] = $9,385
0.06

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