ECN801, V.

Bardis
Sample Test 2

1. Suppose a bank charges a 16% semiannual rate, compounded quartely.

(a) (3 marks) What is the nominal annual rate? What is the nominal quarterly rate?

r_1 = 2 (16%) = 32%

r_4 = (2/4) r_2 = 8% or r_4 = (1/4)r_1 = 8%

(b) (3 marks) What is the effective annual rate?

The effective rate per compounding period (quarterly) is

i_4 = r_4 = 8%
The effective annual rate is
i_1 = (1+i_4)^(4)-1 = (1+.08)^4 - 1 = 36.04 %

(c) (4 marks) If instead the bank compounds interest continuously, what are the effective annual
rate and the effective monthly rate (given the semiannual rate remains 16%)?

i_1 = e^(2 (.16))-1 = 37.7127%

i_12 = e^(.16(2/12))-1 = 2.7025%

2. Consider a project with the following cash flows of income and expenses:
Year
0-3
4-6
7-12

Income
0
2,000
5,000

Expense
3,000
2,000
2,500

Net Income

- 3000
0
2500

(a) (3 marks) Fill in the net-income column.

(b) (5 marks) Find the present worth of the project if the interest rate is 20% per year. (Factor
values for i = 20% appear below.)

P = -3000(P/A,20%,4) (F/P,20%,1)
+2500(P/A,20%,6)(P/F,20%,6)

= -3000(2.5887)(1.2) + 2500( 3.3255)(.3349)

= -6,535.045125

(c) (2 marks) If you had to choose whether to undertake the project or not, what would be your
best choice ? Why?

If the "do nothing" alternative has zero PW (as is implied) then it is best to not
undertake the project since its PW is less than zero.

n
1
2
3
4
5
6
7
8
9
10
11
12

(F/P, i, n)
1.2
1.44
1.728
2.0736
2.4883
2.9860
3.5832
4.2998
5.1598
6.1917
7.4301
8.9161

(P/F, i, n)
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
0.1346
0.1122

(A/F, i, n)
1
0.45455
0.27473
0.18629
0.13438
0.10071
0.07742
0.06061
0.04808
0.03852
0.0311
0.02526

(F/A, i, n)
1
2.2
3.64
5.368
7.4416
9.9299
12.9159
16.4991
20.7989
25.9587
32.1504
39.5805

(A/P, i, n)
1.2
0.65455
0.47473
0.38629
0.33438
0.30071
0.27742
0.26061
0.24808
0.23852
0.23110
0.22526

(P/A, i, n)
0.8333
1.5278
2.1065
2.5887
2.9906
3.3255
3.6046
3.8372
4.031
4.1925
4.3271
4.4392

(P/G, i, n)

(A/G, i, n)

0.6944
1.8519
3.2986
4.9061
6.5806
8.2551
9.8831
11.4335
12.8871
14.233
15.4667

0.4545
0.8791
1.2742
1.6405
1.9788
2.2902
2.5756
2.8964
3.0739
3.2893
3.4841

3. Shane bought a house today for $120,000. The financing terms are as follows: 30-year fixed rate of
12% per year interest, 5% downpayment, zero origination fee. Interest is compounded monthly.
(a) (6 marks) If Shane agrees to make monthly payments to pay for the principal plus interest by
the end of the term period, how much will he have to pay the bank each month?

The effective rate per payment period (month) is i_12 = 12%/12 = 1%.
Then we simply find the equivalent monthly amount given the present value of the loan is
120,000 - .05(120,000) (the amount actually borrowed after the 5% downpayment).
A = (1-.05)120,000(A/P,1%, 360) = (114,000)(0.01029)=1,173.06

(b) (4 marks) Given the above, what will be the total amount of interest paid in the first 10 years?
Denominated in year 10 dollars, he borrowed an amount of
114,000(F/P,1%,120)= 114,000(3.3004)=376,245.6
and he made payments over the 10 years whose total is equivalent to the following amount in year-10
dollars: 1,173.06(F/A,1%,120) = 1,173.06 (230.0387)=269,849.1974
Therefore the balance on the loan is 376,245.6-269,849.1974=106,396.4026
that is, he still owes 106,396.4026 of the principal. This means that over the 10 year period only
114,000-106.396.4026 = 7,603.5974 of the principal was paid. Since the sum of payments made is
120(1,173.06)=140,767.2, the total interest amount paid over the first 10 years is
140,767.2 - 7,603.5974 = 133,163.6026
i = 1%
n
(F/P, i, n)
120
3.3004
240
10.8926
360
35.9496

(P/F, i, n)
0.3030
0.0918
0.0278

(A/F, i, n)
0.00435
0.00101
0.00029

(F/A, i, n)
230.0387
989.2554
3494.96

(A/P, i, n)
0.01435
0.01101
0.01029

(P/A, i, n)
69.7005
90.8194
97.2183

(P/G, i, n)
3334.11
6878.6
8720.43

(A/G, i, n)
47.8349
75.7393
89.6995

i = 2%
n
(F/P, i, n)
120
10.7652
240
115.8887
360
1247.56

(P/F, i, n)
0.0929
0.0086
0.0008

(A/F, i, n)
0.00205
0.00017
0.00002

(F/A, i, n)
488.2582
5744.44
62328

(A/P, i, n)
0.02205
0.02017
0.02002

(P/A, i, n)
45.3554
49.5686
49.9599

(P/G, i, n)
1710.42
2374.88
2482.57

(A/G, i, n)
37.7114
47.911
49.7112

4. Use the least-common-multiple method two compare the following two projects given the applicable
interest rate is 20%. (Factor values are given below.)
Type of Cost
First Cost
Annual Operating Cost
Salvage Value
Life in Years
n
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15

(F/P, i, n)
1.2
1.44
1.728
2.0736
2.4883
2.9860
3.5832
4.2998
5.1598
6.1917
7.4301
8.9161
10.6993
12.8392
15.407

(P/F, i, n)
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
0.2791
0.2326
0.1938
0.1615
0.1346
0.1122
0.0935
0.0779
0.0649

(A/F, i, n)
1
0.45455
0.27473
0.18629
0.13438
0.10071
0.07742
0.06061
0.04808
0.03852
0.0311
0.02526
0.02062
0.01689
0.01388

(F/A, i, n)
1
2.2
3.64
5.368
7.4416
9.9299
12.9159
16.4991
20.7989
25.9587
32.1504
39.5805
48.4966
59.1959
72.0351

Project 1
-10,000
-4,000
1,000
3
(A/P, i, n)
1.2
0.65455
0.47473
0.38629
0.33438
0.30071
0.27742
0.26061
0.24808
0.23852
0.23110
0.22526
0.22062
0.21689
0.21388

Project 2
-20,000
-1,000
5,000
5
(P/A, i, n)
0.8333
1.5278
2.1065
2.5887
2.9906
3.3255
3.6046
3.8372
4.031
4.1925
4.3271
4.4392
4.5327
4.6106
4.6755

(P/G, i, n)

(A/G, i, n)

0.6944
1.8519
3.2986
4.9061
6.5806
8.2551
9.8831
11.4335
12.8871
14.233
15.4667
16.5883
17.6008
18.5095

0.4545
0.8791
1.2742
1.6405
1.9788
2.2902
2.5756
2.8964
3.0739
3.2893
3.4841
3.6597
3.8175
3.9588

LCM = 15 => project 1 will have to be undertaken 5 times and project 2 will be undertaken 3 times.
Project 1: The "first project" has present value
P_1f = -10,000 + (-4,000)(P/A, 20%,3)+1000(P/F,20%,3) =
= -10,000 + (-4,000)(2.1065)+1000(0.5787) =
= -17,847.3
Therefore the present value over a period of 15 years with 5 such identical projects is
P_1 = [ 1 + (P/F,20%,3)+(P/F,20%,6)+(P/F,20%,9)+(P/F,20%,12)](P_1f)
= [ 1+ 0.5787 + 0.3349+ 0.1938+ 0.1122 ] (-17,847.3)
= 19.7899(-16,698)
=-39,613.86708
Project 2: Using the same steps as above we get
P_2 = [ 1 + (P/F,20%,5) + (P/F,20%,10)] (-20,000 - 1,000(P/A,20%,5) +5,000(P/F,20%,5))
= [ 1 + 0.4019 + 0.1615 ] (-20,981.1)=
= -32,801.85174
Since P_2 > P_1, project 2 is better.

5. Jerry bought a company 5 years ago for 10 million dollars. The companys profit was -2 million (a
loss) in the first year of ownership and has increased since then by 1 million each year. This trend
is expected to continue for the foreseeable future. If Jerry wishes to make an annual rate of return
equal to 20%, should he sell the company today for 25 million dollars or sell it 5 years from today
for 35
32 million dollars? (The factor values below are for i = 20%.)
n
5
6
10

(F/P, i, n)
2.4883
2.9860
6.1917

(P/F, i, n)
0.4019
0.3349
0.1615

(A/F, i, n)
0.13438
0.10071
0.03852

(F/A, i, n)
7.4416
9.9299
25.9587

(A/P, i, n)
0.33438
0.30071
0.23852

Offer 1's future value (period 0) in millions

F_1 = -10 (F/P,20%,5) + (-2)(F/A,20%,5)+(1)(F/G,20%,5)+25
= -10(2.4883)+(-2)(7.4416)+(1)(2.4883)(4.9061)+25
= -2.5584
Offer 2's future value (period 5) in millions
F_2 = -10(F/P,20%,10)+(-2)(F/A,20%,10)+(1)(F/G,20%,10)+35
= 0.9586 > 0
Therefore choose offer 2.

(P/A, i, n)
2.9906
3.3255
4.1925

(P/G, i, n)
4.9061
6.5806
12.8871

(A/G, i, n)
1.6405
1.9788
3.0739