Brea ch05 BMM 7e SG

Chapter 05
Inputs are in Blue

Answers are in Red
NOTE: Some functions used in these spreadsheets may require that
the "Analysis ToolPak" or "Solver Add-In" be installed in Excel.
To install these, click on the Office button
then "Excel Options," "Add-Ins" and select
"Go." Check "Analysis ToolPak" and
"Solver Add-In," then click "OK."
2012, The McGraw-Hill Companies
equire that
Quiz 1
Compute the present value of a $100 cash flow for the following combinations
of discount rates and times:
a.
b.
c.
d.
r=
r=
r=
r=
8.00% ,
8.00% ,
4.00% ,
4.00% ,
Cash Flow
t=
t=
t=
t=
10.00
20.00
10.00
20.00
years.
years.
years.
years.
$100.00
Solution:
a.
PV of $100 @ 8% for 10 years
= $46.32
b.
= $21.45
c.
= $67.56
d.
= $45.64
Quiz 2
Compute the future value of a $100 cash flow for the following combinations
of discount rates and times:
a.
b.
c.
d.
r=
r=
r=
r=
8.00% ,
8.00% ,
4.00% ,
4.00% ,
Cash Flow
t=
t=
t=
t=
10.00
20.00
10.00
20.00
years.
years.
years.
years.
$100.00
Solution:
a.
FV of $100 @ 8% for 10 years
= $ 215.89
b.
= $ 466.10
c.
= $ 148.02
d.
= $ 219.11
Quiz 3
In 1880 five aboriginal trackers were each promised the equivalent of 100 Australian dollars for helping to
capture the notorious outlaw Ned Kelley. In 1993 the granddaughters of two of the trackers claimed that
this reward had not been paid. The Victorian prime minister stated that if this was true, the government
would be happy to pay the $100. However, the granddaughters also claimed that they were entitled to
compound interest. How much was each entitled to if the interest rate was 4%? What if it was 8%?
Years passed
Amount promised
Interest rate -1
Interest rate -2
113.00 years
100.00
4.00%
8.00%
Solution:
Amount using 4% interest rate
Amount using 8% interest rate
=
=
$ 8,409.45
$598,252.29
or helping to
Quiz 4
You deposit $1,000 in your bank account. If the bank pays 4% simple interest, how much will you
accumulate in your account after 10 years? What if the bank pays compound interest? How much
of your earnings will be interest on interest?
Deposit
Simple interest
Time period
$1,000.00
4.00%
10.00 years
Solution:
Amount accumulated using simple interest
Amount accumulated using compound interest
Earnings interest on interest
= $1,400.00
= $1,480.24
= $ 80.24
uch will you

? How much
Quiz 5
You will require $700 in 5 years. If you earn 5% interest on your funds, how much will you need to
invest today in order to reach your savings goal?
Future value
Time period
Interest rate
$700.00
5.00 years
5.00%
Solution:
Present value
= $548.47
ill you need to
Quiz 6
Find the interest rate implied by the following combinations of present and future values:
Present Value
$ 400.00
183.00
300.00
Years
11.00
4.00
7.00
Future Value
$ 684.00
249.00
300.00
Years
11.00
4.00
7.00
Future Value
$ 684.00
249.00
300.00
Solution:
Present Value
$ 400.00
183.00
300.00
Interest Rate
###
###
###
Quiz 7
Would you rather receive $1,000 a year for 10 years or $800 a year for 15 years if
a. the interest rate is
5.00%
b. the interest rate is
20.00%
c. Why do your answers to (a) and (b) differ?

Option 1:
Amount
Time period
Option 2:
Amount
Time period
$1,000.00
10.00 years
$ 800.00
15.00 years
Solution:
a.
Present value-1
Present value-2
=
=
$7,721.73
$8,303.73
At 5% interest rate, PV of option 2 is more than option 1, therefore you should

select option 1.
b.
Present value-1
Present value-2
=
=
$4,192.47
$3,740.38
At 20% interest rate, PV of option 1 is more than option 2, therefore you should
select option 2.
c.
When the interest rate is low, as in part (a), the longer (i.e., 15-year) but smaller
annuity is more valuable because the impact of discounting on the present value
of future payments is less significant.
Quiz 8
Find the annual interest rate.
Present Value
Future Value
100.00
200.00
100.00
115.76
262.16
110.41
Time Period
(years)
3.00
4.00
5.00
Solution:
Present Value
Future Value
$ 100.00
200.00
100.00
$ 115.76
$ 262.16
$ 110.41
Time Period
(years)
3.00
4.00
5.00
Interest Rate
###
###
###
Quiz 9
What is the present value of the following cash-flow stream if the interest rate is 6%?
Year
1
2
3
Interest rate
Cash Flow
$ 200.00
$ 400.00
$ 300.00
6.00%
Solution:
Present Value
= $ 796.56
Quiz 10
How long will it take for $400 to grow to $1,000 at the interest rate specified?
a.
b.
c.
4.00%
8.00%
16.00%
Present Value
Desired Future Value
$ 400.00
$1,000.00
Solution:
a. Time period @ 4.00%
23.36 years
b. Time period @ 8.00%
11.91 years
c. Time period @ 16.00% =
6.17 years
Quiz 11
Find the effective annual interest rate for each case.
Compounding
Period
12.00%
1 month
8.00%
3 month
10.00%
6 month
APR
Solution:
APR
12.00%
8.00%
10.00%
Compounding Period
12 / year
4 / year
2 / year
Effective
Annual Rate
12.68%
8.24%
10.25%
Quiz 12
Find the APR (the stated interest rate) for each case.
Effective Annual
Interest Rate
10.00%
6.09%
8.24%
Compounding
Period
1 month
6 month
3 month
Solution:
Effective Annual
Interest Rate
10.00%
6.09%
8.24%
Compounding
Period
12 / Year
2 / Year
4 / Year
Per-Period
APR
Rate
0.0080
9.60%
0.0300
6.00%
0.0200
8.00%
Quiz 13
If you earn 6% per year on your bank account, how long will it take an account with $100 to
double to $200?
Interest rate
PV
FV
6.00%
$ 100.00
$ 200.00
Solution:
Time period
11.9 years
Quiz 14
Suppose you can borrow money at 8.6% per year (APR) compounded semiannually or 8.4% per
year (APR) compounded monthly. Which is the better deal?
APR compounded semiannually
APR compounded monthly
8.60%
8.40%
Solution:
APR
Compounding period
8.6%
8.4%
2 / Year
12 / Year
Effective
Annual Rate
8.78%
8.73%
Choose the 8.4% loan for its slightly lower effective rate.
Quiz 15
Lenny Loanshark charges 1 point per week (that is, 1% per week) on his loans. What APR
must he report to consumers? Assume exactly 52 weeks in a year. What is the effective
annual rate?
Loan Charges
Weeks in a year
1.00% per week

52.00 weeks
Solution:
APR
EAR
=
=
52.00%
67.77%
Quiz 16
Investments in the stock market have increased at an average compound rate of about
5% since 1900. It is now 2012.
a. If you invested $1,000 in the stock market in 1900, how much would that investment
be worth today?
b. If your investment in 1900 has grown to $1 million, how much did you invest in 1900?
Average compound rate
Time period
Amount invested in 1900
Investment grown to in 2012 (FV)
5.00%
112.00 years
$1,000.00
$
1.00 million
Solution:
a.
Present Value
= $236,157.40
b.
Present Value
= $
4,234.46
Quiz 17
Old Time Savings Bank pays 4% interest on its savings accounts. If you deposit
$1,000 in the bank and leave it there, how much interest will you earn in the first
year? The second year? The tenth year?
Interest rate
Deposit
Time period
Time period
Time period
4.00%
$1,000
1.00 year
2.00 year
10.00 year
Solution:
= $40.00
Interest in first year
Interest in second year = $41.60
= $56.93
Interest in tenth year
Quiz 19
A zero-coupon bond that will pay $1,000 in 10 years is selling today for $422.41.
What interest rate does the bond offer?
Face value
Time
Market Value
$1,000.00
10.00
$ 422.41
Solution:
Interest rate
9.00%
Quiz 20
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. Who is better paid? The interest rate is 10%.
Quarterback Contract:
Contract Value
Cash flow per year
Time period
Interest rate
$15.00 million
$ 3.00 million
5.00 years
10.00%
Receiver's Contract:
Contract Value
Cash received this year
Cash flow for next 4 years
Time period
Interest rate
$14.00
$ 4.00
$ 2.00
5.00
10.00%
million
million
million
years
Solution:
Present value of Quarterback's Contract
Present value of Receiver's Contract
= $ 11.37 million
= $ 11.58 million
The receivers contract is worth more than the quarterbacks even though the
receivers undiscounted total payments are less than the quarterbacks.
n a year for
ding $4 million
Practice Problem 21
In mid-2010 a pound of apples cost $1.26, while oranges cost $1.10. Ten years earlier the price
of apples was only $.92 a pound and that of oranges was $.70 a pound. What was the annual
compound rate of growth in the price of the two fruits? If the same rates of growth persist in the
future, what will be the price of apples in 2030? What about the price of oranges?
Apple Cost (per pound)
Oranges Cost (per pound)
$
$
Ten years earlier:

Apple Cost (per pound)
Oranges Cost (per pound)
Time period (prior)
Time period
$
$
1.26
1.10
0.92
0.70
10.00 years
20.00 years
Solution:
Rate of growth for apples
Rate of growth for oranges
Price of apples in 2030
Price of oranges in 2030
= 3.195%
=
4.62%
= $ 2.36
= $ 2.72
Practice Problem 22
If you take out an $8,000 car loan that calls for 48 monthly payments starting after 1 month at an APR
of 10%, what is your monthly payment? What is the effective annual interest rate on the loan?
Car loan
No. of payments
APR
8,000.00
48.00 monthly
10.00%
Solution:
Monthly payment
The monthly interest rate is
Effective annual interest rate
=
=
=
$202.90
0.8333%
10.47%
Practice Problem 23
a. What is the present value of a 3-year annuity of $100 if the discount rate is 6%?
b. What is the present value of the annuity in (a) if you have to wait 2 years instead
of 1 year for the first payment?
Time period(1)
Amount
Discount rate
Time period(2)
3.00 year
$100.00
6.00%
2.00 year
Solution:
a.
Present Value
= $267.30
b.
Present Value
= $252.17
Practice Problem 24
Professors Annuity Corp. offers a lifetime annuity to retiring professors. For a payment
of $80,000 at age 65, the firm will pay the retiring professor $600 a month until death.
a. If the professors remaining life expectancy is 20 years, what is the monthly rate on
this annuity? What is the effective annual rate?
b. If the monthly interest rate is .5%, what monthly annuity payment can the firm offer to
the retiring professor?
Lump sum payment
Monthly income
Life expectancy
Monthly interest rate
$80,000.00
$ 600.00
20.00 years
0.50%
Solution:
a.
Monthly rate on annuity

Effective annual rate
=
=
0.548%
6.78%
b.
Monthly annual payment
= $
573.14
Practice Problem 25
You want to buy a new car, but you can make an initial payment of only $2,000 and can afford
monthly payments of at most $400.
a. If the APR on auto loans is 12% and you finance the purchase over 48 months, what is the
maximum price you can pay for the car?
b. How much can you afford if you finance the purchase over 60 months?
Initial payment
Monthly payments
APR
Time period (1)
Time period (2)
$ 2,000.00
$ 400.00
12.00%
48.00 months
60.00 months
Solution:
a.
Present Value of loan

Maximum price
= $15,189.58
= $17,189.58
b.
Present Value of loan

Maximum price
= $17,982.02
= $19,982.02
Practice Problem 26
In a discount interest loan, you pay the interest payment up front. For example, if a 1-year loan
is stated as $10,000 and the interest rate is 10%, the borrower pays .10 x $10,000 = $1,000
immediately, thereby receiving net funds of $9,000 and repaying $10,000 in a year.
a. What is the effective interest rate on this loan?
Loan
Interest rate
Net funds
$10,000.00
10.00%
$ 9,000.00
Solution:
a.
Effective interest rate
11.11%
Practice Problem 28
If you take out an $8,000 car loan that calls for 48 monthly payments of $240 each, what is the APR of
the loan? What is the effective annual interest rate on the loan?
Car loan
No. of monthly payments
Monthly payment
$8,000.00
48.00
$ 240.00
Solution:
Monthly rate of interest
APR
EAR
=
=
=
1.599%
19.188%
20.97%
, what is the APR of
Practice Problem 29
If you take out an $8,000 car loan that calls for 48 monthly payments of $240 each,
what is the APR of the loan? What is the effective annual interest rate on the loan?
What if the payments are made in four annual year-end installments? What annual
payment would have the same present value as the monthly payment you calculated?
Use the same effective annual interest rate. Why is your answer not simply 12
times the monthly payment?
Car loan
No. of monthly payments
Monthly payment
No. of yearly payments
Monthly payment
$8,000.00
48.00
$ 240.00
4.00
$ 240.00
Solution:
Monthly rate of interest
APR
EAR
=
=
=
1.5990%
19.188%
20.97%
Annual Payment
= $3,147.29
With monthly payment you would pay $2,880.00 per year
This value is lower because the monthly payments come before
year-end and therefore have a higher PV.
Practice Problem 30
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. If the interest
rate your company can earn on its funds is 7%, is it cheaper to buy or lease?
Truck Lease
Time period
Cost of the truck
Interest rate
$ 8,000.00 per year

6.00 years
$ 40,000.00
7.00%
Solution:
Present value of annuity = $ 38,132.32
Since $38132.32 < $40000 (the cost of buying a truck),
it is less expensive to lease than to buy.
Practice Problem 31
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%.
What if the lease payments are an annuity due, so that the first payment comes immediately?
Is it cheaper to buy or lease?
Truck Lease
Time period
Cost of the truck
Interest rate
$ 8,000.00
6.00 years
$40,000.00
7.00%
Solution:
PV of an annuity due
PV of ordinary annuity
PV of an annuity due
= PV of ordinary annuity x (1 + r)
= $38,132.32
= $40,801.58
Since this is greater than $40000 (the cost of buying a truck),

we conclude that, if the first payment on the lease is due immediately,
it is less expensive to buy the truck than to lease it.
Practice Problem 32
A store offers two payment plans. Under the installment plan, you pay 25% down
and 25% of the purchase price in each of the next 3 years. If you pay the entire bill
immediately, you can take a 10% discount from the purchase price. Which is a
better deal if you can borrow or lend funds at a 5% interest rate?
Down payment
Annuity
n
Discount rate
Interest rate
25.00%
25.00%
3.00 years
10.00%
5.00%
Solution:
Assume the product sells for
Installment plan:
Present value
=
Pay in full:
Payment net of discount
=
$ 100.00
$ 93.08
$ 90.00
Choose the second payment plan for its lower present value of payments.
Practice Problem 33
A store offers two payment plans. Under the installment plan, you pay 25% down
and 25% of the purchase price in each of the next 3 years. If you pay the entire bill
immediately, you can take a 10% discount from the purchase price. Which is a
better deal if you can borrow or lend funds at a 5% interest rate?
How will your answer change if the payments on the 4-year installment plan do not
start for a full year?
Down Payment
Annuity
n-1
n-2
Discount rate
Interest rate
25.00%
25.00%
3.00 years
4.00 years
10.00%
5.00%
Solution:
Assume the product sells for
Installment plan:
Present value
Pay in full:
Payment net of discount
$ 100.00
=
$ 88.65
$ 90.00
Now the installment plan offers the lower present value of payments.
Therefore choose the first option.
Practice Problem 34
a. If you borrow $1,000 and agree to repay the loan in five equal annual payments at an interest
rate of 12%, what will your payment be?
b. What if you make the first payment on the loan immediately instead of at the end of the first
year?
Amount borrowed
n
Interest rate
$1,000.00
5.00
12.00%
Solution:
a.
Annual Payment
= $ 277.41
b.
PV factor
Annual Payment
=
3.6048
= $ 247.69
Practice Problem 35
Suppose that you will receive annual payments of $10,000 for a period of 10 years. The first
payment will be made 4 years from now. If the interest rate is 5%, what is the present value
of this stream of payments?
Annual payments
Time period
First payment is made after
Interest rate
10,000.00
10.00
4.00 years
5.00%
Solution:
PV3
PV0
= $
= $
77,217.35
66,703.25
Practice Problem 36
Home loans typically involve points, which are fees charged by the lender. Each point charged
means that the borrower must pay 1% of the loan amount as a fee.
For example, if the loan is for $100,000 and 2 points are charged, the loan repayment schedule
is calculated on a $100,000 loan but the net amount the borrower receives is only $98,000. What
is the effective annual interest rate charged on such a loan assuming loan repayment occurs over
360 months? Assume the interest rate is 1% per month.
Fee charges
Loan amount
Net amount received
Time periods
1.00%
$100,000.00
$ 98,000.00
360.00 months
Solution:
Payment on the loan
Rate
Effective Annual Interest Rate
= $
=
=
1,028.61
1.023%
12.99%
Practice Problem 37
You take out a 30-year $100,000 mortgage loan with an APR of 6% and monthly payments. In
12 years you decide to sell your house and pay off the mortgage. What is the principal balance
on the loan?
Loan amount
Time period
Time period
APR
Pay off the loan in
Pay off the loan in
100,000.00
30.00
360.00
6.00%
12.00
144.00
years
months
years
months
Solution:
Payment on the mortgage = $
599.55
After 12 years, 216 months remain on the loan,
so the loan balance is:
= $
79,079.44
Practice Problem 38
Consider a 4-year amortizing loan. You borrow $1,000 initially, and repay it in four equal annual
year-end payments.
a. If the interest rate is 8%, show that the annual payment is $301.92.
b. Fill in the following table, which shows how much of each payment is interest versus principal
repayment (that is, amortization), and the outstanding balance on the loan at each date.
Loan
Balance
Time
0
1
2
3
4
1,000.00
---------------------$
-
Year-End
Year-End Amortization
Interest
Payment
of Loan
Due on Balance
$
80.00 $ 301.92 $
221.92
-------$ 301.92
--------------$ 301.92
--------------$ 301.92
-------$
---------------
c. Show that the loan balance after 1 year is equal to the year-end payment of $301.92 times the
3-year annuity factor.
No. of installments
Amount
$
Interest rate
Annual payment
$
4.00
1,000.00
8.00%
301.92
Solution:
a.
Annual payment
b.
Time
0
1
2
3
4
c.
= $
$
$
$
$
$
301.92
Year-End
Loan
Year-End Amortization
Interest
Balance
Payment
of Loan
Due on Balance
1,000.00 $
80.00 $ 301.92 $
221.92
778.08 $
62.25 $ 301.92 $
239.67
538.41 $
43.07 $ 301.92 $
258.85
279.56 $
22.36 $ 301.92 $
279.56
$
-
Loan balance after one year
= $
778.08
Practice Problem 39
Youve borrowed $4,248.68 and agreed to pay back the loan with monthly payments
of $200. If the interest rate is 12% stated as an APR, how long will it take you to pay
back the loan? What is the effective annual rate on the loan?
Amount borrowed
Monthly payments
APR
$4,248.68
200.00
12.00%
Solution:
Number of months (t) =
Effective annual rate =
24.00 months
12.68%
Practice Problem 40
The $40 million lottery payment that you just won actually pays $2 million per year for 20 years.
If the discount rate is 8% and the first payment comes in 1 year, what is the present value of the
winnings? What if the first payment comes immediately?
Lottery amount
Per year payment
Time period
Discount rate
$ 40.00 million
$ 2.00 million
20.00 years
8.00%
Solution:
Present Value
= $ 19.64 million
If the first payment comes immediately:
Present Value
= $ 21.21 million
Practice Problem 41
A retiree wants level consumption in real terms over a 30-year retirement. If the
inflation rate equals the interest rate she earns on her $450,000 of savings, how
much can she spend in real terms each year over the rest of her life?
Time period
Savings
30.00 year
$450,000.00
Solution:
Spending each year = $ 15,000.00
Practice Problem 42
You invest $1,000 at a 6% annual interest rate, stated as an APR. Interest is
compounded monthly. How much will you have in 1 year? In 1.5 years?
Amount invested
APR
Time period-1
Time period-2
$1,000.00
6.00%
1.00 years
1.50 years
Solution:
Amount in 1 year
Amount in 1.5 year
=
=
$1,061.68
$1,093.93
Practice Problem 43
You just borrowed $100,000 to buy a condo. You will repay the loan in equal monthly payments
of $804.62 over the next 30 years. What monthly interest rate are you paying on the loan?
What is the effective annual rate on that loan? What rate is the lender more likely to quote
on the loan?
Amount borrowed
Monthly payments
Time period
$100,000.00
$
804.62
30.00 years
Solution:
Monthly Interest
APR
=
=
=
0.750%
9.38%
9.00%
Practice Problem 44
If a bank pays 6% interest with continuous compounding, what is the effective annual rate?
Interest rate
6.00%
Solution:
EAR
6.18%
Practice Problem 45
You can buy a car that is advertised for $24,000 on the following terms:
(a) pay $24,000 and receive a $2,000 rebate from the manufacturer;
(b) pay $500 a month for 4 years for total payments of $24,000, implying zero percent financing.
Which is the better deal if the interest rate is 1% per month?
Car price
(a) Rebate
(b) Monthly payments
Time
Interest rate
$24,000.00
$ 2,000.00
$ 500.00
4.00 years
1.00% per month
Solution:
Present Value of Option (a)
Present Value of Option (b)
= $22,000.00
= $18,986.98
Option (b) is the better deal.
Practice Problem 46
How much will $100 grow to if invested at a continuously compounded interest
rate of 10% for 8 years? What if it is invested for 10 years at 8%?
Amount invested
Time period-1
Interest rate-1
Time period-2
Interest rate-2
$ 100.00
8.00 years
10.00%
10.00 years
8.00%
Solution:
Future Value 1
Future Value 2
=
=
222.54
222.54
Practice Problem 47
I now have $20,000 in the bank earning interest of .5% per month. I need $30,000 to
make a down payment on a house. I can save an additional $100 per month. How
long will it take me to accumulate the $30,000?
Amount in bank
Interest rate
Amount required
Additional savings
$20,000.00
0.50% per month
$30,000.00
$ 100.00
Solution:
Time required
44.74 months
Practice Problem 48
A local bank advertises the following deal: Pay us $100 a year for 10 years and then we
will pay you (or your beneficiaries) $100 a year forever. Is this a good deal if the interest
rate available on other deposits is 6%?
Payments
Receipts
Time
Interest rate
$ 100.00 per year

$ 100.00 per year
10.00 years
6.00%
Solution:
The present value of your payments to the bank equals: = $
Present value of your receipts
= $
736.01
930.66
This is a good deal if you can earn 6% on your other investments.
Practice Problem 49
A local bank will pay you $100 a year for your lifetime if you deposit $2,500 in
the bank today. If you plan to live forever, what interest rate is the bank paying?
Receipts per year
Deposit amount
$ 100.00
$2,500.00
Solution:
Interest rate
4.00%
Practice Problem 50
A property will provide $10,000 a year forever. If its value is $125,000,
what must be the discount rate?
Receipts per year
Value
$ 10,000.00
$125,000.00
Solution:
Interest rate
8.00%
Practice Problem 51
You can buy property today for $3 million and sell it in 5 years for $4 million.
(You earn no rental income on the property.)
a. If the interest rate is 8%, what is the present value of the sales price?
b. Is the property investment attractive to you? Why or why not?
c. Would your answer to (b) change if you also could earn $200,000 per year
rent on the property?
Property price
Time period
Property price after 5 years
Interest rate
Rent per year
3.00 million
5.00 years
$
4.00 million
8.00%
$200,000.00
Solution:
a.
Present value of the sales price
= $
2.722 million
b.
The present value of the sales price is less than the cost of the property,
so this would not be an attractive opportunity.
c.
= $
3.521
Present value of the total cash flows
The property is an attractive investment if you can buy it for $3 million.
Practice Problem 52
A factory costs $400,000. You forecast that it will produce cash inflows of $120,000 in year 1,
$180,000 in year 2, and $300,000 in year 3. The discount rate is 12%. Is the factory a good
investment? Explain.
Factory cost
Cash Flows:
Year 1
Year 2
Year 3
Discount rate
400,000.00
$
$
$
120,000.00
180,000.00
300,000.00
12.00%
Solution:
Present value of Cash Flow
= $464,171.83
This exceeds the cost of the factory, so the investment is attractive
Practice Problem 53
You invest $1,000 today and expect to sell your investment for $2,000 in 10 years.
a. Is this a good deal if the discount rate is 6%?
b. What if the discount rate is 10%?
Amount invested
$ 1,000.00
Investment worth in 10 years $ 2,000.00
Time period
10.00 years
Discount rate-1
6.00%
Discount rate-2
10.00%
Solution:
a.
Present value of the future payoff is

=
$ 1,116.79
This is a good deal: Present value exceeds the initial investment
b.
Present value of the future payoff is

=
$ 771.09
This is now less than the initial investment. Therefore, this is a bad deal.
Practice Problem 54
A store will give you a 3% discount on the cost of your purchase if you pay cash today.
Otherwise, you will be billed the full price with payment due in 1 month. What is the
implicit borrowing rate being paid by customers who choose to defer payment for the
month?
Discount rate
3.00%
Solution:
Monthly rate
=
Effective annual rate =
3.09%
44.12%
Practice Problem 55
Banks sometimes quote interest rates in the form of add-on interest. In this case,
if a 1-year loan is quoted with a 20% interest rate and you borrow $1,000, then you
pay back $1,200. But you make these payments in monthly installments of $100
each. What are the true APR and effective annual rate on this loan? Why should
you have known that the true rates must be greater than 20% even before doing
any calculations?
Time period
Interest rate
Amount
Pay back
Monthly installments
1.00 year
20.00%
$1,000.00
$1,200.00
$ 100.00
Solution:
Monthly rate
APR
=
=
=
2.923%
35.076%
41.302%
If you borrowed $1,000 today and paid back $1,200 one year from today, the true rate
would be 20%.You should have known that the true rate must be greater than 20%
because the twelve $100 payments are made before the end of the year, thus
increasing the true rate above 20%.
Practice Problem 56
Banks sometimes quote interest rates in the form of add-on interest. In this case,
if a 1-year loan is quoted with a 20% interest rate and you borrow $1,000, then you
pay back $1,200. But you make these payments in monthly installments of $100 each.
Suppose you take out a $1,000, 3-year loan using add-on interest with a quoted
interest rate of 20% per year. What will your monthly payments be? (Total payments
are $1,000 + $1,000 x .20 x 3 = $1,600.) What are the true APR and effective annual
rate on this loan? Are they the same as in the previous problem?
Time period -1
Time period -2
Interest rate
Amount
Pay back
Monthly insatallments-1
1.00 year
3.00 year
20%
$1,000.00
$1,200.00
$ 100.00
Solution:
Scenario 1:
Monthly rate
APR
=
=
=
Scenario 2:
Total amount to be repaid
Monthly payments
Monthly rate
APR
= $1,600.00
= $ 44.44
=
2.799%
=
33.588%
=
39.273%
2.923%
35.076%
41.302%
APR and EAR of both the scenario are different
Practice Problem 57
What is the effective annual rate on a 1-year loan with an interest rate quoted on a discount
basis of 20%?
Discount Rate
20.00%
Solution:
25.00%
Practice Problem 58
First National Bank pays 6.2% interest compounded semiannually. Second National Bank
pays 6% interest, compounded monthly. Which bank offers the higher effective annual rate?
First National Bank Interest
Second National Bank Interest
6.20%
6.00%
Solution:
After 1 year, each dollar invested at First National will grow to
After 1 year, each dollar invested at Second National will grow to
First National pays the higher effective annual rate.
= $ 1.0630
= $ 1.0617
Practice Problem 59
You borrow $1,000 from the bank and agree to repay the loan over the next year in 12
equal monthly payments of $90. However, the bank also charges you a loan initiation
fee of $20, which is taken out of the initial proceeds of the loan. What is the effective
annual interest rate on the loan taking account of the impact of the initiation fee?
Amount borrowed
No.of payments
Monthly payments
Loan initiation fee
$1,000.00
12.00
$ 90.00
$ 20.00
Solution:
Monthly rate
=
=
1.527%
19.94%
Practice Problem 60
You believe you will need to have saved $500,000 by the time you retire in 40 years
in order to live comfortably. If the interest rate is 6% per year, how much must you
save each year to meet your retirement goal?
Amount need to be saved
Time period
Interest rate
$500,000.00
40.00 years
6.00%
Solution:
Savings each year
= $
3,230.77
Practice Problem 61
You believe you will need to have saved $500,000 by the time you retire in 40 years
in order to live comfortably. If the interest rate is 6% per year, how much would you
need to save if you believe that you will inherit $100,000 in 10 years?
Amount need to be saved
Time period
Interest rate
Amount inherit
Time to inherit
$ 500,000.00
40.00 years
6.00%
$ 100,000.00
10.00 years
Solution:
Future Value
=
574,349.12
Therefore, you do not need any additional savings; investing the $100,000
produces a future value that exceeds your $500,000 requirement.
Practice Problem 62
You believe you will spend $40,000 a year for 20 years once you retire in 40 years.
If the interest rate is 6% per year, how much must you save each year until
retirement to meet your retirement goal?
Amount to be spent
Time period
Retirement
Interest rate
$ 40,000.00 each year

20.00 years
40.00 years
6.00%
Solution:
Present Value
= $458,796.85
$2,964.53
Savings each year =
Practice Problem 63
A couple thinking about retirement decide to put aside $3,000 each year in a savings plan that
earns 8% interest. In 5 years they will receive a gift of $10,000 that also can be invested.
a. How much money will they have accumulated 30 years from now?
b. If their goal is to retire with $800,000 of savings, how much extra do they need to save
every year?
Savings each year

Interest rate
Time period
Gift amount
Gift (year)
Savings goal
3,000.00
8.00%
30.00 years
$ 10,000.00
5.00 years
$800,000.00
Solution:
a.
Accumulated savings
= $408,334.38
b.
Additional accumulations
Extra savings each year
= $391,665.62
= $ 3,457.40
Practice Problem 64
A couple will retire in 50 years; they plan to spend about $30,000 a year in retirement, which
should last about 25 years. They believe that they can earn 8% interest on retirement savings.
a. If they make annual payments into a savings plan, how much will they need to save each
year? Assume the first payment comes in 1 year.
b. How would the answer to part (a) change if the couple also realize that in 20 years they will
need to spend $60,000 on their childs college education?
Retirement
Interest rate
Yearly spending
Time period
Child's Education amount
Time period (Education)
50.00 years
8.00%
$ 30,000.00
25.00 years
$ 60,000.00
20.00 years
Solution:
a.
Present Value
Savings annuity
PV of consumption
= $320,243.29
= $
558.14
= $ 6,827.98
b.
Additional savings
Total PV of savings
Savings each year
= $ 12,872.89
= $ 19,700.87
=
$1,610.41
Practice Problem 65
An engineer in 1950 was earning $6,000 a year. Today she earns $60,000 a year.
However, on average, goods today cost 8.8 times what they did in 1950. What is
her real income today in terms of constant 1950 dollars?
Earnings in 1950
Current earnings
Goods today cost
$ 6,000.00
$ 60,000.00
8.8 times
Solution:
Real Income
Real income increased by
= $ 6,818.18
= $
818.18
Practice Problem 66
If investors are to earn a 3% real interest rate, what nominal interest rate must
they earn if the inflation rate is
a.
b.
c.
0% ?
4% ?
6% ?
Real interest rate
3.00%
Solution:
a.
Nominal interest rate
= 3.00%
b.
= 7.12%
c.
= 9.18%
Practice Problem 67
If investors receive a 6% interest rate on their bank deposits, what real interest rate
will they earn if the inflation rate over the year is
a.
b.
c.
0% ?
3% ?
6% ?
6.00%
Solution:
a.
Real interest rate
6.00%
b.
Real interest rate
2.91%
c.
Real interest rate
0.00%
Practice Problem 68
You will receive $100 from a savings bond in 3 years. The nominal interest rate is 8%.
a. What is the present value of the proceeds from the bond?
b. If the inflation rate over the next few years is expected to be 3%, what will the real value of
the $100 payoff be in terms of todays dollars?
c. What is the real interest rate?
d. Show that the real payoff from the bond [from part (b)] discounted at the real interest rate
[from part (c)] gives the same present value for the bond as you found in part (a).
Amount
Time period
Inflation rate
$ 100.00
3.00 years
8.00%
3.00%
Solution:
a.
Present Value
= $ 79.38
b.
Real Value
= $ 91.51
c.
Real interest rate
d.
Present Value
= $ 79.38
4.854%
Practice Problem 69
Your consulting firm will produce cash flows of $100,000 this year, and you expect
cash flow to keep pace with any increase in the general level of prices. The interest
rate currently is 6%, and you anticipate inflation of about 2%.
a. What is the present value of your firms cash flows for years 1 through 5?
b. How would your answer to (a) change if you anticipated no growth in cash flow?
Cash Flow
Interest rate
Inflation rate
Time
$100,000.00
6.00%
2.00%
5.00 years
Solution:
a.
Real interest rate

Present Value of Cash flow
=
3.92%
= $446,184.51
b.
Present Value of Cash flow
= $421,236.00
Challenge Problem 70
Good news: You will almost certainly be a millionaire by the time you retire in 50 years.
Bad news: The inflation rate over your lifetime will average about 3%.
a. What will be the real value of $1 million by the time you retire in terms of todays dollars?
b. What real annuity (in todays dollars) will $1 million support if the real interest rate at
retirement is 2% and the annuity must last for 20 years?
Time period
Amount
Inflation rate
Real interest rate at retirement
Annuity term
50.00 years
1.00 million
3.00%
2.00%
20.00 years
Solution:
a.
Real Value of $1 million
= $228,107.00
b.
Real Value of $1 million

Real Annuity
= $228,107.00
= $13,950.00
If the interest rate is 6% per year, how long will it take for your money to quadruple in value?
If the inflation rate is 4% per year, what will be the change in the purchasing power of your
money over this period?
Interest rate
Inflation rate
6.00%
4.00%
Solution:
Time required for money to quadruple
Real interest rate
Purchasing power increases by
= 23.79 years
= 1.92%
= 57.84%
In the summer of 2007, Zimbabwes official inflation rate was about 110% per month.
What was the annual inflation rate
Inflation rate
110.00% per month
Solution:
Prices increased by = 778,635% per year.
British government 4% perpetuities pay 4 interest each year forever. Another bond,
2% perpetuities, pays 2.50 a year forever. What is the value of 4% perpetuities if
the long-term interest rate is 6%? What is the value of 2% perpetuities?
Govt. bond interest rate
Perpetuity interest
Other bond interest rate
Perpetuity interest
Long term interest rate
4.00%
4.00
2.50%
2.50
6.00%
Solution:
The 4% perpetuity will sell for
= 66.67
The 2% perpetuity will sell for = 41.67
a. You plan to retire in 30 years and want to accumulate enough by then to provide yourself
with $30,000 a year for 15 years. If the interest rate is 10%, how much must you accumulate
by the time you retire?
b. How much must you save each year until retirement in order to finance your retirement
consumption?
c. Now you remember that the annual inflation rate is 4%. If a loaf of bread costs $1 today,
what will it cost by the time you retire?
d. You really want to consume $30,000 a year in real dollars during retirement and wish to save
an equal real amount each year until then. What is the real amount of savings that you need
to accumulate by the time you retire?
e. Calculate the required preretirement real annual savings necessary to meet your consumption
goals. Compare with your answer to (b). Why is there a difference?
f. What is the nominal value of the amount you need to save during the first year? (Assume the
savings are put aside at the end of each year.) The thirtieth year?
Time
Annuity
Interest rate
Term
Annual inflation rate
Loaf of bread cost
30.00 years
$30,000.00
10.00%
15.00 years
4.00%
$
1.00
Solution:
a.
Present Value
= $228,182.39
b.
Present Value
PV of the retirement goal
You must save
= $228,182.39
= $ 13,076.80
= $ 1,387.18 per year
c.
Bread loaf future cost
= $
d.
Real interest rate

The retirement goal in real terms
=
5.77%
= $295,796.61
e.
Real interest rate

The retirement goal in real terms
Annual Savings
=
5.77%
= $295,796.61
=
3,895.66
3.24
This value is much higher than the result found in part (b) because the
rate at which purchasing power grows is less than the nominal interest
rate, 10%.
f.
Annual Savings
Nominal value of amount saved in 1st year
Nominal value of amount saved in 30th year
$3,895.66
= $ 4,051.49
= $ 12,635.17
onsumption
A couple will retire in 50 years; they plan to spend about $30,000 a year in retirement, which
should last about 25 years. They believe that they can earn 8% interest on retirement savings.
Assume that the inflation rate over the next 50 years will average 4%.
a. What is the real annual savings the couple must set aside?
b. How much do they need to save in nominal terms in the first year?
c. How much do they need to save in nominal terms in the last year?
d. What will be their nominal expenditures in the first year of retirement? The last?
Retirement
Interest rate
Yearly spending
Time
Inflation rate
50.00 years
8.00%
$ 30,000.00
25.00 years
4.00%
Solution:
a.
Real interest rate

PV of the required real savings
Real annual savings
=
3.85%
= $476,182.14
= $ 3,266.82
b.
Real annual savings

Nominal savings in year 1
$
= $
c.
Real annual savings

Nominal savings in the last year
$ 3,266.82
= $ 23,216.26
d.
Nominal expenditures in the first

= $221,728.52
year of retirement
Nominal expenditures in the last
= $568,357.64
year of retirement
3,266.82
3,397.49
What is the value of a perpetuity that pays $100 every 3 months forever? The
discount rate quoted on an APR basis is 6%.
Perpetuity Pays
n
APR
$ 100.00
3.00 months
6.00%
Solution:
Interest rate per 3 months =
1.50%
Value of the perpetuity = $6,666.67
If the interest rate this year is 8% and the interest rate next year will be 10%,
what is the future value of $1 after 2 years? What is the present value of a
payment of $1 to be received in 2 years?
Interest rate current year
Interest rate next year
Value
8.00%
10.00%
$ 1.00
Solution:
Future Value
Present Value
= $ 1.188
= $0.8418
Your wealthy uncle established a $1,000 bank account for you when you were born.
For the first 8 years of your life, the interest rate earned on the account was 6%.
Since then, rates have been only 4%. Now you are 21 years old and ready to cash in.
How much is in your account?
Deposit
Time period
Interest rate up to 8 years
Age
Interest rate after 8 years
1,000
8.00 years
6.00%
21.00
4.00%
Solution:
Your $1,000 has grown to
= $2,653.87
a. It is 2012, youve just graduated college, and you are contemplating your lifetime budget.
You think your general living expenses will average around $50,000 a year. For the next 8
years, you will rent an apartment for $16,000 a year. After that, you will want to buy a house
that should cost around $250,000. In addition, you will need to buy a new car roughly once
every 10 years, costing around $30,000 each. In 25 years, you will have to put aside around
$150,000 to put a child through college, and in 30 years youll need to do the same for
another child. In 50 years, you will retire, and will need to have accumulated enough savings
to support roughly 20 years of retirement spending of around $35,000 a year on top of your
social security benefits. The interest rate is 5% per year. What average salary will you need
to earn to support this lifetime consumption plan?
b. Whoops! You just realized that the inflation rate over your lifetime is likely to average about
3% per year, and you need to redo your calculations. As a rough cut, it seems reasonable to
assume that all relevant prices and wages will increase at around the rate of inflation. What
is your new estimate of the required salary (in todays dollars)?
General living expenses

Time period 1
Rent
Time period 2
House Cost
New Car
Time period 3
Time period 4
Child 1 College
Time period 5
Child 2 College
Time period 6
Time period 7
Spending
Interest Rate
Inflation Rate
$
$
$
$
$
$
50,000.00
8.00
16,000.00
9.00
250,000.00
30,000.00
10.00
25.00
150,000.00
30.00
150,000.00
50.00
20.00
35,000.00
5.00%
3.00%
per year
years
years
years
years
years
years
years
Solution:
a.
Present Values:
Apartment rental
Home purchase
Automobile purchases:
0 years
10 years
20 years
30 years
40 years
50 years
College education
Retirement portfolio
All lifetime expenditures
Average Salary
$
$
$
$30,000.00
$18,417.00
$ 11,307.00
$ 6,941.00
$ 4,261.00
$ 2,616.00
912,796.00
103,411.00
161,152.00
$
73,542.00
$
79,002.00
$
38,036.00
$ 1,367,939.00
$
74,931.00
b.
Real Rate of Interest

Unrounded interest
Present Values:
Apartment rental
Home purchase
Automobile purchases
0 years
10 years
20 years
30 years
40 years
50 years
College education
Retirement portfolio
All lifetime expenditures
Average Salary
1.940%
1.94175%
$ 1,591,184.00
$ 117,511.00
$ 210,300.00
$30,000.00
$24,756.00
$20,428.00
$16,857.00
$13,910.00
$ 11,479.00
$ 117,430.00
$ 177,070.00
$ 220,210.00
$ 2,433,705.00
$
76,475.00
Suppose you take out a $100,000, 20-year mortgage loan to buy a condo. The interest rate
on the loan is 6%, and to keep things simple, we will assume you make payments on the
loan annually at the end of each year.
a. What is your annual payment on the loan?
b. Construct a mortgage amortization table in Excel in which you compute the interest
payment each year, the amortization of the loan, and the loan balance each year.
(Allow the interest rate to be an input that the user of the spreadsheet can enter and
change.)
c. What fraction of your initial loan payment is interest? What fraction is amortization? What
about the last loan payment? What fraction of the loan has been paid off after 10 years
(halfway through the life of the loan)?
d. If the inflation rate is 2%, what is the real value of the first (year-end) payment? The last?
e. Now assume the inflation rate is 8% and the real interest rate on the loan is unchanged.
What must be the new nominal interest rate? Recompute the amortization table. What
is the real value of the first (year-end) payment in this high-inflation scenario? The
real value of the last payment?
Loan amount
Time
Interest rate
Inflation rate-1
Inflation rate-2
100,000.00
20.00 years
6.00%
2.00%
8.00%
Solution:
a.
Annuity factor
11.4699
b.
Annual payment on loan
= $
Annual payment
Beginning
Balance
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
c.
Initial loan payment:

Interest fraction
Amortization fraction
8,718.47
$8,718.46
Year End
Interest Due
100,000.00
97,281.54
94,399.98
91,345.52
88,107.80
84,675.81
81,037.91
77,181.72
73,094.17
68,761.37
64,168.59
59,300.25
54,139.81
48,669.75
42,871.47
36,725.31
30,210.37
23,304.54
15,984.35
8,224.96
=
=
6,000.00
5,836.89
5,664.00
5,480.73
5,286.47
5,080.55
4,862.27
4,630.90
4,385.65
4,125.68
3,850.12
3,558.02
3,248.39
2,920.18
2,572.29
2,203.52
1,812.62
1,398.27
959.06
493.50
Year End
Payment
$
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
8,718.46
Amortization of
loan
$
2,718.46
2,881.56
3,054.46
3,237.72
3,431.99
3,637.91
3,856.18
4,087.55
4,332.81
4,592.77
4,868.34
5,160.44
5,470.07
5,798.27
6,146.17
6,514.94
6,905.83
7,320.18
7,759.39
8,224.96
End of year
balance
$
69.00%
31.00%
Last loan payment:
97,281.54
94,399.98
91,345.52
88,107.80
84,675.81
81,037.91
77,181.72
73,094.17
68,761.37
64,168.59
59,300.25
54,139.81
48,669.75
42,871.47
36,725.31
30,210.37
23,304.54
15,984.35
8,224.96
-
Interest fraction
Fraction of loan paid off after
10 years
=
=
6.00%
36.00%
d.
Real interest rate

=
Real value of the first payment = $
Real value of the last payment = $
e.
Real interest rate

Real value of the first payment
Real value of the last payment
Beginning
Balance
Year
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
=
=
= $
= $
100,000.00
98,612.12
97,057.70
95,316.74
93,366.88
91,183.02
88,737.11
85,997.68
82,929.53
79,493.19
75,644.50
71,333.96
66,506.16
61,099.02
55,043.02
48,260.30
40,663.66
4.00%
8,383.13
3,978.99
4.00%
12.00%
12,872.96
6,110.05
Year End
Interest Due
$
12,000.00
11,833.45
11,646.92
11,438.01
11,204.03
10,941.96
10,648.45
10,319.72
9,951.54
9,539.18
9,077.34
8,560.07
7,980.74
7,331.88
6,605.16
5,791.24
4,879.64
Year End
Payment
$
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
13,387.88
Amortization of
loan
$
1,387.88
1,554.42
1,740.95
1,949.87
2,183.85
2,445.92
2,739.43
3,068.16
3,436.33
3,848.70
4,310.54
4,827.80
5,407.14
6,056.00
6,782.72
7,596.64
8,508.24
End of year
balance
$
98,612.12
97,057.70
95,316.74
93,366.88
91,183.02
88,737.11
85,997.68
82,929.53
79,493.19
75,644.50
71,333.96
66,506.16
61,099.02
55,043.02
48,260.30
40,663.66
32,155.42
18
19
20
32,155.42
22,626.20
11,953.46
3,858.65
2,715.14
1,434.42
13,387.88
13,387.88
13,387.88
9,529.23
10,672.73
11,953.46
22,626.20
11,953.46
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Chapter 05

Inputs are in Blue

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

PV of $100 @ 8% for 10 years

PV of $100 @ 8% for 20 years

PV of $100 @ 4% for 10 years

PV of $100 @ 4% for 20 years

2012, The McGraw-Hill Companies

FV of $100 @ 8% for 10 years

FV of $100 @ 8% for 20 years

FV of $100 @ 4% for 10 years

FV of $100 @ 4% for 20 years

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

uch will you

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

ill you need to

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

b. the interest rate is

c. Why do your answers to (a) and (b) differ?

At 5% interest rate, PV of option 2 is more than option 1, therefore you should

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

b. Time period @ 8.00%

c. Time period @ 16.00% =

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

1.00% per week

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

Ten years earlier:

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

Monthly rate on annuity

Monthly annual payment

2012, The McGraw-Hill Companies

Present Value of loan

Present Value of loan

2012, The McGraw-Hill Companies

Effective interest rate

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

, what is the APR of

2012, The McGraw-Hill Companies

2012, The McGraw-Hill Companies

$ 8,000.00 per year

2012, The McGraw-Hill Companies

Since this is greater than $40000 (the cost of buying a truck),

2012, The McGraw-Hill Companies