Buenafe , Angelene L.

BSMA 2C

5-3 FINDING THE REQUIRED INTEREST RATE

Your parents will retire in 18 years. They currently have $250,000 saved and they think will need
$1,000,000 at retirement. What annual interest rate must they earn to reach their goal, assuming they don’t
save additional funds?

GIVEN:

FV = $1,000,000

PV = $250,000

n = 18

SOLUTION:

FV = PV (1+i)n

$1,000,000 = $250,000 (1+i)18

$1,000,000/$250,000 = (1+ i)18

4 = (1+i)

nth√ 4 = (1 + I)

1.080059738= 1+i

I = 1. 080059738 – 1

I = 0. 080059738 >> I = 0.08 or 8%

5-5 TIME TO REACH A FINANCIAL GOAL

You have $42,180.53 in a brokerage account, and your plan to deposit an additional $5,000 at the end of
every future year until your account total $230,000. You expect to earn 12% annually on the account. How
many years will it take to reach your goal?

GIVEN:

FV = $250,000

PV = $42,180.53 + $5,000 = $47,180.53

Formula:

n = ln (FV/PV) / ln (1 + i)

ln (in scientific calculator) – Natural Logarithm

SOLUTION:

n = In($250,000/$47,180.53) / In(1 + .12)

n = 1.66747961/0.113328685

n = 14.71 years
5-8 PRESENT AND FUTURE VALUES OF A CASH FLOW STREAM

An investment will pay $100 at the end of each year of the next 3 years. $200 at the end of year 4, $300 at
the end of year 5, and $500 at the end of year 6. If other investments of equal risk earn 8% annually, what
is its present value? Its future value?

GIVEN:

YEAR Cash Flow

1 $100

2 $100

3 $100

4 $200

5 $300

6 $500

Interest = 8%

Formulas:

PV = FV (1+i)-n

FV = PV (1+i)n

SOLUTION:

PV = FV (1+i)-n

100(1+.08)-1 = 92.59
100(1+.08)-2 = 85.73
100(1+.08)-3 = 79.38
200(1+.08)-4 = 147
300(1+.08)-5 = 204.17
500(1+.08)-6 = 315.08
Total 923.95 (Present Value)
FV = PV (1+i)n

100(1+.08)5 = 146.93
100(1+.08)4 = 136.05
100(1+.08)3 = 125.97
200(1+.08)2 = 233.28
300(1+.08)1 = 324
500(1+.08)0 = 500
Total 1,466.23 (Future Value)

5-13 EFFECTIVE RATE OF INTEREST

Find the interest rates earned on each of the following:

You borrow $700 and promise to pay back $749 at the end of 1 year.

You lend $700 and the borrower promises to pay you $749 at the end of 1 year.

You borrow $85,000 and promise to pay back $201,229 at the end of 10 years.

You borrow $9,000 and promise to make payments of $2,684.80 at the end of each year for 5 years.

FORMULA:

FV = PV (1+i)n

A.

Given:

FV=$749, PV= $700, n = 1

$749 = $700 (1+i)

$749/$700 = (1+i)

1.07 = 1 + i

I = 1.07 -1

I = .07 or 7%
B.
Given:

FV=$749, PV= $700, n = 1

$749 = $700 (1+i)

$749/$700 = (1+i)

1.07 = 1 + i

I = 1.07 -1

I = .07 or 7%

C. Given:

FV= $201,229, PV = $85,000, n= 10

201,229 = 85,000(1+i)10
201,229/85,000 = (1+i)10
2.3674 = (1+i)10
nth√2.37 = (1+i)10
1.09 = 1+i
I = 1.09 – 1
I = 0.09 or 9%

D.

Given:

FV = 2684.80 x 5 = 13424, PV= 9,000, n=5

13,424 = 9,000 (1+i)5

13,424/9,000 = (1+i)5
1.49 = (1+i)5
nth√1.49 = (1+i)5
1.08 = 1+i
I = 1.08 – 1
I = 0.08 or 8%

5-17 PRESENT VALUE OF A PERPETUITY

What is the present value of a $100 perpetuity if the interest rate is 7%? If interest rate doubled to 14%,
what would the present value be?

Formula:

PV=PMT/i

Where:

PV- is the present value

PMT- is the regular cash flow

i- is the interest rate

Given:

PMT=$100

(1) i=7%

(2) i=14%

Solution:

(1) PV=PMT/i

=$100/0.07

PV= $1,428.27

(2) PV=PMT/i

= $100/0.14

PMT= $714.285 or $714.29

5-22 PV OF A CASH FLOW STREAM

A rookie midfielder is negotiating his first Japan Soccer Premiere League contract. His opportunity cost is
10%. He has been offered three possible 4-year contracts. Payments are guaranteed, and they would be
made at the end of each year. Terms of each contract are as follows:

1 2 3 4

Contract 1 $3,000,000 $3,000,000 $3,000,000 $3,000,000

Contract 2 $2,000,000 $3,000,000 $4,000,000 $5,000,000

Contract 3 $7,000,000 $1,000,000 $1,000,000 $1,000,000

As his adviser, which contract would you recommend that he accept?

Formula:

PV= FV( 1+i) -n

Where:

PV- is the present value

FV- is the future value

i- is the interest rate

n- no.of compounding period

Solution:
CONTRACT 1

$3,000,000 (1+.10)-1= $ 2,727,272.73

$3,000,000 (1+.10)-2 = $ 2,479,338.84

$3,000,000 (1+.10)-3 = $ 2,253,944.40

$3,000,000 (1+.10)-4 = $ 2,049,040.37

TOTAL PV= $9,509,596.34

CONTRACT 2

$2,000,000(1+.10)-1= $1,818,181.82

$3,000,000(1+.10)-2= $2,479,388.84

$4,000,000(1+.10)-3= $3,005,259.20

$5,000,000(1+.10)-4= $3,415,067.28

TOTAL PV= $10,717,847.24

CONTRACT 3

$7, 000,000(1+.10)-1 = $6,363,636.36

$1, 000,000(1+.10)-2 = $826,446.28

$1, 000,000(1+.10)-3= $751,314.80

$1, 000,000(1+.10)-4= $683,013.46

TOTAL PV = $8,624,410.90

EXPLANATION: As an adviser I would recommend CONTRACT 2 since it has the highest present value.

5-23 EVALUATING LUMP SUMS AND ANNUITIES

Wang Yun just won the lottery, and she must choose among three award options. She can elect to receive
a lump sum today of $61 million, to receive 10 end-of-year payments of $9.5 million, or to receive 30 end-
of-year payments of 5.5 million.

If she thinks she can earn 7% annually, which should she choose?

If she expects to earn 8% annually, which is the best choice?

If she expects to earn 9% annually, which option would you recommend?

Explain how interest rates influence her choice.

a. If she thinks she can earn 7% annually, which should she choose?

Equation: PV= PMT 1-(1+r/n)^-(t)(n)

r/n

1. Receive a lump sum today of $61 million

PMT= $61,000 000 1/Y= 7% n= 0

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 61,000,000*1-(1.07/0)^-(0)(0)

.07/0

=61,000,000*1- 0

=$61,000,000.00
2.Receive 10 end-of-year payments of 9.5 million

PMT= $9,500 000 1/Y= 7% n= 10

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 9,500,000*1-(1.07/1)^-(10)(1)

.07/1

=9,500,000*1- 0.5083492921

.07

=9,500,000 * 0.4916507079

.07

=9,500,000 * 7.0235815414

=$66,724,024.64

3.Receive 30 end-of-year payments of $5.5 million.

PMT= $5,500 000 1/Y= 7% n= 30

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 5,500,000*1-(1.07/1)^-(30)(1)

.07/1

=5,500,000*1- 0.131671172

.07

=5,500,000 * 0.8686328828

.07
=5,500,000 * 12.409041183

=$68,249,726.51

Decision: In this case, it will be better for her to receive a lump sum today of $68,249,726.51 since she will
get the highest value.

b. If she expects to earn 8% annually, which is the best choice?

1.Receive a lump sum today of $61 million

PMT= $61,000 000 1/Y= 8% n= 0

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 61,000,000*1-(1.08/0)^-(0)(0)

.08/0

=61,000,000*1- 0

=$61,000,000.00

2.Receive 10 end-of-year payments of 9.5 million

PMT= $9,500 000 1/Y= 8% n= 10

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 9,500,000*1-(1.08/1)^-(10)(1)

.08/1
=9,500,000*1- 0.4631934881

.08

=9,500,000 * 0.5368065119

.08

=9,500,000 * 6.7100813987

=$63,745,773.29

3.Receive 30 end-of-year payments of $5.5 million.

PMT= $5,500 000 1/Y= 8% n= 30

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 5,500,000*1-(1.08/1)^-(30)(1)

.08/1

=5,500,000*1- 0.0993773325

.08

=5,500,000 * 0.9006226675

.08

=5,500,000 * 11.257783344

=$61,917,808.39

c. If she expects to earn 9% annually, which option would you recommend?

1.Receive a lump sum today of $61 million

PMT= $61,000 000 1/Y= 9% n= 0

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 61,000,000*1-(1.09/0)^-(0)(0)

.09/0

=61,000,000*1- 0

=$61,000,000.00

2.Receive 10 end-of-year payments of 9.5 million

PMT= $9,500 000 1/Y= 9% n= 10

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 9,500,000*1-(1.09/1)^-(10)(1)

.09/1

=9,500,000*1- 0.4224108069

.09

=9,500,000 * 0.5775891931

.09

=9,500,000 * 6.4176577011

=$60,967,748.16

3.Receive 30 end-of-year payments of $5.5 million.

PMT= $5,500 000 1/Y= 9% n= 30

PV= PMT 1-(1+r/n)^-(t)(n)

r/n

= 5,500,000*1-(1.09/1)^-(30)(1)

.09/1

=5,500,000*1- 0.0753711361

.09

=5,500,000 * 0.9246288639

.09

=5,500,000 * 10.273654043

=$56,505,097.24

d. Explain how interest rates influence her choice.

5-30 EFFECTIVE VERSUS NOMINAL INTEREST RATES

Bank A pays 4% interest compounded annually on deposits, while Bank B pays 3.5% compounded daily.

Based on the EAR (or EFF%), which bank should you use?

Could your choice of banks be influenced by the fact that you might want to withdraw your funds during as
opposed to at the end of the year? Assume that your funds must be left on deposit during an entire
compounding period in order to receive any interest.

Formula:

EFF= (1+INominal/M)m-1

Where:
INominal- is the normal interest rate

M- no.of compounding period per year

EFFECTIVE RATE

Solution:

BANK A (compound annually)

EFF= (1+INominal/M)m-1

EFF= (1+0.04/1)1-1

=O.04

EFF =4%

BANK B (compound daily)

EFF= (1+INominal/M)m-1

=(1+0.035/365)365-1

=0.035618

EFF=3.5618% or 3.5%

NOMINAL RATE

Formula:

r = m × [ ( 1 + i)1/m - 1 ]

Where:

i-the effective rate

r-the stated rate

m-the number of compounding periods

Solution:
BANK A (compound annually)

r=1×[(1+0.04)1/1-1

= 0.04

r=4%

BANK B (compound daily)

r = 365× [( 1+0.035)1/365-1

= 0.035

r =3.5%

(A)

I will choose Bank B which pays interest at 3.5 % which is compounded daily because its effective return of
investment is greater than Bank A which is compounded annually.

(B)

No, choice of banks will not influenced by the fact that I will withdraw the funds at the end of the year and
through this I can received interest that will effect on the value of a sum of money.

5-33 REACHING A FINANCIAL GOAL

Shan Chen and Shan Xia, who are twins, just received $30,000 each for their 25th birthday. They both
have aspirations to become millionaires. Each plans to make a $ 5,000 annual contribution to her “early
retirement fund” on her birthday, beginning a year from today. Shan Chen opened an account with the
Asiana Regional Bond Fund, a mutual fund that invests in high-quality bonds whose investors have earned
6% per year in the past. Shan Xia invested in the First Tech Renewable Fund, which invests in small, newly
issued bio-tech stocks and whose investors have earned an average of 20% per year in the funds relatively
short history.

If the two women’s fund earn the same returns in the future as in the past, how old will each be when she
becomes a, millionaire?

How large would Shan Chen’s annual contributors have to be for her to become a millionaire at the same
age as Shan Xia, assuming their expected returns are realized?

Is it rational or irrational for Shan Chen to invest in the bond fund rather than in stocks?

a. If the two women’s fund earn the same returns in the future as in the past, how old will each
be when she becomes a, millionaire?

Given:

Shan Chen

 PV= $30,000

 PMT= $5,000

 I=6%

 FV=$1,000,000

Shan Xia

 PV $30,000

 PMT=$5,000

 I=20%

 FV=$1,000,000
Shan Chen:

$1,000,000=FVA + FV ($30,000)

FV=$30,000 (1+0.06)^n

FVAN=PMT ( (1+I)^n -1)

I.

=$5,000 ((1.06)^N – 1)/0.06

N=38.74

Shan Xia

$1,000,000=FVA + FV ($30,000)

FV=$30,000 (1+0.2)^n

FVAN=PMT ( (1+I)^n -1)

I.

=$5,000 ((1.2)^N – 1)/0.2

N=16.04

a. Shan Chen

25+36.74= 63.74 or 64 years old

Shan Xia

25+16.04= 41.04 or 42 years old

 b. How large would Shan Chen’s annual contributors have to be for her to become a millionaire at
the same age as Shan Xia, assuming their expected returns are realized?

Shan Chen’s annual contribution:

N=16.04

I=6%

PV=$30,000

FV=$1,000,000

PMT=0.06 x 16.04 x 30,000 x – 1,000,000

Required Payment= $35,825.33

c. Is it rational or irrational for Shan Chen to invest in the bond fund rather than in stocks?

5-37 AMORTIZATION SCHEDULE

Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the end of each of
the next 3 years. The interest rate is 10% compounded annually.

What percentage of the payment represents interest and what percentage represents principal for each
year of the 3 years? Why do these percentages change over time?

AMORTIZATION SCHEDULE

a. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at the
end of each of the next 3 years. The interest rate is 10% compounded annually.

PMT= PV (r/n)

1-(1+r/n)^-(t)(n)

Solution:
PMT = $19,000 (0.08/1)÷ 1-(1+0.08/1)^(-3)(1)

=$19,000(0.08)÷ 1-0.793822

=$1,520 ÷ 0.2061678

Annual Payment=$ 7,372.64

Amortization Table

Number of Payment Periodic - Interest Reduction Principal end-

payments Principal of-period

0 $19,000

1 $7,372.64 - $1,520.00 = $5,852.64 $13,147.36

2 $7,372.64 - $1,051.79 =$6,320.85 $6,826.51

3 $7,372.64 - $546.12 =$6,826.51 $0.00

b. What percentage of the payment represents interest and what percentage represents principal
for each year of the 3 years? Why do these percentages change over time?

Interest Principal

Year 1 20.62% 79.38%

Year 2 14.27% 85.73%

Year 3 7.41% 92.59

5-42 REQUIRED ANNUITY PAYMENTS

Your father is 50 years old, and will retire in 10 years. He expects to live for 25 years after he retires, until
he is 85. He wants a fixed -retirement income that has the same purchasing power at the time he retires as
$40,000 has today. (The real value of his retirement income will decline annually after he retires.) His
retirement income will begin the day he retires, 10 years from today at which time he will receive 24
additional annual payments. Annual inflation is expected to be 5%. He currently has $100,000 saved, and
he expects to earn 8% annually on his savings. How much must he save during each of the next 10 years
(end-of-year deposits) to meet his retirement goal?

FV- $658,965.64
r- 8%
n- 1
t- 10
PMT= FV(r/n)

(1+r/n)^(t)(n)-1
= $658,965.64(0.08/1) ÷ (1+0.08/1)^(10)(1)-1
= $52,717.2512 ÷ 2.15892499727279

PMT= $45,488.06

To meet his retirement goal he must save during each of the next 10 years of

$45,488.06.