BBA307 Assignment 4.1 Solutions 1.

Draw a timeline for (1) a $100 lump sum cash flow at the end of year 2, (2) an ordinary annuity of $100 per year for 3 years and (3) an uneven cash flow stream of -$ 0, $100, $! , and $ 0 at the end of years 0 throu"h 3. Solution # time line is a "raphical representation which is used to show the timin" of cash flows. $he tic% mar%s represent end of periods (often years), so time 0 is today& time 1 is the end of the first year, or 1 year from today& and so on. 0 -, 1
' '

2 year
' 100

lump sum cash flow 2

'

0 -,
'

1 100 1
' '

3 annuity 100

' ' 100

'

0 -,
'

2 !

3 uneven cash flow stream 0

- 0

100

# lump sum is a sin"le flow& for e(ample, a $100 inflow in year 2, as shown in the top time line. #n annuity is a series of e)ual cash flows occurrin" over e)ual intervals, as illustrated in the middle time line. #n uneven cash flow stream is an irre"ular series of cash flows which do not constitute an annuity, as in the lower time line. - 0 represents a cash outflow rather than a receipt or inflow.

2. *alculate the followin"+

a. $he future value of an initial $100 after 3 years assumin" annual interest of 10,. Solution:

.how dollars correspondin" to )uestion mar%, calculated as follows+

'

0 10,
'

1
' '

3 /0 1 2

100 #fter 1 year+

/01 1 30 4 -1 1 30 4 30(-) 1 30(1 4 -) 1 $100(1.10) 1 $110.00. .imilarly+ /02 1 /01 4 -2 1 /01 4 /01(-) 1 /01(1 4 -) 1 $110(1.10) 1 $121.00 1 30(1 4 i)(1 4 i) 1 30(1 4 i)2. /03 1 /02 4 -3 1 /02 4 /02(-) 1 /02(1 4 -) 1 $121(1.10)1$133.10130(1 4 -)2(1 4 -)130(1 4 -)3. -n "eneral, we see that+ /0n 1 30(1 4 -)5, .6 /03 1 $100(1.10)3 1 $100(1.3310) 1 $133.10. 5ote that this e)uation has 7 varia8les+ /0 5, 30, -, and 5. 9ere we %now all e(cept /05, so we solve for /0 5. :e will, however, often solve for one of the other three varia8les. ;y far, the easiest way to wor% all time value pro8lems is with a financial calculator. <ust plu" in any 3 of the four values and find the 7th. /indin" future values (movin" to the ri"ht alon" the time line) is called compoundin". 5ote that there are 3 ways of findin" /03+ usin" a re"ular calculator, financial calculator, or spreadsheets. /or simple pro8lems, we show only the re"ular calculator and financial calculator methods. (1) re"ular calculator+ 1. $100(1.10)(1.10)(1.10) 1 $133.10. 2. $100(1.10)3 1 $133.10.

(2)

financial calculator+ $his is especially efficient for more comple( pro8lems, includin" e(am pro8lems. -nput the followin" values+ 5 1 3, - 1 10, 30 1 -100, 3=$ 1 0, and solve for /0 1 $133.10.

8. $he present value of $100 to 8e received in 3 years if the discount rate is 10,. Solution: /indin" present values, or discountin" (movin" to the left alon" the time line), is the reverse of compoundin", and the 8asic present value e)uation is the reciprocal of the compoundin" e)uation+ 0
'

10,
'

1
' '

3 100

30 1 2 /0n 1 30(1 4 -)5 transforms to+ 30 1 thus+ 30 1 $100

1 1 . 10
3

/0n (1 + i)
n

1 /0n

1 1 + i

1 /0n(1 4 i)-n

1 $100(30-/i,n) 1 (0.! 13) 1 $! .13.

$he same methods used for findin" future values are also used to find present values. >sin" a financial calculator input 5 1 3, - 1 10, pmt 1 0, /0 1 100, and then solve for 30 1 $! .13.

3. -f a company?s sales are "rowin" at a rate of 20, per year, how lon" will it ta%e for the sale to dou8le2 Solution:

:e have this situation in time line format+ 0 20,

' ' '

1
' ' '

3.@ 2

-12

.ay we want to find out how lon" it will ta%e us to dou8le our money at an interest rate of 20,. :e can use any num8ers, say $1 and $2, with this e)uation+ /0n 1 $2 1 $1(1 4 i)n 1 $1(1.20)n. (1.2)n n B5(1.2) n n 1 $2A$1 1 2 1 B5(2) 1 B5(2)AB5(1.2) 1 0.CD3A0.1@2 1 3.@.

#lternatively, we could use a financial calculator. :e would plu" - 1 20, 30 1 -1, 3=$ 1 0, and /0 1 2 into our calculator, and then press the 5 8utton to find the num8er of years it FV would ta%e 1 (or any other 8e"innin" amount) to dou8le when "rowth occurs at a 20, 2 rate. $he answer is 3.@ years, 8ut some calculators will round this value up to the ne(t hi"hest whole num8er. $he "raph also 1 shows what is happenin".
3.8

Year

7. -n order for an investment to dou8le in 3 years, what interest rate must it earn2 Solution:

0
' ' '

1
'

2 1(1 4 i)2 1(1 4 i)3

3 2

-1 1(1 4 i) /0 1 $1(1 4 i)3 $1(1 4 i)3 (1 4 i)3 14i 14i i 1 $2. 1 $2. 1 $2A$1 1 2. 1 (2)1A3 1 1.2 DD 1 2 .DD,.

>se a financial calculator to solve+ enter 5 1 3, 30 1 -1, 3=$ 1 0, /0 1 2, then press the - 8utton to find - 1 2 .DD,. *alculators can find interest rates )uite easily, even when periods andAor interest rates are not even num8ers, and when uneven cash flow streams are involved. (:ith uneven cash flows, we must use the E*/B6E function, and the interest rate is called the -FF, or Einternal rate of return&E we will use this feature in capital 8ud"etin".)

. >sin" a timeline, show e(amples of an ordinary annuity and an annuity due. Solution: . 0
' ' '

1
'

2 100

3 100

100

$his is an ordinary annuity--it has its payments at the end of each period& that is, the first payment is made 1 period from today. *onversely, an annuity due has its first payment today. -n other words, an ordinary annuity has end-ofperiod payments, while an annuity due has 8e"innin"-of-period payments. $he annuity shown a8ove is an ordinary annuity. $o convert it to an annuity due, shift each payment to the left, so you end up with a payment under the 0 8ut none under the 3. C. *alculate the future value of a 3-year ordinary annuity of $100 if the interest rate is 10,. Solution+

0
' ' '

1
'

2 100 110

3 100 121 $331

100

Go throu"h the followin" discussion. 6ne approach would 8e to treat each annuity flow as a lump sum. 9ere we have /0#n 1 $100(1) 4 $100(1.10) 4 $100(1.10)2 1 $100H1 4 (1.10) 4 (1.10)2I 1 $100(3.3100) 1 $331.00.

>sin" a financial calculator, 5 1 3, - 1 10, 30 1 0, 3=$ 1 -100. $his "ives /0 1 $331.00.

!. *alculate the present value of a 3-year ordinary annuity of $100 if the discount rate is 10,. Solution: 0
|

1
|

2
|

3
|

100 D0.D1 @2.C7 ! .13 $27@.C@

100

100

$he present value of the annuity is $27@.C@. >sin" a financial calculator, input 5 1 3, - 1 10, 3=$ 1 100, /0 1 0, and press the 30 8utton. .preadsheets are useful for time lines with multiple cash flows. $he followin" spreadsheet shows this pro8lem+ 1 2 3 # 0 27@.CD ; 1 100 * 2 100 D 3 100

$he e(cel formula in cell #3 is 1 530(10,,;2+D2). $his "ives a result of 27@.CD. 5ote that the interest rate can 8e either 10, or 0.10, not Just 10. #lso, note that the ran"e does not include any cash flow at time Kero.

L(cel also has special functions for annuities. /or ordinary annuities, the e(cel formula is 1 30(interest rate, num8er of periods, payment). -n this pro8lem, 1 30(10,,3,-100), "ives a result of 27@.DC. /or the future value, it would 8e 1 /0(10,,3,-100), with a result of 331.

@. Fedo calculations for steps C and ! assumin" an annuity due. Solution: -f the annuity were an annuity due, each payment would 8e shifted to the left, so each payment is compounded over an additional period or discounted 8ac% over one less period. $o find the future value of an annuity due use the followin" formula+ /0#n(#nnuity Due) 1 /0#n(1 4 i). -n our situation, the future value of the annuity due is $3C7.10+ /0#3(#nnuity Due) 1 $331.00(1.10)1 1 $3C7.10. $his same result could 8e o8tained 8y usin" the time line+ $133.10 4 $121.00 4 $110.00 1 $3C7.10. $he 8est way to wor% annuity due pro8lems is to switch your calculator to E8e"E or 8e"innin" or EdueE mode, and "o throu"h the normal process. 5ote that itMs critical to remem8er to chan"e 8ac% to EendE mode after wor%in" an annuity due pro8lem with your calculator. $his formula could 8e used to find the present value of an annuity due+ 30#n(#nnuity Due) 1 30#n(1 4 i) 1 3=$(30-/#i,n)(1 4 i). -n our situation, the present value of the annuity due is $2!3. C+ 30#3(#nnuity Due) 1 $27@.CD(1.10)1 1 $2!3. C. $he L(cel function is 1 30(10,,3,-100,0,1). $he fourth term, 0, tells L(cel there are no additional cash flows. $he fifth term, 1, tells L(cel it is an annuity due. $he result is $2!3. C. # similar modification "ives the future value+ 1 /0(10,,3,-100,0,1), with a result of 3C7.10.

D. *alculate the present value of an uneven cash flow stream of $100 at the end of year 1, $300 at the end of year 2, $300 at the end of year 3, -$ 0 at the end of year 7 assumin" a discount rate of 10,. Solution:

0
' ' '

1
' '

2 300

3 300

7 years - 0

100

9ere we have an uneven cash flow stream. $he most strai"htforward approach is to find the 30s of each cash flow and then sum them as shown 8elow+ 0 10, 1
' ' ' ' '

7 years

100 300 300 - 0 D0.D1 27!.D3 22 .3D (37.1 ) 30.0@ 5ote (1) that the $ 0 year 7 outflow remains an outflow even when discounted. $here are numerous ways of findin" the present value of an uneven cash flow stream. ;ut 8y far the easiest way to deal with uneven cash flow streams is with a financial calculator or a spreadsheet. *alculators have a function which on the 93 1!; is called E*/B6,E for Ecash flow.E 6ther calculators could use other desi"nations such as cf0 and */i, 8ut they e(plain how to use them in the manual. Nou would input the cash flows, so they are in the calculatorMs memory, then input the interest rate, -, and then press the 530 or 30 8utton to find the present value. .preadsheets are especially useful for uneven cash flows. $he followin" spreadsheet shows this pro8lem+ 1 2 3 30.0D $he L(cel formula in cell #3 is 1 530(10,,;2+L2), with a result of 30.0D. # 0 ; 1 100 * 2 300 D 3 300 L 7 - 0

10. *alculate the future value of $100 after years under 12, annual compoundin"2 .emiannual compoundin"2 Ouarterly compoundin"2 =onthly compoundin"2 solution: >nder annual compoundin", the $100 is compounded over periods at a 12.0 percent periodic rate+ i5om 1 12,. annual

5om /0n 1 30 1 $100 1 + 1 $100(1.12) 1 $1!C.23. 1 + m 1 >nder semiannual compoundin", the $100 is compounded over 10 semiannual periods at a C.0 percent periodic rate+

mn

0.12

1P

i5om 1 12,.
5om /0n 1 30 1 + m

mn

1 $100 1 +

0.12 2

2P

1 $100(1.0C)10 1 $1!D.0@.

)uarterly+ /0n 1 $100(1.03)20 1 $1@0.C1. monthly+ /0n 1 $100(1.01)C0 1 $1@1.C!.

11. *alculate the effective rate of interest for a nominal rate of 12, compounded semiannually2 *ompounded )uarterly2 *ompounded monthly2 Solution: /or 12 percent semiannual compoundin", the ear is 12.3C percent+ L#F 1 Lffective #nnual Fate 1
1 + i 5om m
m

1.0.

-/ i5om 1 12, and interest is compounded semiannually, then+ L#F 1

0.12 1 + 1.0 2
2

1 (1.0C)2 Q 1.0 1 1.123C Q 1.0 1 0.123C 1 12,3C,.

/or )uarterly compoundin", the effective annual rate is+ (1.03)7 - 1.0 1 12. ,.

/or monthly compoundin", the effective annual rate is+ (1.1.12 - 1.0 1 12. ,.

12. :ill the effective rate ever e)ual the nominal rate2 Solution: -f annual compoundin" is used, then the nominal rate will 8e e)ual to the effective annual rate. -f more fre)uent compoundin" is used, the effective annual rate will 8e a8ove the nominal rate.