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Present and Future Value

You have just deposited $15,000 in an account earning 8% APR, compounded annually.
If you leave the money in the account for 10 years, how much will you have?

Show Solution

Step 1) Time Line


0 1 2 9 10
| | | … | |
$15,000 ?

Step 2) Formula

FV = PV (1 + r ) t
FV = $15,000(1 + .08)10
FV = $32,383.87

You have just inherited $25,000. You immediately place $5,000 in a mutual fund
earning 12% APR, compounded quarterly. You plan to blow the other $20,000 on a trip
to Las Vegas. Much to your chagrin, after 2 years in Vegas, you not only did not manage
to blow your inheritance, you actually now have $50,000. You now take $10,000 of the
$50,000 and place it in the same mutual fund. Interest rates remain constant. After 10
years and many sad tales, you return home penniless. However, that day you receive
your statement from the mutual fund. You quickly tear it open and discover that your
deposits are now worth…?

Show Solution

Step 1) Time Line


0 4 8 48
| | | … | |
$5,000 $10,000 ???
Note that the time units of the time line are in quarters. Thus, you place the $10,000 in
the account two years, or 8 quarters, from today. Finally, you examine your mutual fund
statement 12 years or 48 quarters from the time you deposit the $5,000.

Step 2) Formula
Note that you will need to use the future value tool two times to answer this
question.
Also note, that APR = r * #pds/yr
Thus, 12% = r * 4, è r = 3%

Part a) FV of $5000.

FV = PV (1 + r ) t
FV = $5,000(1 + .03) 48
FV = $20,661.26

Part b)FV of $10,000

FV = PV (1 + r ) t
FV = $10,000(1 + .03) 40
FV = $32,620.38

Total Value of portfolio = $20,661.26 + $32,620.38 = $53,281.64

Also note, you could solve this by finding the value of the portfolio at t = 8 after the
$10,000 has been added to the FV of the $5000 after 2 years. Then find the future value
of this amount after an addition 10 years (40 quarters). You will find that the answers
are the exact same.
You would like to save for the down payment for a new car. You have just invested
$1,500 in shares of Dell. You believe that Dell will continue to earn its historical return
of 15%, compounded monthly. The car you wish to purchase will have a required down
payment of $2,200. Given this information, how many months must you wait before you
can purchase the car?

Show Solution

Step 1) Time Line


0 ?
| | | … | |
$1,500 $2,200

Step 2) Formula
Note that we are moving a single value through time, so the appropriate tool is the
present/future value tool. However, since our time periods are in months, we need to
determine the monthly rate:

APR = r * #pds/yr
15% = r * 12
r = 1.25%/month

Now we need to manipulate the present value formula to the form that we need it:

FV = PV(1 + r ) t
FV
= (1 + r ) t
PV
 FV 
ln   = ln(1 + r ) t = t ln(1 + r )
 PV 
 FV 
ln 
 PV  = t
ln(1 + r )
 $2,200 
ln 
$1,500 
t=  = 30.83months
ln(1.0125)

or about 2 ½ years.
How much must you place in an account today in order to have accumulated $100,000 is
15 years? Assume that interest rates are 8%, compounded semi-annually.

Show Solution

Step 1) Time Line


0 1 2 29 30
| | | … | |
? $100,000
Note that the number of periods (t) is 30 (2 per year times 15 years).
The rate/period is
APR = r * #pds/yr
8% = r * 2
r = 4% (every 6 months)

Step 2) Formula

FV = PV(1 + r ) t
FV
PV =
(1 + r ) t
$100,000
PV =
(1.04) 30
PV = $30,831.87

You uncle constantly brags about his outstanding performance in the stock market.
Indeed, at the beginning of 1992, his portfolio of assets was worth a mere $25,000. By
the end of 2000, his portfolio had appreciated in value to $750,000 (before he lost almost
all of it when the market declined!). What was his annual rate of return on his portfolio?

Show Solution

Step 1) Time Line


1992 1993 1994 2000 2001
| | | … | |
$25,000 $750,000
Note that since you started at the beginning of 1992 and ended at the end of 2000, the
money was invested for 9 full years. Also note that we want to calculate the answer in
years in order to have, well, an annual rate.

Step 2) Formula
FV = PV(1 + r ) t
FV
= (1 + r ) t
PV
1/ t
 FV 
 PV  = (1 + r )

1/ t
 FV 
 PV  −1 = r

1/ 9
 $750,000 
 $25,000  − 1 = 45.92%!!
 

You have just deposited $1,000 in your mutual fund account and plan to keep it in the
account for forty (40) years. The money earns 16% interest for the first 20 years and 8%
for the last 20 years. Your sibling invests in a different account that earns 8% for the first
20 years and 16% for the next 20 years. Which one of you has the most money after 40
years?

Show Solution

Step 1) Time Line

You:
0 20 40
| 16% | 8% |
$1,000 ???

Sibling
0 20 40
| 8% | 16% |
$1,000 ???

Step 2) Formula
Initially we will solve this in two steps. First, determine the value of your
investment after 20 years (FV1)
FV1 = PV(1+r)t
FV1 = $1000(1.16)20 = $19,460.76
Next, determine the future value of $19,460.76 after 20 years (FV2) at 8%.
FV2 = PV (1+r)t
FV2 = $19,460.76(1.08)20 = $90,705.76
You could repeat this procedure for your sibling. However, note that there is a little
short-cut. In the equation FV = $19,460.76(1+.08)20, the $19,460.76 is really just
$1000(1.16)20. Thus, we could get to the value at time period 40 by conducting the
following calculation:
FV = $1000(1.16)20(1.08)20 = $90,705.76.

So now we can calculate the amount that your sibling will have as:
FV = $1000(1.08)20(1.16)20 = $19,705.76, the same amount. Although this may not be
intuitive, recalling the A * B is the same as B * A, you can see that the two answers must
be the same.

Annuities
You have just won the lottery, a record $500 million, paid in equal annual installments
over the next 20 years. The first payment will be received immediately. If lottery
officials wanted to pay you at the end of the year rather than at the beginning, how much
must they offer you in order for you to be indifferent between the two? Assume the
effective annual interest rate is 10%.

Show Solution
Note that since there are 20 equal payments summing to $500 million, then each payment
is $25 million.
Step 1) Time Line
0 1 2 19 20
| | | … | |
Original $25M $25M $25M $25M $0
Proposed $0 PMT PMT PMT PMT

Step 2) Formula
Note that the best time to solve this question for is at t = 0. If we can determine the value
of the original stream at t = 0, we can then treat this as the present value of the proposed
stream of cash flows to determine the fair PMT.

Recall the annuity tool:


1 1 
PV = PMT  −
t
 r r (1 + r ) 
it is extremely important to note that this tool when applied to the original stream of cash
flows will only tell you the value of the cash flows 1-19, NOT the value of the first $25M
(recall the picture of how this tool works). So to the PV of the annuity, you will need to
add $25M.
1 1 
PV = $25M  −  = $209,123,002
 .1 .1(1 + .1)19 
So the total present value of the cash flows stream is
$209,123,002 + $25,000,000 = $234,123,002

Next, we treat the $234,123,002 as the present value of the proposed payment stream.
Now note, that the annuity tool will work if $234,123,002 is the present value, to
determine the payment stream based on the next 20 periods.

1 1 
$234,123,002 = PMT  − 
 .1 .1(1 + .1) 20 
PMT = $27,500,000
What is the present value today of a constant stream of $500 payments to be received at
the end of the year for the next 10 years. Interest rates are 8% APR, compounded
annually.

Show Solution

Step 1) Time Line


0 1 2 9 10
| | | … | |
$500 $500 $500 $500

Note that there are two ways to solve this question. First, you could individually
discount each of the 10 $500 payments back to t = 0 using the present value formula.
However, a much shorter way is to simply use the annuity tool, which we will use.

Step 2) Formula

1 1 
PV = PMT  − 
 r r (1 + r ) t 
 1 1 
PV = $500 −
10 
 .08 .08(1.08) 
PV = $3,355.04

You are considering the purchase of a Titanic Bond, issued by the U.S. government. This
bond promises the owner a payment of $50/year forever. If the price of this bond is
$850, what will be your rate of return on this investment?

Show Solution

Step 1) Time Line


| | | | | …
$50 $50 $50

Step 2) Formula

PMT
PV =
r
PMT
r=
PV
$50
r=
$850
r = 5.88%

You have just retired after a long career with a nest egg of $800,000. Your lifelong
dream has been to purchase an RV and motor the roads of North and South America for
the 20 expected years of your retirement. You estimate that you will require
$60,000/year with which to live in retirement and you will withdraw the $60,000 at the
beginning of each year. Thus, you will immediately withdraw $60,000 and will do so
again for the next 19 years. Assume interest rates are 10% APR, compounded annually,
how much can you afford to spend on an RV today?

Show Solution

Step 1) Time Line


0 1 2 19 20
| | | … | |
$60 $60 $60 $60 $0
RV Value

To solve this, we will first need to subtract the present value of the 20 $60,000 payments
from your retirement fund of $800,000. What is left over can be spent on the RV.

Step 2) Formula
Present value of twenty $60,000 payments, with the first to be received today.
1 1 
PV = $60,000 + $60,000  −  = $561,895.21
 .1 .1(1.1)19 
$800,000 − $561,895.21 = $238,104.79

Bonds
You have just purchased a bond with an annual coupon of 7%, 8 years remaining until
maturity, that is selling at a price such that the yield to maturity is 12%. Given this
information, what is the price that you paid for the bond?

Show Solution

Time Line
0 1 2 7 8
| | | … | |
$70 $70 $70 $1070

 1 1  $1000
PB = $70 − + = $751.62
 .12 .12(1.12) 8  (1.12) 8

Last year, you purchased a bond issued by IBM that offered 8% annual coupon payments,
had 12 years to maturity, and had a yield to maturity of 8%. The first coupon of $80 has
just been paid and current interest rates have changed such that the yield to maturity on
the bond is now 4%. What was your rate of return and the current yield on this bond?

Show Solution

Step 1: First note that the price of the bond when you purchased it was $1000 because the
coupon rate equaled the YTM.

Current yield = Coupon/Pbond = $80/$1000 = 8%

Coupon + ∆ Pr ice
Rate of Return = Investment or coupon plus change in price divided by the initial
investment. In order to determine this, we need to calculate the ∆ Price. After the first
coupon is paid, the bond will be worth:
 1 1  $1000
PB = $80 − + = $1,350.42
11 11
 .04 .04(1.04)  (1.04)
Thus, ∆ Price = $1,350.42 - $1,000 = $350.42.

$80 + $350.42 $430.42


= = 43.04%
So Rate of Return = $1000 $1000

Der-Bond-Hauffe is a little-known firm that just issued a bond with a maturity of 6 years,
a yield to maturity of 7%, and a price of $904.67. What must be the coupon rate of this
bond?

Show Solution

Time Line
0 1 2 5 6
| | | … | |
C C C C+1000
$904.67

First, we need to determine how much of the current price is due to the payment of the
face value.

$1,000
= $666.34
6
PVface = (1 + .07)

Thus, $904.67 - $666.34 = $238.33 is the value of the coupon payments.

Next, solve for what stream of 6 coupon payments has a present value of $238.33.

 1 1 
$238.33 = C  − 
 .07 .07(1.07) 6 

$238.33
C= = $50
 1 1 
 − 
6
 .07 .07(1.07) 
Stocks
What is the price today of a stock that is expected to pay an annual dividend of $2.50
each year in perpetuity? The appropriate discount rate for a stock of this risk is 15%.

Show Solution

The promised payments are a simple perpetuity. Thus, the value is:

$2.50
PS = = $16.67
.15

What is the price today of a stock that just paid a dividend of $1 and dividends are
expected to grow at a constant rate of 4% per year, indefinitely. The required return on
equity is 18%.

Show Solution

The payments associated with owning this stock are simply a growing perpetuity. We
can use the Gordon Growth model to value this stream of payments.

DIV1 $1(1.04)
PS = = = $7.43
r − g (.18 − .04)

You have just purchased a stock that currently pays no dividends. However, you expect
that after 5 years, the company will begin to pay dividends on their stock of $2.00 per
share, and that this amount will grow at a constant rate of 5% per year thereafter.
Assuming that stocks with similar risks require a rate of return of 20%, what is a fair
price to have paid for this security?

Show Solution

Time Line
0 1 2 3 4 5 6 7
| | | | | | | | …
DIV 0 0 0 0 0 0 2 2.10 …

Once the dividends begin, this is a growing perpetuity. We can value the growing stream
of dividends using the Gordon Growth model.

DIV1 2.00
Ps = = = $13.33
r − g .20 − .05

Note that the stock will have a value of $13.33 at t = 5 (since we are treating the $2 as the
beginning of the perpetuity). Thus, the present value (at t = 0) of this cash flow is:

$13.33
V0 = = $5.36
1 .2 5

We could have achieved that same answer by treating the $2.10 payment as the first
dividend, finding the value of the growing perpetuity at t = 6, adding $2 to this value, and
discounting the entire amount back to t = 0.

A firm has a return on equity of 20% and a plowback ratio of 40%. The risk of this firm
is such that equityholders expect a 30% return. The firm just paid a dividend of $1.
Given this information, what is the price of the stock?

Show Solution

Recall that growth = return on equity * plowback.


Thus, g = .2 * .4 = .08.

We now have sufficient information with which to value the stock. We know that the
next dividend is expected to be $1(1.08) = $1.08, and that dividends are expected to grow
by 8% each year thereafter.

Thus, the price of the stock is:

$1.08 $1.08
Ps = = = $4.91
.30 − .08 .22

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