PROBLEM SETS

Select problems are available in McGraw-Hill’s Connect. Please see the preface for more information.

BASIC
1. Future values If you invest $100 at an interest rate of 15%, how much will you have at the end of eight years?
2. Discount factors If the PV of $139 is $125, what is the discount factor?
3. Present values If the cost of capital is 9%, what is the PV of $374 paid in year 9?
4. Present values A project produces a cash flow of $432 in year 1, $137 in year 2, and $797 in year 3. If the cost of capital is 15%, what is the project’s PV? If the project requires an
investment of $1,200, what is its NPV?
5. Opportunity cost of capital Which of the following statements are true? The opportunity cost of capital:
a. Equals the interest rate at which the company can borrow.
b. Depends on the risk of the cash flows to be valued.
c. Depends on the rates of return that shareholders can expect to earn by investing on their own.
 d. Equals zero if the firm has excess cash in its bank account and the bank account pays no interest.
6. Perpetuities An investment costs $1,548 and pays $138 in perpetuity. If the interest rate is 9%, what is the NPV?
7. Growing perpetuities A common stock will pay a cash dividend of $4 next year. After that, the dividends are expected to increase indefinitely at 4% per year. If the discount rate is 14%,
what is the PV of the stream of dividend payments?
8. Perpetuities and annuities The interest rate is 10%.
a. What is the PV of an asset that pays $1 a year in perpetuity?
b. The value of an asset that appreciates at 10% per annum approximately doubles in seven years. What is the approximate PV of an asset that pays $1 a year in perpetuity beginning in
year 8?
c. What is the approximate PV of an asset that pays $1 a year for each of the next seven years?
d. A piece of land produces an income that grows by 5% per annum. If the first year’s income is $10,000, what is the value of the land?
9. Present values What is the PV of $100 received in: Page 41
a. Year 10 (at a discount rate of 1%)?
b. Year 10 (at a discount rate of 13%)?
c. Year 15 (at a discount rate of 25%)?
d. Each of years 1 through 3 (at a discount rate of 12%)?
10. Continuous compounding The continuously compounded interest rate is 12%.
a. You invest $1,000 at this rate. What is the investment worth after five years?
b. What is the PV of $5 million to be received in eight years?
c. What is the PV of a continuous stream of cash flows, amounting to $2,000 per year, starting immediately and continuing for 15 years?
11. Compounding intervals You are quoted an interest rate of 6% on an investment of $10 million. What is the value of your investment after four years if interest is compounded:
a. Annually?
b. Monthly? or
c. Continuously?

INTERMEDIATE
12. Future values and annuities
a. The cost of a new automobile is $10,000. If the interest rate is 5%, how much would you have to set aside now to provide this sum in five years?
b. You have to pay $12,000 a year in school fees at the end of each of the next six years. If the interest rate is 8%, how much do you need to set aside today to cover these bills?
c. You have invested $60,476 at 8%. After paying the above school fees, how much would remain at the end of the six years?
13. Discount factors and present values
a. If the one-year discount factor is .905, what is the one-year interest rate?
b. If the two-year interest rate is 10.5%, what is the two-year discount factor?
c. Given these one- and two-year discount factors, calculate the two-year annuity factor.
d. If the PV of $10 a year for three years is $24.65, what is the three-year annuity factor?
e. From your answers to (c) and (d), calculate the three-year discount factor.
14. Present values A factory costs $800,000. You reckon that it will produce an inflow after operating costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14%, what is
the net present value of the factory? What will the factory be worth at the end of five years?
15. Present values A machine costs $380,000 and is expected to produce the following cash flows:

If the cost of capital is 12%, what is the machine’s NPV?

16. Opportunity cost of capital Explain why we refer to the opportunity cost of capital, instead of just “cost of capital” or “discount rate.” While you’re at it, also explain the following
statement: “The opportunity cost of capital depends on the proposed use of cash, not the source of financing.”
17. Present values A factory costs $400,000. It will produce an inflow after operating costs of $100,000 in year 1, $200,000 in year 2, and $300,000 in year 3. The opportunity cost of capital
is 12%. Show your calculations in a time line like Figures 2.4 and 2.5 . Calculate the NPV.
18. Present values and opportunity cost of capital Halcyon Lines is considering the purchase of a new bulk carrier for $8 million. The forecasted revenues are $5 million a year Page 42
and operating costs are $4 million. A major refit costing $2 million will be required after both the fifth and tenth years. After 15 years, the ship is expected to be sold for scrap at
$1.5 million.
a. What is the NPV if the opportunity cost of capital is 8%?
b. Halcyon could finance the ship by borrowing the entire investment at an interest rate of 4.5%. How does this borrowing opportunity affect your calculation of NPV?
19. Present values As winner of a breakfast cereal competition, you can choose one of the following prizes:
a. $100,000 now.
b. $180,000 at the end of five years.
c. $11,400 a year forever.
d. $19,000 for each of 10 years.
e. $6,500 next year and increasing thereafter by 5% a year forever.
If the interest rate is 12%, which is the most valuable prize?
20. Annuities Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to invest $20,000 in an annuity that will make a level payment at the end of each year
until his death. If the interest rate is 8%, what income can Mr. Basset expect to receive each year?
21. Annuities David and Helen Zhang are saving to buy a boat at the end of five years. If the boat costs $20,000 and they can earn 10% a year on their savings, how much do they need to put
aside at the end of years 1 through 5?
22. Annuities Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and then $300 a month for the next 30 months. Turtle Motors next door does not offer free
credit but will give you $1,000 off the list price. If the rate of interest is .83% a month, which company is offering the better deal?
23. Present values Recalculate the NPV of the office building venture in Example 2.1 at interest rates of 5, 10, and 15%. Plot the points on a graph with NPV on the vertical axis and the
discount rates on the horizontal axis. At what discount rate (approximately) would the project have zero NPV? Check your answer.
24. Perpetuities and continuous compounding If the interest rate is 7%, what is the value of the following three investments?
a. An investment that offers you $100 a year in perpetuity with the payment at the end of each year.
b. A similar investment with the payment at the beginning of each year.
c. A similar investment with the payment spread evenly over each year.
25. Perpetuities and annuities Refer to Sections 2-3 through 2-4. If the rate of interest is 8% rather than 10%, how much would you need to set aside to provide each of the following?
a. $1 billion at the end of each year in perpetuity.
b. A perpetuity that pays $1 billion at the end of the first year and that grows at 4% a year.
c. $1 billion at the end of each year for 20 years.
d. $1 billion a year spread evenly over 20 years.
26. Continuous compounding How much will you have at the end of 20 years if you invest $100 today at 15% annually compounded? How much will you have if you invest at 15%
continuously compounded?
27. Perpetuities You have just read an advertisement stating, “Pay us $100 a year for 10 years and we will pay you $100 a year thereafter in perpetuity.” If this is a fair deal, what is the rate
of interest?
28. Compounding intervals Which would you prefer? Page 43
a. An investment paying interest of 12% compounded annually.
b. An investment paying interest of 11.7% compounded semiannually.
c. An investment paying 11.5% compounded continuously.
Work out the value of each of these investments after 1, 5, and 20 years.
29. Compounding intervals A leasing contract calls for an immediate payment of $100,000 and nine subsequent $100,000 semiannual payments at six-month intervals. What is the PV of
these payments if the annual discount rate is 8%?
30. Annuities Several years ago The Wall Street Journal reported that the winner of the Massachusetts State Lottery prize had the misfortune to be both bankrupt and in prison for fraud. The
prize was $9,420,713, to be paid in 19 equal annual installments. (There were 20 installments, but the winner had already received the first payment.) The bankruptcy court judge ruled
that the prize should be sold off to the highest bidder and the proceeds used to pay off the creditors.
a. If the interest rate was 8%, how much would you have been prepared to bid for the prize?
b. Enhance Reinsurance Company was reported to have offered $4.2 million. Use Excel to find the return that the company was looking for.
31. Amortizing loans A mortgage requires you to pay $70,000 at the end of each of the next eight years. The interest rate is 8%.
a. What is the present value of these payments?
b. Calculate for each year the loan balance that remains outstanding, the interest payment on the loan, and the reduction in the loan balance.
32. Growing annuities You estimate that by the time you retire in 35 years, you will have accumulated savings of $2 million. If the interest rate is 8% and you live 15 years after retirement,
what annual level of expenditure will those savings support?

Unfortunately, inflation will eat into the value of your retirement income. Assume a 4% inflation rate and work out a spending program for your $2 million in retirement savings that will
allow you to increase your expenditure in line with inflation.
33. Annuities The annually compounded discount rate is 5.5%. You are asked to calculate the present value of a 12-year annuity with payments of $50,000 per year. Calculate PV for each of
the following cases.
a. The annuity payments arrive at one-year intervals. The first payment arrives one year from now.
 b. The first payment arrives in six months. Following payments arrive at one-year intervals (i.e., at 18 months, 30 months, etc.).
34. Annuities Dear Financial Adviser,

My spouse and I are each 62 and hope to retire in three years. After retirement we will receive $7,500 per month after taxes from our employers’ pension plans and $1,500 per month after
taxes from Social Security. Unfortunately our monthly living expenses are $15,000. Our social obligations preclude further economies.

We have $1,000,000 invested in a high-grade, tax-free municipal-bond mutual fund. The return on the fund is 3.5% per year. We plan to make annual withdrawals from the mutual fund to
cover the difference between our pension and Social Security income and our living expenses. How many years before we run out of money?
Sincerely,
Luxury Challenged
Marblehead, MA
You can assume that the withdrawals (one per year) will sit in a checking account (no interest) until spent. The couple will use the account to cover the monthly shortfalls. Page 44
35. Present values Your firm’s geologists have discovered a small oil field in New York’s Westchester County. The field is forecasted to produce a cash flow of C1 = $2 million in
the first year. You estimate that you could earn an expected return of r = 12% from investing in stocks with a similar degree of risk to your oil field. Therefore, 12% is the opportunity cost
of capital.

What is the present value? The answer, of course, depends on what happens to the cash flows after the first year. Calculate present value for the following cases:
a. The cash flows are forecasted to continue forever, with no expected growth or decline.
b. The cash flows are forecasted to continue for 20 years only, with no expected growth or decline during that period.
c. The cash flows are forecasted to continue forever, increasing by 3% per year because of inflation.
d. The cash flows are forecasted to continue for 20 years only, increasing by 3% per year because of inflation.
36. Amortizing loans Suppose that you take out a $200,000, 20-year mortgage loan to buy a condo. The interest rate on the loan is 6%, and payments on the loan are made annually at the end
of each year.
a. What is your annual payment on the loan?
b. Construct a mortgage amortization table in Excel similar to Table 2.1 , showing the interest payment, the amortization of the loan, and the loan balance for each year.
c. What fraction of your initial loan payment is interest? What about the last payment? What fraction of the loan has been paid off after 10 years? Why is the fraction less than half?

CHALLENGE
37. Future values and continuous compounding Here are two useful rules of thumb. The “Rule of 72” says that with discrete compounding the time it takes for an investment to double in
value is roughly 72/interest rate (in percent). The “Rule of 69” says that with continuous compounding the time that it takes to double is exactly 69.3/interest rate (in percent).
a. If the annually compounded interest rate is 12%, use the Rule of 72 to calculate roughly how long it takes before your money doubles. Now work it out exactly.
b. Can you prove the Rule of 69?
38. Annuities Use Excel to construct your own set of annuity tables showing the annuity factor for a selection of interest rates and years.
39. Declining perpetuities and annuities You own an oil pipeline that will generate a $2 million cash return over the coming year. The pipeline’s operating costs are negligible, and it is
expected to last for a very long time. Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline by 4% per year. The discount rate is 10%.
a. What is the PV of the pipeline’s cash flows if its cash flows are assumed to last forever?
b. What is the PV of the cash flows if the pipeline is scrapped after 20 years?