Introduction to the Mathematics of Finance (Extended Review Problems 6.

30)

Extended Review Problems – 6.30

Text: G. D. Prichett & J. C. Saber

Solutions: Muhammad Shamim

1 Carol has joined an employees’ savings plan. She has $200

withheld monthly from her paycheck and placed in her account in
the company credit union. To encourage employees to save, the
company contributes an additional 10 percent to these savings
accounts, with the company’s contribution not to exceed $50 per
month per employee. The company’s contributions, however, do not
become available to the employee unless the account is maintained
for at least 5 years. If the credit union guarantee an interest rate of 8
percent compounded monthly, how much will Carol have in her
account after 3 years? After 10 years?

Solution: Given Payment per period (R) = $200

Interest rate per period (i) = 8%/12 = 0.08/12
Number of periods (n) = (3)(12) = 36 periods
Requirement: Future value of the annuity (F) = ?

After 3 years,
 (1  i) n  1 
F = R 
 i 

 (1  0.08 / 12)36  1 
= $200 
 0.08 / 12 

= $8107.11 [Ans.]

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After 5 years,
 (1  i) n  1 
F = R 
 i 

 (1  0.08 / 12) 60  1 
= $200 
 0.08 / 12 

= $14695.37

After 10 years,
 (1  i) n  1 
F = P(1  i) n + R  
 i 

 (1  0.08 / 12) 60  1 
= $14695.37(1  0.08 / 12)60 + ($200  $20)  
 0.08 / 12 
= $38058.74 [Ans.]

2 Nick has calculated his retirement needs. He would like to receive

$1000 per month for 20 years after retirement. His plan is to retire
in 15 years. He is trying to compute the amount he must put away
now at 8 percent compounded semiannually to generate the sum
needed for retirement. After checking with some financial planners,
he finds that the typical riskfree interest he can expert to receive on
his retirement income is about 7 percent compounded monthly. How
much does Nick have to put away now?

Solution: Given Payment per period (R) = $1000

Interest rate per period (i) = 7%/12 = 0.07/12
Number of periods (n) = (20)(12) = 240 periods
Requirement: Present value (P) = ?

For present value of annuity,

1  (1  i)  n 
P = R 
 i 

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1  (1  0.07 / 12) 240 
= $1000 
 0.07 / 12 
= $128982.51

For present value of single-sum,

P = F(1 + i) – n
= 128982.51 (1 + 0.08/2) – (15)(2)
= $39767.72 [Ans.]

3 Rita is planning ahead for a 3-month world tour to celebrate

completing graduate school. The trip’s estimated cost is $7000. Rita
would like to accumulate that sum over the next 4 years. She plans
to make monthly deposits into her school’s minibank which gives 5
percent interest compounded monthly. How much does she have to
contribute monthly?

Solution: Given Future value of the annuity (F) = $7000

Interest rate per period (i) = 5%/12 = 0.05/12
Number of periods (n) = (4)(12) = 48 periods

Requirement: Payment per period (R) = ?

 i 
R = F n 
 (1  i)  1

 i 
= $7000 48 
 (1  0.05 / 12)  1 

= $132.04 [Ans.]

4 Joan signs a promissory note for $2400 from a bank charging a

discount rate of 12 percent. If Joan receives $1968 now, how long
will she have to pay back the note? What is the effective interest
rate?

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Solution: Given Future value (F) = $2400
Proceeds (P) = $1968
Discount rate (d) = 12% = 0.12
Requirement: Time in years (n) = ?
(a) We know,
Proceeds = Future value – Future value  Interest rate  Time in years
 P =F–Fdn
 $1968 = $2400 – $2400  0.12  n
 $432 = 288n
 n = 1.5 years [Ans.]

(b) We know,
d
Effective interest rate (ie) =
1  dn
0.12
 ie =
1  (0.12)(1.5)

 ie = 14.63% [Ans.]

5 Robert has $10000 he would like to invest for 10 years. What rate
of interest compounded quarterly will he have to get if he wishes his
money to double? Triple? Quadruple? Quintuple?

Solution: Given Present value (P) = $10000

Number of periods (n) = (10)(4) = 40 periods
Requirement: Interest rate per period (i) = ?
(a) For double future value,
F = P(1 + i) n
 $20000 = $10000 (1 + i) 40
 2 = (1 + i) 40
 ln 2 = 40 ln (1 + i)
ln 2
 ln (1 + i) =
40
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 ln (1 + i) = 0.017329
 1 + i = antiln 0.017329
 1 + i = 1.0175
 i = 1.75% [Ans.]

(b) For triple future value,

F = P(1 + i) n
 $30000 = $10000 (1 + i) 40
 i = 2.78% [Ans.]

(c) For quadruple future value,

F = P(1 + i) n
 $40000 = $10000 (1 + i) 40
 i = 3.53% [Ans.]

(d) For quintuple future value,

F = P(1 + i) n
 $50000 = $10000 (1 + i) 40
 i = 4.11% [Ans.]

6 Bill and his wife have found their dream house. It sits on 2 acres of
land in a suburb of Houston, 20 minutes from downtown and within
15 minutes of each of their offices. The purchase price they have
agreed upon is $175000 and they have 20 percent to use as a down
payment. They can secure a 30-year mortgage from one bank at 9.25
percent and a 25-year mortgage from another bank at 9.125 percent.
What are their respective monthly payments and what is the
approximate difference in total payments?

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Solution: Given Present value (P) = $175000  0.80 = $140000
For the 1st option,
Interest rate per period (i) = 9.25% = 0.0925
Number of periods (n) = 30 periods
Requirement: Payment per period (R) = ?

 i 
R = P n 
1  (1  i) 

 0.0925
= $140000 30 
1  (1  0.0925) 
= $13930.20 [Ans.]

For the 2nd option,

Interest rate per period (i) = 9.125% = 0.09125
Number of periods (n) = 25 periods
Requirement: Payment per period (R) = ?
 i 
R = P n 
1  (1  i) 

 0.09125
= $140000 25 
1  (1  0.09125) 
= $14397.48 [Ans.]
Required difference in two payments = ($13930.20  30) – (14397.48  25)
= $57969 [Ans.]
Decision: Since 1st option is more costly, 2nd option is preferable.

7 What is the effective interest rate of 13 percent compounded

quarterly, monthly, daily, hourly, and continuously.
Solution: Given Nominal interest rate (j) = 13% = 0.13
Requirement: Effective interest rate (re) = ?

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(a) For compounding quarterly, m = 4
m 4
 j  0.13 
 r e = 1    1 = 1    1 = 13.648% [Ans.]
 m  4 

(b) For compounding monthly, m = 12

m 12
 j  0.13 
 r e = 1    1 = 1    1 = 13.803% [Ans.]
 m  12 

(c) For compounding daily, m = 365

m 365
 j  0.13 
 r e = 1    1 = 1    1 = 13.880% [Ans.]
 m  365 

(d) For compounding hourly, m = 9125

m 9125
 j  0.13 
 r e = 1    1 = 1    1 = 13.8827% [Ans.]
 m  9125 
(e) For compounding daily, j = 0.13

 re = e j  1 = e0.13  1 = 13.8828% [Ans.]

8 In going through some old belongings of his ancestors, John found

papers indicating that they sold several acres in the town of
Plymouth, Massachusetts, in 1720 for $22. If they had invested this
money at 4.5 percent compounded continuously, how much would it
amount to in the year 1995?

Solution: Given Present value (P) = $22

Nominal interest rate (j) = 4.5% = 0.045
Time in years (t) = 1995 – 1720 = 275
Requirement: Future value (F) = ?
We know,
jt
F = Pe
0.045275
= $22 e
= About $5209750 [Ans.]

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9 Michael is updating his estate plan for himself and his family. He
would like to provide an income of $3000 every month starting 10½
years from now and continuing for the next 20 years. He has started
his account with an initial deposit of $10000; and he knows his life
insurance, maturing in 5 years, will have a cash value of $150000. To
make up the difference, Michael has decided to make monthly
deposits in the account. How much should each deposit be if all
interest is computed at 6 percent compounded monthly?

Solution: Given Income per period (R) = $3000

Interest rate per period (i) = 6%/12 = 0.06/12 = 0.005
Requirement: Monthly deposit per period (R) = ?

1  (1  i)  n 
P = R 
 i 

1  (1  0.005) 2012 
= $3000 
 0.005 

= $418742.315

 P = F(1 + i) – n
= $418742.315(1 + 0.005) – 10½  12
= $223369.0866

 Desired P = $223369.0866 – $10000 – $150000(1 + .005) – 5  12

= $102163.2572

 i 
Required R = P  n 
1  (1  i) 

 0.005 
= $102163.2572 
1  (1  0.005) 10 1 212 
 
= $1094.83 [Ans.]

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10 Joseph added a $4500 Jacuzzi to his condominium’s bathroom.
He signed a bank promissory note with a maturity date 3 years from
the transaction date at 11 percent compounded monthly. One year
later, the bank holding the note was taken over by an international
financial organization that demanded payment in full of the then
present value computed at 5 percent compounded semiannually.
What was the amount demanded?

Solution: Given Present value (P) = $4500

Interest rate per period (i) = 11%/12 = 0.11/12
Time in years (n) = (3)(12) = 36
Requirement: Monthly deposit per period (R) = ?

For the maturity value,

F = P(1 + i)n
= $4500(1 + 0.11/12)36
= $6249.95

 P = F(1 + i) – n
= $6249.95 (1 + 0.05/2) – (3 – 1)(2)
= $5662.15

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Part-III

Introduction to Applied Calculus

and Unconstrained Optimization

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