CHAPTER 5 - Salisbury University - Campus Directoriesfaculty.salisbury.edu/~kxkhazeh/FINA311Solutions7th... · Web viewNOTE: All end-of-chapter problems were solved using a spreadsheet

Chapter 05 - Discounted Cash Flow Valuation

CHAPTER 5DISCOUNTED CASH FLOW VALUATIONAnswers to Concepts Review and Critical Thinking Questions

1. Assuming positive cash flows and a positive interest rate, both the present and the future value will rise.

2. Assuming positive cash flows and a positive interest rate, the present value will fall, and the future value will rise.

3. It’s deceptive, but very common. The deception is particularly irritating given that such lotteries are usually government sponsored!

4. The most important consideration is the interest rate the lottery uses to calculate the lump sum option. If you can earn an interest rate that is higher than you are being offered, you can create larger annuity payments. Of course, taxes are also a consideration, as well as how badly you really need $5 million today.

5. If the total amount of money is fixed, you want as much as possible as soon as possible. The team (or, more accurately, the team owner) wants just the opposite.

6. The better deal is the one with equal installments.

7. Yes, they should. APRs generally don’t provide the relevant rate. The only advantage is that they are easier to compute, but, with modern computing equipment, that advantage is not very important.

8. A freshman does. The reason is that the freshman gets to use the money for much longer before interest starts to accrue.

9. The subsidy is the present value (on the day the loan is made) of the interest that would have accrued up until the time it actually begins to accrue.

10. The problem is that the subsidy makes it easier to repay the loan, not obtain it. However, the ability to repay the loan depends on future employment, not current need. For example, consider a student who is currently needy, but is preparing for a career in a high-paying area (such as corporate finance!). Should this student receive the subsidy? How about a student who is currently not needy, but is preparing for a relatively low-paying job (such as becoming a college professor)?

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Solutions to Questions and Problems

NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem.

Basic

1. To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

PV@10% = $950 / 1.10 + $730 / 1.102 + $1,420 / 1.103 + $1,780 / 1.104 = $3,749.57

PV@18% = $950 / 1.18 + $730 / 1.182 + $1,420 / 1.183 + $1,780 / 1.184 = $3,111.72

PV@24% = $950 / 1.24 + $730 / 1.242 + $1,420 / 1.243 + $1,780 / 1.244 = $2,738.56

2. To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)t]} / r )

At a 6 percent interest rate:

X@6%: PVA = $4,300{[1 – (1/1.06)9 ] / .06 } = $29,247.28

Y@6%: PVA = $6,100{[1 – (1/1.06)5 ] / .06 } = $25,695.42

And at a 22 percent interest rate:

X@22%: PVA = $4,300{[1 – (1/1.22)9 ] / .22 } = $16,281.03

Y@22%: PVA = $6,100{[1 – (1/1.22)5 ] / .22 } = $17,468.20

Notice that the PV of Investment X has a greater PV at a 6 percent interest rate, but a lower PV at a 22 percent interest rate. The reason is that X has greater total cash flows. At a lower interest rate, the total cash flow is more important since the cost of waiting (the interest rate) is not as great. At a higher interest rate, Y is more valuable since it has larger annual payments. At a higher interest rate, getting these payments early are more important since the cost of waiting (the interest rate) is so much greater.

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3. To solve this problem, we must find the FV of each cash flow and sum. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

FV@8% = $910(1.08)3 + $1,140(1.08)2 + $1,360(1.08) + $2,100 = $6,044.83

FV@11% = $910(1.11)3 + $1,140(1.11)2 + $1,360(1.11) + $2,100 = $6,258.74

FV@24% = $910(1.24)3 + $1,140(1.24)2 + $1,360(1.24) + $2,100 = $7,274.29

Notice, since we are finding the value at Year 4, the cash flow at Year 4 is simply added to the FV of the other cash flows. In other words, we do not need to compound this cash flow.


PVA = C({1 – [1/(1 + r)t]} / r )

PVA@15 yrs: PVA = $8,500{[1 – (1/1.09)15 ] / .09} = $68,515.85

PVA@40 yrs: PVA = $8,500{[1 – (1/1.09)40 ] / .09} = $91,437.56

PVA@75 yrs: PVA = $8,500{[1 – (1/1.09)75 ] / .09} = $94,297.15

To find the PV of a perpetuity, we use the equation:

PV = C / r

PV = $8,500 / .09 PV = $94,444.44

Notice that as the length of the annuity payments increases, the present value of the annuity approaches the present value of the perpetuity. The present value of the 75-year annuity and the present value of the perpetuity imply that the value today of all perpetuity payments beyond 75 years is only $147.29.

5. Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $25,000 = $C{[1 – (1/1.079)12 ] / .079}

We can now solve this equation for the annuity payment. Doing so, we get:

C = $25,000 / 7.57528C = $3,300.21

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PVA = C({1 – [1/(1 + r)t]} / r )PVA = $45,000{[1 – (1/1.0825)9 ] / .0825} PVA = $278,210.88

The present value of the revenue is greater than the cost, so your company can afford the equipment.

7. Here we need to find the FVA. The equation to find the FVA is:

FVA = C{[(1 + r)t – 1] / r}

FVA for 20 years = $4,000[(1.09520 – 1) / .095] FVA for 20 years = $216,488.93

FVA for 40 years = $4,000[(1.09540 – 1) / .095] FVA for 40 years = $1,546,079.97

Notice that doubling the number of periods more than doubles the FVA.

8. Here we have the FVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Using the FVA equation:

FVA = C{[(1 + r)t – 1] / r}$25,000 = $C[(1.04758 – 1) / .0475]


C = $25,000 / 9.46414C = $2,641.55

9. Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r )$60,000 = C{[1 – (1/1.09)7 ] / .09}


C = $60,000 / 5.03295 C = $11,921.43

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10. This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / rPV = $35,000 / .06 PV = $583,333.33

11. Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. Using the PV of a perpetuity equation:

PV = C / r$600,000 = $35,000 / r

We can now solve for the interest rate as follows:

r = $35,000 / $600,000 r = .0583 or 5.83%

12. For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.08 / 4)]4 – 1 = .0824 or 8.24%

EAR = [1 + (.18 / 12)]12 – 1 = .1956 or 19.56%

EAR = [1 + (.14 / 365)]365 – 1 = .1502 or 15.02%

EAR = [1 + (.10 / 2)]2 – 1 = .1025 or 10.25%

13. Here we are given the EAR and need to find the APR. Using the equation for discrete compounding:

EAR = [1 + (APR / m)]m – 1

We can now solve for the APR. Doing so, we get:

APR = m[(1 + EAR)1/m – 1]

EAR = .12 = [1 + (APR / 2)]2 – 1 APR = 2[(1.12)1/2 – 1] = 11.66%

EAR = .08 = [1 + (APR / 12)]12 – 1 APR = 12[(1.08)1/12 – 1] = 7.72%

EAR = .13 = [1 + (APR / 52)]52 – 1 APR = 52[(1.13)1/52 – 1] = 12.24%

EAR = .11 = [1 + (APR / 365)]365 – 1 APR = 365[(1.11)1/365 – 1] = 10.44%

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14. For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

So, for each bank, the EAR is:

First National: EAR = [1 + (.101 / 12)]12 – 1 = .1058 or 10.58%

First United: EAR = [1 + (.103 / 2)]2 – 1 = .1057 or 10.57%

For a borrower, First United would be preferred since the EAR of the loan is lower. Notice that the higher APR does not necessarily mean the higher EAR. The number of compounding periods within a year will also affect the EAR.

15. The reported rate is the APR, so we need to convert the EAR to an APR as follows:

EAR = [1 + (APR / m)]m – 1

APR = m[(1 + EAR)1/m – 1]APR = 365[(1.16)1/365 – 1] = .1485 or 14.85%

This is deceptive because the borrower is actually paying annualized interest of 16% per year, not the 14.85% reported on the loan contract.

16. For this problem, we simply need to find the FV of a lump sum using the equation:

FV = PV(1 + r)t

It is important to note that compounding occurs semiannually. To account for this, we will divide the interest rate by two (the number of compounding periods in a year), and multiply the number of periods by two. Doing so, we get:

FV = $1,560[1 + (.09/2)]26 FV = $4,899.46

17. For this problem, we simply need to find the FV of a lump sum using the equation:

FV = PV(1 + r)t

It is important to note that compounding occurs daily. To account for this, we will divide the interest rate by 365 (the number of days in a year, ignoring leap year), and multiply the number of periods by 365. Doing so, we get:

FV in 5 years = $5,000[1 + (.053/365)]5(365) = $6,517.03

FV in 10 years = $5,000[1 + (.053/365)]10(365) = $8,494.33

FV in 20 years = $5,000[1 + (.053/365)]20(365) = $14,430.74

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18. For this problem, we simply need to find the PV of a lump sum using the equation:

PV = FV / (1 + r)t

It is important to note that compounding occurs on a daily basis. To account for this, we will divide the interest rate by 365 (the number of days in a year, ignoring leap year), and multiply the number of periods by 365. Doing so, we get:

PV = $80,000 / [(1 + .06/365)6(365)] PV = $55,815.76

19. The APR is simply the interest rate per period times the number of periods in a year. In this case, the interest rate is 15 percent per month, and there are 12 months in a year, so we get:

APR = 12(15%) APR = 180%

To find the EAR, we use the EAR formula:

EAR = [1 + (APR / m)]m – 1

EAR = (1 + .15)12 – 1 EAR = 4.3503 or 435.03%

Notice that we didn’t need to divide the APR by the number of compounding periods per year. We do this division to get the interest rate per period, but in this problem we are already given the interest rate per period.

20. We first need to find the annuity payment. We have the PVA, the length of the annuity, and the interest rate. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r )$73,800 = $C[1 – {1 / [1 + (.062/12)]60} / (.062/12)]

Solving for the payment, we get:

C = $73,800 / 51.47757C = $1,433.63

To find the EAR, we use the EAR equation:

EAR = [1 + (APR / m)]m – 1EAR = [1 + (.062 / 12)]12 – 1 EAR = .0638 or 6.38%

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21. Here we need to find the length of an annuity. We know the interest rate, the PV, and the payments. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r )$14,720 = $500{ [1 – (1/1.009)t ] / .009}

Now we solve for t:

1/1.009t = 1 – [($14,720)(.009) / ($500)]1.009t = 1 / 0.73504 = 1.36047 t = ln 1.36047 / ln 1.009 t = 34.36 months

22. Here we are trying to find the interest rate when we know the PV and FV. Using the FV equation:

FV = PV(1 + r)$6 = $4(1 + r) r = $6/$4 – 1 r = .5000 or 50.00% per week

The interest rate is 50.00% per week. To find the APR, we multiply this rate by the number of weeks in a year, so:

APR = (52)50% = 2,600.00%

And using the equation to find the EAR, we find:

EAR = [1 + (APR / m)]m – 1EAR = [1 + .50]52 – 1 EAR = 14,346,483,744,816 or 143,464,837,448.16%

23. Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. Using the PV of a perpetuity equation:

PV = C / r$325,000 = $3,100 / r

We can now solve for the interest rate as follows:

r = $3,100 / $325,000 r = .0095 or 0.95% per month

The interest rate is 0.95% per month. To find the APR, we multiply this rate by the number of months in a year, so:

APR = (12)0.95% APR = 11.45%

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And using the equation to find the EAR, we find:

EAR = [1 + (APR / m)]m – 1EAR = [1 + .0095]12 – 1 EAR = .1207 or 12.07%

24. This problem requires us to find the FVA. The equation to find the FVA is:

FVA = C{[(1 + r)t – 1] / r}FVA = $400[{[1 + (.105/12) ]360 – 1} / (.105/12)] FVA = $1,006,560.40

25. In the previous problem, the compounding period is monthly. This assumption still holds. Since the cash flows are annual, we need to use the EAR to calculate the future value of annual cash flows. It is important to remember that you have to make sure the compounding periods of the interest rate matches with the cash flows. In this case, we have annual cash flows, so we need the EAR since it is the true annual interest rate you will earn. So, finding the EAR:

EAR = [1 + (APR / m)]m – 1EAR = [1 + (.105/12)]12 – 1 EAR = .1102 or 11.02%

Using the FVA equation, we get:

FVA = C{[(1 + r)t – 1] / r}FVA = $4,800[(1.110230 – 1) / .1102] FVA = $959,033.87

26. The cash flows are simply an annuity with four payments per year for four years, or 16 payments. We can use the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $2,500{[1 – (1/1.0065)16] / .0065} PVA = $37,873.60


PV = FV / (1 + r)t

PV = $1,200 / 1.084 + $1,100 / 1.0842 + $800 / 1.0843 + $600 / 1.0844 PV = $3,105.74

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PV = FV / (1 + r)t

PV = $1,900 / 1.0929 + $2,300 / 1.09292 + $4,500 / 1.09293 + $5,100 / 1.09294 PV = $10,686.11

Intermediate

29. The total interest paid by First Simple Bank is the interest rate per period times the number of periods. In other words, the interest by First Simple Bank paid over 10 years will be:

.08(10) = .8

First Complex Bank pays compound interest, so the interest paid by this bank will be the FV factor of $1, or:

(1 + r)10

Setting the two equal, we get:

(.08)(10) = (1 + r)10 – 1

r = 1.81/10 – 1 r = .0605 or 6.05%

30. We need to use the PVA due equation, which is:

PVAdue = (1 + r) PVA

Using this equation:

PVAdue = $43,000 = [1 + (.0625/12)] × C[{1 – 1 / [1 + (.0625/12)]60} / (.0625/12)$42,777.20 = $C{1 – [1 / (1 + .0625/12)60]} / (.0625/12)C = $831.98

Notice, to find the payment for the PVA due, we find the PV of an ordinary annuity, then compound this amount forward one period.

31. Here we need to find the FV of a lump sum, with a changing interest rate. We must do this problem in two parts. After the first six months, the balance will be:

FV = $10,000[1 + (.021/12)]6 FV = $10,105.46

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This is the balance in six months. The FV in another six months will be:

FV = $10,105.46[1 + (.17/12)]6 FV = $10,995.43

The problem asks for the interest accrued, so, to find the interest, we subtract the beginning balancefrom the principal. The interest accrued is:

Interest = $10,995.43 – 10,000.00 Interest = $995.43

32. We will calculate the time we must wait if we deposit in the bank that pays simple interest. The interest amount we will receive each year in this bank will be:

Interest = $92,000(.06) Interest = $5,520 per year

The deposit will have to increase by the difference between the amount we need by the amount we originally deposit with divided by the interest earned per year, so the number of years it will take in the bank that pays simple interest is:

Years to wait = ($175,000 – 92,000) / $5,520 Years to wait = 15.04 years

To find the number of years it will take in the bank that pays compound interest, we can use the future value equation for a lump sum and solve for the periods. Doing so, we find:

FV = PV(1 + r)t

$175,000 = $92,000 [1 + (.06/12)]t t = 128.92 months or 10.74 years

33. Here we need to find the future value of a lump sum. We need to make sure to use the correct number of periods. So, the future value after one year will be:

FV = PV(1 + r)t

FV = $1(1.0127)12 FV = $1.16

And the future value after two years will be:

FV = PV(1 + r)t

FV = $1(1.0127)24 FV = $1.35

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34. Here we are given the PVA, number of periods, and the amount of the annuity. We need to solve for the interest rate. Even though the currency is pounds and not dollars, we can still use the same time value equations. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r )£440 = £60[{1 – [1 / (1 + r)]31}/ r]

To find the interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial and error. If you use trial and error, remember that increasing the interest rate decreases the PVA, and decreasing the interest rate increases the PVA. Using a spreadsheet, we find:

r = 13.36%

Not bad for an English Literature major!

35. Here we need to compare two cash flows. The only way to compare cash flows is to find the value of the cash flows at a common time, so we will find the present value of each cash flow stream. Since the cash flows are monthly, we need to use the monthly interest rate, which is:

Monthly rate = .07 / 12Monthly rate = .0058 or .58%

The value today of the $6,800 monthly salary is:

PVA = C({1 – [1/(1 + r)t]} / r )PVA = $6,800{[1 – (1 / 1.0058)24 ] / .0058} PVA = $151,878.68

To find the value of the second option, we find the present value of the monthly payments and add the bonus. We can add the bonus since it is paid today. So:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $5,500{[1 – (1/1.0058)24] / .0058} PVA = $122,843.05

So, the total value of the second option is:

Value of second option = $122,843.05 + 30,000Value of second option = $152,843.05

The difference in the value of the two options today is:

Difference in value today = $152,843.05 – 151,878.68Difference in value today = $964.37

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What if we found the future value of the two cash flows? For the annual salary, the future value will be:

FVA = C{[(1 + r)t – 1] / r}FVA = $6,800{[(1 + .0058)24 – 1] / .0058}FVA = $174,631.01

To find the future value of the second option we also need to find the future value of the bonus as well. So, the future value of this option is:

FV = C{[(1 + r)t – 1] / r} + PV(1 + r)t

FV = $5,500{[(1 + .0058)24 – 1] / .0058} + $30,000(1 + .0058)24

FV = $175,739.85

So, the first option is still the better choice. The difference between the future value of the two options is:

Difference in future value = $175,739.85 – 174,631.01Difference in future value = $1,108.84

No matter when you compare two cash flows, the cash flow with the greatest value on one period will always have the greatest value in any other period. Here’s a question for you: What is the future value of $964.37 (the difference in the cash flows at time zero) in 24 months at an interest rate of .58 percent per month? With no calculations, you know the future value must be $1,108.84, the difference in the cash flows at the same time!

36. The cash flows are an annuity, so we can use the present value of an annuity equation. Doing so, we find:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $12,000[1 – (1/1.09)20 / .09] PVA = $109,542.55

37. The investment we should choose is the investment with the higher rate of return. We will use the future value equation to find the interest rate for each option. Doing so, we find the return for Investment G is:

FV = PV(1 + r)t

$150,000 = $85,000(1 + r)6 r = ($150,000/$85,000)1/6 – 1 r = .0993 or 9.93%

And, the return for Investment H is:

FV = PV(1 + r)t

$270,000 = $85,000(1 + r)13 r = ($270,000/$85,000)1/13 – 1 r = .0930 or 9.30%

So, we should choose Investment G.

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38. The present value of an annuity falls as r increases, and the present value of an annuity rises as r decreases. The future value of an annuity rises as r increases, and the future value of an annuity falls as r decreases.

Here we need to calculate the present value of an annuity for different interest rates. Using the present value of an annuity equation and an interest rate of 10 percent, we get:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $15,000{[1 – (1/1.10)10] / .10} PVA = $92,168.51

At an interest rate of 5 percent, the present value of the annuity is:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $15,000{[1 – (1/1.05)10] / .05} PVA = $115,826.02

And, at an interest rate of 15 percent, the present value of the annuity is:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $15,000{[1 – (1/1.15)10] / .15} PVA = $72,281.53

39. Here we are given the future value of an annuity, the interest rate, and the number of payments. We need to find the number of periods of the annuity payments. So, we can solve the future value of an annuity equation for the number of periods as follows:

FVA = C{[(1 + r)t – 1] / r}$50,000 = $175[{[1 + (.10/12)]t – 1 } / (.10/12) ]175 = {[1 + (.10/12)]t – 1 } / (.10/12) 1.458 = (1 + .0083)t – 1 2.458 = (1.0083)t ln 2.458 = t ln 1.0083 t = ln 2.458 / ln 1.0083 t = 146.79 payments

40. Here we are given the PVA, number of periods, and the amount of the annuity. We need to solve for the interest rate. Using the PVA equation:

PVA = ({1 – [1/(1 + r)t]} / r ))$58,000 = $1,200[{1 – [1 / (1 + r)]60}/ r]

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r = .00738 or .738%

This is the monthly interest rate. To find the APR with a monthly interest rate, we simply multiply the monthly rate by 12, so the APR is:

APR = .00738 × 12APR = .0886 or 8.86%

41. To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a

lump sum, we use:

PV = FV / (1 + r)t

PV = $2,000,000 + $27,000,000/1.11 + $33,000,000/1.112 + $33,000,000/1.113 + $32,000,000/1.114 + $30,000,000/1.115 + $32,000,000/1.116 + $25,000,000/1.117 + $21,000,000/1.118 + $20,000,000/1.119 + $20,000,000/1.1110

PV = $169,244,719.67


PV = FV / (1 + r)t

PV = $16,000,000 + $6,500,000/1.11 + $7,000,000/1.112 + $8,500,000/1.113 + $9,000,000/1.114 + $9,000,000/1.115 + $11,500,000/1.116

PV = $51,170,349.96

43. Here we are given the PVA, number of periods, and the amount of the annuity. We need to solve for the interest rate. First, we need to find the amount borrowed since it is only 80 percent of the building value. So, the amount borrowed is:

Amount borrowed = .80($3,200,000)Amount borrowed = $2,560,000

Now we can use the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r ))$2,560,000 = $15,300[{1 – [1 / (1 + r)]360}/ r]

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r = .00498 or .498%


APR = .00498 × 12APR = .0597 or 5.97%

And the EAR is:


44. Here, we have two cash flow streams that will be combined in the future. To find the withdrawal amount, we need to know the present value, as well as the interest rate and periods, which are given. The present value of the retirement account is the future value of the stock and bond account. We need to find the future value of each account and add the future values together. For the bond account the future value is the value of the current savings plus the value of the annual deposits. So, the future value of the bond account will be:

FV = C{[(1 + r)t – 1] / r} + PV(1 + r)t

FV = $8,000{[(1 + .07)10 – 1] / .07} + $160,000(1 + .07)10

FV = $425,275.80

The total value of the stock account at retirement will be the future value of a lump sum, so:

FV = PV(1 + r)t FV = $600,000(1 + .105)10

FV = $1,628,448.51

The total value of the account at retirement will be:

Total value at retirement = $425,275.80 + 1,628,448.51Total value at retirement = $2,053,724.31

This amount is the present value of the annual withdrawals. Now we can use the present value of an annuity equation to find the annuity amount. Doing so, we find the annual withdrawal will be:

PVA = C({1 – [1/(1 + r)t]} / r ))$2,053,724.31 = C[{1 – [1 / (1 + .0625)]25}/ .0625]C = $164,492.27

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45. Here we are given the PVA for an annuity due, number of periods, and the amount of the annuity. We need to solve for the interest rate. Using the PVA equation:

PVA = [{1 – [1 / (1 + r)]60}/ r](1 + r)$34,000 = $645[{1 – [1 / (1 + r)]60}/ r](1 + r)


r = .0045 or .45%


APR = .0045 × 12APR = .0540 or 5.40%

46. a. If the payments are in the form of an ordinary annuity, the present value will be:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $12,000[{1 – [1 / (1 + .09)]5}/ .09]PVA = $46,675.82

If the payments are an annuity due, the present value will be:

PVAdue = (1 + r) PVAPVAdue = (1 + .09)$46,675.82PVAdue = $50,876.64

b. We can find the future value of the ordinary annuity as:

FVA = C{[(1 + r)t – 1] / r}FVA = $12,000{[(1 + .09)5 – 1] / .09}FVA = $71,816.53

If the payments are an annuity due, the future value will be:

FVAdue = (1 + r) FVAFVAdue = (1 + .09)$71,816.53FVAdue = $78,280.01

c. Assuming a positive interest rate, the present value of an annuity due will always be larger than the present value of an ordinary annuity. Each cash flow in an annuity due is received one period earlier, which means there is one period less to discount each cash flow. Assuming a positive interest rate, the future value of an annuity due will always higher than the future value of an ordinary annuity. Since each cash flow is made one period sooner, each cash flow receives one extra period of compounding.

5-17


47. Here, we need to find the difference between the present value of an annuity and the present value of a perpetuity. The present value of the annuity is:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $8,500{[1 – (1/1.08)30] / .08} PVA = $95,691.16

And the present value of the perpetuity is:

PVP = C / rPVP = $8,500 / .08PVP = $106,250

So, the difference in the present values is:

Difference = $106,250 – 95,691.16Difference = $10,558.84

There is another common way to answer this question. We need to recognize that the difference in the cash flows is a perpetuity of $8,500 beginning 31 years from now. We can find the present value of this perpetuity and the solution will be the difference in the cash flows. So, we can find the present value of this perpetuity as:

PVP = C / rPVP = $8,500 / .08PVP = $106,250

This is the present value 30 years from now, one period before the first cash flows. We can now find the present value of this lump sum as:

PV = FV / (1 + r)t

PV = $106,250 / (1 + .08)30

PV = $10,558.84

This is the same answer we calculated before.

48. Here we need to find the present value of an annuity at several different times. The annuity has semiannual payments, so we need the semiannual interest rate. The semiannual interest rate is:

Semiannual rate = 0.09/2 Semiannual rate = .045

Now, we can use the present value of an annuity equation. Doing so, we get:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $7,800{[1 – (1 / 1.045)10] / .045} PVA = $61,719.20

5-18


This is the present value one period before the first payment. The first payment occurs nine and one-half years from now, so this is the value of the annuity nine years from now. Since the interest rate is semiannual, we must also be careful to use the number of semiannual periods. The value of the annuity five years from now is:

PV = FV / (1 + r)t

PV = $61,719.20 / (1 + .045)8

PV = $43,400.02

And the value of the annuity three years from now is:

PV = FV / (1 + r)t

PV = $61,719.20 / (1 + .045)12

PV = $36,393.58

And the value of the annuity today is:

PV = FV / (1 + r)t

PV = $61,719.20 / (1 + .045)18

PV = $27,946.48

49. Since the first payment is received six years form today and the last payment is received 20 years from now, there are 15 payments. We can use the present value of an annuity formula, which will give us the present value four years from now, one period before the first payment. So, the present value of the annuity in four years is:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $1,625{[1 – (1/1.07)15] / .07} PVA = $14,800.36

And using the present value equation for a lump sum, the present value of the annuity today is:

PV = FV / (1 + r)t

PV = $14,800.36 / (1 + .07)5

PV = $10,552.45

50. Here, we have an annuity with two different interest rates. To answer this question, we simply need to find the present value in multiple steps. The present value of the last six years payments at a 7 percent interest rate is:

PVA = C({1 – [1/(1 + r)t]} / r ))PVA = $2,500[{1 – 1 / [1 + (.07/12)]72} / (.07/12)] PVA = $146,636.11

5-19


We can now discount this value back to time zero. We must be sure to use the number of months as the periods since interest is compounded monthly. We also need to use the interest rate that applies during the first four years. Doing so, we find:

PV = FV / (1 + r)t

PV = $146,636.11 / (1 + .09/12)48

PV = $102,442.06

Now we can find the present value of the annuity payments for the first four years. The present value of these payments is:

PVA = C({1 – [1/(1 + r)t]} / r )PVA = $2,500[{1 – 1 / [1 + (.09/12)]48} / (.09/12)] PVA = $100,461.95

So, the total present value of the cash flows is:

PV = $102,442.06 + 100,461.95PV = $202,904.01

51. To answer this question we need to find the future value of the annuity, and then find the present value that makes the lump sum investment equivalent. We also need to make sure to use the number of months as the number of periods. So, the future value of the annuity is:

FVA = C{[(1 + r)t – 1] / r}FVA = $1,680{[(1 + .08/12)120 – 1] / (.08/12)}FVA = $307,349.34

Now we can find the present value that would permit the lump sum investment to be equal to this future value. This investment has annual compounding, so the number of periods is the number of years. So, the present value we would need to deposit is:

PV = FV / (1 + r)t

PV = $307,349.34 / (1 + .10)10

PV = $118,496.48

52. Here we need to find the present value of a perpetuity at a date before the perpetuity begins. We will begin by find the present value of the perpetuity. Doing so, we find:

PVP = C / rPVP = $3,100 / .0635PVP = $48,818.90

5-20


This is the present value of the perpetuity at year 19, one period before the payments begin. So, using the present value of a lump sum equation to find the value at year 7, we find:

PV = FV / (1 + r)t

PV = $48,818.90 / (1 + .0635)12

PV = $23,320.51

53. Here we are given the PVA, number of periods, and the amount of the annuity. We need to solve for the interest rate. We need must be careful to use the cash flows of the loan. Using the present value of an annuity equation, we find:

PVA = C({1 – [1/(1 + r)t]} / r )$23,400 = $1,950[{1 – [1 / (1 + r)]12}/ r]

To find the interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial and error. If you use trial and error, remember that increasing the interest rate lowers the PVA, and increasing the interest rate decreases the PVA. Using a spreadsheet, we find:

r = .02502 or 2.502%


APR = .02502 × 12APR = .3003 or 30.03%

And the EAR is:


54. To solve this problem, we must find the FV of each cash flow and add them. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

FV = $21,000(1.078)3 + $39,000(1.078)2 + $57,000 FV = $128,628.53

Notice, since we are finding the value at Year 5, the cash flow at Year 5 is simply added to the FV of the other cash flows. In other words, we do not need to compound this cash flow. To find the value in Year 10, we simply need to find the future value of this lump sum. Doing so, we find:

FV = PV(1 + r)t

FV = $128,628.53(1.078)5 FV = $187,254.01

5-21


55. The payment for a loan repaid with equal payments is the annuity payment with the loan value as the PV of the annuity. So, the loan payment will be:

PVA = C({1 – [1/(1 + r)t]} / r )$60,000 = C{[1 – 1 / (1 + .09)3] / .09}C = $23,703.29

The interest payment is the beginning balance times the interest rate for the period, and the principal payment is the total payment minus the interest payment. The ending balance is the beginning balance minus the principal payment. The ending balance for a period is the beginning balance for the next period. The amortization table for an equal payment is:

YearBeginning

BalanceTotal

PaymentInterest

PaymentPrincipalPayment

Ending Balance

1 $60,000.00 $23,703.29 $5,400.00 $18,303.29 $41,696.712 41,696.71 23,703.29 3,752.70 19,950.58 21,746.133 21,746.13 23,703.29 1,957.15 21,746.13 0

In the third year, $1,957.15 of interest is paid.

Total interest over life of the loan = $5,400.00 + 3,752.70 + 1,957.15 Total interest over life of the loan = $11,109.86

56. This amortization table calls for equal principal payments of $20,000 per year. The interest payment is the beginning balance times the interest rate for the period, and the total payment is the principal payment plus the interest payment. The ending balance for a period is the beginning balance for the next period. The amortization table for an equal principal reduction is:

Year

Beginning

BalanceTotal

PaymentInterest

PaymentPrincipalPayment

Ending Balance

1 $60,000.00 $25,400.00 $5,400.00 $20,000.00 $40,000.002 40,000.00 23,600.00 3,600.00 20,000.00 20,000.003 20,000.00 21,800.00 1,800.00 20,000.00 0

In the third year, $1,800 of interest is paid.

Total interest over life of the loan = $5,400 + 3,600 + 1,800 Total interest over life of the loan = $10,800

Notice that the total payments for the equal principal reduction loan are lower. This is because more principal is repaid early in the loan, which reduces the total interest expense over the life of the loan.

5-22


Challenge

57. To find the APR and EAR, we need to use the actual cash flows of the loan. In other words, the interest rate quoted in the problem is only relevant to determine the total interest under the terms given. The cash flows of the loan are the $15,000 you must repay in one year, and the $12,600 you borrow today. The interest rate of the loan is:

$15,000 = $12,600(1 + r)r = ($15,000 / 12,600) – 1 r = .1905 or 19.05%

Because of the discount, you only get the use of $12,600 and the interest you pay on that amount is 19.05%, not 16%.

58. Here we have cash flows that would have occurred in the past and cash flows that would occur in the future. We need to bring both cash flows to today. Before we calculate the value of the cash flows today, we must adjust the interest rate so we have the effective monthly interest rate. Finding the APR with monthly compounding and dividing by 12 will give us the effective monthly rate. The APR with monthly compounding is:

APR = 12[(1.09)1/12 – 1] = 8.65%

To find the value today of the back pay from two years ago, we will find the FV of the annuity, and then find the FV of the lump sum. Doing so gives us:

FVA = ($47,000/12) [{[1 + (.0865/12)]12 – 1} / (.0865/12)] FVA = $48,908.59

FV = PV(1 + r)t

FV = $48,908.59(1.09) FV = $53,310.36

Notice we found the FV of the annuity with the effective monthly rate, and then found the FV of the lump sum with the EAR. Alternatively, we could have found the FV of the lump sum with the effective monthly rate as long as we used 12 periods. The answer would be the same either way.

Now, we need to find the value today of last year’s back pay:

FVA = ($50,000/12) [{[1 + (.0865/12)]12 – 1} / (.0865/12)] FVA = $52,030.41

Next, we find the value today of the five year’s future salary:

PVA = ($54,000/12){[{1 – {1 / [1 + (.0865/12)]12(5)}] / (.0865/12)}PVA = $218,570.57

The value today of the jury award is the sum of salaries, plus the compensation for pain and suffering, and court costs. The award should be for the amount of:

Award = $53,310.36 + 52,030.41 + 218,570.57 + 150,000 + 20,000 Award = $493,911.34

5-23


As the plaintiff, you would prefer a lower interest rate. In this problem, we are calculating both the PV and FV of annuities. A lower interest rate will decrease the FVA, but increase the PVA. So, by a lower interest rate, we are lowering the value of the back pay. But, we are also increasing the PV of the future salary. Since the future salary is larger and has a longer time, this is the more important cash flow to the plaintiff.

59. Again, to find the interest rate of a loan, we need to look at the cash flows of the loan. Since this loan is in the form of a lump sum, the amount you will repay is the FV of the principal amount, which will be:

Loan repayment amount = $10,000(1.10) = $11,000

The amount you will receive today is the principal amount of the loan times one minus the points.

Amount received = $10,000(1 – .02) = $9,800

Now, we simply find the interest rate for this PV and FV.

$11,000 = $9,800(1 + r) r = ($11,000 / $9,800) – 1 = .1224 or 12.24%

60. We need to find the FV of the premiums to compare with the cash payment promised at age 65. We have to find the value of the premiums at year 6 first since the interest rate changes at that time. So:

FV1 = $750(1.11)5 = $1,263.79

FV2 = $750(1.11)4 = $1,138.55

FV3 = $850(1.11)3 = $1,162.49

FV4 = $850(1.11)2 = $1,047.29

FV5 = $950(1.11)1 = $1,054.50

Value at year six = $1,263.79 + 1,138.55 + 1,162.49 + 1,047.29 + 1,054.50 + 950 = $6,616.62

Finding the FV of this lump sum at the child’s 65th birthday:

FV = $6,616.62(1.07)59 = $358,326.50

The policy is not worth buying; the future value of the deposits is $358,326.50, but the policy contract will pay off $350,000. The premiums are worth $8,326.50 more than the policy payoff.

Note, we could also compare the PV of the two cash flows. The PV of the premiums is:

PV = $750/1.11 + $750/1.112 + $850/1.113 + $850/1.114 + $950/1.115 + $950/1.116 PV = $3,537.51

5-24


And the value today of the $350,000 at age 65 is:

PV = $350,000/1.0759 = $6,462.87

PV = $6,462.87/1.116 = $3,455.31

The premiums still have the higher cash flow. At time zero, the difference is $82.20. Whenever you are comparing two or more cash flow streams, the cash flow with the highest value at one time will have the highest value at any other time.

Here is a question for you: Suppose you invest $82.20, the difference in the cash flows at time zero, for six years at an 11 percent interest rate, and then for 59 years at a seven percent interest rate. How much will it be worth? Without doing calculations, you know it will be worth $8,326.50, the difference in the cash flows at time 65!

Calculator Solutions

1.CFo $0 CFo $0 CFo $0C01 $950 C01 $950 C01 $950F01 1 F01 1 F01 1C02 $730 C02 $730 C02 $730F02 1 F02 1 F02 1C03 $1,420 C03 $1,420 C03 $1,420F03 1 F03 1 F03 1C04 $1,780 C04 $1,780 C04 $1,780F04 1 F04 1 F04 1

I = 10 I = 18 I = 24NPV CPT NPV CPT NPV CPT$3,749.57 $3,111.72 $2,738.56

2.Enter 9 6% $4,300

N I/Y PV PMT FVSolve for $29,247.28

Enter 5 6% $6,100N I/Y PV PMT FV

Solve for $25,695.42



5-25




3.CFo $0 CFo $0 CFo $0C01 $910 C01 $910 C01 $910F01 1 F01 1 F01 1C02 $1,140 C02 $1,140 C02 $1,140F02 1 F02 1 F02 1C03 $1,360 C03 $1,360 C03 $1,360F03 1 F03 1 F03 1C04 $2,100 C04 $2,100 C04 $2,100F04 1 F04 1 F04 1

I = 8 I = 11 I = 24NFV CPT NFV CPT NFV CPT$6,044.83 $6,258.74 $7,274.29

4.Enter 15 9% $8,500






5.Enter 12 7.9% $25,000


6.Enter 9 8.25% $45,000


5-26


7.Enter 20 9.5% $4,000


Enter 40 9.5% $4,000N I/Y PV PMT FV

Solve for $1,546,079.97

8.Enter 8 4.75% $25,000


9.Enter 7 9% $60,000


12.Enter 8% 4

NOM EFF C/YSolve for 8.24%

Enter 18% 12NOM EFF C/Y

Solve for 19.56%


Solve for 15.02%


Solve for 10.25%

13.Enter 12% 2


5-27



Solve for 7.72%


Solve for 12.24%


Solve for 10.44%

14.Enter 10.1% 12


Enter 10.3% 2NOM EFF C/Y

Solve for 10.57%

15.Enter 16% 365


16.Enter 13 × 2 9% / 2 $1,560


17.Enter 5 365 5.3% / 365 $5,000


Enter 10 365 5.3% / 365 $5,000N I/Y PV PMT FV

Solve for $8,494.33

5-28


Enter 20 365 5.3% / 365 $5,000N I/Y PV PMT FV


18.Enter 6 365 6% / 365 $80,000


19. APR = 12(15%) = 180%


Solve for 435.03%

20.Enter 60 6.2% / 12 $73,800



Solve for 6.38%

21.Enter 0.9% $14,720 $500

N I/Y PV PMT FVSolve for 34.36

22.Enter 1 ±$4 $6

N I/Y PV PMT FVSolve for 50%

APR = 52(50.00%) = 2,600%

Enter 2,600% 52NOM EFF C/Y

Solve for 143,464,837,448%

5-29


24.Enter 30 12 10.5% / 12 $400

N I/Y PV PMT FVSolve for $1,006,560.40

25.Enter 10.5% 12



Solve for $959,033.87

26.Enter 4 4 .65% $2,500


27.CFo $0C01 $1,200F01 1C02 $1,100F02 1C03 $800F03 1C04 $600F04 1

I = 8.40NPV CPT$3,105.74

28.CFo $0C01 $1,900F01 1C02 $2,300F02 1C03 $4,500F03 1C04 $5,100F04 1

I = 9.29NPV CPT$10,686.11

5-30


29. First Simple: $100(.08) = $8; 10 year investment = $100 + 10($8) = $180

Enter 10 ±$100 $180N I/Y PV PMT FV

Solve for 6.05%

30. 2nd BGN 2nd SET

Enter 60 6.25% / 12 $43,000N I/Y PV PMT FV

Solve for $831.98

31.Enter 6 2.10% / 12 $10,000


Enter 6 17% / 12 $10,105.46N I/Y PV PMT FV


Interest = $10,995.43 – 10,000 Interest = $995.43

32. First: $92,000 (.06) = $5,520 per year($175,000 – 92,000) / $5,520 = 15.04 years

Second:Enter 6% / 12 $92,000 $175,000


128.92 / 12 = 10.74 years

33.Enter 12 1.27% $1

N I/Y PV PMT FVSolve for $1.16

Enter 24 1.27% $1N I/Y PV PMT FV

Solve for $1.35

5-31


34.Enter 31 ±£440 £60

N I/Y PV PMT FVSolve for 13.36%

35.Enter 24 7% /12 $6,800


Enter 24 7% / 12 $5,500N I/Y PV PMT FV

Solve for $122,843.05

$122,843.05 + 30,000 = $152,843.05

36.Enter 20 9% $12,000


37.Enter 6 ±$85,000 $150,000


Enter 13 ±$85,000 $270,000N I/Y PV PMT FV

Solve for 9.30%

38.Enter 10 10% $15,000



Solve for $115,826.02



5-32


39.Enter 10% / 12 ±$175 $50,000


40.Enter 60 ±$58,000 $1,200

N I/Y PV PMT FVSolve for .738%

APR = .738%(12) = 8.86%

41. 42.CFo $2,000,000 CFo $16,000,000C01 $27,000,000 C01 $6,500,000F01 1 F01 1C02 $33,000,000 C02 $7,000,000F02 2 F02 1C03 $32,000,000 C03 $8,500,000F03 1 F03 1C04 $30,000,000 C04 $9,000,000F04 1 F04 2C05 $32,000,000 C05 $11,500,000F05 1 F05 1C06 $25,000,000 C06F06 1 F06C07 $21,000,000 C07F07 1 F07C08 $20,000,000 C08F08 2 F08

I = 11% I = 11%NPV CPT NPV CPT$169,244,719.67 $51,170,349.96

43.Enter 30 12 .80($3,200,000) ±$15,300

N I/Y PV PMT FVSolve for .498%

APR = 0.498%(12) = 5.97%


Solve for 6.14%

5-33


44. Future value of bond account:

Enter 10 7% $160,000 $8,000N I/Y PV PMT FV

Solve for $425,275.80

Future value of stock account:


Solve for $1,628,448.51Future value of retirement account:FV = $425,275.80 + 1,628,448.51FV = $2,053,724.31

Annual withdrawal amount:

Enter 25 6.25% $2,053,724.31N I/Y PV PMT FV

Solve for $164,492.27

45. 2nd BGN 2nd SET

Enter 60 $34,000 $645N I/Y PV PMT FV

Solve for 0.45%

APR = 0.45%(12) = 5.40%

46.a.Enter 5 9% $12,000


2nd BGN 2nd SET



b.Enter 5 9% $12,000


5-34


2nd BGN 2nd SET



47. Present value of annuity:



And the present value of the perpetuity is:

PVP = C / rPVP = $8,500 / .08PVP = $106,250.00

So the difference in the present values is:

Difference = $106,250 – 95,691.16Difference = $10,558.84

48. Value at t = 9

Enter 10 9% / 2 $7,800N I/Y PV PMT FV


Value at t = 5

Enter 4 2 9% / 2 $61,719.20N I/Y PV PMT FV


Value at t = 3



Value today



5-35


49. Value at t = 5



Value today

Enter 5 7% $14,800.36N I/Y PV PMT FV


50. Value at t = 4

Enter 6 12 7% / 12 $2,500N I/Y PV PMT FV

Solve for $146,636.11

Value today

Enter 4 12 9% / 12 $2,500 $146,636.11N I/Y PV PMT FV

Solve for $202,904.01

51. FV of A

Enter 10 12 8% / 12 $1,680N I/Y PV PMT FV

Solve for $307,349.34

Value to invest in B


Solve for $118,496.48

53.Enter 12 ±$20,000 $1,950


APR = 2.502%(12) = 30.03%


Solve for 34.52%

5-36


54.CFo $0C01 $0F01 1C02 $21,000F02 1C03 $39,000F03 1C04 $0F04 1C05 $57,000F05 1

I = 7.8%NPV NFV$128,628.53

Enter 5 7.8% ±$128,628.53N I/Y PV PMT FV

Solve for $187,254.01

57.Enter 1 ±$12,600 $15,000


58.Enter 9% 12


Enter 12 8.65% / 12 $47,000 / 12 N I/Y PV PMT FV

Solve for –$48,908.59



Enter 12 8.65% / 12 $50,000 / 12 N I/Y PV PMT FV

Solve for –$52,030.41

5-37


Enter 60 8.65% / 12 $54,000 / 12N I/Y PV PMT FV

Solve for $218,570.57

Award = $53,310.36 + 52,030.41 + 218,570.57 + 150,000 + 20,000 = $493,911.34

59.Enter 1 $9,800 $11,000


60. Value at Year 6:

Enter 5 11% $750N I/Y PV PMT FV

Solve for $1,263.79


Solve for $1,138.55


Solve for $1,162.49


Solve for $1,047.29


Solve for $1,054.50

So, at Year 5, the value is: $1,263.79 + 1,138.55 + 1,162.49 + 1,047.29 + 1,054.50 + 950 = $6,616.62

At Year 65, the value is:


Solve for $358,326.50

The policy is not worth buying; the future value of the deposits is $358,326.50 but the policy contract will pay off $350,000.

5-38

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CHAPTER 5 - Salisbury University - Campus Directoriesfaculty.salisbury.edu/~kxkhazeh/FINA311Solutions7th... · Web viewNOTE: All end-of-chapter problems were solved using a spreadsheet