Chapter 02 - How to Calculate Present Values

CHAPTER 2
How to Calculate Present Values
Answers to Problem Sets
1. If the discount factor is .507, then .507*1.12 6 = $1
2. 125/139 = .899
3.

PV = 374/(1.09)9 = 172.20

4.

PV = 432/1.15 + 137/(1.152) + 797/(1.153) = 376 + 104 + 524 = $1,003

5. FV = 100*1.158 = $305.90
6.

NPV = -1,548 + 138/.09 = -14.67 (cost today plus the present value of the
perpetuity)

7. PV = 4/(.14-.04) = $40
8. a. PV = 1/.10 = $10

9.

b.

Since the perpetuity will be worth $10 in year 7, and since that is roughly
double the present value, the approximate PV equals $5.
PV = (1 / .10)/(1.10)7 = 10/2= $5 (approximately)

c.

A perpetuity paying $1 starting now would be worth $10, whereas a

perpetuity starting in year 8 would be worth roughly $5. The difference
between these cash flows is therefore approximately $5. PV = 10 5= $5
(approximately)

d.

PV = C/(r-g) = 10,000/(.10-.05) = $200,000.

a.

PV = 10,000/(1.055) = $7,835.26 (assuming the cost of the car does not

appreciate over those five years).

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Chapter 02 - How to Calculate Present Values

10.

b.

You need to set aside (12,000 6-year annuity factor) = 12,000 4.623 =
$55,476.

c.

At the end of 6 years you would have 1.08 6 (60,476 - 55,476) = $7,934.

a.

FV = 1,000e.12x5 = 1,000e.6 = $1,822.12.

b.

PV = 5e-.12 x 8 = 5e-.96 = $1.914 million

c.

PV = C (1/r 1/rert) = 2,000(1/.12 1/.12e .12 x15) = $13,912

a.

FV = 10,000,000x(1.06)4 = 12,624,770

b.

FV = 10,000,000x(1 + .06/12)(4x12) = 12,704,892

c.

FV = 10,000,000xe(4x.06) = 12,712,492

a.

PV = $100/1.0110 = $90.53

b.

PV = $100/1.1310 = $29.46

c.

PV = $100/1.2515 = $ 3.52

d.

PV = $100/1.12 + $100/1.122 + $100/1.123 = $240.18

11.

12.

13.

a.

b.

DF1

1
0.905
1 r1
r1 = 0.1050 = 10.50%

DF2

1
1

0.819
2
(1 r2 )
(1.105) 2

c. AF2 = DF1 + DF2 = 0.905 + 0.819 = 1.724

d. PV of an annuity = C [Annuity factor at r% for t years]
Here:
$24.65 = $10 [AF3]

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Chapter 02 - How to Calculate Present Values

AF3 = 2.465

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Chapter 02 - How to Calculate Present Values

e. AF3 = DF1 + DF2 + DF3 = AF2 + DF3

2.465 = 1.724 + DF3
DF3 = 0.741
14.

The present value of the 10-year stream of cash inflows is:

1
1

$886,739.6 6
10
0.14 0.14 (1.14)

PV $170,000
Thus:

NPV = $800,000 + $886,739.66 = +$86,739.66

At the end of five years, the factorys value will be the present value of the five
remaining $170,000 cash flows:

1
1

$583,623.7 6
5
0.14 0.14 (1.14)

PV $170,000

15.

10

NPV
t0

Ct
$50,000 $57,000 $75,000 $80,000 $85,000
$380,000

t
1.12
(1.12)
1.12 2
1.12 3
1.12 4
1.12 5

16.

a.

$92,000 $92,000 $80,000 $68,000 $50,000

$23,696.15
1.12 6
1.12 7
1.12 8
1.12 9
1.12 10

Let St = salary in year t

30

PV
t 1

40,000 (1.05) t 1
(1.08) t

1
(1.05) 30

$760,662.5 3
30
(.08
.05)
(.08
.05)

(1.08)

40,000

b.

PV(salary) x 0.05 = $38,033.13

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Chapter 02 - How to Calculate Present Values

Future value = $38,018.96 x (1.08)30 = $382,714.30

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Chapter 02 - How to Calculate Present Values

c.
1

1
PV C
t
r r (1 r)
1

1
$382,714.30 C

20
0.08 0.08 (1.08)

1
1
$38,980.30

0.08 0.08 (1.08) 20

C $382,714.30

17.
Present
Value

Period
0
1
2
3

18.

400,000.00
+100,000/1.12 =
+ 89,285.71
2
+200,000/1.12 =
+159,438.78
+300,000/1.123 =
+213,534.07
Total = NPV = $62,258.56

We can break this down into several different cash flows, such that the sum of
these separate cash flows is the total cash flow. Then, the sum of the present
values of the separate cash flows is the present value of the entire project. (All
dollar figures are in millions.)

Cost of the ship is $8 million

PV = $8 million

Revenue is $5 million per year, operating expenses are $4 million. Thus,

operating cash flow is $1 million per year for 15 years.

1
1

$8.559 million
15
0.08 0.08 (1.08)

PV $1 million

Major refits cost $2 million each, and will occur at times t = 5 and t = 10.
PV = ($2 million)/1.085 + ($2 million)/1.0810 = $2.288 million

Sale for scrap brings in revenue of $1.5 million at t = 15.

PV = $1.5 million/1.0815 = $0.473 million

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Chapter 02 - How to Calculate Present Values

Adding these present values gives the present value of the entire project:
NPV = $8 million + $8.559 million $2.288 million + $0.473 million
NPV = $1.256 million
19.

a.

PV = $100,000

b.

PV = $180,000/1.125 = $102,136.83

c.

PV = $11,400/0.12 = $95,000

d.
e.

1
1

$107,354.2 4
10
0.12 0.12 (1.12)

PV $19,000

PV = $6,500/(0.12 0.05) = $92,857.14

Prize (d) is the most valuable because it has the highest present value.

20.

Mr. Basset is buying a security worth $20,000 now. That is its present value.
The unknown is the annual payment. Using the present value of an annuity
formula, we have:
1

t
r r (1 r)

PV C

1
1

12
0.08 0.08 (1.08)

$20,000 C

C $20,000

21.

1
1
$2,653.90

0.08 0.08 (1.08) 12

The Zhangs need to accumulate $20,000. This is a sinking fund. Use the
sinking fund factor.
$20,000 X .062745 = $1,254.91 saved per year.
Question: Is this at the beginning or at the end of each year?

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Chapter 02 - How to Calculate Present Values

Confirm your answer by finding the FV of annuity at 10%, 10 yrs. It Should equal
$20,000.

22.

The fact that Kangaroo Autos is offering free credit tells us what the cash
payments are; it does not change the fact that money has time value. A 10%
annual rate of interest is equivalent to a monthly rate of 0.83%:
rmonthly = rannual /12 = 0.10/12 = 0.0083 = 0.83%
The present value of the payments to Kangaroo Autos is:

1
1

$8,93 8
30
0.0083 0.0083 (1.0083)

$1,000 $300

A car from Turtle Motors costs $9,000 cash. Therefore, Kangaroo Autos
offers the better deal, i.e., the lower present value of cost.

23.

The NPVs are:

NPV $170,000

$100,000 $320,000

$25,011
1.05
(1.05) 2

NPV $170,000

$100,000 320,000

$3,554
1.10
(1.10) 2

NPV $170,000

$100,000 320,000

$14,991
1.15
(1.15) 2

at 5%
at 10%
at 15%

The figure below shows that the project has zero NPV at about 11%.

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Chapter 02 - How to Calculate Present Values

As a check, NPV at 11% is:

NPV $170,000

24.

a.

$100,000 320,000

$371
1.11
(1.11) 2

This is the usual perpetuity, and hence:

30

20

NPV

10

NPV

-10

-20

0.05

0.10

0.15

Rate of Interest

PV

b.

C $100

$1,428.57
r
0.07

This is worth the PV of stream (a) plus the immediate payment of $100:
PV = $100 + $1,428.57 = $1,528.57

c.

The continuously compounded equivalent to a 7% annually compounded

rate is approximately 6.77%, because:
e0.0677 = 1.0700
Thus:
PV

C
$100

$1,477.10
r 0.0677

Note that the pattern of payments in part (b) is more valuable than the
pattern of payments in part (c). It is preferable to receive cash flows at the
start of every year than to spread the receipt of cash evenly over the year;
with the former pattern of payment, you receive the cash more quickly.

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Chapter 02 - How to Calculate Present Values

25.

a.

PV = $1 billion/0.08 = $12.5 billion

b.

PV = $1 billion/(0.08 0.04) = $25.0 billion

c.
d.

1
1

$9.818 billion
20
0.08 0.08 (1.08)

PV $1 billion

The continuously compounded equivalent to an 8% annually compounded

rate is approximately 7.7% , because:
e0.0770 = 1.0800
Thus:
1
1

PV $1 billion

$10.203 billion
(0.077)(20 )
0.077 0.077 e

This result is greater than the answer in Part (c) because the endowment
is now earning interest during the entire year.
26.

With annual compounding: FV = $100 (1.15)20 = $1,636.65

With continuous compounding: FV = $100 e(0.1520) = $2,008.55

27.

One way to approach this problem is to solve for the present value of:
(1) $100 per year for 10 years, and
(2) $100 per year in perpetuity, with the first cash flow at year 11.
If this is a fair deal, these present values must be equal, and thus we can solve
for the interest rate (r).
The present value of $100 per year for 10 years is:

10
r (r) (1 r)

PV $100

The present value, as of year 10, of $100 per year forever, with the first payment
in year 11, is: PV10 = $100/r
At t = 0, the present value of PV10 is:

1 $100

10
(1 r) r

PV

Equating these two expressions for present value, we have:

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Chapter 02 - How to Calculate Present Values

1

1
1 $100

10
10
r (r) (1 r) (1 r) r
Using trial and error or algebraic solution, we find that r = 7.18%.

$100

28.

Assume the amount invested is one dollar.

Let A represent the investment at 12%, compounded annually.
Let B represent the investment at 11.7%, compounded semiannually.
Let C represent the investment at 11.5%, compounded continuously.
After one year:
FVA = $1 (1 + 0.12)1

= $1.1200

FVB = $1 (1 + 0.0585)2

= $1.1204

FVC = $1 e(0.115 1)

= $1.1219

After five years:

FVA = $1 (1 + 0.12)5

= $1.7623

FVB = $1 (1 + 0.0585)10 = $1.7657

FVC = $1 e(0.115 5)

= $1.7771

After twenty years:

FVA = $1 (1 + 0.12)20

= $9.6463

FVB = $1 (1 + 0.0585)40 = $9.7193

FVC = $1 e(0.115 20)

= $9.9742

The preferred investment is C.

29.

Because the cash flows occur every six months, we first need to calculate the
equivalent semi-annual rate. Thus, 1.08 = (1 + r/2) 2 => r = 7.85 semi-annually
compounded APR. Therefore the rate for six months is 7.85/2 or 3.925%:

1
1

$846,081
9
0.03925 0.03925 ( 1.03925 )

PV $100 ,000 $100 ,000

30.

a.

Each installment is: $9,420,713/19 = $495,827

1
1

$4,761,724
19
0.08 0.08 (1.08)

PV $495,827

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Chapter 02 - How to Calculate Present Values

b.

If ERC is willing to pay $4.2 million, then:

1

1
$4,200,000 $495,827
19
r r (1 r)
Using Excel or a financial calculator, we find that r = 9.81%.

31.

1
1

$402,264.7 3
8
0.08 0.08 (1.08)

PV $70,000

a.
b.

Year
1
2
3
4
5
6
7
8

32.

Beginningof-Year
Balance
402,264.73
364,445.91
323,601.58
279,489.71
231,848.88
180,396.79
124,828.54
64,814.82

Year-end
Interest on
Balance
32,181.18
29,155.67
25,888.13
22,359.18
18,547.91
14,431.74
9,986.28
5,185.19

Total
Year-end
Payment
70,000.00
70,000.00
70,000.00
70,000.00
70,000.00
70,000.00
70,000.00
70,000.00

Amortization
of Loan

End-of-Year
Balance

37,818.82
40,844.33
44,111.87
47,640.82
51,452.09
55,568.26
60,013.72
64,814.81

364,445.91
323,601.58
279,489.71
231,848.88
180,396.79
124,828.54
64,814.82
0.01

This is an annuity problem with the present value of the annuity equal to
$2 million (as of your retirement date), and the interest rate equal to 8%
with 15 time periods. Thus, your annual level of expenditure (C) is
determined as follows:
1

t
r r (1 r)

PV C

1
1

15
0.08 0.08 (1.08)

$2,000,000 C

C $2,000,000

1
1
$233,659

0.08 0.08 (1.08)15

With an inflation rate of 4% per year, we will still accumulate $2 million as of our
retirement date. However, because we want to spend a constant amount per
year in real terms (R, constant for all t), the nominal amount (C t ) must increase
each year. For each year t: R = C t /(1 + inflation rate)t
Therefore:

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Chapter 02 - How to Calculate Present Values

PV [all C t ] = PV [all R (1 + inflation rate)t] = $2,000,000

(1 0.04)1 (1 0.04) 2
(1 0.04)15

.
.
.

$2,000,000
1
2
(1 0.08)15
(1 0.08) (1 0.08)

R [0.9630 + 0.9273 + . . . + 0.5677] = $2,000,000

R 11.2390 = $2,000,000
R = $177,952
(1 0.08)
1 .03846
(1

0.04)
Alternatively, consider that the real rate is
. Then, redoing
the steps above using the real rate gives a real cash flow equal to:

1
1
$177,952

0.03846 0.03846 (1.03846) 15

C $2,000,000

Thus C1 = ($177,952 1.04) = $185,070, C2 = $192,473, etc.

33.

a.
b.

1
1

$430,925.8 9
12
0.055 0.055 (1.055)

PV $50,000

The annually compounded rate is 5.5%, so the semiannual rate is:

(1.055)(1/2) 1 = 0.0271 = 2.71%
Since the payments now arrive six months earlier than previously:
PV = $430,925.89 1.0271 = $442,603.98

34.

In three years, the balance in the mutual fund will be:

FV = $1,000,000 (1.035)3 = $1,108,718
The monthly shortfall will be: $15,000 ($7,500 + $1,500) = $6,000
Annual withdrawals from the mutual fund will be: $6,000 12 = $72,000
Assume the first annual withdrawal occurs three years from today, when the
balance in the mutual fund will be $1,108,718. Treating the withdrawals as an
annuity due, we solve for t as follows:

(1 r)
t
r r (1 r)

PV C

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Chapter 02 - How to Calculate Present Values

1
1

1.035
t
0.035 0.035 (1.035)
Using Excel or a financial calculator, we find that t = 22.5 years.

$1,108,718 $72,000

35.

a. PV = 2/.12 = $16.667 million

b. PV =

1
1

$14.939
20
0.12 0.12 (1.12)
million

$2

c. PV = 2/(.12-.03) = $22.222 million

d. PV =
36.

a.

1
1.03 20

$18.061
20
(0.12
.03)
(0.12
.03)

(1.12)

million

$2

Using the Rule of 72, the time for money to double at 12% is 72/12,
or 6 years. More precisely, if x is the number of years for money to
double, then:
(1.12)x = 2
Using logarithms, we find:
x (ln 1.12) = ln 2
x = 6.12 years

b.

With continuous compounding for interest rate r and time period x:

erx = 2
Taking the natural logarithm of each side:
r x = ln(2) = 0.693
Thus, if r is expressed as a percent, then x (the time for money to double)
is: x = 69.3/(interest rate, in percent).

37.

Spreadsheet exercise.

38.

a.

This calls for the growing perpetuity formula with a negative growth rate
(g = 0.04):

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Chapter 02 - How to Calculate Present Values

PV

b.

$2 million
$2 million

$14.29 million
0.10 ( 0.04)
0.14

The pipelines value at year 20 (i.e., at t = 20), assuming its cash flows last
forever, is:
C21
C1 (1 g)20
PV20

rg
rg
With C1 = $2 million, g = 0.04, and r = 0.10:
PV20

($2 million) (1 0.04)20 $0.884 million

$6.314 million
0.14
0.14

Next, we convert this amount to PV today, and subtract it from the answer
to Part (a):
$6.314 million
PV $14.29 million
$13.35 million
(1.10) 20

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