Practice Problem Set #1: Time Value of Money I

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. What is compounding? What is discounting?

2. What is simple interest? What is compound interest?
3. What happens to present value when you increase or decrease the discount rate (r)?
4. Explain how you would use the rule of 72?
5. Are APR and EAR interest rates the same?
6. When would an EAR and APR rate be the same?

Practice Problems:
1. (a) An $8,000 loan calls for simple interest payments of 9 percent per year. Repayment
of principal and all accumulated interest is to be made at the end of year 4. What amount
needs to be repaid?

(b) Assume the same loan as under (a), but with interest now compounded annually.
How much needs to be repaid at the end of year 4?

(c) Assume the same loan as under (a), but now with APR interest of 9 percent
compounded quarterly. How much needs to be repaid at the end of year 4?

2. Suppose you deposit $1 in the bank today. If the yearly interest rate is 10% per year,
what will the dollar be worth in 100 years? Suppose the interest rate is 11% per year.
What will your dollar be worth in 100 years?

3. An investor deposits $300 today and will deposit $400 one year from today. If the
investor earns interest at 8% compounded yearly, how much will the investor have two
years from the date of the first deposit?

4. (a) If a bank pays 6 percent per year interest compounded annually on a $1,000 deposit,
what will be the value of this deposit at the end of 10 years?

(b) If another bank pays 6 percent per year interest on the same $1,000 deposit but
compounds interest quarterly, what will be the value of this deposit at the end of 10
years? What is the effective annual interest rate being paid?

(c) If interest were paid continuously at 6 percent per year on this $1,000 deposit, what
would it be worth in 10 years?

5. Bank A offers an 8 percent per year APR, compounded monthly on its savings deposits.
Bank B also offers an 8 percent per year APR, but compounds continuously. Compare
the two alternatives on the basis of (a) the future value of $5,000 in 5 years; and (b) the
effective annual interest rate. Is continuous compounding a significant advantage over
the more typical monthly compounding?
6. An investor invests $700 and 8 years later the investment is worth $935. Determine the
annual rate of return of this investment if interest was compounded annually.

7. How many years will it take for $200 to grow to $360 if the effective annual interest rate
is 9%?

8. Some investors use a very rough approximation called the “rule of 72”. It estimates that
invested money will double in value (so that $1 invested will grow to approximately $2)
whenever the interest rate and investment horizon multiplied together equal 72. Use the
FV formula to determine how close this approximation is for the following rates and
investment horizons: (a) 3%, 24 years; (b) 6%, 12 years; (c) 12%, 6 years; (d) 36%, 2
years.

9. A property owner is considering whether to repaint the wooden outside walls of the
house, or whether to install vinyl siding. Painting currently costs $3,500 and would have
to be done every 5 years. Future painting costs would increase with the rate of inflation,
which is expected to average 6 percent per year. In order to proceed with painting, some
wooden boards with rot would have to be replaced at a one-time cost of $2,000; with
these repairs the wooden siding is expected to last for 25 years. Vinyl siding that can be
installed over the old wooden boards (without repairs) costs $13,000 and is maintenance
free with an expected life of 25 years. Work on the house is to be financed by
withdrawing funds from investments where they are expected to earn an average
interest of 10 percent per year. From a financial point of view, which is the preferred
alternative?
 Practice Problem Set #2: Time value of Money

Theoretical and conceptual questions:

(see notes or textbook for solutions)
1. Describe three special case annuities.
2. Describe how to calculate the future and present values of a series of uneven cash flows.
3. What is our assumption about the timing of cash flows within a period, unless we are told
otherwise?
4. What compounding period would provide an EAR closest to continuous compounding?

Practice Problems:
1. (a) If $2,000 is placed in a savings account at the end of each year for 5 years, what is the
value of this account at the end of the fifth year, given that money paid into the account
earns 10 percent simple interest?

(b) What is the value of the account at the end of 5 years if all balances held in the account
earn interest of 10 percent compounded annually?

(c) Recompute your answer under (b) assuming that $2,000 is paid into the account at the
beginning of each year. The first of these 5 payments is made immediately.

2. (a) What is the present value of $7,000 to be received at the end of each year for 6 years if
the APR is 10 percent compounded annually?

(b) What is the present value of $3,500 to be received at the beginning of every 6-month
period for 6 years if the APR is 10 percent compounded semi-annually?

3. (a) Assume that a pension plan offers to pay a lump sum of $200,000 on a person's 65th
birthday, or an annuity of $x for the remainder of the person's life. A person’s life
expectancy has been determined statistically to be 80 years. The first annuity payment
would be on the person’s 65th birthday and it is expected that the last payment would be
on the person’s 79th birthday. Interest rates are 10 percent per year. What is the value
of x (the amount of the annuity) that would make the two alternatives equivalent on an
expected present value basis?

(b) A person joins the pension plan at age 30. How much will this person have to pay into
the pension fund at the end of each year in order to accumulate a balance of $150,000
in the fund at age 65? The first contribution will be on the person’s 31st birthday and the
final contribution will be on the person’s 65th birthday.

4. (a) Assume that Luke Smith wants to retire in 20 years. He expects to live for another 15
years after his retirement, and during retirement he wants to withdraw $12,000 at the
beginning of each year from his savings account. How much will he have to deposit in
his account at the end of each year for the next 20 years, given that the interest rate is
10 percent per year compounded annually?
 (b) How would the amount computed under (a) be altered if Mr. Smith expects his wife to
live for 5 years after his death and if, in addition to the amounts provided for under (a),
he wants her to be able to withdraw $6,000 at the beginning of each year during this
additional period?

5. How much is a perpetuity of $10 per year starting today worth if the interest rate is 18% per
year?
6. After getting a $500 bonus at the nuclear power plant, Homer is deciding whether to save it
or buy a lifetime membership in the Duff Beer Club. If he joins the club, he will save $1 per
week on his weekly Duff beer purchases. If Homer earns 0.10% per week on his bank
account, how long in years does he have to live before the membership is worth
purchasing? Assume his first purchase is one week from now.

7. On their statements, MasterCard is currently quoting a daily interest rate of 0.04315% and a
yearly rate of 15.75%. Is the yearly rate effective or APR? Justify your answer.

8. Canadian mortgages are almost always compounded semi-annually, but the frequency of
payments can vary. Suppose a mortgage is for $100,000, the APR is 6% compounded
semi-annually, and the mortgage is to be paid monthly over 25 years.

(a) Find the interest rate that you would use to calculate the payment.

(b) Calculate the payment.

9. How much will you have at the end of 20 years if you invest $100 today at 15% per year,
compounded annually? How much will you have if you invest at 15% per year, compounded
continuously?

10. For the following, assume the APR is 6%.

(a) What is the effective annual interest rate if interest is compounded semiannually?

(b) What is the effective annual interest rate if interest is compounded daily?

(c) Suppose you have $100 in the bank earning interest at 6% per year compounded
monthly. How much can you withdraw at the end of each month so that your balance
will be zero after 12 equal monthly withdrawals?

11. You wish to buy a $1,250 appliance. The friendly folks at Appliance Warehouse will let you
pay for it in 36 monthly instalments at an APR of 18% per year, compounded monthly. What
will your payments be?
 Practice Problem Set #3: Time Value of Money

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. Differentiate between the following loans and provide an example:

a) Pure discount loans
b) Interest only loans
c) Two types of amortized loans (equal payment and equal principal payment)
2. How can you determine the outstanding principal amount on a loan, at a date prior to
maturity, without using an amortization table?
3. What is a bullet or balloon payment?
4. What are payday loans? Are these loans legal? Are they ethical?

Practice Problems:

1. You are given the choice between an annuity with yearly payments of $813.73 for 10 years
and a perpetuity with payments of $500 per year. The payments on both start one year from
now. What annual interest rate will make you indifferent between the two offers?

2. You just had your twentieth birthday. A salesman offers you the following deal: “Pay our
company $500 per year for 15 years starting in one year and, when you retire, we’ll guarantee
you an income of $40,000 per year for 15 years starting on your 66th birthday.” Is this a good
deal if your opportunity cost of capital is 10% per year?

3. For a 25-year, $100,000 mortgage at an 8% APR, calculate:

(a) the yearly payment, assuming the interest is compounded annually;
(b) the principal outstanding just after you have made the 16th payment;
(c) the interest portion of the 17th payment;
(d) the monthly payment, if instead the interest is compounded semi-annually.

4. Your 12% APR, compounded monthly, 36-month car loan requires monthly payments of $625
at the end of each month. Immediately after making the 10th payment, you realize that you
can't afford the car. A friend offers to take over making the payments if you, in return, give
your friend the car. If the car’s market value is $15,000, is this a good deal for you?

5. Exactly four years ago, Jill took out a $175,000 mortgage to buy a condominium. The original
terms of the loan agreement called for monthly payments of $1,926.43 at an APR of 12.3%,
compounded semi-annually, over a period of 20 years. This morning Jill made her 48th
payment. Someone offers Jill $180,000 today for her condo. If she sells, how much cash will
she have after paying off the bank?

6. You are considering purchasing a new stereo. The purchase price of the stereo is $2,200.
The manager at the stereo store offers you the following options: 1) take $200 off the price of
the stereo and pay cash now or 2) pay off the $2,200 stereo over 12 months at a contract
interest rate of 0.9% per month. The contract interest rate determines the amount of the
monthly payments.

(a) Calculate the monthly payments for the 12-month pay-back option.
(b) If your personal interest rate is 0.9% per month (i.e., this is the rate you use to discount
cash flows), which payment option do you prefer? Note: no calculations are required to
answer this.

(c) If your personal interest rate is 0.5% per month (i.e., this is the rate you use to discount
cash flows), which payment option do you prefer? Note: no calculations are required to
answer this.

(d) If your personal interest rate is 2.5% per month (i.e., this is the rate you use to discount
cash flows), which payment option do you prefer?
7. Benway Motors is currently offering dealer financing packages for its new cars. You are
interested in the $25,000 Interzone Sonic Roadster and can choose between two deals: A.
$3,500 cash back from the manufacturer (Interzone) and dealer financing from Benway
in the form of a 36-month loan at a contract interest rate of 12% APR, compounded
monthly. Payments would begin in one month.
B. a 48-month “Benway Special” loan at a contract interest rate of 6% APR, compounded
monthly. Payments would begin immediately.
(a) Calculate the monthly payment for deal A.
(b) Calculate the monthly payment for deal B.
(c) Assume that your personal interest rate is 12% APR, compounded monthly. Which is the
better deal for you? Why?
 Practice Problem Set #4: Bonds

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. Distinguish between pure discount bonds, coupon bonds and perpetual bonds.
2. Describe the cash flows associated with a bond and how you would value a bond.
3. How are bonds similar and different to interest only bank loans?
4. Describe two risks associated with owning a bond.
5. Two bonds with identical maturities have different yields, what could be the reason/s for
that?
6. What is a bond’s yield to maturity? Is the yield to maturity an APR or effective rate?
7. What is the relationship between interest rates and bond prices?
8. What are credit rating agencies and what role do they play in financial markets?

Practice Problems:
[Note: some of these questions involve solving for yield to maturity (YTM). On an
exam, you will not be asked to solve for YTM using trial and error. However, you
will develop good intuition about bond prices and yields by solving for YTM in
practice problems.]

1. (a) Calculate the market price of an annual coupon bond having these characteristics: face
value of $1,000, matures in 2 years, coupon rate of 10 percent, and YTM of 12 percent.
(b) Compute the market price of the bond in part (a) assuming that it matures in 20 years.
(c) What would be the market price of the bond if it were perpetual (i.e. it never matures)?

2. (a) A $1,000, 20-year bond with a coupon rate of 14 percent and coupons paid annually is
selling at $1,300. Determine the YTM.
(b) Determine the YTM of the bond in part (a) if the coupons are now paid semi-annually.

3. Suppose a 12 percent, $1,000 bond with 7 years left to maturity is selling for $1,208.25. What
is the YTM on the bond, assuming that coupons are paid annually?

4. You find an old copy of the Financial Post newspaper. In that issue you observe that the
following $100 face value Government of Canada bonds all maturing on January 2, 2045 were
trading in the market.

Bond Maturity Date Price Coupon Rate

1 2045-Jan-02 26 0%
2 2045-Jan-02 79 5%
3 2045-Jan-02 100 7%
4 2045-Jan-02 132 10%

Answer the following questions:

(a) Which bond or bonds are selling at a premium?
(b) Suppose the reported YTM on all four bonds is the same. Without performing any
calculations, determine the YTM. How did you determine that amount?
5. Consider a Government of Canada bond with the following characteristics: face value = $100;
coupon rate = 9.50% (coupons paid semi-annually); maturity date = June 1, 2034; issue date
= June 1, 2014; YTM = 9.82%. Assume today is September 1, 2018 and exactly three months
have passed since June 1, 2018. Calculate the price of this bond.

6. Suppose a 20-year Government of Canada bond has a coupon rate of 7%, a face value of
$1,000 and a YTM of 5%.
(a) If the bond pays its coupons annually, what is the price of the bond?
(b) If the bond pays its coupons semi-annually, what is the price of the bond?

7. Set up the equation to find the YTM of a bond with a coupon rate of 10%, coupons paid
annually, a face value of $1,000 and two years left to maturity that is currently selling for
$1,073.34.

8. Determine the YTM of a $1,000, 25-year, 3% coupon, Government of Canada bond that
makes semi-annual coupon payments and is currently selling for $930.
 Practice Problem Set #5: Bonds
Theoretical and conceptual questions:
(see notes or textbook for solutions)

1. How would you calculate the realized return on a bond for a holding period?
2. Why is it likely that the realized return is different from the bond’s yield to maturity when the
bond was purchased?
3. What is the difference between nominal and real returns?
4. What is the term structure of interest rates and what determines the shape of the yield
curve?
5. What components make up a bond’s yield to maturity?

Practice Problems:
[Note: some of these questions involve solving for yield to maturity (YTM). On an
exam, you will not be asked to solve for YTM using trial and error. However, you
will develop good intuition about bond prices and yields by solving for YTM in
practice problems.]

1. ABC International has issued $1,000 face value bonds that pay coupons
semiannually. The coupon rate is 8% and the bonds have 20 years until maturity.
(a) If you require a YTM of 9% for a bond of this risk, how much would you be willing
to pay?
(b) Assume you still require a YTM of 9%. If the YTM on the bond were 7%, would
you buy the bond? Explain.

2. A bond was issued seven years ago. The bond pays an annual coupon of 10.5%, and
has 28 years left to maturity. The YTM has declined since the bond was issued and
the bond is now trading at a price of $1,151.74.
(a) What is the current YTM?
(b) You buy the bond today, having missed getting this year’s coupon by mere
seconds. You hold the bond for three years, and sell it just after collecting the
coupon that year. You invest the coupons in your ING savings account, which
pays you a 3% APR, compounded annually. At the time of the sale, the bond’s
YTM has increased sharply to 12%. At the end of 3 years, what is your ROR
(annual realized rate of return) from this investment scheme?
(c) Why is the ROR different from the YTM calculated in (a)

3. You have just bought a newly issued $1,000 ten year bond at par. The bond’s coupon
rate is 12% and coupons are paid semi-annually. You intend to hold the bond for 5
years, at which point you believe the YTM will be 11.5%. You believe you will be able
to reinvest the coupons at 14% APR, compounded semiannually.

(a) If all goes according to plan, what will your ROR be at the end of the five years?
 (b) What was the original YTM at purchase and why is the ROR different from the
original YTM at purchase?

4. One year ago, you purchased a newly issued, 20 year Government of Canada bond
that was issued at its par value of $1,000. The coupon rate on this bond is 7% per year
and the coupons are paid annually (you received the first coupon this morning). Today,
the bond is priced to yield 8% and you have just sold it. What was your return over the
past year?
 Practice Problem Set #6: Stocks I

Theoretical and conceptual questions:

(see notes or textbook for solutions)

1. Distinguish debt from equity. Consider rights of shareholders vs. debtholders, nature of cash
flows, taxation etc.
2. How is preferred stock like debt?
3. Does the value of a share of stock depend on how long you keep it?
4. Why does the value of a share of stock depend on dividends?
5. How would you value shares of a company that does not pay dividends?
6. What are the two components of the return on common stock?
7. Differentiate between realized return and expected returns on stock.
8. Explain how you could use multiples such as the P/E ratio to value stock.

Practice Problems:

1. Suppose you bought one share of Pouce Coupe Resorts (PCR) one year ago for $9.
Today, you received a dividend payment of $1 and sold the share for $9.50. What was
your realized return on PCR over the last year?

2. Suppose you bought a share of Apple Computer one year ago for $51. This morning
you received a dividend of $0.48 and sold the share for $59. What was your realized
return?

3. This morning, the Bank of Dawson Creek (BDC) paid a $2 dividend (it pays dividends
once per year) and these are expected to grow at the constant rate of 5% per year. If
the required return on BDC is 15%, calculate the current stock price of BDC.

4. Yesterday, the Hudson Hope Computer (HHC) announced a $3 dividend to be paid in

one year's time. If the current price of HHC is $30 and the required return on HHC is 20%,
what is the (constant) growth rate consistent with the current stock price?

5. Dilbert Conglomerated has just gone public. Over the first year, dividends are expected
to grow 18%. The next two years after that, dividend growth will be 12%. Finally,
dividend growth will settle into a rate of growth of 10% from then on. Assume the company
just paid a dividend of $1.00.
(a) If investors require a rate of return of 14%, how much should you pay for this
stock?

(b) Assume the required rate of return continues to be 14%. If you buy the stock at
the price found in part(a) above, and sell it after 3 years, what is your realized
rate of return if you just put your dividends under your mattress as you get them?
6. Intercar Manufacturing produces audio equipment for the automotive market. It is
growing very rapidly and does not expect to pay a dividend for the next few years. At
the end of year 5 it expects to pay a dividend of $1.00 per share. The dividend is then
expected to grow at 15% in year 6 and from year 7 settle down to a long run growth rate
of 4% per year. If investors require a 14% return to hold the common stock, what price
per Intercar share would you expect to pay today?

7. Pratt Inc. manufactures aircraft parts. Pratt has earnings per share (EPS) of $7.50 and
just paid a dividend of $3.75. The growth rate expected is 3% in perpetuity and
investors require a 8% return. The share is currently selling for $75 per share. A very
good comparable company, Whitney Co. has a P/E ratio of 15.

(a) What is your estimate of Pratt Inc.’s share price if you use a multiples valuation
method?

(b) What does the share price calculated in a. tell you about the current value of
Pratt Inc.?

(c) Using a discounted cash flow valuation model, what is your best estimate of
Pratt’s share price?

8. Duffs Co. is growing quickly. Dividends are expected to grow at a 24% rate for the next
three years, with the growth rate falling off to a constant 6% thereafter. If the required
return is 11% and the company just paid a $1.90 dividend, what is the current share
price?
 Practice Problem Set #7: Stocks – Market Efficiency

1. What are the characteristics of an efficient market?

2. Net Present Value (NPV) is equal to the PV of the benefits minus the PV of the costs of an
investment. If securities markets are efficient, what is the NPV of any security, regardless of
its risk?

3. Given the following situations, determine in each case whether there is evidence against the
semi-strong form EMH:

a) You have discovered that the square root of any given stock price multiplied by the day of
the month provides an indication of the direction in price movement of that particular stock
with a probability of 95%.

b) On average, investors in the stock market this year are expected to earn a positive return
(profit) on their investment. Some investors will earn considerably more than others will.

c) An Ontario Securities Commission lawsuit was filed against ATI Technologies. ATI
Technologies’ founder and chairman Mr. Kwok Yuen Ho and his wife Betty Ho were
accused of avoiding almost $7 million in losses by selling ATI shares prior to a May 2000
negative earnings announcement.

4. Insider trading is illegal. Individuals who have traded on inside information about their own
firms have frequently been been prosecuted. What conclusion can you draw from this, and
how does this information affect which form of the EMH you might adopt?

5. Suppose that the market, as confirmed by numerous unbiased studies, is determined to be

semi-strong form efficient. Investment firms therefore decide to retire all the financial analysts
and portfolio managers and let random choice govern the security selection process. What
mistake are investment firms likely making?

6. Suppose you observe that companies’ CEOs make abnormally high returns on investments
in their own company’s stock. Is this evidence against the weak-form EMH? Is this evidence
against the strong-form EMH?

7. Does weak-form efficiency imply strong-form efficiency? What about the reverse?

8. Suppose that Canadian Tire announced this morning that its profit from last quarter has
dropped 15% compared to the previous quarter. The closing price today of Canadian Tire
was up 2% from yesterday. Is this evidence against the EMH?

9. Illustrate market over-or-under reaction with an example.

10. Is market over-or-under reaction evidence against market efficiency?