FINM7006 Applied Foundations of Finance

Tutorial 1 Solutions

Question One
Calculate the future value of $500 invested today for a period of 4 years at an interest
rate of 10% p.a. compounded annually. Show how and discuss why your answer
would change if interest was compounded daily.

The future value of this amount given the interest rate compounds annually is
$732.05, and is calculated as follows:

If the interest rate was compounded daily, the future value of the investment would be
greater given the increased impact of compounding. The future value of the
investment with daily compounding is calculated as follows:

Question Two
You have just successfully applied for a home loan. Calculate how much you are
borrowing given that the terms of the loan are as follows:

 Your monthly repayments are $2,500;

 The loan is taken over 15 years; and,
 The interest rate you will pay on funds borrowed is fixed at 10% p.a.
compounded monthly.

Show how and discuss why your answer would change if interest were compounded
annually.

To work how much you borrowed, simply calculate the present value of all
repayments. As payments are evenly spaced and identical in amount, we can calculate
the present value of the cash flows using the ordinary annuity formula:

If the interest rate were compounded annually, the amount you borrowed would be
higher as there is less compounding of interest and a larger portion of repayments
pertaining to the principal. The amount borrowed with annual compounding is
calculated as follows:

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 FINM7006 Applied Foundations of Finance

Question Three
Calculate the present value of an ordinary perpetuity that comprises one cash flow of
$50 at the end of each year given an interest rate of 9% p.a. compounded annually.
Show how and discuss why your answer would change if interest were compounded
weekly.

If interest rates were compounded weekly, the present value of the perpetuity would
be lower due to the increased effects of compounding. The present value of the
perpetuity if interest were compounded weekly is:

Question Four
What would be the balance of my bank account exactly 3 years from today if I made
deposits in the account as described below and earned interest at a rate of 10% p.a.
compounded annually on my account balance:

Time (from today) 1 year 2 years 3 years

Amount $50 $100 $150

Show how and discuss why your answer would change if interest were compounded
daily.

As the cash flows are of different sizes, I have to compound each cash flow
individually and sum the resultant values in order to calculate the balance of my bank
account 3 years from today:

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 FINM7006 Applied Foundations of Finance

If interest was compounded daily, my account balance would be higher 3 years from
today given the increased impact of compounding:

Question Five
‘Mad Dog’ McNamara wishes to accumulate $9,500 at the end of three years. How
much does he need to deposit now if the interest rate is:
a) 10% p.a. compounded annually?
b) 8% p.a. compounded annually?
c) 8% p.a. compounded monthly?
Can you explain why they differ in each case?

We need to find the present value of the future amount of $9,500.

a)

b)

c) With monthly compounding, the interest rate must be divided by 12 to find the
interest rate per compounding period (r), and the number of years must be
multiplied by 12 to find the total number of periods (n).

FV 9500
PV = = =$ 7 , 478. 92
(1+r ) (1+ 0 .08 )36
n

12

The answer to (b) is greater than the answer to (a) because the interest rate is lower.
The deposit will not earn as much interest under the scenario in part (b), so more
needs to be deposited in order to grow to the desired amount. The answer to (c) is less
than the answer to (b) because interest is compounded more frequently. This means
that the deposit earns ‘interest on interest’ more often. More frequently throughout the
year, interest is calculated and added to the deposit, which means that next time
interest is calculated it is calculated on a larger amount. As a result, less needs to be
deposited in order to grow to the desired amount.

Question Six
An investment repays $40,000 in five years and a further $60,000 in 10 years. If the
interest rate over the period is 12% p.a compounded monthly, what is the
investment’s present value?

Whenever you have a problem involving multiple cash flows, it is often advisable to
draw a diagram showing all cash flows and identifying the value to be calculated.

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 FINM7006 Applied Foundations of Finance

There are three steps required to solve this problem. First, you must find the interest
rate per compounding period. Second, the cash flows of $40,000 and $60,000 are
discounted using the monthly rate of interest over 60 months (5 years *12
compounding periods per year) and 120 months (10 years * 12 compounding periods
per year). In the third step the two discounted values are added together

0 .12
=0 . 01
Monthly interest rate = 12 or 1% per month

40 ,000 60 , 000
PV = + =$ 40 , 197 .67
Present value of the cash flows (1+0 . 01)60 (1+0. 01 )120

Question Seven
a) You have the opportunity to purchase security Y that will pay $2,000 per year
forever. At an interest rate of 8% p.a., compounded annually, what is this
security worth?
b) An alternative security, Z, will pay $2,000 per year for the next 20 years.
Assuming the same interest rate compounded annually, what is this security
worth?
c) Explain the difference between the values of securities Y and Z.

F 2 , 000
PV Y = = =$ 25 , 000
a) r 0 . 08

b)
PV Z =F [
1−(1+r )−n
r ]
=2 , 000 [
1−(1 . 08)−20
0 . 08 ]
= $ 19 , 636 . 29

c) Y is more valuable than Z because it has more cash flows. The cash flows
continue forever, rather than just 20 years. However, it may seem surprising
that an infinite stream of cash flows beyond 20 years adds very little to the
value of the security – just over $5,000. This is because cash flows in the
distant future are discounted very heavily and are worth very little in present
value terms.

Question Eight
The British government has a consol bond outstanding paying £100 per year, forever.
Assume the current interest rate is 4% per year (compounded annually).
a) What is the value of the bond immediately after a payment is made?
b) What is the value of the bond immediately before a payment is made?

The timeline for this investment is:

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 FINM7006 Applied Foundations of Finance
a)The value of the bond is equal to the present value of the cash flows. By the
perpetuity formula, which assumes the first payment is at period 1, the value
of the bond is:

100
PV = =
0 .04 £2,500

b)The value of the bond is equal to the present value of the cash flows. The first
payment will be received at time zero. The cash flows are the perpetuity plus
the payment that will be received immediately:

100
PV =100+
0 . 04 = £2,600

Question Nine
When you purchased your car, you took out a five-year annual-payment loan with an
interest rate of 6% per year (compounded annually). The annual payment on the car
is $5,000. You have just made a payment and have now decided to pay the loan off by
repaying the outstanding balance. What is the payment amount if:
a) You have owned the car for one year (so there are four years left on the
loan)?
b) You have owned the car for four years (so there is one year left on the loan)?

The timeline for the loan cash flows at time 0 is as follows:

Time: 0 1 2 3 4 5
Payment: 5000 5000 5000 5000 5000

a) At time 1, the timeline for the remaining loan cash flows becomes:

Original time: 1 2 3 4 5
Current time: 0 1 2 3 4
Payment: 5000 5000 5000 5000

To pay off the loan you must repay the remaining balance. The remaining balance is
equal to the present value of the remaining payments. The remaining payments are a
4-year annuity, so:

[ ]
−4
1−( 1.06 )
PV =5,000 = $ 17,325.53
0.06

b) At time 4, the timeline for the remaining cash flows becomes:

Original time: 4 5
Current time: 0 1
Payment: 5000

There is only one remaining payment, one year from now, so:
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FINM7006 Applied Foundations of Finance

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5000
PV = =$ 4 ,716 . 98
(1 .06 )

Evaluate: To pay off the loan after owning the vehicle for one year will require
$17,325.53. To pay off the loan after owning the vehicle for four years will require
$4,716.98.