Exercise 2 (Berk DeMarzo Chapter 4 and 5) Solutions

4-1. You have just taken out a five-year loan from a bank to buy an engagement ring. The ring costs $7000.
You plan to put down $1000 and borrow $6000. You will need to make annual payments of $1250 at the
end of each year. Show the timeline of the loan from your perspective. How would the timeline differ if
you created it from the bank’s perspective?
0 1 2 3 4 5

$6,000 –$1,250 –$1,250 –$1,250 –$1,250 –$1250

From the bank’s perspective, the timeline is the same except all the signs are reversed.

4-3. Calculate the future value of $7000 in

a. Four years at an interest rate of 8% per year.

b. Eight years at an interest rate of 8% per year.

c. Four years at an interest rate of 16% per year.

d. Why is the amount of interest earned in part (a) less than half the amount of interest
earned in part (b)?

a. Timeline:
0 1 2 3 4

$7,000 FV = ?

FV = $7,000 × 1.084 = $9,523.42

b. Timeline:
0 1 2 8

$7,000 FV = ?
FV = $7,000 × 1.088 = $12,956.51

c. Timeline:
0 1 2 3 4

$7,000 FV=?
FV = $7,000 × 1.164 = $12,674.48
 d. Because in the last 4 years you get interest on the interest earned in the first 4 years in addition to
interest on the original $7,000.

4-4. What is the present value of $13,000 received

a. Fourteen years from today when the interest rate is 10% per year?

b. Twenty-eight years from today when the interest rate is 20% per year?

c. Seven years from today when the interest rate is 5% per year?

a. Timeline:
0 1 2 3 14

PV = ? $13,000
$13,000
𝑃𝑉 = = $3,423.31
1.1014

b. Timeline:
0 1 2 3 28

PV = ? $13,000
$13,000
𝑃𝑉 = = $78.86
1.2028

c. Timeline:
0 1 2 3 4 7

PV = ? $13,000
$13,000
𝑃𝑉 = = $9,238.86
1.057

4-5. Your brother has offered to give you either $75,000 today or $150,000 in 9 years. If the interest rate
is 8% per year, which option is preferable?
Timeline:
0 1 2 3 4 9

PV = ? $150,000
$150,000
𝑃𝑉 = = $75,037.35 > $75,000
1.089
4-11. Suppose you receive $100 at the end of each year for the next three years.

a. If the interest rate is 7%, what is the present value of these cash flows?

b. What is the future value in three years of the present value you computed in (a)?

c. Suppose you deposit the cash flows in a bank account that pays 7% interest per year. What
is the balance in the account at the end of each of the next three years (after your deposit is made)?
How does the final bank balance compare with your answer in (b)?
$100 $100 $100
a. 𝑃𝑉 = + + = $93.46 + $87.34 + $81.63 = $262.43
1.071 1.072 1.073

b. 𝐹𝑉 = $262.43 × 1.073 = $321.49

c. Year 1: $100

Year 2: 100 × 1.07 + 100 = $207

Year 3: 100 × 1.072 + 100 × 1.07 + 100 = $321.49

4-14. You have been offered a unique investment opportunity. If you invest $15,000 today, you will
receive $750 one year from now, $2250 two years from now, and $15,000 ten years from now.

a. What is the NPV of the opportunity if the interest rate is 12% per year? Should you take
the opportunity?

b. What is the NPV of the opportunity if the interest rate is 8% per year? Should you take
it now?

Timeline:
0 1 2 3 10

-15,000 $750 $2,250 $15,000

$750 $2,250 $15,000

a. 𝑁𝑃𝑉 = −$15,000 + + +
1.121 1.122 1.1210

= −$15,000 + $669.64 + $1,793.69 + $4,829.60 = −$7,706.87

Since the NPV < 0, don’t take it.

$750 $2,250 $15,000

b. 𝑁𝑃𝑉 = −$15,000 + + +
1.081 1.082 1.0810

= −$15,000 + $694.44 + $1,929.01 + $6,947.90 = −$5,428.65

Since the NPV < 0, don’t take it.

4-18. The British government has a consol bond outstanding paying £300 per year forever. Assume the
current interest rate is 4% per year.
a. What is the value of the bond immediately after a payment is made?
b. What is the value of the bond immediately before a payment is made?
Timeline:
0 1 2 3
 £300 £300 £300
a. The value of the bond is equal to the present value of the cash flows. By the perpetuity formula:
£300
= £7,500
0,04

b. The value of the bond is equal to the present value of the cash flows. The cash flows are the
perpetuity plus the payment that will be received immediately.
PV = 300/0.04 + 300 = £7,800

4-19. What is the present value of $9000 paid at the end of each of the next 88 years if the interest rate
is 10% per year?
Timeline:
0 1 2 3 88

$9,000 $9,000 $9,000 $9,000

1 1
𝑃𝑉 = $9,000 × (1 − )
0.1 (1 + 0.1)88

𝑃𝑉 = $9,000 × 9.997722577 = $89,979.50

4-36. You have decided to buy a perpetuity. The bond makes one payment at the end of every year
forever and has an interest rate of 8%. If you initially put $1000 into the bond, what is the payment
every year?
Timeline:
0 1 2 3

–1,000 C C C

𝐶
𝑃𝑉 =
𝑟
𝐶
$1,000 =
0.08
𝐶 = $1,000 × 0.08 = $80

5-4. You have found three investment choices for a one-year deposit: 9% APR compounded monthly,
12% APR compounded annually, and 9% APR compounded daily. Compute the EAR for each
investment choice. (Assume that there are 365 days in the year.)
For an account with 9% APR with monthly compounding you will have:
0.09 12
𝐸𝐴𝑅 = (1 + ) − 1 = 0.09381 = 9.381%
12
For an account with 12% APR with annual compounding you will have:
𝐸𝐴𝑅 = (1 + 0.12)1 − 1 = 0.12 = 12%
 For an account with 9% APR with daily compounding you will have:
0.09 365
𝐸𝐴𝑅 = (1 + ) − 1 = 0.09416 = 9.416%
365

5-5. You are considering moving your money to a new bank offering a one-year CD that pays a 12% APR
with monthly compounding. Your current bank’s manager offers to match the rate you have been
offered. The account at your current bank would pay interest every six months. How much interest will
you need to earn every six months to match the CD?
With 12% APR, we can calculate the EAR as follows:
0.12 12
𝐸𝐴𝑅 = (1 + ) − 1 = 0.12683 = 12.683%
12
1
Over six months, this works out to be 1.126832 − 1 = 0.06152 = 6.152%. Hence, you need to earn
6.152% interest every six months to match the CD.

5-6. Your bank account pays interest with an EAR of 9%. What is the APR quote for this account based
on semiannual compounding? What is the APR with monthly compounding?
Using the formula for converting from an EAR to an APR quote:
𝐴𝑃𝑅 𝑘
(1 + ) = 1.09
𝑘
Solving for APR:
1
𝐴𝑃𝑅 = ((1.09)𝑘 − 1) 𝑘
With semiannual payments, k = 2, so:
1
𝐴𝑃𝑅 = ((1.09)2 − 1) 2 = 0.08806 = 8.806%
With monthly payments k =12, so:
1
𝐴𝑃𝑅 = ((1.09)12 − 1) 12 = 0.08649 = 8.649%