(1) If you receive $100 today and $300 two years from now, what is the

present value of each of these two cash flows? Assume that r = .10.
r: 0.1

t= Cash flow
0 $ 100.00
2 $ 300.00
NPV

(2) If you pay out $300 today and receive $170 a year from now and $200
two years from now, what is the present value of each of three cash flows?
Assume that r = .10.
r: 0.1

t= Cash flow
0 $ (300.00)
1 $ 170.00
2 $ 200.00

NPV of cash flows

(3) Jennifer Clooney has a choice between receiving one of the following
sequences of cash flows. Jennifer knows (without any calculations) which
sequence of cash flows she should choose. Explain her reasoning.

Both sequences add up to $5000, and there are only two time periods
involved, so sequence 1, where $4000 is available upfront and the rest
in a year, is preferable to sequence 2, where only $3000 is available
upfront. Sequence Cash flow today
1 $ 4,000
2 $ 3,000
PV of cash flow
$ 100.00
$ 247.93
$ 347.93

PV of cash flow
$ (300.00)
$ 154.55
$ 165.29

$ 19.83

Cash flow a year from today

$ 1,000
$ 2,000
(1) Suppose that you can invest $1000 today and obtain $2000 in 2 years. What is the
IRR of this investment?
41.4% t=
0
1
2

irr:

(2) A bank has lent you $1,000,000 today. You have agreed to pay back $100,000 at the
end of each year for 20 years. If you pay back the money as promised, what is the IRR on
the bank's loan?
-7.75% t=
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

irr:
$ (1,000.00)
$ -
$ 2,000.00

41.4%

$ (1,000,000)
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000
$ 100,000

7.75%
(1) Suppose that a new X-ray machine costs $100,000 and is
estimated to generate the following cash flows: Year 1, $80,000; Year
2, $60,000; Year 3, $60,000. Estimate the project's payback period. If
a two-year payback period is required, should the X-ray machine be
purchased?

After one year, the X-ray machine has generated cash flows of
$80,000. After two years, it has generated cash flows totalling
$140,000. The payback period must be between one and two
years, and so the X-ray machine meets the payback period
requirement of two years. t= Cash flows

Assuming cash flows are received at a constant rate during a year 0 $ (100,000)
the project would be paid back in 1.33 years. 1 $ 80,000
2 $ 60,000
3 $ 60,000

If a two-year payback period is required, should the X-ray machine be

purchased?
Given the answer above, yes, it should.
 Cash flows generated
by X-ray machine
(running total)

$ 80,000
$ 140,000
$ 200,000

n the answer above, yes, it should.

(1) If the interest rate is 12%, what is the future value of $10,000 in 5 years?
$17,623.42 r
0.12

(2) Suppose that you receive $2 today, $1 a year from now, $2 two years from now, and $3 three
years from now. If the interest rate is 10%, what is the future value of this income three years from
today?
$9.07 r:

t
0
1
2
3

(3) Legend has it that Native Americans sold Manhattan to Peter Minuit in 1626 for $24. If the Native
Americans could instead have earned 5% interest per year all that time, did they get a good deal from
Minuit? (Assume that the 2010 value of all real estate in Manhattan is about $8 trillion.)
Assuming r = .05, $24 in 1626 would have grown to r
$5,100,418,075.65 0.05
today.
So the Native Americans were paid only $3 billion in today's dollars.
bad deal!
n K FV
5 10000 $ 17,623.42

0.1

n K FV
3 $ 2.00 $ 2.66
2 $ 1.00 $ 1.21
1 $ 2.00 $ 2.20
0 $ 3.00 $ 3.00

sum: $ 9.07

n K FV
393 24 $ 5,100,418,075.65
(1) What is the present value of receiving $5000 at times 1, 2,
and 3 if the interest rate is 10% per period?
$12,434.26 r: 0.1

n C PV
3 $ 5,000.00 $ 12,434.26

(2) What is the present value of receiving $5000 at times 1, 2, 3,

4, 5, and 6 if the interest rate is 10% per period?
r: 0.1

n C PV
6 $ 5,000.00 $ 21,776.30

(3) What is the present value of receiving $5000 at times 4, 5,

and 6 if the interest rate is 10% per period? Hint: Use the
answers to problems 1 and 2.
$21,776.30 - $12,434.26, or $9,342.04
check
$12,434.26

check
$21,776.30
(1) Suppose that you will receive $5000 per year at times 1, 2, 3, . . . .
If r = .20, what is the present value of these cash flows?
The present value of this perpetuity is $25,000. r C
0.2 $ 5,000.00

$ 25,000.00

(2) As the interest rate increases, what happens to the present value
of the perpetuity? Why?

It decreases, because the higher the interest rate, the less each
$1 received in the future is worth.
(1) The local Fourbucks coffee shop generated $130,000 in profits last
year. If we assume that the shop's profits will grow at 10% per year and
we discount future profits at 15%, what would be the value of all future
profits?
$2,860,000.00 r g
0.15 0.1
C
$ 143,000.00
(1) Recall the legend that Native Americans sold Manhattan to Peter
Minuit in 1626 for $24. If the Native Americans could have earned 5%
interest per year continuously compounded, did they get a good deal from
Minuit? (Again, assume the 2010 value of all real estate in Manhattan is
about $8 trillion.)
Assuming r = .05, $24 in 1626 with continuous compounding would
have grown to r t
$8,205,363,234.03 0.05 393
today.
Bad deal for the Native Americans. $ 8,205,363,234.03
They got nearly $5 billion in today's dollars<$8 trillion.
(2) You have $100 in the bank. If you earn 8% interest compounded
semiannually, what will you have in three years?
$126.53 r t
0.08 3

$ 126.53

(3) You have $100 in the bank. If you earn 8% interest compounded
quarterly, what will you have in three years?
$126.82 r t
0.08 3

$ 126.82

(4) If you earn 8% interest compounded semiannually, what is the

effective annual interest rate?
We find that $1 compounded semiannually will grow to $1.0816 in one
year, making the effective interest rate 8.16%. r t
0.08 1

(5) If you earn 8% interest compounded six times per year, what is the
effective annual interest rate?
We find that $1 compounded six times per year will grow to $1.082715 in
one year, making the effective interest rate 8.27%. r t
1.0827145507 0.08 1
C
$ 24.00

m C
2 $ 100.00

1.268242

m C
4 $ 100.00

m C0 C1
2 $ 1.00 $ 1.0816

m C0 C1
6 $ 1.00 $ 1.082715
(1) Assuming a required interest rate of 5%, value a 20-year bond
with a $500 face value.
$188.44 r N F
0.05 20 $ 500.00

$ 188.44

(2) Assuming an annual interest rate of 5%, value a 20-year bond

with a $500 face value that makes annual payments at a coupon
rate of 6%.
$562.31 r N F
0.05 20 $ 500.00

$ 562.31

(3) Show that, for a bond making annual payments having a coupon
rate equal to the required annual interest rate, the value of the
bond equals the bond's face value.
When C=rF we see the bond price reduces to F. r N F
0.05 20 $ 500.00

value of bond: $ 500.00

(4) Assuming an annual interest rate of 5%, value a 20-year bond

with a $500 face value that makes semiannual payments at a
coupon rate of 6%.
$562.76
r N F
0.025 40 $ 500.00

$ 562.76
 check check
Problem 1 Problem 2
$188.44 $562.31 check
rate 0.05 0.05 $562.76

Problem 4
C 1 0 30 1 15
$ 30.00 2 0 30 2 15
3 0 30 3 15
4 0 30 4 15
5 0 30 5 15

6 0 30 6 15
coupon rate C 7 0 30 7 15
0.05 $ 25.00 8 0 30 8 15
9 0 30 9 15
10 0 30 10 15
11 0 30 11 15

12 0 30 12 15
13 0 30 13 15
C 14 0 30 14 15
$ 15.00 15 0 30 15 15
16 0 30 16 15
17 0 30 17 15
18 0 30 18 15
19 0 30 19 15
20 500 530 20 15
21 15
22 15
23 15
24 15
25 15
26 15
27 15
28 15
29 15
30 15
31 15
32 15
33 15
34 15
35 15
36 15
37 15
38 15
39 15
40 515
(5) Find the yields of the bonds in problems 1, 2, and 4.

For problem 1, the yield is simply the rate r that satisfies the following equation:

For problem 1, we have

500 = (1 + r)20 * (188.44)

500/188.44 = (1 + r)20
2.65371/20 = 1 + r
r = 2.65371/20 - 1 = roughly 5% 0.050008

For problems 2 and 4, bonds that pay coupons, the yield is the rate r that
satisfies the following equation:

1 1  F
C    bond price
 r r  1 r    1 r  n
n
 
For problem 2, we have
problem 2
1 1  500 r price of bond
30    562.31 0.044 604.97
 r r  1 r    1 r  20
20
  0.045 597.56
0.046 590.27
for a yield of 5%. 0.047 583.11
0.048 576.06
0.049 569.13
0.050 562.31
0.051 555.61
For problem 4, we have
problem 4
  r price of bond
  0.044 605.68
1 1   500  562.76
15 
0.045 598.23
 r r r  
40
r
40 0.046 590.89
 
2 2 1 2   1 2 
0.047 583.68
  0.048 576.59
0.049 569.62
0.050 562.76
for a yield of 5%. 0.051 556.01
price of bond

price of bond
(1) The revenue growth figures for the PastaQuick restaurant during the last five years are
40%, 30%, 10%, -10%, and 20%. What is the five-year CAGR for PastaQuick's revenue growth?
16.67% R1
R2
R3
R4
R5

CAGR:

(2) Consider a stock that grew by 20% one year and then declined in value by 20% the next
year. What is the two-year CAGR for the stock?
-2.02% R1
R2

CAGR:
 40%
30%
10%
-10%
20%

16.67%

20%
-20%

-2.02%
(1) Today, Bridges Consolidated sells for $20 per share. Value a six-month European put or call option with
an exercise price of $25 if the risk-free rate is 5%, the stock's annual volatility is 40%, and the stock pays
out 5% of its value annually in dividends.

Call price:
Put price:

(2) True or False: If the risk-free rate increases to 10%, the put and call price will both increase.
False; the call price increases and the put price decreases.

(3) True or False: If the exercise price drops to $22, the call price will increase and the put price will
decrease.
True.

(4) True or False: If the volatility drops to 25%, the call price and put prices will both decrease.
True.

(5) Suppose that oil has been found on the Smalltown High School athletic fields. BigRigs Oil Company has
offered $10 million for the rights to the oil. Sarah Lopez Clooney has been called in to determine whether
the high school should accept the offer. The high school cannot begin drilling for five years. Sarah
estimates that at current oil prices, the oil's value in today's dollars is $50 million. In five years, it will cost
$70 million to extract the oil. Should the high school sell the oil rights? Assume that the risk-free rate is 5%
and that the annual volatility of the oil's value is 30%.
School owns a call option with S=50
X=70 r =.05 T=5.
Value of this call option is
from template is
11.58 million so accept the money!
Predicted
$ 0.75
$ 5.63