Seminar 3.

Foundations of Finance MN1019

Academic year 2016-2017

1. You saved £1, 500 at the end of each year in a 6-year savings plan
bearing 5.5% interest. How much money do you have at the end of the
6 years?
2. Mary has recently won the Lottery ABC and she has been awarded a
prize of £500, 000. However, the fine print in the award letter says that
she will be paid, starting at the end of the year, £25, 000 every year for
the next 20 years. She knows this is not the same as getting £500, 000
now. With respect to this situation, answer to the following questions:
(i) Explain why Mary would have preferred to receive £500, 000 now.
(ii) Calculate the present value of this cash flow stream of £25, 000
every year for 20 years if the interest rate is 7%.
3. You have recently constructed a machine that is expected to produce
cash flows of £150, 000 a year, and you know that the machine has a
useful life of 6 years. You want to make a profit by selling the machine.
(i) Assuming a 6.5% annual market interest rate, what is the minimum
amount for which you would sell the machine?
(ii) What is the annual coupon C of a perpetuity that has the same
present vaue of the machine above?
(iii) Purchasing a consol bond guarantees a stream of perpetual cash
flows. What is the market value of a consol bond that pays £650
annually in interest at an interest rate of 8%?
4. An investment offers £4, 000 per year for 10 years, with the first pay-
ment occurring one year from now. Suppose that the required return
is 9%. Calculate:
(i) The value of the investment.
(ii) The value of the investment if the payments occur for 20 years.
(iii) The value of the investment if the payments grow at the constant
rate of 5% and occur forever.

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5. Calculate the present value of the following three investments, assuming
a relevant interest rate of 8%.
(i) £100, 000 at the end of each year in perpetuity.
(ii) A perpetuity that pays £100, 000 at the end of the first year and
that grows at 4% a year.
(iii) £100, 000 at the end of each year for 20 years.

6. Your employer decides to grant you a bonus of £1, 500 now. Alterna-
tively, you can choose to receive £2, 100 in 5 years. If the interest rate
is 8%, which option would you choose? Make sure you compare both
future and present values.

7. Consider the following stream of cash flows: £1, 000 in year 1, £1, 200
in year 2, £800 in year 3, and £300 in year 5. Calculate the present
value of these cash flows at a discount rate of 5%.