Fin 502 - Business Finance

Homework 1 SOLUTIONS
Winter 2020
Due January 13

1 Individual Questions
1. (1 pt) Suppose you are saving to buy a house which costs $1,000,000. You currently have
$100,000 deposited in a savings account that pays 6% annual interest. How many years will
need to pass before you can buy the house? Assume the price of the house does not change
and that you do not invest any additional money into your account.

FV ln(F V /P V ) ln($1,000,000/$100,000)
PV = (1+r)N
→N = ln(1+r) →N = ln(1.06) → N = 39.5 years

2. (1 pt) Suppose you have $100 deposited in a bank account that pays 4% annual interest this
year.The bank then raises the interest rate it pays you to 8% the following year, and to 12%
the year after that. Assuming you do not deposit or withdraw any money from the account,
what will your balance be at the end of the third year?

Ending balance = $100(1.04)(1.08)(1.12) = $125.80

3. (1 pt) Now suppose you also had $100 in a second bank account that did not change its
interest rate at all over the three years. However, you discover that you have the same ending
balance after three years in this account as the one in question 2. What constant interest
rate must this account have given you over the three years?

$125.8
$100 = (1+r)3
→ r = ( $125.8
$100 )
1/3 − 1 = .0795

4. (1 pt) You work for a pharmaceutical company that developed a new drug. The patent on
the drug will last 15 years. You expect that the drug’s profits will be $6 million in its first
year and that this amount will grow at a rate of 4% per year during the life of the patent.
Assume each year’s profits are received at the end of the period. Once the patent expires,
other pharmaceutical companies will be able to produce the same drug and competition will
drive profits to $0. What is the present value of the new drug if the interest rate is 8% per
year?
PV = C
r−g (1 − ( 1+g N
1+r ) ) =
$6,000,000
.08−.04 (1 − ( 1.04 15
1.08 ) ) = $64.84 million

5. (1 pt) Suppose you are a free agent basketball player and have contract offers from competing
clubs. The first team offers to pay you $25 million a year for the next five years and then $5

1
 million a year for the five years after that. The second team cannot afford to pay you such a
high annual salary in any year because they would then go over the salary cap. They instead
offer you $15 million a year for the next 10 years. Assuming the relevant interest rate is 5%,
which contract offer should you take? Assume the first payment occurs one year from now.
$25,000,000 $5,000,000
Option 1: 5n=1 + 10
P P
1.05n n=6 1.05n = $125.2 million
$15,000,000
Option 2: 10
P
n=1 1.05n = $115.8 million

Consequently, you should take the first contract.

6. (1 pt) Suppose you have a bank account with a 2% APR that compounds by the hour. What
is the EAR?
AP R m .02 8760
EAR = (1 + m ) − 1 = (1 + 8760 ) − 1 = 2.02%

7. (1 pt) You are deciding between two credit cards. One is quoted as a nominal APR of 7%
compounded daily. The other is quoted as a real APR of 5%, compounded monthly. Assume
inflation is 2% APR, compounded annually. Which is the higher rate?
To compare the two rates we need to convert both to nominal EARs. For the first rate:
r1 = (1 + APmR1 )m − 1 = (1 + 0.07
365 )
365 − 1 = 7.25%

AP R2 m
Now for the second rate we calculate a real EAR first: r2,real = (1 + m ) −1 =
(1 + 0.05 12
12 ) − 1 = 5.116%

Finally, convert the real EAR for card 2 to a nominal rate. r2,nom = (1+r2,real )(1+rinf )−1 =
(1.05116)(1.02) − 1 = 7.219%. Thus the first rate is higher.

8. (1 pt) Suppose Chase is offering a 96-month, 4.99% APR auto loan, compounded monthly.
If you need to borrow $60,000 to purchase your dream car, what will your monthly payment
be? Assume your first payment will be made one month from now.
We want to use the formula for an ordinary annuity. First we need to compute the monthly
interest rate by dividing the APR by 12. In this case we have 4.99%/12 = .4158%. Now
apply the regular annuity formula:

C 1 N C 1
PV = r (1 − ( 1+r ) ) → $60, 000 = 0.4158% (1 − ( 1+0.4158% )96 ) → C = $759.31

2 Group Questions
1. (4 pts) Your father has offered to give you $1,500 starting at the end of this year, and will
increase the amount that he gives you by 6% each year for the next 20 years. You want to
know the value of this offer by calculating how much money you would need to deposit in
your local bank so that the account will generate the same cash flows that he is offering you.
Your local bank will guarantee an 8% annual interest rate as long as you have money in the
account.

(a) How much money will need to be deposited in the account today?

$23,393.61 (see Excel)

2
(b) Using Excel, show explicitly that you can deposit this amount into the account and every
year withdraw the amount that your father has promised you, leaving the account with
nothing after the last withdrawal.
(See Excel)