Name: ___________________________________ NetID: _______________________

HADM 2250 Spring 2018, Prof. Andrey Ukhov

Homework assignment
#2

1. Seaborn Co. has identified an investment project with the following cash flows. If the discount rate is 10
percent, what is the present value of these cash flows? What is the present value at 18 percent? At 24 percent?
Year Cash Flow
1 $1,100
2 720
3 940
4 1160

Solution:
To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a
lump sum, we use:

PV = FV / (1 + r)t
2 3 4
PV@10 % = $1,100 / 1.10 + $72 0 / 1.10 + $94 0 / 1.10 + $1,160 / 1.10 = $3,093.57
2 3 4
PV@18 % = $1,100 / 1.18 + $72 0 / 1.18 + $94 0 / 1.18 + $1,160 / 1.18 = $2,619.72
2 3 4
PV@24 % = $1,100 / 1.24 + $72 0 / 1.24 + $94 0 / 1.24 + $1,160 / 1.24 = $2,339.03

2. Paradise, Inc., has identified an investment project with the following cash flows. If the discount rate is 8
percent, what is the future value of these cash flows in year 4? What is the future value at a discount rate of
11 percent? At 24 percent?
Year Cash Flow
1 $700
2 950
3 1,200
4 1,300
Solution:
To solve this problem, we must find the FV of each cash flow and add them. To find the FV of a
lump sum, we use:

FV = PV( 1 + r)t
3 2
FV@8 % = $700( 1.08) + $950( 1.08) + $1,200( 1.08) + $1,300 = $4,585.88
3 2
FV@11 % = $700( 1.11) + $950( 1.11) + $1,200( 1.11) + $1, 300 = $4, 759.84
3 2
FV@24 % = $700( 1.24) + $950( 1.24) + $1,200( 1.24) + $1, 300 = $5, 583.36

Notice we are finding the value at Year 4, the cash flow at Ye ar 4 i s simp ly added to the FV of the other
cash flows. In other words, we do not need to compound this cash flow.

3. An investment offers $4,600 per year for 15 years, with the first payment occurring one year from now. If
the required return is 8 percent, what is the value of the investment? What would the value be if the
payments occurred for 40 years? For 75 years? Forever?

Solution:

Hadm 2250, Prof. Andrey Ukhov 1/5

Name: ___________________________________ NetID: _______________________

To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)]t } / r )

PVA@15 yrs: PVA = $4,600{[1 – (1/1.08)15] / .08} = $39,373.60

PVA@40 yrs: PVA = $4,600{[1 – (1/1.08)40] / .08} = $54,853.22
PVA@75 yrs: PVA = $4,600{[1 – (1/1.08)75] / .08} = $57,320.99

To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $4,600 / .08 = $57,500.00

Notice that as the length of the annuity payments increases, the present value of the annuity
approaches the present value of the perpetuity. The present value of the 75 year annuity and the
present value of the perpetuity imply that the value today of all perpetuity payments beyond 75
years is only $179.01.

4. If you put up $28,000 today in exchange for an 8.25 percent, 15-year annuity, what will the annual cash flow
be?

Solution:
Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the
annuity payment. Using the PVA equation:

PVA = C({1 – [1/(1 + r)]t } / r )

PVA = $28,000 = $C{[1 – (1/1.0825)15 ] / .0825}

We can now solve this equation for the annuity payment. Doing so, we get:
C = $28,000 / 8.43035 = $3,321.33

5. Your company will generate $65,000 in annual revenue each year for the next eight years from a new
information database. If the appropriate interest rate is 8.5 percent, what is the present value of the savings?

Solution:
To find the PVA, we use the equation:
PVA = C({1 – [1/(1 + r)]t } / r )
PVA = $65,000{[1 – (1/1.085)8 ] / .085} = $366,546.89

6. You want to have $80,000 in your savings account 10 years from now, and you’re prepared to make equal
annual deposits into the account at the end of each year. If the account pays 6.5 percent interest, what
amount must you deposit each year?

Solution:
Here we have the FVA, the length of the annuity, and the interest rate. We want to calculate the
annuity payment. Using the FVA equation:

FVA = C{[(1 + r)t – 1] / r}

$80,000 = $C[(1.06510 – 1) / .065]
We can now solve this equation for the annuity payment. Doing so, we get:
C = $80,000 / 13.49442 = $5,928.38

Hadm 2250, Prof. Andrey Ukhov 2/5

Name: ___________________________________ NetID: _______________________

7. Find the EAR in each of the following cases:

State Rate (APR) Number of Times Compounded Effective Rate (EAR)

7% Quarterly _________
18% Monthly _________
10% Daily _________
14% Infinite _________

Solution:
For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.07 / 4)]4 – 1 = .0719 or 7.19%
EAR = [1 + (.18 / 12)]12 – 1 = .1956 or 19.56%
EAR = [1 + (.10 / 365)]365 – 1 = .1052 or 10.52%

To find the EAR with continuous compounding, we use the equation:

EAR = eq – 1
EAR = e.14 – 1 = .1503 or 15.03%

8. Tarpley Credit Corp. wants to earn an effective annual return on its consumer loans of 14 percent per year.
The bank uses daily compounding on its loans. What interest rate is the bank required by law to report to
potential borrowers? Explain why this rate is misleading to an uninformed borrower.

Solution:
The reported rate is the APR, so we need to convert the EAR to an APR as follows:

EAR = [1 + (APR / m)]m – 1

APR = m[(1 + EAR)1/m – 1]
APR = 365[(1.14)1/365 – 1] = .1311 or 13.11%

This is deceptive because the borrower is actually paying annualized interest of 14% per year, not
the 13.11% reported on the loan contract.

9. If the appropriate discount rate for the following cash flows is 11 percent compounded quarterly, what is the
present value of the cash flows?
Year Cash Flow
1 $900
2 850
3 0
4 1,140

Solution:
Discount each cash flow separately and sum the result. Note that the interest is compounded quarterly.
4 8
PV = 900/(1.0275) + 850/(1.0275) + 0/(1.0275) 12 + 1140/(1.0275) 16

PV = $2,230.20

Hadm 2250, Prof. Andrey Ukhov 3/5

Name: ___________________________________ NetID: _______________________

10. You are planning to save for retirement over the next 30 years. To do this, you will invest $600 a month in a
stock account and $300 a month in a bond account. The return of the stock account is expected to be 12
percent, and the bond account will pay 7 percent. When you retire, you will combine your money into an
account with a 9 percent return. How much can you withdraw each month from your account assuming a
25-year withdrawal period?

Solution:
We need to find the annuity payment in retirement. Our retirement savings ends and the
retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the
retirement savings.

So, we find the FV of the stock account and the FV of the bond account and add the two FVs.
Stock account: FVA = $600[{[1 + (.12/12)]360 – 1} / (.12/12)] = $2,096,978.48
Bond account: FVA = $300[{[1 + (.07/12)]360 – 1} / (.07/12)] = $365,991.30

So, the total amount saved at retirement is:

$2,096,978.48 + 365,991.30 = $2,462,969.78

Solving for the withdrawal amount in retirement using the PVA equation gives us:
PVA = $2,462,969.78 = $C[1 – {1 / [1 + (.09/12)]300} / (.09/12)]
C = $2,462,969.78 / 119.1616 = $20,669.15 withdrawal per month

11. You have just won the lottery and will receive $1,000,000 in one year. You will receive payments for 25 years,
which will increase 5 percent per year. If the appropriate discount rate is 9 percent, what is the present value
of your winnings? (Please refer to formulas in the textbook)

Solution:
We can use the present value of a growing annuity equation to find the value of your deposits
today. Doing so, we find:
PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}
PV = $1,000,000{[1/(.09 – .05)] – [1/(.09 – .05)] × [(1 + .05)/(1 + .09)]25}
PV = $15,182,293.68

12. You just won the TVM Lottery. You will receive $1 million today plus another 10 annual payments that
increase by $400,000 per year. Thus, in one year, you receive $1.4 million. In two years you get $1.8 million,
and so on. If the appropriate interest rate is 9 percent, what is the present value of your winnings?

Solution:
To solve this problem, we simply need to find the PV of each lump sum and add them together. It
is important to note that the first cash flow of $1 million occurs today, so we do not need to
discount that cash flow. The PV of the lottery winnings is:

$1,000,000 + $1,400,000/1.09 + $1,800,000/1.092 + $2,200,000/1.093 + $2,600,000/1.094 +

$3,000,000/1.095 + $3,400,000/1.096 + $3,800,000/1.097 + $4,200,000/1.098 +
$4,600,000/1.099 + $5,000,000/1.0910 = $19,733,830.26

Hadm 2250, Prof. Andrey Ukhov 4/5

Name: ___________________________________ NetID: _______________________

13. A local finance company quotes a 15 percent interest rate on one-year loans. So, if you borrow $20,000, the
interest for the year will be $3,000. Because you must repay a total of $23,000 in one year, the finance
company requires you to pay $23,000/12, or $1,916.67, per month over the next 12 months. Is this a 15
percent loan? What rate would legally have to be quoted? What is the effective annual rate?

Solution:
To find the APR and EAR, we need to use the actual cash flows of the loan. In other words, the
interest rate quoted in the problem is only relevant to determine the total interest under the terms
given. The interest rate for the cash flows of the loan is:

PVA = $20,000 = $1,916.67{(1 – [1 / (1 + r)]12 ) / r }

Again, we cannot solve this equation for r, so we need to solve this equation on a financial
calculator, using a spreadsheet, or by trial and error. Using a spreadsheet, we find:

r = 2.219% per month

So the APR is:

APR = 12(2.219%) = 26.62%

And the EAR is:

EAR = (1.02219)12 – 1 = .3012 or 30.12%

14. Prepare an amortization schedule for a five-year loan of $36,000. The interest rate is 9 percent per year, and
the loan calls for equal annual payments. How much interest is paid in the third year? How much total
interest is paid over the life of the loan?

Solution:
The payment for a loan repaid with equal payments is the annuity payment with the loan value as
the PV of the annuity. So, the loan payment will be:
PVA = $36,000 = C {[1 – 1 / (1 + .09)5] / .09}

C = $9,255.33
The interest payment is the beginning balance times the interest rate for the period, and the
principal payment is the total payment minus the interest payment. The ending balance is the
beginning balance minus the principal payment. The ending balance for a period is the beginning
balance for the next period. The amortization table for an equal payment is:

Year Beginning Total Interest Principal Ending

Balance Payment Payment Payment Balance
1 $36,000.00 $9,255.33 $3,240.00 $6,015.33 $29,984.67
2 29,984.67 9,255.33 2,698.62 6,556.71 23,427.96
3 23,427.96 9,255.33 2,108.52 7,146.81 16,281.15
4 16,281.15 9,255.33 1,465.30 7,790.02 8,491.13
5 8,491.13 9,255.33 764.20 8,491.13 0.00

In the third year, $2,108.52 of interest is paid.

Total interest over life of the loan = $3,240 + 2,698.62 + 2,108.52 + 1,465.30 + 764.20 =
$10,276.64

Hadm 2250, Prof. Andrey Ukhov 5/5