Additional Review Questions Answers

Answers are available on Myuni on Friday Week 3

All questions use one of the following formulas:

Future value annuity formula

* 1 i 1
pmt
FV
n

i
Present value annuity formula

pmt 1
PV * 1
i 1 i
n

27. Find the future value of the following ordinary annuities (payments begin one year
from today and all
interest rates compound annually):
a. $100 per year for 10 years at 9%.
b. $500 per year for 8 years at 15%.
c. $800 per year for 20 years at 7% .
d. $1,000 per year for 5 years at 0%.
e. Now find the present values of the annuities in a-d.
f. What is the relationship between present values and future values?

Solution:
a. FVPMT(100, 9%, 10) = 1519.29
b. FVPMT(500, 15%, 8) = 6863.41
c. FVPMT(800, 7%, 20) = 32796.39
d. Too easy! It is just $5,000 for both the future value and the present value.
e.
a) PVPMT(100, 9%, 10) = 641.77
b) PVPMT(500, 15%, 8) = 2243.66
c) PVPMT(800, 7%, 20) = 8475.21

f. Present values of cash streams are less (unless the interest rate is zero) than future
values and the difference increases with the interest rate.

8. You win a $1 million lottery which pays you $50,000 per year for 20 years, beginning
one year from now. How much is your prize really worth assuming an interest rate of
8% per year?
 Solution: PVPMT(50000, 8%, 20) = 490907.37

That million dollar lottery is really only a $490,907.37 lottery.

11. You borrow $100,000 from a bank for 30 years on a one-year adjustable rate
mortgage(ARM), which means that the 10.5% interest applies for only the first year. If
the interest rate goes up to12% in the second year of the loan, what will your new
monthly payment be?

Solution:
Three steps (similar to question 2)

1) First calculate the monthly payment :

PVPMT 914.74 (100,000 PV, 10.5%/12 rate and 12*30 (n*m))

2) Then calculate the outstanding balance at the end of the first year. The balance
remaining is equal to the present value, at that point in time, of the remaining
payments discounted at the loan interest rate.
Therefore after the first 12 payments there are 348 remaining $914.74 payments.
The present value is then: PVPMT 914.74
= 99499.57 or an outstanding balance of $99,499.57.

3) The new payment is then calculated on a loan of $99,499.57 at a 12% APR over
29 years. This gives a new monthly payment for the ARM of: PMTPV 99499.57
= 1027.19 So the new payment is $1,027.19 per month.