FINM1001 Foundations of Finance

Financial Mathematics: Solutions to Extra Practice Questions

Note: In attempting these questions, particularly the more complex ones, it may
prove useful to draw a time-line to determine the magnitude and timing of cash flows
before undertaking any calculations.

Question One
Calculate the future value of $1,000 invested today for a period of 20 years at an
interest rate of 10% p.a. compounded daily. Show how and discuss why your answer
would change if interest was compounded quarterly.

The future value of this amount given the interest rate compounds daily is $7,387.03,
and is calculated as follows:

If the interest rate was compounded quarterly, the future value of the investment
would be lower given the decreased impact of compounding. The future value of the
investment with quarterly compounding is calculated as follows:

Question Two
You made a deposit in a bank account exactly 18 months ago today. You have not
made any subsequent deposits, and the balance of your account is now $4,400.
Calculate the value of your initial deposit given you earned an interest rate of 15%
p.a. compounded semi-annually. Show how and discuss why your answer would
change if interest were compounded annually.

The value of the initial deposit is calculated as follows:

If the interest rate were compounded annually, the initial deposit you made in the
bank would be greater as the decreased impact of compounding means you would
need to make a larger initial deposit to obtain $4,400 in 18 months’ time. The
required deposit with annual compounding is calculated as follows:

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1/ 2
convert r e ¿r p :r p =( 1.15 ) −1=0.07238052948

$ 4,400
P= =$ 3,567.84
( 1.07238052948 )3

Alternatively, the exponent operations can be combined in a single step (1/2*3 = 1.5):

Question Three
You have just successfully applied for a home loan. Calculate how much you are
borrowing given that the terms of the loan are as follows:

 Your monthly repayments are $1,000;

 The loan is taken over 25 years; and,
 The interest rate you will pay on funds borrowed is fixed at 10% p.a.
compounded quarterly.

Show how and discuss why your answer would change if interest were compounded
annually.

To work how much you borrowed, simply calculate the present value of all
repayments. As payments are evenly spaced and identical in amount, we can
calculate the present value of the cash flows using the ordinary annuity formula:

Note: Here the compounding frequency of the annual nominal rate does not match the
cash flow frequency. You must therefore first convert the annual nominal rate into an
annual effective rate, and then convert the annual effective rate into the monthly
periodic rate:

0 .1 4
r e =( 1+ ) −1=0 .10381289
4
1
12
r p =(1+ 0. 10381289) −1=0 . 008264835

PV =$ 1, 000 [ 1−(1. 008264835)−300

0 . 008264835 ]
=$ 110 , 752. 67

If the interest rate were compounded annually, the amount you borrowed would be
higher as there is less compounding of interest and a larger portion of repayments
pertaining to the principal. The amount borrowed with annual compounding is
calculated as follows:
1
12
r p =(1 . 10) −1=0 . 0079741 4

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PV =$ 1, 000 [
1−(1. 00797414 )−300
0 . 00797414 ]
= $ 113 , 830. 96

Question Four
Calculate the present value of an ordinary perpetuity that comprises one cash flow of
$200 at the end of each year given an interest rate of 15% p.a. compounded annually.
Show how and discuss why your answer would change if interest were compounded
weekly.

If interest rates were compounded weekly, the present value of the perpetuity would
be lower due to the increased effects of compounding. The present value of the
perpetuity if interest were compounded weekly is:

Question Five
A man invests $500 at 15% p.a. compounded fortnightly and plans to hold this
investment for 10 years. Assuming there are exactly 26 fortnights in a year, how
much will he have at the end of his holding period?

The value of the man’s investment at the end of her holding period is calculated as:

Question Six
A business needs $20,000 in 2 years time to replace a piece of equipment. How much
must be invested now at an interest rate of 6% p.a. compounded monthly in order to
provide for this replacement?

To determine the amount the business must invest now, simply calculate the present
value of $20,000 paid in 2 years, bearing in mind that the interest rate is compounded
monthly.

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Question Seven
A woman wants to provide a $10,000 university scholarship every year for 50 years.
The first scholarship is to be awarded one year from now. If the university can earn a
6% p.a. compounded daily as a return on their investments, how much should the
woman give now?

To determine the amount the woman must invest now, simply use the present value of
an ordinary annuity formula, bearing in mind that the interest rate is compounded
daily.

( )
365
0 .06
r= 1+ −1=0 .06183131
365

PV =$ 10 ,000 [
1−(1. 06183131)−50
0 . 06183131
= ]
$153,676.29

Question Eight
How much will $500 grow to if invested for 10 years at an interest rate of 12% p.a.
compounded annually?

Question Nine
What will the following investments accumulate to if interest is compounded
annually?
a) $1,000 invested at 10% p.a. for 6 years?

b) $125.47 invested at 12% p.a. for 8 years?

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Question Ten
In 30 years time when I retire, I will have $4 million in my retirement fund. What is
this worth in today's dollars (i.e., what is the present value) assuming an average
annual interest rate of 10% p.a. compounded annually?

Question Eleven
You invest $100 for a period of 7 years, after which it has grown to $200. If interest
was compounded annually, what was the average rate of interest earned?

Question Twelve
How long does it take $100 to grow to $150 if the interest rate is 10% p.a.
compounded annually?

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Question Thirteen
If the interest rate is 10% p.a. compounded annually, what is the present value of the
following cash flows:

a) $1,000 to be received in 3 year's time?

b) $1,500 to be received in 10 year's time?

Question Fourteen
You have just been signed to a major record label and have been promised $20,000 in
one year's time plus another $10,000 in two year's time. What is the value of this
consideration to you today assuming that you can invest your money at 5% p.a.
compounded annually?

Question Fifteen
At the end of each of the next 10 years, you will place $1,000 into an investment that
returns 12% p.a. compounded annually. How much will this investment have grown
to by the end of year 10?

Question Sixteen

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You wish to purchase a new car, valued at $55,000. The purchase will be financed as
follows. An upfront payment of $10,000 is due immediately. The balance ($45,000)
will be paid off over the next four years. Repayments are due at the end of each
month. The finance company quotes an interest rate of 12% p.a. compounded
monthly. Calculate the monthly repayment amount.

Question Seventeen
Reconsider the previous question. You will have trouble meeting the monthly
repayments calculated in the previous question. If you can talk the finance company
into allowing you to pay off the balance over five years (rather than four years), by
how much does this reduce your monthly repayment?

Therefore, increasing the loan term to five years instead of four years reduces your
monthly repayment by $1,185.02 - $1,001.00 = $184.02.

Question Eighteen
Your child will commence university in 15 year's time. You wish to put away money
regularly (one deposit at the end of each year) to provide for her education, which
you estimate will cost $200,000. You anticipate that the average rate of return on an
investment fund will be 8% p.a. compounded annually. How much will you have to
put away at the end of each of the next 15 years so that you will have the $200,000
required?

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Question Nineteen
Reconsider the previous question. As opposed to putting money away regularly to
accumulate $200,000, you decide to make a once-off investment now. How much will
you have to invest today to have the required $200,000 in 15 year's time?

Question Twenty
Your generous uncle decides to endow his alma mater with sufficient monies to fund a
scholarship of $5,000 per year in perpetuity. If the school can earn a return of 8%
p.a. compounded annually on the endowment, how much does he need to donate as a
lump sum today? In providing an answer, assume that the first scholarship payment
will be made one year from now.

Question Twenty-One
You have won a lottery and will receive $10,000 at the end of each year in perpetuity.
If we assume an interest rate of 10% p.a. compounded annually, what this infinite
series of payments worth in today's dollars?

Aside: As an interesting exercise to prove the formula for the present value of a
perpetuity, you might try preparing a spreadsheet. Listing the payments you will
receive (maybe go out to 200 years), discount each $10,000 payment to present value
using the interest rate and the relevant number of years, and add up the present
values. You'll see that a payment made 200 years from now is effectively worthless in
today's dollars.

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Question Twenty-Two
What is the present value of $500 to be received in 5 year's time if the interest rate is
8% p.a. compounded quarterly?

Question Twenty-Three
What will $550 amount to in four year's time at a nominal interest rate of 12% p.a. if
interest is:
a) Compounded annually?

b) Compounded monthly?

c) Paid on daily balances (assume that the bank ignores the extra day in leap
years).

Question Twenty-Four
Different banks offer different interest rates. Which bank gives the greatest return?
 Commonstealth 15% p.a. compounded annually;

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 Eastpac 14.75% p.a. compounded quarterly;
 Metaway 14.675% p.a. compounded semi-monthly; and,
 ANX 14.5% p.a. compounded monthly.

One way to conclude which bank provides the greatest return is to calculate the
annual effective rate implied by each quoted interest rate, as follows, and compare
them:

Based on these calculations, Metaway offers the best return on funds invested.

Question Twenty-Five
You decide to start saving for a vacation to the Whitsunday Islands, leaving on New
Year's day (1st January). You will invest $100 on the first day of each month (starting
today 1st March), with the final investment on 1st December. Assuming you earn
interest at a rate of 12% p.a. compounded monthly, how much will you have to spend
when you withdraw all invested funds on New Year’s day?

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Question Twenty-Six
It is the first day of January 2003. Starting from the first day of the year 2006 you
will deposit $5,000 into a bank. You will continue to deposit this amount into the bank
every New Year's day up to and including New Year’s day 2010. On New Year's day
2011, instead of depositing any money, you will instead withdraw all of your
deposited funds and accumulated interest. Assuming an interest rate of 15% p.a.
compounded annually, how much will you withdraw from your account?

Question Twenty-Seven
You are considering the
purchase of a home for
$300,000. You have
available a deposit of
$50,000. The bank will lend you the balance ($250,000) at 6% p.a. over a period of
20 years. Interest is compounded monthly.

a) Calculate your regular monthly repayment.

b) Five years later, you have made 60 repayments. What is the payout figure on
the loan? That is, how much do you still owe the bank?

c) Assume that, just after your 60th payment, the interest rate rises to 9% p.a.
(still compounded monthly). Of course, this means your monthly payment

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must rise if you are to pay the loan off over 20 years in total (there are now 15
years to go). Calculate your revised monthly loan repayment.

Aside: A spreadsheet is ideal for checking and proving these calculations.

Question Twenty-Eight
At the end of each of the next four years, you will receive a payment of $1,000. The
interest rate is 10% p.a. compounded annually.
At the end of each of the next four years, you will receive a payment of $1,000. The
interest rate is 10% p.a. compounded annually.

a) Equate this series of cash flows to a single cash flow received today. That is,
calculate the present value of the 4-payment annuity.

b) Equate this series of cash flows to a single cash flow received at the end of
year four. That is, calculate the future value of the annuity.

c) Take your answer to (a). Assume that you invest this amount for four years.
How much will it grow to?

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d) Take your answer to (b). If this was a once-off payment to be received at the
end of four years, what is its present value.

e) Equate the original series of cash flows to a single cash flow received after
two years.

f) Take your answer to (e) and discount it back to present value.

Question Twenty-Nine
Consider the following series of cash flows. Today is time 0. You receive nothing for
the first two years. At the end of years 3 and 4, you receive $2,000. At the end of years
5 and 6, you receive $5,000. The interest rate is 6% p.a. compounded annually.
Calculate the present value of this series of payments (there are several different
ways of approaching this question - all giving the correct answer).

Below are two ways you could have answered this question. The first involves
discounting each cash flow separately as follows:

Alternatively, you could have calculated the same answer by recognising the cash
flow stream describes comprises two deferred annuities as follows:
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