Problems

Copyright Michael R. Roberts

Problem Instructions
These problems are designed to test your understanding
of the material and ability to apply what you have
learned to situations that arise in practice both
personal and professional. I have tried to retain the spirit
of what you will encounter in practice while recognizing
that your knowledge to this point may be limited. As
such, you may see similar problems in future modules
that expand on these or incorporate important
institutional features.
Know that all of the problems can be solved with what
you have learned in the current and preceding modules.
Good luck!
Copyright Michael R. Roberts

Problem 1. Notation
Which of the following present value notations
denotes the value as of period 4 of a cash flow
received in period 12?
a)
b)
c)
d)
e)

PV0(CF)
PV0(CF12)
PV4(CF)
PV4(CF12)
PV12(CF4)

Solution: d)
0

10

11

12
CF12

Copyright Michael R. Roberts

PV4(CF12)

Problem 2. Notation
Which of the following present value notations
denotes the value as of today of a cash flow
received in period 6?
a)
b)
c)
d)
e)

PV0(CF6)
PV6(CF0)
PV4(CF)
PV4(CF12)
PV4(CF4)

Solution: a)
0

6
CF6

Copyright Michael R. Roberts

PV0(CF6)

Problem 3. Inheritance
You will receive an inheritance of $500,000 in 20
years on your 40th birthday. What is the value of
the inheritance today if the discount rate is 10%?
Solution:
0

Copyright Michael R. Roberts

19

20

$500,000

Problem 4. Inheritance
Your brother offers you $150,000 today for a claim
to your future inheritance. Should you accept his
offer?
Solution:
Yes. The present value of your inheritance,
$74,321, is substantially less than your brothers
offer, $150,000. Your brother should take finance.

Copyright Michael R. Roberts

Problem 5. Bond Price

What is the present value (i.e., price) today of a
bond that will pay its owner $1,000,000 five years
from today if the discount rate is 4% per annum?
(This is called a zero-coupon or pure discount
bond)
Solution:
0
1
?

Copyright Michael R. Roberts

5
$1 mil

Problem 6. Bond Price

The price today of a bond that will pay its owner
$1,000,000 in five years is $747,258.17. What is
the annual rate of return on this bond? (This rate is
also called a bond yield or yield-to-maturity.)
Solution:
0

$1 mil

$747,258.17
Price PV0 CF5 747, 258.17

1, 000, 000

1 R
1/5

Copyright Michael R. Roberts

1, 000, 000
R
1 0.0600

747, 258.1729

Problem 7. Bond Price

What is the price two years from today of a bond
that will pay its owner $1,000,000 five years from
today if the discount rate is fixed at 4% per
annum?
Solution:
0

Copyright Michael R. Roberts

$1 mil

Problem 8. Education
Some studies estimate that private college will cost
$130,428
per
year
in
2030
(http://www.cnbc.com/id/47565202). Assuming your child
will attend college for four years at a constant cost of
$130,428 per year, how much money do you need at the
start of their first year when the first bill is due to finance
all of their college years if you can earn a risk-free return of
5%?

Copyright Michael R. Roberts

Problem 8. Education (Cont.)

Solution:
College
1
Year
Period 0
130,428
?

Copyright Michael R. Roberts

130,428

130,428

130,428

Problem 9. Education
Continuing the previous problem, assume that you put the
money into a savings account earning an annual risk-free
return of 5% per annum. How much money will be in the
account at the end of the first year after you make the
second payment of $130,428?

Solution:

Copyright Michael R. Roberts

Problem 10. Stock Return

If you invested $100 in a portfolio of small stocks in 1925
and reinvested all dividends, your portfolio would be worth
$2,655,590 in 2011. (This is true.) What is the typical
annual rate of return on your investment?
Solution:
0

85

100
PV0 CF86

86

$2,655,590
CF86

1 R

Copyright Michael R. Roberts

86

100

2, 655,590

1 R

86

1/86

2, 655,590
R

100

1 0.1258

Problem 11. Company Value

Your candy store generates enough after-tax profit to pay
dividends of $50,000 per year. You plan on closing the
store and liquidating all of the assets for $200,000 three
years from today immediately after receiving the last
dividend payment. What is the value of your store today if
the discount rate is 12%, you do not owe any money (i.e.,
no debt), and the next dividend will be received one year
from today?

Copyright Michael R. Roberts

Problem 11. Company Value

(Cont)
Solution:
0

50,000

50,000

250,000

Copyright Michael R. Roberts