FNCE5008 – Financial Principles and Analysis

Tutorial Set 2 – KEY SOLUTIONS

Question 1
When Alfred Nobel died, he left the majority of his estate to fund five prizes, each to be
awarded annually in perpetuity starting one year after he died.
a. If he wanted the cash award of each of the five prizes to be $47,000 and his estate
could earn 10% per year, how much would he need to fund his prizes?
b. If he wanted the value of each prize to grow by 4% per year (perhaps to keep up with
inflation), how much would he need to leave? Assume that the first amount was still $47,000
per prize.
c. His heirs were surprised by his will and fought it. If they had been able to keep the
amount of money you calculated in (b), and had invested it at 10% per year, how much
would they have in 2014, 118 years after his death?

Answer:

Plan: Nobel’s bequest is a perpetuity. The total amount is 5  $47,000  $235,000. With a cash flow
of $235,000 and an interest rate of 10% per year, we can solve for the total amount he would need to
use to endow the prizes. In part (b), we will need to use the formula for a growing perpetuity to find
the new value he would need to leave. Finally, in part (c), we can use the FV equation to solve for
the future value his descendants would have had if they had kept the money and invested it at 10%
per year.

a) In order to endow a perpetuity of $235,000 per year with a 10% interest rate per year, he
would need to leave $235,000/0.10  $2,350,000.

b) In order to endow a growing perpetuity with an interest rate of 10% and a growth rate of 4%
and an initial cash flow of $235,000, he would have to leave:

CF 1 235,000
PV = = =3,916,666,67
r−g 0.10−0.04

c) FV  PV(1  r)n  3,916,666.67(1.10)118  $ 300,091,338,715.31

Evaluate: The prizes that bear Nobel’s name were very expensive to endow—$4 million
was an enormous sum in 1896. However, Nobel’s endowment has been able to generate enough
interest each year to fund the prizes, which now have a cash award of approximately $1,500,000
each!

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FNCE5008 – Financial Principles and Analysis

Question 2
A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a
year and will be $3000. Each year after that, you will receive a payment on the anniversary
of the last payment that is 3% larger than the last payment. This pattern of payments will go
on forever. Assume that the interest rate is 13% per year.
a. What is today’s value of the bequest?
b. What is the value of the bequest immediately after the first payment is made?

Answer:

Plan: The bequest is a perpetuity growing at a constant rate. The bequest is identical to a firm that
pays a dividend that grows forever at a constant rate. We can use the constant dividend
growth model to determine the value of the bequest.
Execute:

a.
0 1 2 3

3,000 3,000(1.03) 3,000(1.03)2

Using the formula for the PV of a growing perpetuity gives

PV = ( 0.13−0.03
3,000
)=30,000
which is the value today of the bequest.

b.
1 2 3 4
0 1 2 3

3000(1.03) 3000(1.03)2 3000(1.03)3

the formula for the PV of a growing perpetuity gives: PV =¿

which is the value of the bequest after the first payment is made.

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 FNCE5008 – Financial Principles and Analysis

Evaluate: The bequest is worth $30,000 today and will be worth $30,900 in one year’s time.
Question 3

You have just purchased a car and taken out a $52,000 loan. The loan has a five-year
term with monthly payments and an APR of 5.7%.
a. How much will you pay in interest, and how much will you pay in principal,
during the first month, second month, and first year? (Hint: Compute the loan balance
after one month, two months, and one year.)
b. How much will you pay in interest, and how much will you pay in principal,
during the fourth year (i.e., between three and four years from now)?
Answer:
Plan: Draw a timeline and compute the sums that are indicated.

Execute:
a. Timeline:
0 1 2 3 60

52,000 –C –C –C –C

First, solve for the monthly mortgage payment at 5.7% APR. The 5.7% APR

a monthly rate of .

Each monthly payment is $998.06. After one month, the balance (principal) of the loan will be the PV of
the 59 remaining payments.

52,000 51,248.528  751.472 is amount of the payment that went to paying the principal,
while 998.06  751.472  246.588 was interest.
For the second month, solve for the value of the remaining 58 payments:

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 FNCE5008 – Financial Principles and Analysis

51,248.528  50,493.89  754.638 is the amount of the payment that went to paying the
principal, while 998.06 – 754.638  243.422 was interest.

b. At the end of year 3, there are 24 payments remaining. The balance of the loan is:

At the end of year 4, there are only 12 payments remaining. The balance of the loan at the end of the four
year is:

22,587.92  11,614.99  10,972.93 is amount of the payment that went to paying the principal, while
(998.06  12)  10,972.93  1,003.79 was interest.

Evaluate: A financial analyst can determine the amount of any loan payment. The financial analyst can
also determine the outstanding amount on the loan at any time over its life.

Question 4
You are thinking about investing $4565 in your friend’s landscaping business. Even
though you know the investment is risky and you can’t be sure, you expect your investment
to be worth $5767 next year. You notice that the rate for one-year Treasury bills is
1%. However, you feel that other investments of equal risk to your friend’s landscape
business offer a 10% expected return for the year. What should you do?

Answer

Plan: Because the investment in your friend’s business is risky, the 1% riskless rate
from Treasuries is not relevant. The 10% rate you could expect to earn on other similarly
risky investments is the correct opportunity cost of capital, so you should discount the
expected value of your investment using the 10% rate to see if it is greater than the
$4,565 cost.
Execute: 5,767/(1.10) = 5,242.72, so the PV of the benefit (discounted at your opportunity
cost of capital) exceeds the cost, making it a good investment.
Evaluate: By recognizing your cost of capital and applying it to the payoffs from the
investment, you can make the right decision about whether to invest in your friend’s
business.