Holding Period Returns

Question 1. The holding rate of return is defined as the total return over the period which the
investment is held

a) What is the holding rate of return for a 20 year investment that earns 5% a year each year?
What is the future value in 20 years of an investment of £200 today?

b) At a constant rate of return of 3%, what is the minimum holding period before your money
has doubled? What now is its present value?

Net Present Value

Question 2.

a) Determine the NPV of the project with the cash flows described in the table below if the
per period interest rate were 5% ? Would you invest in the project?

b) What if the interest rate were 9% ?

Leases and Rental Equivalents

Often leases – and indeed different machines that make the same product – have different
expected lives and time-varying costs. We might wish to calculate which lease or machine is
the better value. We can do this by calculating the rental equivalent of the costs over the life
of the lease. The rental equivalent is the value of the cash flow per period of an annuity which
has
i) the same life as the lease
ii) and whose price is equal to the present value of the leases cash flows

Question 3 Assume Lease A has a £2,000 up front charge, and lasts for 18 years with an annual cost
of £1000 per year. Lease B costs £2,500 up front, lasts for 22 years, and has an annual charge of £900
per year. The interest rate is 12% per annum.

a) What is the PV cost of each lease?

b) What is the rental equivalent of each lease?
c) Which lease is a better purchase if you assume no value to flexibility and that lease costs will
remain constant in the future?

Internal Rate of Return (IIR)

A project with a large up front negative cash flow and subsequent positive cash flows will
always have a finite unique IIR. However this is not always the case if the cash flows are a
more variable.

Question 4 Consider a project that has the cash flows described by the time line below

0 1 2 3 4

1000 -5000 9350 -7750 2402.4

a) Calculate the NPV of these cash flows for a interest rate of 10%,20%,30% and 40%.

b) Draw a plot of the NPV of these cash flows as a function of the prevailing interest rate.
Some Harder Questions on Annuities

Question 5. When you purchased your house, you took out a 30-year annual-payment mortgage with
an interest rate of 6% per year. The annual payment on the mortgage is £12,000.

a) What is the value of the house?

You have just made a payment and have now decided to pay the mortgage off by repaying the
outstanding balance. What is the payoff amount if
b) You have lived in the house for 12 years (so there are 18 years left on the mortgage)? So what
proportion of the house do you now own assuming it still has the same value?
c) You have lived in the house for 18 years (so there are 12 years left on the mortgage)? What
proportion do you now own?

Question 6 Your grandmother bought an annuity from Rock Solid Life Insurance Company for
$200,000 when she retired. In exchange for the $200,000, Rock Solid will pay her $25,000 per year
until she dies. The interest rate is 5%. How long must she live after the day she retired to come out
ahead (that is, to get more in value than what she paid in)?