PRACTICE 2

1. The 2-year discount factor is 0.92. What is the present value of $1 to be received in year 2?
What is the present value of $2,000?

Answer:

a. $0.92

b. $1,840

Explanation:

a. 2 year discount factor is 0.92

Present value of $1 to be received in 2 years =

$1 * discount factor

Present value = $1 * 0.92

Present value = $0.92

b. Present value of $2000 can also be calculated in the same manner by using the 2
year discount factor.

Present value = $2000 * 0.92

Present value = $1,840

2. A famous quarterback just signed a $15 million contract providing $3 million a year for 5 years.
A less famous receiver signed a $14 million 5-year contract providing $4 million now and $2
million a year for 5 years. The interest rate is 10%. Who is better paid?

Answer:

The less famous receiver is better paid.

PV of $15m for famous quarterback:

The famous quarter back will receive the 15 million in equal payments for five years. We
consider the payments are received at the end of period. We calculate the 5 year discount
factor for such annuity at 10%.

 The discount factor is calculated using the simple formula for Present value of
ordinary annuity
 The PV = 3/1.1 + 3/(1.1)^2 + 3/(1.1)^3 + 3/(1.1)^4 + 3/(1.1)^5= $11.3724
 PV of $14 million for less famous receiver:

The less famous receiver is receiving $4 million today which are worth exactly the same
that is $4 million. Apart from that, the remaining payments of $10 million is received in
ordinary annuity of $2 million a year. We calculate the PV of $4 million today and $2
million annuity for five years to calculate the value of $14 million today

 The annuity discount factor is same as the interest rate and time period is same.
 The PV = $4 millions + 2/1.1 + 2/(1.1)^2 + 2/(1.1)^3 + 2/(1.1)^4 + 2/(1.1)^5
* = $11.58158 million
he less famous receiver is better paid at $11.5816 million compared to $11.3724 million

3. Would you rather receive $1,000 a year for 10 years or $800 a year for 15 years if the interest rate
is 5%? What if the interest rate is 20%?

4. ) If the interest rate is 5% the

$800 a year for 15 years is
better.
5. That is 800 +40+ 800 +80+ 800
+120+ 800+ 160 ...
6. will be more than 1000 +50+
1000 +100+ 1000 +150+ ...
7.

8. b) If the interest rate is 20% the

$1000 a year for 10 years will
be better.
9. That is 1000 +200+ 1000
+400+ 1000+ 600+...
10. will be more than 800 +160+
800 +320+ 800 +480+ ...
11.

12. c) Although in both cases the

total of payments is 800x15 =
12000 versus 1000 x 10 =10000
13. when the interest rate is at 5%
the additional interest that will
be earned by having more
14. payment sooner (with $1000 a
year) is not enough to offset the
additional 2000 (12000 -
15. 10000) that was received from
the 800 a year payments.
16. But, when the interest rate is
20% the ability to earn interest
"sooner" on the $1000 a year
17. payments more than makes up
for the smaller (10000 vs
12000) amount paid to you with
the
18. smaller but longer (800x15)
payments.
19. ) If the interest rate is 5% the
$800 a year for 15 years is
better.
20. That is 800 +40+ 800 +80+ 800
+120+ 800+ 160 ...
21. will be more than 1000 +50+
1000 +100+ 1000 +150+ ...
22.
23. b) If the interest rate is 20% the
$1000 a year for 10 years will
be better.
24. That is 1000 +200+ 1000
+400+ 1000+ 600+...
25. will be more than 800 +160+
800 +320+ 800 +480+ ...
26.

27. c) Although in both cases the

total of payments is 800x15 =
12000 versus 1000 x 10 =10000
28. when the interest rate is at 5%
the additional interest that will
be earned by having more
29. payment sooner (with $1000 a
year) is not enough to offset the
additional 2000 (12000 -
30. 10000) that was received from
the 800 a year payments.
31. But, when the interest rate is
20% the ability to earn interest
"sooner" on the $1000 a year
32. payments more than makes up
for the smaller (10000 vs
12000) amount paid to you with
the
33. smaller but longer (800x15)
payments.
34. ) If the interest rate is 5% the
$800 a year for 15 years is
better.
35. That is 800 +40+ 800 +80+ 800
+120+ 800+ 160 ...
36. will be more than 1000 +50+
1000 +100+ 1000 +150+ ...
37.

38. b) If the interest rate is 20% the

$1000 a year for 10 years will
be better.
39. That is 1000 +200+ 1000
+400+ 1000+ 600+...
40. will be more than 800 +160+
800 +320+ 800 +480+ ...
41.

42. c) Although in both cases the

total of payments is 800x15 =
12000 versus 1000 x 10 =10000
43. when the interest rate is at 5%
the additional interest that will
be earned by having more
 44. payment sooner (with $1000 a
year) is not enough to offset the
additional 2000 (12000 -
45. 10000) that was received from
the 800 a year payments.
46. But, when the interest rate is
20% the ability to earn interest
"sooner" on the $1000 a year
47. payments more than makes up
for the smaller (10000 vs
12000) amount paid to you with
the
48. smaller but longer (800x15)
payments.
a. If the interest rate is 5% the $800 a year for 15years is better.
That is 800 + 40 + 800 + 80 + 800 + 120 + 800 + 160
Wll be more than 1000 + 50 + 1000 + 100 + 1000 + 150
b. If the interest rate is 20% the $1000 a year for 10 years will be better.
c. If the interest rate is 5% the $800 a year for 15years is better.
49. a.What is the present value of a 3-year annuity of $100 if the discount rate is 6%?
-pplying the formula, the present value of the annuity is: 100(1−(1+6%)−3)6%=267.30.

b. What is the present value of the annuity in part (a) if you have to wait 2 years instead of 1 year
for the first payment?

50. Your landscaping company can lease a truck for $8,000 a year (paid at year-end) for 6 years. It
can instead buy the truck for $40,000. The truck will be valueless after 6 years. The interest rate
your company can earn on its funds is 7%.
a. What is the present value of the cost of leasing?
b. Is it cheaper to buy or lease?
c. What is the present value of the cost of leasing if the lease payments are an annuity due, so the
first payment comes immediately?
d. Is it now cheaper to buy or lease?