BFM – Spring 2020, Professor Mukharlyamov Problem Set #1 – Time Value of Money
Due: (Tuesday) February 4
In Class, Before Lecture Begins
Instructions:
Complete the following problems. This problem set will be graded on a 10-point scale; your score counts
as 3 percent of your course grade. Each student must submit an individual assignment which reflects
their own work.
Final answers should be expressed with 2 decimal places. Place a box around your final answer. You
must also show your work to receive full credit.
Do NOT write your answers on this assignment sheet. You should start with a blank sheet of paper
and give full answers to the problems in the order of them being listed here.
You must submit a single hard copy report of this assignment by the beginning of class on the due date.
Assignments may be turned in early, but will be penalized if turned in late. At the discretion of the
professor, a problem set turned in after class discussion of that problem set may not be accepted.
Missing class is not an acceptable excuse for missing an assignment due date.
* * * Important: Place a box or circle around your final answer * * *
Problem #1
What is the future value of $20,000 received today if it is invested at 6.5% compounded annually for 5
years?
Problem #2
You just won the lottery and had a baby and want to put some money away for your child’s college
education. College will cost $90,000 in 18 years. You can earn 3% compounded annually. How much do
you need to invest today?
Problem #3
An insurance company promises to pay Ana $1 million on her 65th birthday in return for a one-time
payment of $175,000 today. Ana just turned 20 years old. At what rate of interest would Ana be
indifferent between accepting the company’s offer and investing the premium on her own?
Problem #4
You need $5,000 to buy a new stereo for your car. If you have $2,200 to invest at 4.25% compounded
annually, how long will you have to wait to buy the stereo?
Problem #5
What is the total future value four years from now of the following set of cash flows?
Year 1 Year 2 Year 3 Year 4
$300 -$300 $300 -$300
Assume an interest rate of 7%.
Use the following information to answer problems #6 – #8:
You can invest $15,000 in a certificate of deposit (CD) offered by your bank. The CD is for 10 years and
the bank quotes you a rate of 2.5%. How much will you have in 5 years if the 2.5% is…
1
Problem #6
…an EAR?
Problem #7
…a quarterly APR?
Problem #8
…a continuously compounded APR?
Problem #9
Sara receives $500 on the first of each month. Morgan receives $500 on the last day of each month.
Both Sara and Morgan will receive payments for four years. At a rate of 4.8% compounded monthly,
what is the difference in the present value of these two sets of payments?
Problem #10
An insurance company wants to sell you an annuity which will pay you $3,500 per quarter for 25 years.
You want to earn a minimum rate of return of 5.4%. What is the most you are willing to pay as a lump
sum today to buy this annuity? [Hint: 5.4% is an EAR.]
Problem #11
Congratulations! As winner of the DC lottery, you can choose one of the following prizes:
A: $1,000,000 today
B: $200,000 today and for each of the next 4 years
C: $200,000 today and $40,000 per half-year for the next 15 years
D: $200,000 today and $10,000 per quarter next period until forever
If the interest rate is 5%, which of the above will you choose? If you were the Director of Lottery in
charge of lottery payments, which of the above will you prefer? Why? [Hint: 5% is an EAR.]
Problem #12
Imagine that Problems #10 and #11 did not offer a hint about the interest rate being an EAR. Would you
have solved the questions in the same way? Why or why not?
Use the following information to answer problems #13 – #14:
A factory costs $1,000,000 to build. You determine that it will produce cash for 10 years with an inflow
of $230,000 a year for the first five years and an inflow of $170,000 a year for last five years. Suppose
the interest rate is 10 percent.
Problem #13
What is the factory worth today? Should you build the factory?
Problem #14
What will the factory be worth at the end of five years (i.e. five years from now)? (HINT: the price of an
asset at a specific point in time is equivalent to the present value of the cash flows that the buyer is
expected to receive once she purchases the asset). After five years, you are offered $600,000 to sell the
factory. Should you sell it?
