Problem Set 1 1.

Over the 74 years from 1926 through 1999, the average annual return on common stocks (the S&P index) was 13.3% and the average return on corporate bonds was 5.9%. A. If you had invested $1,000 in common stocks at the beginning of 1926 and held it through 1999, what would it have been worth at the end of 1999? B. If you had invested $1,000 in bonds at the beginning of 1926 and held it through 1999, what would it have been worth at the end of 1999? 2. The stock of Warren Buffet's company, Berkshire Hathaway, sold for about $12 per share in 1968. As of December 30, 2005, the price was $88,620. What was the annual return to shareholders if we assume the shareholders earned the same return each year? Calculate the present value of the following cash flow streams: A. $10,000 in 1 year, $20,000 in 2 years, and $10,000 in 3 years. Assume an interest rate of 6% for the first year, 8% for the second year, and 12% for the third year. B. $50,000 a year for 20 years. The first payment is to be received in 1 year. Assume a constant interest rate of 7% over that time. C. $50,000 a year for 20 years. The first payment is to be received in 10 years. Assume a constant interest rate of 7% over that time. D. $50,000 every other year for 20 years. The first payment is to be received in 2 years. Assume a constant interest rate of 7% over that time. E. A stream of 20 annual payments, the first is $1,000 and will be received in 1 year. They will grow at 8% per year. The discount rate is 6%. 4. Suppose that, at age 50, you pay $50,000 to an insurance company in exchange for an annuity that makes annual payments for 20 years after you turn 65. Assume an interest rate of 8%. How much should you expect to receive each year? Jamie King, the Finance Director of Smooth Ride, a maker of expensive cars, has to set the terms for the loans that Smooth Ride will make to customers who want to finance the purchase of the new Sigma cars. Each car has a non-negotiable sticker price of $55,000. ` The appropriate interest rate is 8%. A. Suppose that Jamie decides to require a down payment of $5,000. What annual payment should she ask buyers to make so that the firm breaks even on the loan and the loan is entirely paid off at the end of 4 years? B. After setting the above terms, Jamie finds that car sales are very sluggish. Smooths closest competitor is offering an identical car for $48,000. Jamie does not want to cheapen the Sigma car's image by offering a rebate or otherwise lowering the stated price. Instead, she retains the down payment of $5,000, but asks for a lower annual payment such that the customer's effective interest rate on the outstanding amount is 2.9%. Are these terms more attractive than the competitor's terms (e.g., the $48,000 price) if the loan is still to be repaid in four years?

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6.

Your firm has a retirement plan that matches all contributions on a one to two basis. That is, if you contribute $1,000 per year, the company will add $500 to

make it $1,500. The firm guarantees 8% return on the funds. Alternatively, you can do it yourself; you think you can earn 11% on your money by doing it yourself. The first contribution will be made one year from today. At that time, and every year thereafter, you will put $1,000 into the retirement account. If you want to retire in 25 years, which way are you better off? 7. As a winner of a local competition, you can choose one of the following prizes: (a) $100,000 now (b) $180,000 at the end of 4 years (c) $11,400 a year forever (d) $19,000 for each of 10 years (e) $6,500 next year and increasing thereafter by 5% a year forever If the interest rate is 12%, which is the most valuable prize? 8. Find the interest rates implied by the following: (a) You lend $500 today and receive a promise for repayment three years from now of $595.23. (b) You invest $1,400 today and will receive $2,592.59 back at the end of eight years. How long does it take for money to triple if you earn 7% annual interest? If $1,000 is invested today, how much will it be worth in five years if the interest rate is 12% compounded quarterly?

9. 10.