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TUTORIAL QUESTION AN D
SOLUTION
Question 1
Present and future
values
S O L U T IO N
a.
Given,
Present value (PV) = . 500
Interest rate (i) = 6%
0
6%
- 500
b.
FV = ?
FVn
= PV(1 + i)n
FV1
= PV (1 + i)1
= 500 (1 + 0.06)1 = . 530
Present value (PV) = . 500
Interest rate (i) = 6%
0
6%
- 500
FVn
FV2
c.
d.
2
FV = ?
i)n
= PV(1 +
= PV (1 + i)2
= . 500 (1 + 0.06)2 = . 561.80
Answer:
= . 471.70
Future value (FV) = . 500
Interest rate (i) = 6%
No. of periods (n) = 2
Present value (PV) = ?
0
6%
PV = ?
PV
FVn
FV2
= (1 + i)n = (1 + i)2
= 445
2
FV = 500
Question 2
Future value
Suppose John deposits 10,000 in a bank account that pays 10 percent interest annually.
How much money will be in his account after 5 years?
SOLUTION
10%
FV = ?
10,000
We have,
FV5 = PV (1 + k)n = 10,000 (1.10)5
= 10,000 1.6105
= 16,105.10
John will have 16,105.10 at the end of year 5 in his account.
Question 3
Present value
SOLUTION
What is the present value of a security that promises to pay you 5,000 in 20 years?
Assume that you can earn 7 percent if you were to invest in other securities of equal risk?
Here, Future value (FV) = 5,000
Number of years (n) = 20 years
Interest rate (k) = 7%
Present value (PV) = ?
0
7%
PV = ?
20
5,000
We have,
FV20
PV = (1 + k)n = 5000/ (1.07)20
=5000/3.8697 = 1,292.09
Question 4
Time for a lump
sum to double
If you deposit money today into an account that pays 6.5 percent interest, how long will it
take for you to double your money?
SOLUTION
6.5%
PV = 1000
We have,
FV
Present value (PV) = (1 + i)n
or,
n=?
FV = 2,000
Question 5
Effective rate of
interest
Your broker offers to sell a note for 13250 that will pay 2345.05 per year for 10 years. If
you buy the note, what rate of interest will you be earning? Calculate to the closest
percentage.
S O L U T IO N
Here,
Present value of annuity (PVA) = . 13,250
Periodic equal payment (PMT) = . 2345.05
No. of periods (n) = 10 years
Interest rate (i) = ?
Time Line
0
PVA =
13250
1
2345.05
2345.05
2345.05
2345.05 2345.05
2345.05
2345.05
8
2345.05
10
2345.05 2345.05
We have,
PVA = PMT PVIFA i n yrs.
or,
. 13,250 = . 2345.05 PVIFAi% 10 yrs
or,
PVIFAi%, 10 yrs = 5.6502
From the PVIFA table, the value of 5.6502 in 10 years lies at 12%.
Question 6
Effective rate of
interest
Your parents are planning to retire in 18 years. They currently have 250,000, and they
would like to have 1,000,000 when they retire. What annual rate of interest would they
have to earn on their 250,000 in order to reach their goal, assuming they save no more
money?
SOLUTION
i=?
18
1,000,000
We have,
FV = PV (1 + i)n
or, 1,000,000 = 250,000 (1 + i)18
or, (1 + i)18 = 1,000,000/ 250,000
or, (1 + i)18 = 4
or, 1 + i = (4)1/18
or, i = 1.08 - 1 = 0.08 or 8%
Question 7
Future value of an
annuity
SOLUTION
What is the future value of a 5-year ordinary annuity that promises to pay you 300 each
year? The rate of interest is 7 percent.
7%
300
300
3
300
We have,
300
FVA = ?
(1 + i) - 1
i
(1 + 0.07)5 - 1
= 300
0.07
FVA = PMT
Question 8
Future value of an
annuity due
What is the future value of a 5-year annuity due that promises to pay out 300 each year?
Assume that all payments are reinvested at 7% a year, until year 5.
SOLUTION
7%
300
2
300
3
300
FVA (due) = ?
We have,
(1 + i)n - 1
i
(1 + i)
(1 + 0.07)5 - 1
= 300
0.07 (1 + 0.07)
= 300 5.7507 1.07 = 1,845.97
FVAdue = PMT
Question 9
Expected rate of
return
A company invests 4 million to clear a tract of land and to set out some young pine
trees. The trees will mature in 10 years, at which time the company plans to sell the forest
at an expected price of 8 million. What is company's expected rate of return?
SOLUTION
i=?
We have,
4 million
FV = PV (1 + i)n
or, 8,000,000
or, (1 + i)10
or, (1 + i)10
or, 1 + i
i
Question 10
Solving for payment
10
8 million
= 4,000,000 (1 + i)10
=8,000,000/ 4,000,000
=2
= (2)1/10
= 1.0718 - 1
= 0.0718 or 7.18%
Rachel wants a refrigerator that costs 12000. She has arranged to borrow the total
purchase price of refrigerator from a finance company at a simple interest rate equal to 12
percent. The loan requires quarterly payments for a period of three years. If the first
payment is due three months after purchasing the refrigerator, what will be the amount
of her quarterly payments on the loan?
SOLUTION
Given,
Present value of an annuity (PVA) = . 12,000
Simple interest rate per annum (i) = 12%
Loan requires quarterly payment i.e. m = 4
Number of years (n) = 3 year
Periodic equal payment (PMT) = ?
Time line:
0 12% 1
-12000
PMT
PMT
PMT
PMT
12
PMT
We have,
or,
or,
Question 11
Reaching a financial
goal
1
1 n m
(1
+
i/m)
PVA = PMT
i
1
1 3 4
(1 + 0.12/4)
12,000 = PMT
0.12
You need to accumulate 10,000. To do so, you plan to make deposits of 1,250 per year,
with the first payment being made a year from today, in a bank account which pays 12
percent annual interest compounded annually. Your last deposit will be less than 1,250
if less is needed to round out to 10,000. How many years will it take you to reach your
10,000 goal, and how large will the last deposit be?
SOLUTION
Here,
Annual payment (PMT) = 1,250
Future value of annuity (FVAn) = 10,000
Question 12
Loan amortization
SOLUTION
Payments
298,311.5566
298,311.5566
InterestPayment of Principal
150,000
127,753.2665
148,311.5566
170,558.2901
Ending Balance
851,688.4434
681,130.1533
Question 13
Loan amortization
You are branch manager of town centre Natwest Bank, Manchester. A borrower
approaches you for a term loan of 500,000. You agreed to give loan to be fully
amortized in a period of 5 year at 10 percent, annual payment. What will be the size of
each installment? What fraction of the payment made at the end of second year represents
repayment of interest?
SOLUTION
PVA
PMT = PVIFA
i n
= 131898.28
Preparation of Amortization Schedule,
Amortization schedule
Year
Beginning
balance
1
2
500,000
418,101.72
PMT
Interest
131,898.28
131,898.28
Repayment of
principal
50,000
41,810.17
81898.28
90,088.11
Ending
balance
418,101.72
328,013.61
Question 14
a.
Non annual
compounding
b.
It is now January 1, 2007. You plan to make 5 deposits of 100 each, on every 6
months, with the first payment being made today. If the bank pays a nominal
interest rate of 12 percent, but uses semiannual compounding, how much will be
in your account after 10 years?
Ten years from today you must make a payment of 1,432.02. To prepare for this
payment, you will make 5 equal deposits, beginning today and for the next 4
quarters, in a bank that pays a nominal interest rate of 12 percent, quarterly
compounding. How large must each of the 5 payments be?
SOLUTION
a.
Here,
Number of deposits (n) = 5 deposits;
Semiannual (every 6 months), payment = 100;
Nominal interest rate (i) = 12%,
Present value of annuity (PVA) = ?
0
100
6%
100
100
2
100
100
10
FV = ?
We have,
(1 + i)n - 1
(1 + 0.06)5 - 1
(1 + i) = 100
i
0.06 (1 + 0.06)
= 100 5.6371 1.06 = 597.5326
Now remaining period is 15 periods (20 periods - 5 periods), so we calculate the
future value of this 597.5326 for remaining periods.
We have,
FV = PV (1 + i)n = 597.5326 (1 + 0.06)15 = 1,432.02
b.
Here,
Future value at the end of 10 years = 1,432.02;
n = 35 periods because quarterly compounding (in 10 years there are 40 quarters);
Quarterly interest rate = 3%,
PMT = ?, PV = ?
FVA = PMT
3%
We have,
10
FV = 1,432.02
FV
PV = (1 + i)n = 1,432.02/(1+0.03)35 = 508.91
Now we calculate the payment (PMP)
Here, n = 5 periods, i = 3%, PV = ?; FV = 508.91, FVA = 508.91
PMT = ?
We have,
(1 + i)n - 1
FVA = PMT
i (1 + i)
(1 + 0.03)5 - 1
or, 508.91
= PMT
0.03 (1 + 0.03)
or, 508.91
= PMT 5.3091 1.03
PMT
= 508.91/ 5.4684 = 93.06
Question 15
Value of an annuity
The prize in last week's Lottery was estimated to be worth 35 million. If you were lucky
enough to win, then it will pay you 1.75 million per year over the next 20 years. Assume
that the first installment is received immediately.
a.
If interest rates are 8 percent, what is the present value of the prize?
b.
If interest rates are 8 percent, what is the future value after 20 years?
c.
How would your answers change if the payments were received at the end of each
year?
SOLUTION
(1 + 0.08)
PVA = PMT
i
0.08
(1 + i) = 1.75
b.
(1 + i)
= 1.75
(1 + 0.08)20 - 1
0.08
(1 + 0.08)
1
1
(1 + 0.08)20
= 1.75
0.08
= 1.75 9.8181
= 17.18 million
Future value of annuity (FV) = ?, Interest rate (i) 8%
FVA
20
(1 + i)n - 1
(1 + 0.08) - 1
=
1.75
i
0.08
= PMT
= 1.75 45.7620
= 80.08 million
Question 16
Solving for time
Ashley has 42,180.53 in brokerage account, and plans to contribute an additional 5,000
every year at an annual interest rate of 12 percent. If Ashley has to accumulate 250,000,
how many years will it take for him to reach his goal?
SOLUTION
12%
5000
5000
3
5000
2,50,000
We have,
(1 + 0.12)n - 1
0.12
= 250,000
or, 5,061.66 (1.12)n + 5,000 (1.12)n - 5,000 = 30,000
or, 10,061.66 (1.12)n = 35,000
or, (1.12)n = 35,000/ 10,061.66
or, (1.12)n = 3.4786
... (i)
In above eqn. (i) if we go for trying several values of 'n', the left hand side is exactly
equal to right hand side at n = 11.
The required no. of years to reach the goal is 11 years.
42,180.53 (1 + 0.12)n + 5,000
Question 17
Future value of an
annuity
Your client is 40 years old and wants to begin saving for retirement. You advise the client
to put 5,000 a year into the stock market. You estimate that the market's return will be,
on average, 12 percent a year. Assume the investment will be made at the end of the year.
a.
If the client follows your advice, how much money will she have by age 65?
b.
How much will she have by age 70?
SOLUTION
Here, Your client is 40 years old, Payment (PMT) = 5,000, Interest rate (i) = 12%
Investment will be made at the end of the year
a.
Future value of annuity (FVA) at the age of 65?
Number of periods (n) = 65 - 40 = 25 years
(1 + i)n - 1
(1 + 0.12)25 - 1
FVA = PMT
= 5,000
i
0.12
,
5,000
i
0.12
= 5,000 241.3327
= 1,206,66
Question 18
Solving for payment
Jason has inherited 25,000 and wishes to purchase an annuity that will provide him with
a steady income over the next 12 years. He has heard that the local savings and loan
association is currently paying 6 percent compound interest on an annual basis. If he were
to deposit his funds, what year-end equal pound amount (to the nearest pound) would he
be able to withdraw annually such that he would have a zero balance after his last
withdrawal 12 years from now?
SOLUTION
Here,
Present value of annuity (PVA) = 25,000
Number of years (n) = 12 years
Interest rate (i) = 6%
Equal annual withdraw (PMT) = ?
1 - 1 n
(1 + i)
PVA = PMT
i
1
1
(1 + 0.06)12
or,
25,000 = PMT
0.06
or,
25,000 = PMT 8.3838
PMT = 2,981.9414
Question 19
Solving for payment
You need to have 50,000 at the end of 10 years. To accumulate this sum, you have
decided to save a certain amount at the end of each of the next 10 years and deposit it in
the bank. The bank pays 8 percent interest compounded annually for long term deposits.
How much will you have to save each year (to the nearest Pound)?
SOLUTION
Question 20
Annual interest rate
(1 + i)n - 1
i
FVA
= PMT
or, 50,000
= PMT
or, 50,000
= PTM 14.4866
PMT
= 50,000/14.4866
= 3,451.46
(1 + 0.08)10 - 1
0.08
Louise wishes to borrow 10,000 for three years. A group of individuals agrees to lend
her this amount if she contracts to pay them 16,000 at the end of the three years. What is
the implicit compound annual interest rate you receive (to the nearest whole percent)?
SOLUTION
or,
or,
Question 21
Uneven cash flow
stream
SOLUTION
(1.6)1/3 - 1 = 1
i = 0.1695 or 16.95%
Calculate the present value of the following cash flow stream. Assume that the stated rate
of interest is 14 percent per annum discounted semiannually.
Cash flow
1000
1600
1500
End of year
1
2
If stated annual rate is014 percent, discounted
semiannually,
first we3 calculate the effective
annual rate as follows:
Effective interest rate (EAR) = (1 + 0.14/2)2 - 1 = 14.49%
Now present value of given cash flow stream discounted at 14.49 percent effective annual
rate is calculated as follows:
Year
0
1
2
3
Cash flow
1,000
1,600
1,500
850
14.49% PVIF
1.0000
0.8734
0.7629
0.6663
Question 22
Uneven cash flow
stream
850
PV
1,000.00
1,397.44
1,144.35
566.36
4,108.15
National Lottery has offered you the choice of the following alternative payments.
Alternative 1: 10,000 one year from now
Alternative 2: 20,000 five years from now.
a.
Which should you choose if the discount rate is 0 percent? 20 percent?
b.
What rate makes the options equally attractive?
SOLUTION
a.
Calculation of present value if discount rate is 0 percent
Alternative 1:
FV
10000
PV = (1+i)n = (1+0)1 = 10,000
Alternative 2:
FV
20000
PV = (1+i)n = (1+0)5 = 20,000
If discount rate is 0 percent, Alternative 2 is preferable because of higher present
value.
Calculation of present value if discount rate is 20 percent
Alternative 1:
FV
10000
PV = (1+i)n = (1+0.20)1 = 8,333.33
Alternative 2:
FV
20000
PV = (1+i)n = (1+0.20)5 = 8,037.55
If discount rate is 20 percent, Alternative 1 is preferable because of higher present
value.
b.
Calculation of rate of interest (i) at which both the options are equally likely
PV of Alternative 1 = PV of Alternative 2
10000 20000
(1+i)1 = (1+i)5
(1+i)4 = 2
i = (2)1/4 1 = 0.1892 or 18.92%
That is, if the discount rate is 18.92 percent both the alternative would produce equal
present value so that both are equally likely.