Problem Set-Solutions

Financial Management
Professor Kuhle

1. Find the future value at the end of year 3 of the following stream of cash flows
received at the end of each year, assuming the firm can earn 8% on its
investments:

Year Amount

1 $10,000 $11,664
2 $16,000 $17,280
3 $19,000 $19,000
$47,440

2. What is the highest effective rate attainable with a 12% nominal rate? 12.75%

3. Bill plans to fund his individual retirement account with the maximum
contribution of $2,000 at the end of each year for the next 20 years. If Bill can
earn 12% on his contributions, how much will he have at the end of the twentieth
year? $2000 = pmt; 20 = n; 12 = I; comp FV = $144,000

4. The future value of an annuity of $1,000 each year for 10 years, deposited at
12% compounded quarterly is: -$1,000 = pmt; 10 = n; 12 = i; comp FV = $17,548.74

5. The future value of a $2,000 annuity due deposited at 8% compounded annually

for each of the next 10 years is: -$2,000 pmt; 8 = I; 10 = n; comp FV = $28,973.12

6. The present value of a $25,000 perpetuity at a 14% discount rate is: 25000/.14 =
$178,571.43

7. What is the present value of $100 received at the end of year 1, $200 received at
the end of year 2, $300 at the end of year 3, and $400 received at the end of year
4, when the discount rate is 9%. 9 = i; 0 CFi ; 100 CFi ; 200 CFi ; 300 CFi ;
400 CFi ; NPV = $775.10

8. Ms. Smith owns stock in a company, which has consistently paid a growing
dividend over the last 10 years. The first year she owned the stock, she received
$4.50 per share and in the 10th year she received $5.62 per share. What is the
growth rate of the dividends over the last 10 years? -4.5 = PV; 5.62=FV; 10= n;
comp i = 2.25%

9. A local brokerage firm is offering a zero coupon certificate of deposit for

$10,000. At maturity, three years from now, the investor will receive $14,000.
What is the annual rate of return on this investment? –10000 = PV; 14,000 = FV;
3= n; comp i = 11.87%
10. A beach house in southern California now costs $1,000,000. Inflation is
expected to cause this price to increase at 4% per year over the next 20 years
before Louis and Kate retire. How large of an equal annual end-of-year deposit
must be made in order to be able to buy the beach house at retirement? Assume
the couple can earn 15% per year on their deposits. PV = 1000000; i = 4; 20 = n;
comp FV = $2,191,123 need this much in 20 years. Now 2,191,123 = FV;15= i;
20 = n; comp pmt = $21,388.

11. To purchase a piece of new equipment for your company, you have narrowed
down the possibilities to two models, which perform equally well. However,
their methods of payments are different. Alternative 1 requires $5,000 per year
for the next five years. Alternative 2 requires the following payment schedule.
Which alternative should you select if your cost of capital is 8%?

Year Payment
1 $7,000
2 $6,000
3 $5,000
4 $4,000
5 $3,000 Alternative 1: -5000 = pmt; 8 = i; 5 = n;
comp PV = $19,964; Alternative 2: 8=I; 0 = Cfi; 7000 =
Cfi; 6000 = Cfi; 5000 = Cfi; 4000 = Cfi; 3000 = Cfi;
NPV = $20,577; select alternative 1 it is less money.

12. A firm wishes to establish a fund, which in 10 years will accumulate to

$10,000,000. The fund will be used to repay an outstanding bond issue. The firm
plans to make deposits, which will earn 12%, to this fund at the end of each of
the 10 years prior to maturity of the bond. How large must these payments be to
accumulate the $10,000,000? $10,000,000 = FV; 10 = n; 12 = I; comp pmt =
$569,842

13. To expand its operation, the ITC Company has applied for a $3,500,000 loan.
According to ITC’s financial manager, the company can only afford a maximum
yearly loan payment of $1,000,000. The bank has offered 1) a 3-year loan with a
10% annual interest rate, 2) a 4-year loan with an 11% annual interest rate, or 3) a
5-year loan with a 12% annual interest rate.
a. Compute the loan payments under each option.
b. Which option should the ITC Company choose based on your
analysis?

1) -3,500,000 = PV; 3 = N; 10 = I; comp pmt = $1,407,402

2) -3,500,000 = PV; 4 = N; 11= I; comp pmt = $1,128,142
3) -3,500,000 = PV; 5 = N; 12 = I; comp pmt = $970,934
 14. To buy his favorite car, Larry is planning to accumulate money by investing his
Christmas bonuses for the next five years in a security, which pays 15% annually.
The car will cost $40,000 at the end of the fifth year and Larry’s Christmas bonus
is $7,200 a year. Will Larry accumulate enough money to buy the car?

5 = N; $7200 = pmt; 15 = I; comp FV = $48,545

15. Suzy wants to buy a house but does not want to get a loan. The average price of
her dream house is $500,000 and its price is growing at 5% per year. How much
should Suzy invest in a project at the end of each year for the next 5 years in order to
accumulate enough money to buy her dream house with cash at the end of the fifth
year? Assume the project pays 12% annually.

Part I: Determine the cost of the house 5 years from now:

$500,000 = PV; 5 = I; 5 = N; comp FV = $638,140

Part II: Determine the payment:

$598,356 = FV; 5 = N; 12 = I; comp pmt = $100,449.

15. The Associated Dry Goods Corp. zero coupon bond has 7 years to
maturity and a face value of $1,000. What is the YTM on the bond if it
sells $759.92?.
7 = N; 1000 = FV; -759.92 = PV; CPT I/Y = 4%

16. To raise funds for Gravina Island Bridge, the Government of

Alaska issued bonds. The bonds have a face value of $1,000, 15 years
to maturity and a 3% coupon rate. If the bond has a AA rating and
bonds of similar risk yield 2.75%, what would the bond be selling at in
the market?

15 = N; 1000 = FV; 30 = PMT; 2.75 = I/Y; CPT PV = 1030.39

17. How much should an investor pay for a bond that returns $10,000
at the end of five years if market interest rates are 4%?

10000 = FV; 5 = N; 4 = I/Y; CPT PV= $8,219.27

18.) In September 2000 the Pullman Group arranged a bond issue for
the estate of the late Marvin Gaye. The collateral on the bonds (and
source of cash flow for interest and principal payments) consisted of
future royalties from classic songs such as "What's Going On," and "I
Heard It Though The Grapevine." The bond issue had a $1,000 face
value and a coupon rate of 5%. If the bond matures in 26 years, pays
semiannual coupons, and the yield to maturity is 3%, what will the
bond sell for? Calculate your answer to two decimal points.
1000 = FV; 52 = N; 25 = PMT; 1.5 = I/Y; CPT PV = $1,359.29