Problem Set 1: Review Time Value of Money

1. Answer the following questions:

a. The cost of a new automobile is $10,000. If the interest rate is 5%, how much would you have
to set aside now to provide this sum in five years?
b. You have to pay $12,000 a year in school fees at the end of each of the next six years. If the
interest rate is 8%, how much do you need to set aside today to cover these bills?
c. You have invested $60,476 at 8%. After paying the above school fees, how much would
remain at the end of the six years?

2. Mike Polanski is 30 years of age and his salary next year will be $40,000. Mike forecasts that his
salary will increase at a steady rate of 5% per annum until his retirement at age 60.

a. If the discount rate is 8%, what is the PV of these future salary payments?
b. If Mike saves 5% of his salary each year and invests these savings at an interest rate of 8%,
how much will he have saved by age 60?
c. If Mike plans to spend these savings in even amounts over the subsequent 20 years, how
much can he spend each year?

3. As winner of a breakfast cereal competition, you can choose one of the following prizes. Which
one would you choose?
(Note: Assume an interest rate of 12%)

a. $100,000 now.
b. $180,000 at the end of five years.
c. $11,400 a year forever.
d. $19,900 for each of 10 years.
e. $6,500 next year and increasing thereafter by 5% a year forever.

4. Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to invest
$20,000 in an annuity that will make a level payment at the end of each year until his death. If the
interest rate is 8%, what income can Mr. Basset expect to receive each year?

5. Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 now and then $300
a month for the next 30 months. Turtle Motors next door does not offer free credit but will give
you $1,000 off the list price. If the rate of interest is 10% a year, (about 0.83% a month) which
company is offering the better deal?

6. If the interest rate is 7%, what is the value of the following three investments?

a. An investment that offers you $100 a year in perpetuity with the payment at the end of each
year.
b. A similar investment with the payment at the beginning of each year.

7. Five years ago, your aunt won the $1,000,000 lottery. The prize money is paid out $50,000 per
year for 20 years. Unfortunately, your aunt needs as much as $250,000 cash now to pay for
medical bills that she and your uncle incurred as a result of an accident. A local finance company
has proposed to provide her with the $250,000 cash in return for the $50,000 annual payments
over the next 9 years. She has asked your advice. What should you tell her?

a. What is the interest rate implicit to the local finance company proposal? (Hint: Use the IRR
function in excel).

Financial Management Page 2

 b. What advice would you give to your aunt?

8. You can buy a bond today for $1,000 and it will pay you $1,260 three years from now. What is
the annual rate of return that you are earning?

9. A five-year bond with a face value of $1,000 pays a coupon of 6.5%. If the current yield to
maturity is 3%. How much would an investor be ready to pay for the bond?

10. PG paid an annual dividend of $1.72 last year and you expect dividends to increase at 3% per year
for ever. If the appropriate cost of equity for PG is 8% per year (this is the discount rate), estimate
how much would an investor be ready to pay for this share?

11. [Optional] Suppose that you have decided to set up a personal pension fund for your retirement.
You just turned 25. You expect to retire at age 65 and believe it reasonable to count on living at
least 20 years after retirement. Further, you wish to have an annual income of $100,000 during
your retirement starting when you turn 65, and that upon receipt of the twentieth payment, the
entire capital sum would have been distributed. You have been offered two investment plans by
your financial advisor: an “aggressive” portfolio of well-diversified equities that promise to yield
on average the historic long term 12% rate; a “conservative” portfolio of government bonds that
promise to yield on average the historic long term 6% rate.

a. How much must you invest in each of the two savings scheme each year, starting at the end of
this year until you retire to assure the $100,000 per year retirement income?
b. What investment strategy would you recommend?

Financial Management Page 3

 10000
1. a) cost 18000, =

i 51,
=

n 5
=
>PU: 1,055 7835,26
=

12000 12000
b)12000, n 6,
=

i 81<
=

PU: 1,08
-

11082
t

12000 12 -
-
228 128 +

55474,56
=

60476
2) 60476, i 81,
=

i 5 1. >
=

PU:
11066

O 60
30
2. I I I
-
10000
51.
+

a) i 81,w 0
=
=

88805.(1-(185() 7601662.500
=
rg(n (21-8)7
=
-

b)PV:760'662.5.0,05 =
381033113

FU:38033,13. 1108" 382714,3

=
FU c.(1
=

r)
+

a) n 20,
=
PU c. =
1 -

382714,75
↑
r.(1 r) +

I l
I l
382714,75 = C 000(110s(0 38980,3
=

C.
=
=

aorosp
0,08
0,08

3. i 12% =

a) PU 100000
=

b) pr
180000
=

102"136,83
=

1,125

c) OU 1400 95000
0,12=
=

l 1
d) PU 191900 = -

M2439, 44
=

0.12 0112 (1,12)

e) PV
0
=

88,05 92857,14
=

The
=>
d) is the most
interesting since it has the PV
highest

4. Annulity, 1: 8%, n 12=

l l l
PU (Annuity):C. => 20000 c.1
-r(n r)
=
-

r 12
0108 0,08 (1,08L
+

c
=>
20000
=

=
l 2653,90
·Tos 0,08(1,08L 12

5. 10000 months, 0,83%/

1000 now, 300/month 30 i 10%./year i month
=
=

0,10
r month =
0,83%
=

12
l l
PV:1000 300 8938 Turtle ossers 9000
-
=
+
-

0,0083 0,0083 (1,0083/30

Kangovoo Antos deal is better

6. i 71.
=

C 100
->
PU) perpetuity) PU
-

a) 0,07 =1428,57
= =

b) PU 100
=
1426,57
+

1528,57
=
7. Was 1000000 50000/year for
=>

20 years, 250000 medical bills

a) PU=
250000

250000 50000 50000 50000 50000 50000 +

50000 +
50000
+ + + +
= +

1 IRR+
[1 IRR2
+

(1 IRR)3
+

(1 IRR)"+

(1 IRR)5+

(1 IRR)S
+

(1+IRR*

50000 50000
+

(1 IRR)8
+

(1 IRR)
+
=> IRR:13,7%

b)Ifit's impossible for her to get the 250000$ by other mean, she doesn't have a choice.

If she could borrow 250000$ from a bank a

at lower rate, she would refuse the offer

8. Band 1000,
=

FU 1260 =

n 3
=

Fu pu. (n r
=
+
= (YY)an -
1
=

r (28)
= -
1 81.
=

9. FV 1000 =

c 6,5%n 5
= =
4TM 31 =
P (1
= -

xeu+rn) EY
+

C 1000. 6151. 65
=
=

65 65 1000
+

65 65
PU 65
=
+
I I t =-
1160,3
11032 1,03
3
1,034 1,035
1,03

10 Dir 1,72g =
=
31i 81. =

P Div(1
=

g)
+

Price 1,72.(1,03)
=

36149
=
r -

g
0,08-0103

M. Optional