Problem Set: Time Value of Money b) $500 per year forever, with the first payment two
years from today.
RJW 4th Ed
RJW 4.1’ Compute the future value of $1,000, annually
compounded for:
a) 10 years at 5%.
b) 10 years at 7%.
c) 20 years at 5%.
d) Why is the interest earned in part c not twice the
amount earned in part a?
RJW 4.2’ Calculate the present value of the following
cash flows discounted at 10%.
a) $1,000 received seven years from today.
b) $2,000 received one year from today.
c) $500 received eight years from today.
RJW 4.7 You are selling your house. The Smiths have
offered you $115,000. They will pay you immediately.
The Joneses have offered you $150,000, but they
cannot pay you until three years from today. The
relevant interest rate is 10%. Which offer should you
choose?
RJW 4.15’ What is the future value three years hence
of $1,000 invested in an account with a stated annual
interest rate of 8%,
a) compounded annually?
b) compounded semiannually?
c) compounded monthly?
d) compounded continuously?
e) Why does the future value increase as the
compounding period shortens?
RJW 4.22’ Assuming an interest rate of 10%, calculate
the present value of the following streams of yearly
payments:
a) $1,000 per year forever, with the first payment one
year from today.
c) $2,420 per year forever, with the first payment three
years from today.
RJW 4.24’ Harris, Inc. is about to pay a $3 dividend. If
the firm raises its dividend at 5% every year and the
appropriate discount rate is 12%, what is the price of
Harris stock?
RJW 4.36 You have recently won the super jackpot in
the Illinois state lottery, with a payoff of $4,960,000.
On reading the fine print, you discover that you have
the following two options:
a) You receive $160,000 at the beginning of each year
for 31 years (i.e. $4,960,000 / 31). The income would
be taxed at an average rate of 28%. Taxes are withheld
when the checks are issued.
b) You receive $1,750,000 by now, but you do not have
access to the full amount immediately. The $1,750,000
would be taxed at an average rate of 28%. You are able
to take $446,000 of the after-tax amount now. The
remaining $814,000 will be placed in a 30-year annuity
account that pays $101,055 on a before-tax basis at the
end of each year.
Using a discount rate of 10%, which option should you
select?
Additional Problems
1. PS1. A firm plans to start a major capital expenditure
program in the future. Three and one half years from
today (today is date zero), the firm will make the first
of eight $640 equipment purchases. These equipment
purchases will occur at six-month intervals. Currently
the firm has no excess cash.
Profit forecasts for the firm suggest that it should be
able to build up its cash reserves through the deposit
of an amount G starting six months from today, a
second payment of the amount G (1+.03) made twelve
months from today, a third payment of the amount G
(1+.03)2 made eighteen months from today, and so on.
In total, the firm will make six of these payments to
build up cash reserves. Suppose that cash reserves can
be invested at a stated annual rate of 18% with two
compounding periods per year.
(a) What is the cost of the capital expenditure program
in terms of date-zero dollars?
(b) How large does the value for G have to be for the
firm to pay for the planned capital expenditures out of
the accumulate cash reserves? Assume the initial cash
reserves are zero.

2. PS3. It is currently year zero. The annual interest rate

is 8% and will remain at 8% in the future. You are
offered the following two alternatives.

(a) A level perpetuity that makes its first payment of

$200 in year 11. Of course, the payments of $200
continue every year thereafter.

(b) A 10-year annuity, making its first payment of $200

in year 1.

What is the year-zero present value of each

alternative?

3. PS4. Joe is in the market for a new car which he will

keep for at least 10 years. A car salesman tells Joe that
his dealership is offering 50-month loans at a 12%
stated annual rate “SAR”, compounded monthly. (The
loan will involve 50 payments of identical amounts.)

(a) If the car costs $10,000, what will Joe’s monthly

payments be?

(b) What is the effective annual rate on the loan?

(c) Suppose a lease is available that requires payments

of $200 per month for the next 50 months, plus an
additional “balloon-payment” of $4,000 at maturity of
the lease. Assume the relevant discount rate for the
lease payments is same as the discount rate for the
loan payments. Is Joe better off buying or leasing the
car from this dealer?

(d) Another dealer has offered to sell Joe the identical

car for $365.56 per month for 40 months. If the car is
worth $10,000, what is the implicit effective annual
rate “EAR” for the loan?