BA 2802 – Principles of Finance

Solutions to Problems for Recitation #2

1. Your parents just gave you a gift of $15,000. You are investing this money in a bank account
for 12 years at a 5% interest rate per year.
a. Suppose bank pays you simple interest over that time period. Calculate the amount
of money you will have at the end of 12 years.

You will have:

FV12 = PV0 + PV0 × 0.05 × 12
= 15,000 + 15,000 × 0.05 × 12 = $24,000

b. Suppose bank pays you compound interest over that time period. Calculate the
amount of money you will have at the end of 12 years.

You can calculate the amount of money you will have using the FV equation:
FV12 = PV0 × (1 + 0.05)12
= 15,000 × (1 + 0.05)12 = $26,937.85

Or, the FVIF tables:

FV12 = PV0 × FVIF5%, 12
= 15,000 ×1.7959 = $26,938.5

c. Calculate the amount of interest you earned on the interest during this time period.

Interest Earned on Interest = FV12 with compound interest-FV12 with simple interest
= 26,937.5 – 24,000 = $2,937.5

2. Travis invests $12,500 today into a retirement account. He expects to earn 8 percent
compounded interest per year, on his money for the next 26 years. After that, he wants to be
more conservative, so only expects to earn a 6 percent interest rate compounded semiannually
per year for another 12 years. Suppose $12,500 he deposited today is the only deposit he
makes into the account during this time period. Calculate the amount of money he will have
in his account when he retires 38 years from now.

Let’s prepare the time line for our problem:

t = 26 years t = 12 years
|_________________________|___________________|
|--------|--------|-- ……..… --|--------|--------|--. ……...---|--------|
0 1 2 25 26 27 37 38
|_________________________|___________________|
r = 8% r = 6% compounded semiannuall

Let’s first find the FV of 12,500 deposited into the account today at end the 26th years from
today using the FV equation:

𝐹𝑉26 = 𝑃𝑉0 × (1 + 𝑟)26

𝐹𝑉26 = 12,500 × (1 + 0.08)26 = $92,454.42

Or we can solve this part of the problem using FVIF tables. Let’s first find the FV of 12,500
 deposited into the account today at end the 26th years from today:

FV26 = PV0 × FVIF8%, 26 = 12,500 ×7.3964 = $92,455

Then find the FV of this amount at the end the 38th years from today using the FV equation.
In order to be able to do that we need to either calculate the effective annual interest rate or
work with semiannual time periods. If we calculate effective annual rate, our number of
compounding periods (m) is 2 and n = 1:
m*n 21
 APR   0.06 
Effective Annual Rate = 1    1  1    1  6.09%
 m   2 

𝐹𝑉38 = 𝐹𝑉26 × (1 + 𝑟)12

𝐹𝑉38 = 92,454.42 × (1 + 0.0609)12 = $187,940.10

Or, we can work with semiannual time periods. In a 12 year time period, we have 12 × 2 =
24 semiannual time periods. Interest rate for each of these semiannual time periods will be
0.06
= 0.03 = 3%.
2

𝐹𝑉38 = 𝐹𝑉26 × (1 + 𝑟)24

𝐹𝑉38 = 92,454.42 × (1 + 0.03)24 = $187,940.10

Now, we can use the FVIF tables. Let’s find the FV of $92,454.42 at end the 38th years from
today using r=3% and t=24 semiannual time periods:

FV38 = FV26 × FVIF3%, 24 = 92,455 × 2.0328 = $187,942.52

3. Good news: You won $10,000 in a lottery.

Bad New: You cannot get the money until 5 years from today. So, at the end of the 5 th year
from today, you will be paid $10,000.
a. You decided to borrow some money against your lottery winnings today from a bank
and pay it back in 5 years with any interest on that loan. You use the $10,000 you will
collect from your lottery winnings in year 5 to pay back this loan. You think you will
be able to borrow this money at 6% interest rate per year from your bank. Calculate
the amount of money you can borrow today.

You can borrow the PV of $10,000 today. At a 6% interest rate, this PV will be
Using the PV equation:
𝐹𝑉5 10,000
𝑃𝑉0 = = = $7,472.58
(1 + 0.06)5 (1 + 0.06)5

Using the PVIF Table:

PV0 = FV5 × PVIF6%, 5 = 10,000 × 0.7473 = $7,473

b. Suppose your bank is willing to loan you $6,500 today and wants you to pay $10,000
in 5 years from today to cover the principal and interest on the loan. Determine the
interest rate charged by your bank on this loan.

Now we know the FV5 and PV0 and t, we are trying to solve for r:
 𝐹𝑉𝑡 = 𝑃𝑉0 × (1 + 𝑟)𝑡

𝐹𝑉𝑡
= (1 + 𝑟)𝑡
𝑃𝑉0

𝐹𝑉𝑡 1/𝑡
( ) = (1 + 𝑟)
𝑃𝑉0
𝐹𝑉𝑡 1/𝑡
𝑟= ( ) −1
𝑃𝑉0

For our problem, FV5 = $10,000 and PV0 = $6,500 and t = 5. Substituting these
values into the formula, we can solve for r.

10,000 1/5
𝑟= ( ) − 1 = 8.9977% ≈ 9%
6,500

c. Suppose you found another bank which is willing to loan you $6,500 at 7% interest
rate per year compounded weekly. Determine how long it would take for $6,500 to
become $10,000.

Now we know the FV5 and PV0 and r, we are trying to solve for t:

𝐹𝑉𝑡 = 𝑃𝑉0 × (1 + 𝑟)𝑡

𝐹𝑉𝑡
= (1 + 𝑟)𝑡
𝑃𝑉0

𝐹𝑉𝑡
𝑙𝑛 ( ) = 𝑡 × 𝑙𝑛(1 + 𝑟)
𝑃𝑉0
𝐹𝑉
𝑙𝑛 (𝑃𝑉𝑡 )
0
𝑡=
ln(1 + 𝑟)

Since interest rate is compounded weekly and there are 52 compounding periods in a
year, we have to calculate the Effective Annual Rate. So our number of compounding
periods in a year (m) is 52. Since we need to calculate the effective annual rate our n
is 1.
m*n 521
 APR   0.07 
Effective Annual Rate = 1    1  1    1  7.246%
 m   52 

For our problem, FV5 = $10,000 and PV0 = $6,500 and r = 7.246%. Substituting these
values into the formula, we can solve for t.

10,000
𝑙𝑛 ( ) 0.4308
6,500
𝑡= = = 6.158 𝑦𝑒𝑎𝑟𝑠
ln(1 + 0.07246) 0.069955
4. Friendly Credit Corp. wants to earn an effective annual return on its consumer loans of 13
percent per year. The bank uses daily compounding on its loans. Determine the APR the
bank should quote to its potential borrowers in order to be able to earn an effective rate of
13% per year with daily compounding.

We are given the effective rate and we need to calculate the APR. So, we are going to solve
the EAR equation for the APR.
mn

EAR = 1 
APR 
 
 1  APR  (1  EAR )1 / mn  1  m 
 m 

In this question m=365 and n=1

 
APR  (1  0.13)1 / 3651  1  365  12.225%

5. Suppose you are offered an investment alternative that pays $3,600 at the end of each year
for 7 years. The first payment is paid at the end of year 3. The appropriate discount rate is 12
percent per year.
a. Calculate the value of this investment today.

Length of our payment period is 1 year. Therefore, we need to know the annual
interest rate. Since no compounding period is given in the question, we can work with
the annual interest rate of 12%.

Since the first payment is made at the end of year 3 and PVIFA gives us the PV of an
annuity at the beginning of the first payment period, we will find the PVA at the
beginning of year 3. The beginning of year 3 is also the end of year 2. Since our
subscripts are always as of year ends, we will find PVA2 first.
PVA2 = C × PVIFA12%, 7 = 3,600 × 4.5637 = $16,429.32

We need to find the PV of this sum at the end of year 0. So, we need to discount this
amount for 2 more years at 12% per year.
PV0 = FV2 × PVIF12%, 2 = 16,429.32 × 0.7972 = $13,097.45

b. Suppose your cousin Külyutmaz purchased the same investment plan with a small
difference. His first payment of $3,600 is made at the beginning of year 3 instead of
at the end of year 3 and he will still have a total of 7 payments. Calculate the value
of his investment today.

Length of his payment period is 1 year as well. Therefore, we need to know the annual
interest rate. Since no compounding period is given in the question, we can work with
the annual interest rate of 12%.

His first payment is made at the beginning of year 3. PVIFA table and formula is
designed to find the PVA of payments that are made at the end of every year. The
beginning of year 3 is also the end of year 2. So, we can calculate the PVA of annuity
payments where the first payment is made at the end of year 2. PVIFA gives us the
PV of an annuity at the beginning of the first payment period. Therefore, we will find
the PVA at the beginning of year 2. The beginning of year 2 is also the end of year 1.
Since our subscripts are always as of year ends, we will find PVA1 first.
PVA1 = C × PVIFA12%, 7 = 3,600 × 4.5637 = $16,429.32
 We need to find the PV of this sum at the end of year 0.
PV0 = FV1 × PVIF12%, 1 = 16,429.32 × 0.8928 = $14,668.10

6. Anne plans to save $40 a week for the next 5 years. She expects to earn 3 percent for the first
2 years and 5 percent for the last 3 years. Calculate the value of her savings at the end of the
5 years.

Length of her payment period is one week. Therefore, we need to know the one-week interest
rate. Since, there is no compounding going on during a one-week period, we can calculate
the one-week rate as = APR/52.

First we need to find the FVA of first 2 years’ weekly payments. FVIFA gives us the FVA
at the end of last payment period. The last payment of this 2 year time period will happen on
the 104th week. So, we will find the FVA104.
FVA104 = C × FVIFA3/52%, 104 = 40 × 107.1372 = $4,285.49
0.03 104
(1 + ) − 1 (1.000577)104 − 1
FVIFA 3 %,2×52 = 52 = = 107.1372
52 0.03/52 0.000577

We need to find the value of this amount by the end of 5th year. The interest rate during year
3 through 5 is 5% per year. So, we need to carry this amount for 3 × 52 = 156 more weeks
into the future at an annual interest rate of 5%.
FV260 = PV104 × FVIF5/52%, 156 = 4,285.49 × (1.00096154)156
= 4,285.49 × 1.16175 = $4,978.67

Now, we need to find the FVA of last 3 years’ weekly payments. FVIFA gives us the FVA
at the end of last payment period. The last payment of this 3 year time period will happen on
the 156th week. So, we will find the FVA156.
FVA156 = C × FVIFA5/52%, 156 = 40 × 168.2273 = $6,729.09
0.05 156
(1 + ) − 1 (1.00096154)156 − 1
FVIFA 5 = 52 = = 168.2273
52
%, 3×52 0.05/52 0.00096154

Total amount of money she has in the account by the end of year 5 is:
Total FV260 = 4,978.67 + 6,729.09 = $11,707.76

7. Given an interest rate of 4.85 percent per year, calculate the value at year t = 8 of a perpetual
stream of $2,500 payments every other year that begins at year t = 25.

The length of time between two consecutive payments is two years. Therefore, we need to
know the effective 2-year interest rate. Since no compounding period is given in the question,
we can assume that the interest rate is compounded annually. Our m=1 and n=2 in this
question.

mn 12
 APR   0.0485 
Effective 2-year Rate = 1    11    1  0.09935  9.935%
 m   1 

This is a perpetuity example. The first payment will be received at the end of year 25. PVA∞
formula will give us the PV of this perpetuity at the beginning of first 2-year payment period
which is the beginning of year 24. The beginning of year 24 is also the end of year 23. So,
 we will find the PVA∞ at the end of year 23 using the formula.

𝐶 2,500
𝑃𝑉𝐴∞
23 = = = $25,163.56
𝑟 0.09935

We are asked to find the PV of this amount at the end of year 8. There are 15 more years
between the end of year 8 and the end of year 23. So, we will discount this amount for 15
more years at an interest rate of 4.85% per year.

1
𝑃𝑉8 = 𝑃𝑉𝐴∞
23 × 𝑃𝑉𝐼𝐹4.85%,15 = 25,163.56 ×
(1 + 0.0485)15

𝑃𝑉8 = 25,163.56 × 0.4914 = $12,365.37

8. Your grandfather started his own business 52 years ago. He opened a savings account at the
end of his third month of business and contributed $x. Every three months since then, he
faithfully saved another $x. His savings account has earned an average rate of 4.5 percent per
year compounded monthly. Today, his account is valued at $364,209.11. Calculate the
amount of money your grandfather invested in that account every 3 months.

Our payment periods are 3 months long. Therefore, we need to know the three-month interest
rate. Since interest rate is compounded monthly, during our three-month time period, interest
rate will be compounded three times. Therefore, first we need to calculate the 3-month
effective rate.

mn
 APR 
3-month Effective Rate = 1   1
 m 

In this question m=12 (monthly compounding) and n=1/4 (3 month periods)

1
12
 0.045  4
3-month Effective Rate = 1    1  1.13%
 12 

We know the FVA at the end of 52 × 4 = 208th quarter. That FV is $364,209.11. We need
to solve the FVA formula for the payment amount.

𝐹𝑉𝐴208 = 𝐶 × 𝐹𝑉𝐼𝐹𝐴1,13%,208
(1 + 0.0113)208 − 1
364,209.11 = 𝐶 ×
0.0113
364,209.11
364,209.11 = 𝐶 × 827.6470 → 𝐶 = = $440.06 in every 3-months
827.6470

9. Currently, you owe the bank $9,800 for a car loan. The loan has an interest rate of 7.75 percent
per year with monthly compounding. You were making monthly payments of $310. Your
financial situation has recently changed such that you can no longer afford to make these $310
payments. After talking with your banker and explaining the situation, he has agreed to lower
your monthly payments to $225 while keeping the interest rate at 7.75 percent per year with
monthly compounding. Determine how much longer it will take you to repay this loan than
you had originally planned with this new payment schedule.
 We need to solve for time periods given the PVA, C and interest rates. With the first
payment schedule, we have the following equation to solve for t.

1
1−
0.0775 𝑡
(1 + 12 )
9,800 = 310 × 𝑃𝑉𝐼𝐹𝐴7.75 = 310 ×
12
%,𝑡 0.0775/12

1
9,800 1 − (1 + 0.006458)𝑡
=
310 0.006458
1
31.6129 × 0.006458 = 1 −
(1 + 0.006458)𝑡

1
(1 + 0.006458)𝑡 =
1 − 0.204156

𝑙𝑛(1.256528) 0.22835
𝑡= = = 35.47 𝑚𝑜𝑛𝑡ℎ𝑠
ln(1.006458) 0.006437

With the second payment schedule, we have the following equation to solve for t

1
1−
0.0775
(1 + 12 )𝑡
9,800 = 225 × 𝑃𝑉𝐼𝐹𝐴7.75 = 225 ×
12
%,𝑡 0.0775/12

1
9,800 1 − (1 + 0.006458)𝑡
=
225 0.006458
1
43.5556 × 0.006458 = 1 −
(1 + 0.006458)𝑡

1
(1 + 0.006458)𝑡 =
1 − 0.281282
𝑙𝑛(1.391366) 0.330386
𝑡= = = 51.31 𝑚𝑜𝑛𝑡ℎ𝑠
ln(1.006458) 0.006437

Difference = 51.31 - 35.47 = 15.84 months

10. Your uncle Varyemez just won the Milli Piyango. He has been given the option of receiving
either $62 million today or $5 million a year for the next 30 years, with the first payment
made today. Determine the interest rate that would make your uncle indifferent between these
two payment options.

In order for your uncle Varyemez to be indifferent between these two payment options, their
PVs today should be the same. So, we are going to solve for the interest rate that makes the
 PVA of thirty $5 million payments equal to $62 million. We have the following equation to
solve for the interest rate:

𝑃𝑉𝐴0 = 𝐶 × 𝑃𝑉𝐼𝐹𝐴𝑟%, 30 × (1 + 𝑟) → 62 = 5 × 𝑃𝑉𝐼𝐹𝐴𝑟%, 30 × (1 + 𝑟)

Solving for r is a trial and error process. Length of our payment period is 1 year. So, we are
trying to solve for the annual interest rate. Let’s try an interest rate of 8% per year and find
the PVA of thirty $5 million payments at that interest rate today.

𝑃𝑉𝐴0 = 5 × 𝑃𝑉𝐼𝐹𝐴8%, 30 × (1 + 0.08) = 5 × 11.2528 × 1.08 = $60.792 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

This is lower than $62 million we are trying to get as the PVA of these annuity payments.
So, we need to decrease the interest rate. Let’s try an interest rate of 6% per year and find the
PVA of thirty $5 million payments at that interest rate today.

𝑃𝑉𝐴0 = 5 × 𝑃𝑉𝐼𝐹𝐴6%, 30 × (1 + 0.06) = 5 × 13.7648 × 1.06 = $72.9535 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

This is higher than $62 million we are trying to get as the PVA of these annuity payments.
Now, we need to increase the interest rate. Let’s try an interest rate of 7% per year and find
the PVA of thirty $5 million payments at that interest rate today.

𝑃𝑉𝐴0 = 5 × 𝑃𝑉𝐼𝐹𝐴7%, 30 × (1 + 0.07) = 5 × 12.4090 × 1.07 = $66.385 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

This is almost equal to $62 million we are trying to get as the PVA of these annuity payments.
So, we can say that interest rate that makes your uncle indifferent between these two payment
schedules is closer to 8% per year. The actual rate solved by using a financial calculator or
excel is 7.77% per year.

11. Your cousin, Esra, had a baby boy, Emre today. They are delighted but at the same time
concerned about cost of his college education. In order to plan ahead, she and her husband,
Engin, want to start saving for his college education. Esra and Engin decide that they can
make equal deposits into a “tuition fund” account in every 3 months. They made the first
payment into this account today. The last payment will be made on Emre’s 17th birthday.
The college tuitions will be paid on Emre’s 18th, 19th, 20th and 21st birthdays. At that time,
college tuition is expected to be $15,000 per year for the next 4 years. The bank quoted them
a rate of 7.95% per year, compounded monthly.
a. Draw a timeline of the cash flows.

-1/4 0 1 17 18 19 20 21
|---|---|---|---|---|-- ---|---|---|---|---|---|---|---|---|
C C C C C C
P P P P

b. If the couple wants Emre’s entire college tuition to be available in this account on his
18th birthday, determine the amount to be deposited in the account in every 3 months
until Emre’s 17th birthday.

To be able to solve for the quarterly deposits into the account, we need to know either
the PVA-1/4 or FVA17. It is easier to calculate the FVA17. FVA17 of deposits has to
be equal to the PVA17 of tuition payments. To find the PVA17 of tuition payments,
we need to know the effective annual interest rate.
 0.0795 12
Effective 1- year rate = (1 + ) − 1 = 8.2462%
12

PVA17 = 15,000 × PVIFA8.2462%,4

1
1−
(1 + 0.082462)4
𝑃𝑉𝐴17 = 15,000 × = 15,000 × 3.294 = $49,410
0.082462

This is equal to the FV of annuity payments that Esra and Engin has to make into the
account in every 3 months. Therefore we need to know the quarterly interest rate.
Since the interest rate is compounded monthly, we need to calculate the effective 3-
month rate:
1
0.0795 12×4
Effective 3-month rate = (1 + ) − 1 = 2%
12

Since the couple is going to make quarterly payments into the account for the next 17
years starting from today immediately, the number of payments will be 17×4 + 1 =
69.

𝐹𝑉𝐴69 = 𝐶 × 𝐹𝑉𝐼𝐹𝐴2%,69

(1 + 0.02)69 − 1
49,410 = 𝐶 ×
0.02
49,410
49,410 = 𝐶 × 146.0568 → 𝐶 = = $338.29
146.0568

c. Suppose 18 years has already passed and it is time for Emre to decide whether he
wants to attend college or not. He estimates that after graduation he will make $7,000
more per year than his peers who did not go to college and work at Migros. Assume
that Emre will graduate from college on his 22nd birthday, gets his first paycheck on
his 22nd birthday as well. Also assume that if Emre decides not to go to college, he
has to lay around the house and watch TV for the next 4 years and then get a job at
Migros on his 22nd birthday and get his first paycheck on his 22nd birthday. He also
cannot the touch the money in the “tuition fund” account until his 22nd birthday and
that money will continue to earn 7.95% interest per year compounded monthly. He
also expects to work for 45 years starting from his 22nd birthday. Based purely on
financial criteria, decide whether Emre should pay the tuition and attend college, or
he should not attend college, enjoy his life for the next 4 years and then work at
Migros.

To decide whether to go to college or not, Emre has to compare cost of college to the
additional income he will get from going to college. He have already calculated the
PV of tuition payments on his 17th birthday. Therefore, we have to find the PV of
$7,000 extra income per year he will earn by going to college on his 18th birthday too.

17 18 19 20 21 22 23 65 66
|---|---|---|---|---|---|---|---|---|---|---|---|...|---|---|
P P P P
 7 7 7 7

Using the PVA tables and formula we will be able to find the PV of $7,000 annuity
payments on his 21st birthday. Then we have to discount this amount to his 17th
birthday.

𝑃𝑉𝐴21 = 7,000 × 𝑃𝑉𝐼𝐹𝐴8.2462%,45 𝑦𝑒𝑎𝑟𝑠

1
1−
(1+0.082462)45
𝑃𝑉𝐴21 = 7,000 × = 7,000 × 11.7836 = $82,485.20
0.082462

Now we need to find the PV of this amount on Emre’s 17th birthday.

82,485.20 82,485.20
𝑃𝑉17 = = = $60,081
(1 + 0.082462)4 1.3729

Since PV of cost of college education ($49,410) is less than the PV of additional

income he will get from attending college, Emre should go to college.