ISyE 3025, Fall 2010, HW1, Solutions

This homework is intended for Learning Cycle 1, leading to Exam 1

1. In 1948 your grandfather left your mother a $5,000 U.S. government bond, to be used for your education. The
annual interest rate was 1.9%. The annual interest was left to accumulate with the bond according to
compound interest. Then your mother redeemed (cashed in) the bond. What were the cash proceeds many
years later, in 2004? Solution: Answer uses F/P factor.

F
0 i per year N

F = $5,000 (F/P, 1.9%, 2004-1948) =

5,000(1 + .019)^56 = $14,346.
2. You wish to join a club that has an initiation fee of $40,000. You only have $23,000 available for this right
now. You can invest in a fund that pays 3.5% per year. If you invest your money in this fund, how many
years must you wait until it will grow to the required amount for the initiation fee? [Assume the initiation fee
does not change, due to inflation or other reasons] Solution: Answer involves manipulation of F/P factor.
$40,000 = $23,000 (F/P, 3.5%, N) = 23,000(1 + .035)^N
40,000/23,000 = 1.035^N
N = ln(40/23)/ln(1.035) = 0.5534/0.0344 = 16.09, round up to 17 because interest is paid at the end of the year
on this account. It will take 17 years to accumulate. [Can also solve by trial-and-error.]
[Diagram is similar to previous one.]
3. A certain investment is available that promises to return $7,000 five years from now. If the investor's "time
value of money" is 4.5% per year, find the equivalent present value of this proposed investment.
Solution: Answer uses P/F factor.
P = $7,000 (P/F, 4.5%, 5) = 7,000(1.045)^(-5) = $5,617. [Diagram is similar to previous one.]
4. You expect to receive a future amount at the end of year 200Y. However, you wish instead to receive this
amount earlier, at the end of year 200X, with years shown in the table. At the annual interest rate shown in the
table, what is the equivalent amount at the end of Year 200X?
Future amount Year 200Y Annual interest rate Year 200X
$ 2,000 2008 6% 2005
Solution: Answer uses P/F factors. Take year 2005 as reference point.
P = $2,000 (P/F, 6%, 2008-2005) = $2,000(1.06)^-3 = $1,679.
5. You are presented with two investment opportunities, A and B as described below. A choice of either one
would require the initial investment now (if you select either investment opportunity, you cannot invest less or
more in that opportunity, only the amount shown). In addition, you can always invest in a fund that pays 5%
per year. You currently have $4,000 to invest. If you wish to maximize your cash amount at the end of year 6,
which of the two investments, A or B, is the better choice? You cannot select both. Explain numerically.
Investment opportunity A B
Initial investment needed $4,000 $3,200
Annual interest rate 7% 9%
Length of investment 6 years 5 years
Solution: Answer requires use of F/P factor, selection of a common horizon time, and consideration of
unused funds, which would be invested at 5%.
Option A: F = $4,000 (F/P, 7%, 6)
= $4,000(1.5007) = $6,003.
Option B: F = $3,200 (F/P, 9%, 5)(F/P, 5%, 1) + 800(F/P, 5%, 6)
= $3,200(1.5386)(1.05) + $800(1.3401) = $5,170+ $1,072 = $6,242.
Option B will provide more money.

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Alternative A F = 6003
0 1 2 3 4 5 6

P = 4000 7% per year

Alternative B, part one F = 4924 F = 5170

0 1 2 3 4 5 5 6
5% per year
P = 3200 9% per year P = 4924

Alternative B, part two F = 1072

0 1 2 3 4 5 6

P = 800 5% per year

6. A graduate student is considering the choice of residence while attending college in a city. In addition to the
usual choices, in a distant suburb there is a family relative who has an extra bedroom. List three important
monetary factors and three important non-monetary factors that should be considered in the selection.
Monetary factors: Rent cost, transportation (commuting) cost, utility cost.
Non-monetary factors: Living space, home-cooked food (value of), friends vs. family, commuting time.
Concepts: non-monetary factors for decision making.
7. You wish to deposit A = $3,000 at the end of each year into an account that pays i = 2.5% interest per year, for
N = 16 years. How much money will you have accumulated in the account after the last deposit?
Solution: Answer uses F/A factor. F = $3,000 (F/A, 2.5%, 16) = 3,000(19.380) = $58,140.

F = 58140
2.5% per year
1 2 3 4 5 6 15 16

A = 3000

8a. You arrange to borrow P = $19,000 for an automobile purchase. The loan will be repaid in N = 48 equal,
monthly payments, with end-of-month payments. Interest is compounded monthly at the rate of i = 0.65% per
month. What is the amount of the monthly payment?

Solution: Answer uses A/P factor. A = $19,000 (A/P, 0.65%, 48) = $19,000(0.024319) = $462.06.
Major concept: A/P factor; timing issue: first payment is one period after the loan contract is made;
sanity check: periodic repayment is greater than (Loan proceeds/N).

P = 19000
0.65% per month
1 2 3 4 5 6 47 48

A = 462

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8b. After making the xth = 36th payment you consider selling the car, and you wish to determine the remaining loan
balance. What is the remaining debt (principal) on the loan?
Solution: Answer uses P/A factor. P = $462.06 (P/A, 0.65%, 12) = $462.06 (11.508) = $5,318.
Major concept: taking the finance company's viewpoint and applying the P/A factor;
sanity check: value of remaining payments at time 36 is less than (remaining N)(periodic payment)
Alternative solution: Take the initial loan proceeds and move it forward to time 36 using (F/P,i,36), and take
the payments already made and accumulate them forward to time 36 using (F/A,i,36), and then take the
difference between these two values.

P = 5318
0.65% per month
37 38 [old time scale] 47 48
0 1 2 3 4 5 6 11 12

A = 462

9. How much must be invested today in order to provide an annuity of $40,000 per year for 30 years, with the
first payment occurring exactly 42 years from now, if the interest rate is 3.5% per year?
Solution: Answer uses deferred annuities. Let N1 be time of first deposit, and N2 be total number of
payments.
P1 = $40,000 (P/A, 3.5%, 30) = $40,000 (18.392) = $735,682.
P2 = P1(P/F, 3.5%, 41) = $735,682(1.035)^(-41) = $179,529.

F = 735,682
3.5%/year A = 40000, 30 withdrawals

0 41 41 42 43 44 45 70 71

P = 179,529

P = 735,682

10. Consider the sequence of cash flows given in the table. Convert the sequence to an equivalent uniform
sequence over N = 11 periods. The interest rate is i = 4% per period.
End of period 1 2 3 4 5 6 7 8 9 10 11
Cash flow $ 200 180 160 140 120 100 80 60 40 20 0
Solution: Answer uses A/G factor. EUV = $200 – 20 (A/G, 4%, 11) = $200 – 20(4.609) = $107.82.
Diagram is only for the linear gradient conversion, since the contained uniform series does not to be converted.
Major concept: application of the A/G factor to convert a linear gradient series to a uniform series.
Timing issue: the time 1 element of the linear gradient series is zero, but the converted uniform series has a
non-zero element. This is the way most analysts would want the conversion to work.
In this example the timing works according to the assumption behind the conversion formula. If it did not, we
would have to use another method to solve the problem, perhaps a longer method.
Common sense item: Don't forget the uniform series that was initially subtracted to get the linear gradient
series.

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 0 1 2 3 4 5 6 7 8 9 10 11

-20 G = -20
-40
-60
-200
Convert this to:
0 1 2 3 4 5 6 7 8 9 10 11

A = -92.18

11. You wish to deposit a sum today in an account to provide for annual fuel expenses for the next 9 years. The
fuel expenses are paid at the end of each year. The expenses at the end of the first year are expected to be
$5,000, and you expect that this amount will increase by 9% each year compared to the previous year. If the
account pays 3.4% interest, what sum must you deposit now?
Solution: Use geometric gradient series. P = $5,000 (P/g, i= 3.4%, g=9%, 9) = $5,000 (10.848) = $54,240.
12. You wish to save for retirement by depositing $500 every 3 months for a period of 40 years. The first deposit
occurs 3 months from now, and the last coincides with the end of year 40. The savings fund earns 0.5% per
month, compounded monthly. How much will you have accumulated when you retire?
Solution: First, find effective interest rate for 3 months.
1 + i3-mo = (1 + imo)^3 =1.005^3 = 1.015075 interest factor for effective rate of 1.5075% per quarter.
F = $500 (F/A, 1.5075%, 160) = $500(660.51) = $330,256.
Major concepts: Recognize that to use the F/A factor one must have an interest rate that matches the deposit
series; compute the effective interest rate for the deposit cycle; application of the F/A factor.
Sanity checks: effective interest rate is greater than (months in deposit cycle)(monthly interest rate);
accumulated sum is greater than (periodic deposit)(number of deposits).
Alternative solution would require individual F/P manipulation of each deposit and adding the resulting values.
Another approach is to convert the quarterly 500 to a monthly amount using 500(A/F,imo,3), and then use the
monthly rate and total number of months with F/A.

F = 330,256
1.015075% per period (per quarter)
0 1 2 3 4 5 6 159 160

A = 500
13. You wish to compare two savings plans: one with monthly compounding (plan 1) and one with quarterly
compounding (plan 2). These are at different banks. In either situation, you plan to make annual deposits, so
you need to find the effective annual interest rates. For your convenience, the rates are given in both percent
and decimal form. You may write your answer in either percent or decimal form. Use three digits of accuracy,
for example, 7.52% or 0.0752.
Plan 1, monthly Plan 1, monthly Plan 2, quarterly Plan 2, quarterly
interest rate, interest rate, interest rate, interest rate,
percent decimal percent decimal
0.521% .00521 1.52% .0152
a. What is the equivalent annual interest rate for plan 1?
1+iannual = (1+imo)^12 = 1.00521^12 = 1.06434, iannual = 6.434%.
b. What is the equivalent annual interest rate for plan 2?
1+iannual = (1+iquart)^4 = 1.0152^12 = 1.06220, iannual = 6.22%.
c. What would be the difference in accumulated amounts between the two plans if you deposited $5,000 each
year (end-of-year deposits) for twenty years? Any interest earned will be left in the account to accumulate.
Plan 1: F = $5,000 (F/A, 6.434%, 20) = $5,000(38.5488) = $192,744.
Plan 2: F = $5,000 (F/A, 6.220%, 20) = $5,000(37.6675) = $188,337.
Plan 1 makes $4,407 more than Plan 2.

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14. You wish to save money for retirement by making annual (end-of-year) deposits into an account for the next N1
years. The first deposit will be $A1 and each deposit thereafter will be g % larger than the preceding deposit.
The account will earn i % compound interest. After the last deposit, you will leave the accumulated fund in the
account for another N2 years (but without making deposits). How much will you have in the fund at the end?
A1 N1, years N2, years g i
$ 3,500 35 10 2.0% 5.0%
Solution: Answer uses geometric gradient and F/P factor.
F1 = $3,500 (F/g, i=5%, g=2%, N1=35) = $3,500(117.204) = $410,214.
F2 = $410,214 (F/P, 5%, N2=10) = $410,214(1.6289) = $668,195.
Major concept: Application of (F/g, g, i, N) factor, application of F/P factor.
There are no tricky timing issues. Sanity checks: The intermediate accumulated sum should be considerably
larger than (N1)(first deposit); the final sum should be larger than the intermediate sum.
15. You arrange to borrow a loan amount for some new furniture. The loan will be repaid in N equal, monthly
payments (end-of-month payments) with interest compounded monthly at the monthly interest rate. What is the
amount of the monthly payment?
Loan amount Monthly interest rate N, months to repay
$ 7,500 0.8% 36
Solution: Answer uses A/P factor. A = $7,500 (A/P, 0.8%, 36) = $7,500(0.0321) = $241.
Major concept: A/P factor; timing issue: first payment is one period after the loan contract is made;
sanity check: periodic repayment is greater than (Loan proceeds/N).

P = 7500 0.8% per period (per month)

0 1 2 3 4 5 6 35 36

A= 241

16. You are still negotiating for the same loan as in Problem 15, but the finance manager at the
furniture store offers you a plan where you don't make the first payment until M months after
you buy the items. [For example, if you buy on July 31, and M is 3, then your first payment
is on October 30.] However, interest will accumulate on the unpaid loan, so the monthly
payment amount will be larger. The total number of payments remains the same as in Problem 15, and the
interest rate is the same. Use the value of M shown in the table. What is the monthly payment?
M, months before 1st payment
10

We can think of each payment as delayed by 9 months: F = $241 (F/P, 0.8%, 9) = $241(1.008)^9 = $258.

P = F(1+i )^9
P = 7500 0.8% per period (per month)
9 10 11 12 13 [old time scale] 44 45
0 9 0 1 2 3 4 5 6 35 36

F = P(1+i )^9 A= 241(1+i )^9

Or we can recalculate the original loan amount accumulating interest for 9 months, and then the annuity as
follows: A = [$7500(F/P, 0.8%, 9)](A/P, 0.8%, 36).
Major concept: Application of F/P factor to determine new loan amount in the future (using 2nd method).
Timing issue: Original loan amount is shifted to one period before the first payment.
Sanity check: The monthly payment in the delayed loan repayment series is larger than in the original series.

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