KEY TERMS ‘5. We stressed a few practical considerations in the application of these formulas: ‘a. The numerator in each of the formulas, C, i the cash flow to be received one full period hence. ice. To avoid unwieldy problems, assumptions to k and in practice. b. Cash flows are generally irregular in pra create more regular cash flows are made both in this textboo . A number of PV problems involve annuities (or perpetuities) beginning a few periods hence. Students should practise combining the annuity (or perpetuity) formula with the discounting formula to solve these problems. “Annuities and perpetuities may have periods of every two or every m years, rather than once fa year, They may also have shorter periods like one month or one quarter. The annuity and perpetuity formulas can easily handle such circumstances ce. One frequently encounters problems where the PV of one annuity must be equated with the PY of another annuity. eee tte Annual percentage rate 109 Discounting 104 Perpetuity 113, Annuity 116 Effective annual Present value (PV) ” Annuity factor 117 interest rate 109 Present value factor 104 Compound interest 100 Future value 97 Simple interest 100 ‘Compound value 97 Growing annuity 122 Stated annual interest rate 109 ‘Compounding 99 Growing perpetuity 114 Continuous compounding 111 Net present value (NPV) 98 QUESTIONS & PROBLEMS Simple Interest Versus Compound Interest 5.1 _ First City Bank pays 8 percent simple interest on its savings account balances, whereas Sec- ank pays 8 percent interest compounded annually. If you made a $5,000 deposit ank, how much more money would you earn from your Second City Bank account at thy/end of 10 years? CalculAting Future Values ‘a. Compute the future value of $1,000 compounded annually for i. 10 years at S percent. i, 10 years at 10 percent. 20 years at S percent. /Why is the interest earned in part not twice the amount earned in part (i)? Caleyfating Present Values For each of the following, compute the PV: Future value $13,827 9 Is 43,852 18 n 725,380 2B 18 590,710 Interest rate __ Future value $22 4 3 307 410 8 896 1,700 16 162,181 18,750 2” 483,500of Periods 7 ¥ Celeufatng the Number of Perio ce flowing: 5,5 lve for the unknown nu! rt Future value | Years Interest rate i Present value “ mare | $625 i; iat “0 " 402,662 8 173439 ‘At 8 pereent interest, how long does i take to double your money” To quadruple je? 5.6 At8 perc 7 ‘ing Present Values es Shae tia Tne, has an unfunded pension liability of $750 million that must be paid in See arianero assess the vale ofthe firm's stock, financial analysts want to discount this Tabity back to the present. I the relevant discount rate is 8.2 percent, what isthe PV of this liability? Calculating Rates of Return 5.8 Although appealing to more refined tastes, art as a collectible has not always performed so profitably. During 2010, Deutscher-Menzies sold Arkies Under the Shower, a paint- ing by renowned Australian painter Brett Whiteley, at auction for a price of $1,100,000. Unfortunately for the previous owner, he had purchased it three years earlier at a price of $1,680,000. What was his annual rate of return on this painting? Perpetuities 5.9 An investor purchasing a British consol is entitled to receive annual payments from the British government forever. What isthe price of a consol that pays $150 annually if the next ‘payment occurs one year from today? The market interest rate is 4.6 percent. Continuous Compounding | 5.10 Compute the future value of $1,900 continuously compounded for eXce 4, 7 years ata stated annual interest rate of 12 percent, b. 5 years ata stated annual interest rate of 10 percent. ¢. I2 years ata stated annual interest rate of 5 percent. d. 10 years ata stated annual interest rate of 7 percent. Present Value and Multiple Cash Flows 5.11 Conoly Co. has identified an investment project with the followis discount rate is 10 percent, what is the PV of these cash flows? Wher Flows. Ifthe 18 percent? 24 percent? at is the PV at 5.12, Investment X offers to pay you $4,500 per year for nine years, whereas tn 5 , nvestmey 4p pay you $7,000 per year for five years. Which of these cash flow streams has ees 'V ifthe discount rate is § pervent? 22 percent? leher Calfulating Annuity Present Value °$.19) An investment offers $4,900 per year for 15 yeurs, Year from now. Ifthe required reiurn is 8 ‘Wines wend tha eet il Oa with the frst payment occurring one srcent, what is the value of the investment? jce culating Perpetuity Values Se Perpetual Life Insurance Co. i trying to sell you an investment and ois $20.0 per yer en Ith ed et ent, how mach wil yon pay forthe policy? Supe the Pepet You the poli costs $340,000. At what terest ate would this be a Calculating Effective Annual Rate $.15 Find the EAR in each ofthe following cases [Stated rate (APR) Number of times compounded __Effective rate (FAR) | eee ‘Quarry | | 18 Monthly | n Day | u Infinite ) Ny Calculating Annual Percentage Rate ind the APR, or stated rate, in each ofthe ellowing eases Stated rate (APR) __Number of times compounded _Effective rate (EAR) ) Semiantly oe | Mon v6 | Weey 23 | tite ua Calgdlating Effective Annual Rate First National Bank charges 11.2 percent compounded monthly on ish United Bank charges 114 percent compounded semiannvaly. As a potent ‘which Bank would you go fora new loan? ss loans. First borrower, to Interest Rates 5.18 Well-known financial writer Andrew Tobias argues that he ean earn 177 percent per year buying wine by the case. Specifically, he assumes that he will consume one S10 bottle of fine Bordeaux per week forthe next 12 weeks. He can either pay $10 per week or buy acase ‘of 12 bottles today. Ife buys the case, he receives a 10 percent discount and, by doing so, { the 177 percent. Assume he buys the wine and consumes the first botle today. Do you ‘with his analysis? Do you see a problem with his numbers? Caloylating Number of Periods 5.19 JOne of your customers is delinquent on his accounts payable balance, You've mutually dered toa repayment schedule of $700 per month. You wll charge 1.3 percent per meth aarveston the overdue balance. Ith curent balance is $21.0, how long wll take foe the account to be paid off”? Calculating Effective Annual Rate 5.20. Friendly's Quick Loans Inc. offers yo you get $3 today and repay $4 when you get yo the EAR Friendly’s earns on tis lending bu ‘APR would Friendly’s sty you were paying? hnee for four oF Lknock on your door.” This means our payeheyue in one week (or else), What's ress? IF yo were brave enough to ask, what Future Value 5.21 a. What isthe fare valve in six years of $1,000 i annual interest ate of 9 pee 1. Compounds annually? 4i, Compoundea semianally? invested in an account with a statedxd monthly? .d continuously? value increase as the COMPO iii, Compounder iv, Compounde 1b, Why does the future winding period shortens? und Interest jnterest on its investment accounts, IF Fit Co, pounded annually, what rate Should the hans ent horizon of 10 years? ef{ce| wer the next 30 years. To do this, you will inves “t month in a bond account. The return of the 6 percent. When t Versus Compo! ays 5 percent simpl accounts COM Bank over an invest Simple Interes' cirst Simple Bank ps plex Bank pays interest onits if it wants to match First Simple Calculating Annuities 5.23 Youare planning to save for retirement 0 $700 a month in a stock aecount and $300 are account is expected tobe 10 percent and Me bond account will to an account with an 8 percent return. How ie your money i month From your account, assuming, a 25-year withrawal you retire, you will combin ‘much can you withdraw ac! period? eit). What Calculating Rates of Return 5.24 Suppose an investment offers to quadruple your money in 12, months (don't beli rate of return per quarter are you being offered”? 525. You've uying to choose between (wo different investments, both of which have up-front costs of $65,000. Investment G returns $125,000 in six years. Investment ‘Af returns $185,000 in 10 years. Which of these investments has the higher return? eel Growing Perpetuities Mark Weinstein has been working on an advanced technology in laser eye surgery. His tech- nology will be avaiable in the near term. He anticipates his first annual cash flow from the technology to be $215,000, received two years from today. Subsequent annual cash flows will grow at 4 percent in perpetuity. What is the PV of the technology if the discount rate is 10 percent? Perpetuities 527A pesigous investment bank designed a new security that pays a quarterly dividend of '50 in perpetuity. The first dividend occurs one quarter from today. Wha i the security if the stated annual interest rate is 6.5 percent ai pee Leal I. ly? Annuity Present Values 5.28 What is the PV of an annuity of $6,500 i 500 per year, with the first cash flow recei years from today and the last one received 25 ye: eee ee, years from today? Use a discount rate of 5.29 What is the value today of a 15-year annuity y that pays $650 a year? ment occurs six years from today. The annual interest rate is eco y's first pay- 5, and 13 percent thereafter. nt for years | through Balloon Payments 5.30 Audrey Sanborn has just arranged to purchase a $450,000 cone 20 percent down payment. The mortgage has a 7.5 percent pa ie interes aly pow socal, aod cll for sxpal onethly payments nec te rent'30 yours, Hor free event al be due one month fom no. However, the morgage hasan cight-yore bat payment, meaning that the balance of the loan must be paid off at the end Srecaeeee aaa ther natsution costs or finance charges. How much will Audrey's bellona er? ment be in eight years? rey's balloon pay- Calculating Interest Expense 5.31 You receive a credit card applic -ard application from Shady Banks offering an introductoy 240) percent per year, compounded monthly for the first six months, peearar Gaal) a Spero oreo ‘monthly. Assuming you transfer the $7,500 balance fron a -xisting credit card and make no subsequent ents, how i Perea existing eet ear and quent payments, how much interest will you owe atPerpetuities 5.32 Barrett Pharmaceuticals is considering a drug project that costs $2.5 million today and is expected to generate end-of-year annual cash flows of $227,000, forever. At what discount rate would Barrett be indifferent between accepting and rejecting the project? Growing Annuity 5.33 Ninnipeg Publishing Company is trying to decide whether to revise its popular textbook. Financial Psychoanalysis Made Simple. The company has estimated that the revision will cost $75,000, Cash flows from inereased sales will be $21,000 the first year. These cash flows will increase by 4 percent per year. The book will go out of print five years from now. ‘Assume that the initial cost is paid now and revenues are received at the end of each year. Ifthe company requires a 10 percent return for such an investment, should it undertake the revision? eYXcel 5.34 Your job pays you only once a year forall the work you did over the previous 12 months. Today, December 31, you just received your salary of $65,000, and you plan to spend all of it. However, you want to stat saving for retirement beginning next year. You have decided that one year from today you will begin depositing 5 percent of your annual salary in an account that will earn 10 percent per year. Your salary will increase at 4 percent pet year throughout your career. How much money will you have on the date of your retire- ment 40 years from today? ent Value and Interest Rates 5.35 What is the relationship between the value of an annuity and the level of interest rates? Suppose you just bought a 15-year annuity of $6,800 per year at the current interest rate of 10 percent per year. What happens to the value of your investment if interest rates suddenly drop to 5 percent? What if interest rates suddenly rise to 15 percent? Calculating the Number of Payments 5.36 You're prepared to make monthly payments of $350, beginning at the end of this month, into an account that pays 10 percent interest compounded monthly. How many payments ‘will you have made when your account balance reaches $35,000? Calculating Annuity Present Values 5.37 You want to borrow $65,000 from the bank to buy a new sailboat. You can afford to make ‘monthly payments of $1,320, but no more. Assuming monthly compounding, what is the highest APR you can afford on a 60-month loan? Calglllating Loan Payments 39 You need a 30-year, fixed-rate mortgage to buy a new home for $250,000. Your bank will end you the money ata 5.3 percent APR for this 360-month loan, However, you can only {ford monthly payments of $950, so you offer to pay off any remaining loan balance atthe tend of the loan in the form of a single balloon payment, How large will this balloon pay~ ‘ment have to be for you to keep your monthly payments at S9SO? Present and Future Values 5.39. The PV of the following cash flow stream is $7,300 when discounted at 8 percent annually ‘What is the value of the missing cash flow? i : Year 5.40 You are offered an annuity that will pay $20,000 per ye discount rate is 8%, What is the annuity worth to you to for 10 years. The appropriate i the first payment will be5.51 You want to lease a set of golf elubs from Pings Ltd. The lease contract is in the form of 24 ‘equal monthly payments at a 10.4 percent stated annual interest rate, compounded monthly. Because the clubs cost $2,300 retail, Pings wants the PV of the lease payments to equal $2,300, Suppose that your first payment is due immediately. What will your monthly lease payments be? Annuities 5.52. You are saving for the university education of your two children. They are two years apart in age: one will begin university 15 years from today and the other will begin 17 years from today. You estimate your children’s university expenses to be $45,000 per year per child, payable at the beginning of each school year. The annual interest rate is 7.5 percent. How ‘much money must you deposit in an account each year to fund your children’s education? ‘Your deposits begin one year from today. You will make your last deposit when your older child enters university. Assume four years of university. Growing Annuities 5.53. Tom Adams has received a job offer from a large investment bank as a clerk to an associ- ate banker. His base salary will be $55,000. He will receive his first annual salary payment ‘one year from the day he begins to work. In addition, he will get an immediate $10,000 ‘bonus for joining the company. His salary will grow at 3.5 percent each year. Each year he wil] receive a bonus equal to 10 percent of his salary. Tom is expected to work for 25 years. ‘What is the PV of the offer if the discount rate is 9 percent? lating Annuities You have recently won the super jackpot in the Alberta Provincial Lottery. On reading the fine print, you discover that you have the following two options: ‘a, You will receive 31 annual payments of $250,000, with the first payment being deliv- ered today. The income will be taxed at a rate of 28 percent, Taxes will be withheld when the cheques are issued. b. You will receive $530,000 now, and you will not have to pay taxes on this amount. In addition, beginning one year from today. you will receive $200,000 each year for 30 years. The cash flows from this annuity will be taxed at 28 percent. Using a discount rate of 7 percent, which option should you select?” Calculating Growing Annuities 5.55 You have 30 years left until retirement and want to retire with $2 million. Your salary is paid annually, and you will receive $70,000 at the end of the current year. Your salary will increase at 3 percent per year, and you can earn a 9 percent return on the money you invest. Ifyou save a constant percentage of your salary, what percentage of your salary must you save each year? Balloon Payments 5,56 On September 1, 2017, Susan Chao bought a motoreycle for $30,000. She paid $1,000 down nd financed the balance with a five-year loan at a stated annuisl interest rate of 7.2 percent, ‘compounded monthly. She started the monthly payments exactly one month after the pur chase (ie., October 1, 2017). Two years later, at the end of October 2019, Susan got a new job and decided to pay off the loan. Ifthe bank charges her a 1 perceat prepayment penalty based on the loan balance, how much must she pay the bank on November 1, 2019? Caloilating Annuity Valu 5,57/ Bilbo Baggins wants to save money to meet three objectives. First, he would like to be able to retire 30 years from now with a retirement income of $23,000 per month for 20 years, with the first payment received 30 years and L month from now, Second, he would like to purchase a cabin in Regina in 10 years ata estimated eost of $320,000, Thitd, after he passes on at the end of the 20 yeary of withdrawals, he would like to leave an inheritance Cf $1,000,000 1 his nephew Frodo, He can afford to save $2,100 per month for the next 10 years, Ifhe can earn an 11 percent EAR before he retives and an 8 percent EAR after he retires, how much will he have to save each month in years HE through 307)—~— ee Calculating Effective Annual Rate With Add-On Inter 5.64 This problem ithustrates a deceptive way of quoting interest rates called addon interest ‘utyre Value and Multiple Cash Flows ‘Sons Mortgage Bank is not, The current disclosure law requires that any fees that will be refunded if the applicant is rejected be includ in calculating the APR, but this is not required with non-refundable fees (presumably because refundable fees are part of the loan ‘ather than a fee). What are the EARS on these (wo loans? What are the APRS? Imagine that you see an advertisement for Crazy July's Stereo City that reads something like this: “$1,000 Instant Credit! 18% Simple Interest! Three Years to Pay! Low, Low Monthly Payments!” You're not exactly sure what allthis means and somebody has spilled {nk over the APR on the loan contract, so you ask the manager for clarification. Judy explains that if you borrow $1,000 for three years at 18 percent interest, in three years you will owe $1,000 x 1.18 = $1,000 x 1.64303 = $1,643.03 Jody recognizes that coming up with $1,643.03 all at once might be a strain, so she lets you make “low, low monthly payments" of $1,643.03/36 = $45.64 per month, even though {his is extra bookkeeping work for her. Is this an 18 percent loan? Why or why not? What is the APR on this loan? What is the EAR? Why do you think this is called add-on interest? Calculating Annuity Payments 5.65 Your friend is celebrating her 30h birthday today and wants to start saving for her anti pated retirement at age 65. She wants to be able to withdraw $100,000 from her savings account on each birthday for 25 years following her retirement, with the frst withdrawal on her 66th birthday. Your friend intends to invest her money in the local credit union, which offers 8 percent interest per year. She wants to make equal annual payments on each birth- {day into the account established atthe credit union for her retirement fund. 4. If she starts making these deposits on her 30th birthday and continues to make deposits ntl she is 65 (the last deposit will be on her 65th birthday), what amount must she ‘deposit annually to be able to make the desired withdrawals at retirement? '. Suppose your friend has just inherited a large sum of money. Rather than making equal annual payments, she has decided to make one lump-sum payment on her 30th birthday to cover her retirement needs. What amount does she have to deposit? ‘c. Suppose your friend’s employer will contribute $1,300 to the account every year as part of the company’s profit-sharing plan. In addition, your friend expects a $45,000 distribution from a family trust fund on her $Sth birthday, which she will also put into the retirement account, What amount must she deposit annually now to be able to make the desired withdrawals at retiement? Calculating the Number of Periods 5.66 Your Christmas ski vacation was great, but it unfortunately ran abit over budge. Alls not Jost; you just received an offer in the mailto transfer your $10,000 balance from your cur rent credit ear, which charges an annual rate of 18.6 percent, toa new credit car charging ‘rate of 8.2 percent How much faster could you pay the loan off by making your planned ‘monthly payments of $200 withthe new cand? What if there was a2 percent fe charged on any balances transferred? bought by a parent or grandparent for a child atthe child's birth, The details ofthe policy ‘are as follows, ‘The purchaser (say, the parent) makes the following six payments to the insurance company: 1 ietaday ssw } ‘Second binhay sw | “Third bray s m0 | Pout bitty S800 | Fifth binday s m0 Sisth birdy: S100alue and Capital Budgeting chil hes age 65, After the child’s sixth birthday, no more payments are made. When the ot ee he or she receives $275,000. If the relevant interest rate is 11 percent for the first six years and 7 percent for all subsequent years, is the policy worth buying? Annuity Present Values and Effective Rates 5.68 You have just won the lottery. You will receive $2,500,000 today and then receive 40 pay- ments of $1,250,000. These payments will start one year from now and will be paid every six months. A representative from Greenleaf Investments has offered to purchase all the Payments from you for $23 million. If the appropriate interest rate is a 9 percent APR compounded daily, should you take the offer? Assume there are 12 months in a year, each with 30 days. Calculating Interest Rates 5.69 A financial planning service offers a university savings program. The plan calls for you to make six annual payments of $11,000. each, with the first payment occurring today, your child's 12th birthday. Beginning on your child’s 18th birthday, the plan will provide $25,000 Per year for four years. What return is this investment offering? Break-Even Investment Returns 5.70 Your financial planner offers you two different investment plans. Plan X is a $15,000 annual per- petuity. Plan Y is a 10-year, $26,000 annual annuity. Both plans will make their first payment one year from today. At what discount rate would you be indifferent between. these two plans? Perpetual Cash Flows 5.71 What is the value of an investment that pays $30,000 every other year forever, if the first pay- ment occurs one year from today and the discount rate is 13 percent compounded daily? What is the value today if the first payment occurs four years from today? Assume 365, days in a year, Ordinary Annuities and Annuities Due 5.72 As discussed in the text, an annuity due is identical to an ordinary annuity except that the periodic payments occur at the beginning of each period and not at the end of the period, Show that the relationship between the value of an ordinary annuity and the value of an otherwise equivalent annuity due is Annuity due value = Ordinary annuity value x (1 + r) Show this for both present and future values. Calculating the Effective Annual Rate