Homework 1

IEOR 221 - SPRING 2016

Due 01/29/2016

1 + EAR = (1 + r)n
if n is number of compounding periods per year and r is the interest rate per period.

1. A well-known insurance company offers a policy known as the ”Estate Creator Six Pay.”
Typically the policy is bought by a parent or grandparent for a child at the child’s birth.
The details of the policy are as follows: The purchaser (say, the parent) makes a payment
of $750 at the child’s first, second and third birthday, and makes a payment of $800 at the
child’s fourth, fifty and sixth birthday to the insurance company (there are six payments in
total). No more payments are made after the child’s sixth birthday. When the child reaches
age 65, he or she receives $250,000. If the effective annual rate (EAR) is 6% for the first six
years and 7% for all subsequent years! Is the policy worth buying?

2. Your company is considering leasing a $120,000 piece of equipment for the next 10 years.
Your company can buy the equipment outright or lease it. The annual lease payments of
$15,000 are due at the beginning of each year. The lease includes an option for your company
to buy the equipment for $25,000 at the end of the leasing period (i.e., 10 years). Should
your company accept the lease offer if the EAR is 8%?

3. You are saving for your retirement. You have decided that one year from today you
will deposit 2% of your annual salary in an account which will earn 8% per year. Your salary
last year was $50,000, and it will increase at 4% per year throughout your career. How much
money will you have for your retirement, which will begin in 40 years?

4. You must decide whether or not to purchase a new capital equipment. The cost of
the machine is $5,000. It will produce the following cash flow stream (0, $700, $900, $1,000,
$1,000, $1,000, $1,000; $1,250, $1,375). Should you purchase the equipment if the EAR is
10%?

5. Your younger brother has come to you for advice. He is about to enter college and
has two options open to him. His first option is to study engineering. If he does this, his
undergraduate degree would cost him $12,000 a year for four years. Having obtained this, he
would need to gain two years of practical experience: in the first year he would earn $20,000,
in the second year he would earn $25,000. He would then need to obtain his master’s degree,
which will cost $15,000 a year for two years. After that he will be fully qualified and can
earn $40,000 per year for 25 years.
His other alternative is to study accounting. If he does this, he would pay $13,000 a year for
four years and then he would earn $31,000 per year for 30 years.

1
The effort involved in the two careers is the same, so he is only interested in the earnings
the jobs provide. All earnings and costs are paid at the end of the year. What advice would
you give him if the market interest rate is 5%? A day later he comes back and says he took
your advice, but in fact, the market interest rate was 6%. Has your brother made the right
choice?

6. In January 1984, Richard ”Goose” Gossage signed a contract to play for the San Diego
Padres that guaranteed him a minimum of $9,955,000. The guaranteed payments were
$875,000 for 1984, $650,000 for 1985, $800,000 in 1986, $1 million in 1987, $1 million in
1988, and $300,000 in 1989. In addition, the contract called for $5,330,000 in deferred
money payable at the rate of $240,000 per year from 1990 through 2006 and then $125,000
a year from 2007 through 2016. If the EAR is 9% and all payments are made on July 1
of each year, what would the present value of these guaranteed payments be on January 1,
1984? If he were to receive an equal annual salary at the end of each of the five years from
1984 through 1988, what would his equivalent annual salary be? Ignore taxes throughout
this problem.

7. Ms. Adams has received a job offer from a large investment bank as an assistant to
the vice president. Her base salary will be $35,000. She will receive her first annual salary
payment one year from the day she begins to work. In addition, she will get an immediate
$10,000 bonus for joining the company. Her salary will grow at 4% each year. Each year
she will receive a bonus equal to 10% of her salary. Ms. Adams is expected to work for 25
years. What is the present value of the offer if the EAR is 12%?