BITSoM -Finance for Global companies

Take-Home Problem Set Three (THPS-3)

SOLUTION KEY

1. Which following statement is true, assuming an interest rate of greater than 0%:
a. The present value of a dollar to be received one year from today is ALWAYS worth less than one
dollar.
b. The present value of a dollar to be received one year from today is ALWAYS worth more than one
dollar.
c. The present value of a dollar to be received one year from today is ALWAYS equal to one dollar.
d. None of the answers listed above is correct (in particular, the word ALWAYS in the answers
negates any one of them from being strictly correct).
e. All of the answers listed above (even answer d) are incorrect.
For TVM, it is ALWAYS true that a dollar today is worth more than a dollar in the future (and vice
versa).

2. Which one of the following investments provides the highest effective annual rate of return (i.e., which
of the following investments is the BEST = the largest EAR) over an investing horizon of 10 years)?
a. An investment which has a 3.0 percent nominal rate with annual compounding.
b. An investment which has a 2.98 percent nominal rate with semi-annual compounding.
c. An investment which has a 2.965 percent nominal rate with quarterly compounding.
d. An investment which has a 2.9575 percent nominal rate with monthly compounding.
e. An investment which has a 2.955 percent nominal rate and daily (365) compounding.
Compute the EAR of each investment and compare. Or, find the FV of $1000 invested in each account
at the end of 10 years. These values are computed and shown in the table below. Note that investment
choice b has the largest EAR and the largest FV at the end of 10 years and choice D has the lowest
EAR and smallest FV at the end of 10 years.
Choice EAR FV (of $1000 after 10 years)
a 3.0000% $1,343.92
b 3.0022% $1,344.20
c 2.9981% $1,343.67
d 2.9979% $1,343.65
e 2.9990% $1,343.78

3. For a given nominal interest rate greater than 0%, if the number of compounding periods per year
decreases (for example, from monthly to quarterly), the present value of $1000 to be received exactly
10 years from today will:
a. increase.
b. decrease.
c. remain unchanged.
d. either increase or decrease, depending on the nominal interest rate.
Fewer compounding periods per year means a lower effective interest rate (EAR). PV and interest rate
are inversely related. So, if number of compounding periods decreases, PV increases (and vice versa).
4. Harrison, Inc. is considering two investment opportunities. Each investment costs $7,000 (i.e., year 0
cash flow associated with each opportunity is -$7,000) and will provide the same total future cash
inflows. The schedule of estimated cash receipts for each investment follows (assume cash is received
at year-end):
Year Investment I Investment II
1 $4,000 $1,000
2 $2,500 $2,000
3 $2,000 $3,000
4 $1,500 $4,000

Total Cash Flow $10,000 $10,000

Which investment should Harrison choose assuming all other variables for the two investments are the
same (specifically, the appropriate discount rate for both investments is 4% p.a.)?
a. Harrison should be indifferent between the two investments since they provide the same total cash
inflows.
b. Harrison should choose Investment I because of the time value of money.
c. Harrison should be indifferent between the two investments since the initial cash outflow is the
same.
d. Harrison should choose Investment II because it generates larger cash inflows at the end of the
investment's useful life.
e. None of the answers listed above are correct.
Find the NPV of each option. The investment with the largest NPV is the best. NPV (Investment I) =
9217.74; NPV (Investment II) = 8896.86. So, Investment I is worth more and thus preferred by the
investor. Note that both investments provide the same total cash flow, but Investment I returns money
sooner than Investment II. The faster you get money, all else equal, the better.

5. Which of the following will decrease the present value of the mixed cash flows for years 1 through 5
of $1,000; $4,000; $9,000; $5,000; and $2,000 respectively given a 10% discount rate? (Choose all that
apply - this is an all or nothing problem; if you choose an option that is wrong or do not choose an
option that is correct, your entire answer will be marked wrong).
a. Decrease the discount rate by 2%.
b. Switch cash flows for years 1 and 5 so that year 1 is $2,000 and year 5 is $1,000.
c. Switch cash flows for years 3 and 4 so that year 3 is $5,000 and year 4 is $9,000.
d. Switch cash flows for years 2 and 5 so that year 2 is $2,000 and year 5 is $4,000.
e. Switch cash flows for years 3 and 1 so that year 1 is $9,000 and year 3 is $1,000.

Option c and d will DECREASE the PV (all else constant and with an interest rate greater than 0%, the
later you receive money, the lower PV; and vice versa). Options a, b and e will all INCREASE the PV.
6. Which of the following banks is offering the WORST rate (assuming that you plan to deposit $10,000
in the account today and leave the money in the account for 25 years)?

Bank Nominal Rate Number of Compounding Periods Per Year

A 16.000% 2
B 15.700% 4
C 15.500% 12
D 15.350% 365
E 15.250% Continuous

a. Bank A which offers a rate of 16.000% with semi-annual compounding.

b. Bank B which offers a rate of 15.700% with quarterly compounding.
c. Bank C which offers a rate of 15.500% with monthly compounding.
d. Bank D which offers a rate of 15.350% with daily compounding.
e. Bank E which offers a rate of 15.250% with continuous compounding.

Bank Nominal Rate Number of Compounding Periods Per Year EAR

A 16.00% 2 16.6400%
B 15.70% 4 16.6488%
C 15.50% 12 16.6500%
D 15.35% 365 16.5870%
E 15.25% Continuous 16.4742%
The bank that offers the lowest EAR is the bank offering the worst rate. The bank that offers the highest
EAR is offering the best rate.

7. In 3 years you are to receive $5,000. If the current interest rate (which is 3.284%) were to suddenly
decrease, the present value of this future amount to you would
a. decrease.
b. increase.
c. remain unchanged.
d. cannot be determined without more information.

8. In a typical loan amortization schedule, the dollar amount of interest paid each period ____________.
a. increases with each payment
b. decreases with each payment
c. remains constant with each payment

9. The concept of compound interest refers to:

a. earning interest on the original investment.
b. payment of interest on previously earned interest.
c. investing for a multi-year period of time.
d. determining the APR of the investment.
10. Suppose that you can subscribe to a magazine using either a one-year rate of $27, a two-year rate of
$52, a three-year rate of $65, or a four-year rate of $100. If want to receive this magazine for four years
and if your opportunity cost of funds is 8%, which rate offers the lowest cost?
a. A four-year subscription costing $100 and paid immediately.
b. Four one-year subscriptions, of $27 each, paid at the beginning of each year.
c. A two-year subscription paid immediately, costing $52, followed by another two-year subscription
costing $52 and paid at the beginning of the third year.
d. A one-year subscription paid immediately, costing $27, followed by a three-year subscription
costing $65 and paid at the beginning of the second year.
e. There is not enough information provided to answer this question.
Calculate the PV of each option. The one with the lowest present value is offering the lowest cost. From
table below, choice d is the lowest cost. Note that paid immediately is paid in year 0, the beginning of
year 1 is the end of year 0, the beginning of year 2 is the end of year 1 and so on.

Year Choice a Choice b Choice c Choice d

0 100 27 52 27
1 0 27 0 65
2 0 27 52 0
3 0 27 0 0

PV $100.00 $96.58 $96.58 $87.19

Part II: PROBLEMS – Compute a final numerical answer for each of the following problems. You should
work out your solutions on loose leaf paper, however, I may or may not collect your worked out solutions.
To be safe, however, I suggest that you write out a solution for every problem and be ready to turn it in if
asked. Round all dollar answers to 2 decimal places, round time (years or months) answers to one (1)
decimal place and record interest rates as percent values rounded to one (1) decimal place. However, be
sure to NOT input a dollar sign, commas, or percent sign on D2L. For example, record $3,284.33965 as
3284.34, record 37.285432 years as 37.3 and record .064358 = 6.4358% as 6.4.
11. What will be the population of the United States (rounded to the nearest whole number), if its current
population of 325,337,730 grows at a compound rate of 2.1% annually for 25 years?
PV = 329,256,465; I = 2.1; N = 25; CPT FV = 553,576,778
12. According to www.numbeo.com, the current price of a McMeal at McDonalds (or Equivalent Combo
Meal) in the U.S. is $7.00. If the average annual inflation rate over the past 30 years was 2.57% p.a.,
what did a McMeal at McDonalds cost 20 years ago?
FV = 7.00; I = 2.57; N = 20; CPT PV = $4.21
13. What is the future value on the day of the last deposit of 35 annual deposits of $750 per year (first
deposit to be made today) given an interest rate of 5.5% p.a.?
PMT = 750; N = 35; I = 5.5; CPT FV = $75,188.52
14. Assume that I deposited $2750 into an account exactly 10 years from today. How much will be in my
account at the end of year 60, assuming that my account pays interest of 8.5% p.a.?
PV = 2750; N = 50 (from end of year 10 to end of year 60 = 50 years); I = 8.5; CPT FV = $162,487.37
15. What is the future value at the end of year 15 of $10,000 deposited today into an account that pays
interest of 5.4% p.a., but with monthly compounding?
PV = 10000; I = 5.4/12=; N = 180; CPT FV = $22,438.27
16. Max Payne is evaluating an investment that will provide the following returns at the end of each of the
following years: year 1, $12,500; year 2, $10,000; year 3, $7,500; year 4, $5,000; year 5, $2,500; year
6, $0; and year 7, $12,500. Max believes that he should earn an annual rate of 8 percent on this
investment. How much should he pay for this investment?
CF0 = 0; C01 = 12500; F01 = 1; C02 = 10000; F02 = 1; C03 = 7500; F03 = 1; C04 = 5000; F04 = 1;
C05 = 2500; F05 = 1; C06 = 0; F06 = 1; C07 = 12500; F07 = 1; CPT NPV(I = 8%) = $38,771.44
17. Assume that Princess Peach started a paper route on January 1, 1970. Since that day, at the end of every
three (3) months (first deposit made on April 1, 1970), she deposited $500.00 into a savings account,
which paid her interest of 4 percent annually but with quarterly compounding. On January 1, 1980, she
took the balance in her savings account and transferred it to an account that paid 11.5% p.a. Assuming
that Princess Peach did not deposit any additional money into the account after the transfer, how much
did she have in her account on January 1, 2014?
The most important part of this problem is counting correctly. If it helps, create an Excel sheet where
you list Apr 1, 1970 as 1, July 1, 1970 as 2, Oct 1, 1970 as 3, Jan 1, 1971 as 4 and so on to Jan 1, 1980.
Then count the number of deposits that Claudia will make – the total will be 40. So, first find the amount
in the account on the day she makes the last deposit, let this amount = PV and find FV at 11.5% per
year with N now being from Jan 1, 1980 to Jan 1, 2014 = 34 years.
PMT = 500; N = 40; I = 4/4; CPT FV = 24443.1867. Then, PV = 24443.1867; I = 11.5; N = 34; CPT
FV = $989,699.42
18. On the day that his first child was born, Ezio Auditore de Firenze deposited $3,000 into an investment
account. The only purpose for the account was to pay for his son’s first year of college tuition. Assume
that his son, Flavia, started college on his 18th birthday and his first year tuition payment had to be made
that day. The amount needed on that day was $26,000. If that was indeed the amount of money in the
account on Flavia’s 18th birthday, what annual rate of return did Ezio earn on his investment account?
PV = -3000; FV = 26000; N = 18; CPT I = 12.75%
19. Desmond Miles has $1500 that he will use as a down payment on a car. Assuming that he can afford a
payment of $325 per month, how much can Desmond spend on a car (that is, what is the total cost of
the car that Desmond can purchase) if the interest rate is 5.75% and if he will finance his purchase with
a 5 year, monthly payment loan?
PMT = 325; N = 60; I = 5.75/12=; CPT PV = 16,912.31. This is the amount that Desmond can borrow,
so the total cost of the car can be amount borrowed plus down payment = 16,912.31 + 1500 =
$18,412.31
20. Suppose that John Marston just deposited $15,000 into an account earning 4 percent interest,
compounded monthly. How many years (rounded to one decimal place – for example, 32.1843 year =
32.2) will it take for Marston’s account to be worth $38,500?
PV = -15000; FV = 38500; I = 4/12=; CPT N =. Note that this is the number of MONTHS it will take
for the money to grow. The number of years = 283.2535/12 = 23.6 years.
21. Suppose you deposit $5,000 into an account earning 4 percent interest, compounded monthly and you
also make monthly contributions of $50 (first monthly contribution made one month after the initial
deposit is made). How many years (rounded to one decimal place – for example, 32.1843 year = 32.2)
will it take for the account to grow to $7,500 in this case?
For this problem you must either enter both PV and PMT as negatives or enter FV as a negative. Either
will produce the same final answer.
PV = 5000; PMT = 50; FV = -7500; I = 4/12=; CPT N = 35.3938. Note that this is the number of
MONTHS it will take for the money to grow. The number of years = 35.39382/12 = 2.9 years.
22. Assume that Geralt of Rivia is trying to borrow money from you to finance his new business. Assume
that Geralt promises to repay you in three installments, one payment of $5,000 to be made exactly 2
years from today, a second payment of $10,000 to be made exactly 6 years from today, and a final
payment of $15,000 to be made 8 years from today. If your opportunity cost of funds is 7.5% p.a., (that
is, use an interest rate of 7.5% for this question), how much should be willing to lend Geralt today?
You should be willing to lend Geralt the present value of the promised payments. Thus, PV =
5000/(1.075)2 + 10000/(1.075)6 + 15000/(1.075)8 = $19,216.81
23. What is the future value at the end of year 25 of depositing $5,000 today, $3,500 at the end of years 1,
2 and 3, $5,000 at the end of years 4, 5, 6 and 7 and $4,250 at the end of years 8, 9, 10, 11 and 12 into
an account that pays 9.5% p.a.? (No deposits will be made into the account after year 12).
CF0 = 5000; C01 = 3500; F01 = 3; C02 = 5000; F02 = 4; C03 = 4250; F03 = 5; CPT NPV(I = 9.5) =
34630.1664; Now let this = PV and find FV at end of year 25: PV = 34630.1664; I = 9.5; N = 25; CPT
FV = $334,817.04
24. If Duke Nukem wants to fund a scholarship that would pay $12,500 per year forever at GSU, how much
must Duke deposit today if he wants the scholarship to start paying seven (7) years from today? Assume
the endowment will earn 6.5% p.a. interest forever.
PV6 = CF7/r = 12500/.065 = 192,307.6923. Now find PV of this today (i.e., in year 0) as: FV =
192,307.6923; N = 6; I = 6.5; CPT PV = $131,795.02
Or, enter CF0 = 0; C01 = 0; F01 = 6; C02 = 12500; F02 = 999 (the largest number of repeating values
you can enter on the BA II Plus calculator – this is enough to approximate infinity); CPT NPV(I=6.5)
= 131,795.02.
25. You currently owe $20,000 on a car loan at 8.25 percent interest. If you make monthly payments of
$596.59 per month, how long (i.e., number of months rounded to one decimal place) will it take you to
fully repay the loan?
PV = -20000; I = 8.25/12=; PMT = 596.59; CPT N = 38.2
26. It is now January 1. Kratos plans to make 5 deposits of $300 each, one every 6 months, with the first
payment being made exactly six months from today. If the bank pays a nominal interest rate of 12%,
but uses semiannual compounding, how much will be in Kratos’ account exactly 15 years from today?
First find PV of the deposits and then find FV of that amount. PMT = 300; I = 12/2=; N = 5; CPT PV
= 1263.7091. Then: PV = 1263.7091; N = 30; I = 12/2=; CPT FV = $7,258.57
27. You must make a payment of $3,800 exactly 8 years from today. To prepare for this payment, you will
make 5 equal deposits into an account that pays a nominal interest rate of 7.6% p.a., with quarterly
compounding. If your first deposit is made today (and then you make four additional deposits in each
of the next four quarters – that is, a deposit 3 months from today, another 6 months from today and so
on), what must each of the 5 payments be for you to exactly achieve your goal?
 Note that your last deposit into the account will be at the end of year 1 (a deposit made today, then one
at end of Q1, Q2, Q3 and Q4 = end of year 1). First find out how much you must have in the account
on the day you make the last deposit into the account: FV = 3800; N = 28; I = 7.6/4=; CPT PV =
2243.3986. Now let that be FV and find PMT for 5 deposits that will “grow up” to be that amount: FV
= 2243.3986; N = 5; I = 7.6/4=; CPT PMT = 431.9507 = $431.95
Note that you can now check to make sure this answer is correct. Use CF register and enter: CF0 =
431.9507; C01 = 431.9507; F01 = 4; CPT NPV (I = 7.6/4=) = 2080.7012. Then: PV = 2080.7012; I =
7.6/4=; N = 32; CPT FV = 3800 (so our answer is correct!!!)

USE THE INFORMATION BELOW TO ANSWER THE FOLLOWING THREE QUESTIONS

Vito Scaletta just bought his dream car, 2014 Aston Martin DB9 that cost $208,700. He paid $35,000 down
and financed the balance over 84 months at 6.25% p.a. (Assume that Vito makes all required payments on
time).
28. What is the monthly payment on Vito’s loan?
PV = 208700 - 35000 = 173,700; N = 84; I = 6.25/12=; CPT PMT = 2558.3751
29. What will the balance on Vito’s loan be at the end of the fourth year (that is, immediately after Vito
makes his 48th payment on the loan)?
PMT = 2558.3751; N = 84 – 48 = 36; I = 6.25/12=; CPT PV = payoff = 83,784.07
30. What is the total amount of interest that Vito will pay over the entire term of the loan (that is, the total
amount of interest that is paid on payments 1 through 84)?
Total amount paid over all 84 months = (2558.3751)(84) = 214,903.51. Total amount borrowed =
173,700. Thus, interest paid over entire term of loan = 214,903.51 – 173,700 = 41,203.51
31. Today is your 30th birthday and you have a dream of retiring on your 65th birthday. You want to put
aside however much is necessary on your 31st through 65th birthdays (35 annual payments) to have
enough to retire. You've estimated that you will live until you are 90 and you want the first withdrawal
to occur on your 66th birthday, with the last payment occurring on your 90th birthday. You think that
you will need $150,000 per year to spend during retirement. You estimate constant interest rates of
11.25%. Assuming that you currently have $7,500 deposited in your retirement account, how much
must you put aside each year in order to have sufficient money to retire at age 65?
First set up a cash flow chart so you know what you are exactly looking for:
Age Year Cash Flow
30 0 7500
31 1 X
. . .
. . .
. . .
64 34 X
65 35 X
66 36 -150,000
67 37 -150,000
. .
 . .
. .
90 60 -150,000
Now enter all cash flows into CF register with the unknown cash flow (i.e., X) entered as 0. Find NPV.
The NPV you find is the PV of the missing cash flows.
CF0 = 7500; C01 = 0; F01 = 35; C02 = -150000; F02 = 25; CPT NPV(I=11.25) = 22,224.5958.
Then, PV = 22,224.5958; N = 35; I = 11.25; CPT PMT = $2561.65
32. Gordon Freeman recently invested $5,000 in a project that is promising to return 6.5 percent per year.
The cash flows are expected to be as follows:
End of Cash
Year Flow
1 $1000
2 950
3 875
4 ???
5 850
Note that the 4th year cash flow is unknown. Assuming the present value of this cash flow stream is
$5,000 (that is, CF0 = -5000), what is the missing cash flow value (that is, what is the cash flow at the
end of the 4th year)?
This is a missing cash flow problem. Enter all cash flows into CF register with the unknown cash flow
= 0. The NPV of the cash flows is the PV of the missing cash flow. CF0=-5000; C01=1000; C02=950;
C03=875; C04 = 0; C05 = 850; CPT NPV(I=6.5)= -1878.6899. THIS IS THE PV OF THE MISSING
CASH FLOW. TO FIND THE MISSING CASH FLOW: PV=1878.6899; I=6.5; N=4; CPT FV =
$2416.8713. Note that you can confirm that this is the correct answer by going back to CF register and
entering C04=2416.8713. If this is the correct answer, then NPV of the cash flow will equal zero, which
it does.

33. You have a $25,000 balance on your credit card. You plan to make monthly payments of $450 until the
balance is paid off. The interest rate on your credit card is 17.5% p.a., compounded monthly. A letter
in the mail informs you that you are approved for a new credit card and balance transfers are subject to
a 9.5% p.a., compounded monthly. How many months sooner will you pay off your bill?
Original: PV = -25000; PMT = 450; I = 17.5/12=; CPT N = 114.7744 months.
New Offer: PV = -25000; PMT = 450; I = 9.5/12=; CPT N = 73.4878 months.
Payoff is in 41.3 months sooner.