CHAPTER 4 The Time Value of Money and Discounted Cash Flow Analysis 137 Quick Check 46 Suppose you deposit $1,000 now and then $2,000 a year from now. How much will you have two years from now, ifthe interest rate is 10% per year? ANSWER: Future Value of the Initial $1,000 = $1,000 x 1.17 = $1,210 Future Value of the $2,000 ='$2,000 x 1.1 = $2,200, ‘Total Future Value = $3,410 Quick Check 4-7 if the exchange rate between the U.S. dollar and the deutsche mark is $0.50 per deutsche mark, the dollar interest rate is 6% per year, and the deutsche mark in- terest rate is 4% per year, what is the “break-even” value of the future dollar/deutsche mark exchange rate one year from now? Nowe: You could invest $1 today in dollar-denominated bonds and have $1.06 one year from now. Or you could convert the dollar today into 2 deutsche marks and invest in deutsche-mark-denominated bonds to have 2.08 deutsche mark one year from now. For you to break even, the 2.08 deutsche mark would have to be worth $1.06 one year from now,so the break-even exchange rate is:$1.06/2.08DM, or $0.509615 per deutsche mark. Questions and Problems sf] 1436441 1. If you invest $1,000 today at an interest rate of 10% per year, how much will you have 20 years from now, assuming no withdrawals in the interim? 2. a. Ifyou invest $100 every year for the next 20 years starting one year from today and you earn interest of 10% per year, how much will you have at the end of the 20 years? bb. How much must you invest each year if you want to have $50,000 at the end of the 20 years? 3. What is the prescat value of the following cash flows at ait interest rate of 10% pet year? a. $100 received five years from now. b, $100 received 60 years from now. €. $100 received each year beginning one year from now and ending 10 years from now. 4. $100 received each year for 10 years beginning now. . $100 cach year beginning one year from now and continuing forever. (Hint: You do not need to use the financial keys of your calculator for this, just some com- ‘mon sense.) 4. You want to establish a “wasting” fund, which will provide you with $1,000 per year for four years. at which time the fund will be exhausted. How much must you put in the fund now if you can earn 10% interest per year? 5. You take a one-year installment loan of $1,000 at an interest rate of 12% per year (1% per month) to be repaid in 12 equal monthly payments. a. What is the monthly payment? b. What isthe total amount of interest paid over the 12-month term of the loan? 6. You are taking out a $100,000 mortgage loan to be repaid over 25 years in 300 monthly payments. a. Ifthe interest rate is 16% per year, what is the amount of the monthly payment? b. Ifyou can only afford to pay $1,000 per month, how large a loan could you take? €. IF you can afford to pay $1,500 per month and need to borrow $100,000, how ‘many months would it take to pay off the mortgage? 4. If you can pay $1,500 per month, need to borrow $100,000, and want a 25-year ‘mortgage, what is the highest interest rate you can pay?138 PART I Time and Resource Allocation 7. In 1626 Peter Minuit purchased Manhattan Island from the Native Americans for about $24 worth of trinkets. If the tribe had taken cash instead and invested it to ‘earn 6% per year compounded annually, how much would the Indians have had in 1986, 360 years later? 8 You win a $1 million lottery. which pays you $50.000 per year for 20 years. How ‘much is your prize really worth, assuming an interest rate of 8% per year? 9. Your great aunt left you $20,000 when she died. You can invest the money to earn 12% per year. If you spend $3,540 per year out ofthis inheritance, how long will the money last? 10. You borrow $100,000 from a bank for 30 years at an APR of 10.5%. What is the ‘monthly payment? If you must pay two points up front, meaning that you only get {$98,000 from the bank, what isthe true APR on the mortgage loan? 11. Suppose that the mortgage loan described in question 10 is a one-year adjustable rate mortgage (ARM).Wwhich means that the 10.5% interest applies or only the frst ‘year Ifthe interest rate goes up to 1246 the second year ofthe loan. what will your ‘ew monthly payment be? 12, You just received a gift of $500 from your grandmother and you are thinking about saving this money for graduation, which is four years away. You have your choice between Bank A, which is paying 7% for one-year deposits, and Bank B, which is, paying 6% on one-year deposits. Each bank compounds interest annually a, What is the future value of your savings one year from today if you save your money in Bank A? Bank B? Which is the better decision? 'b, What savings decision will most individuals make? What likely reaction will Bank B have? 13. Sue Consultant has just been given a bonus of $2,500 by her employer. She is think- ing about using the money (0 statt saving, for dhe future. She eau invest to ear a annual rate of interest of 10% a. According to the Rule of 72, approximately how long will it take for Sue to in- crease her wealth to $5,000? b. Exactly how long does it actually take? 14, Larry’s bank account has a “floating” interest rate on certain deposits. Every year the interest rate is adjusted. Larry deposited $20,000 three years ago, when inter est rates were 7% (annual compounding). Last year the rate was only 6%, and this, year the rate fell again to 5%. How much will be in his account at the end of this, year? 15, You have your choice between investing in a bank savings account, which pays 8% compounded annually (Bank Annual).and one which pays 7-5% compounded daily (BankDaily). a Based on effective annual rates, which bank would you prefer? ', Suppose Bank Annual is only offering one-year certificates of deposit and if you withdraw your money early you lose all interest. How would you evaluate this additional piece of information when making your decision? 16. What are the effective annual rates of the following: 4 12% APR compounded monthly? . 10% APR compounded annually? ‘6% APR compounded daily? 17. Harry promises that an investment in his firm will double in six years Interest is as sumed to be paid quarterly and reinvested. What effective annual yield does this represent?CHAPTER 4 The Time Value of Money and Discounted Cash Flow Analysis 139 18, Suppose you know that you will need $2,500 two years from now in order to make ‘a down payment on a car. a, BankOne is offering 4% interest (compounded annually) for two-year accounts, and Bank Two is offering 4.5% (compounded annually) for two-year accounts. If you know you need $2,500 two years from today, how much will you need to in- vest in BankOne to reach your goal? Alternatively, how much will you need to invest in Bank Two? Which bank account do you prefer? b. Now suppose you do not need the money for three years. How much will you need to deposit today in BankOne? Bank Iwo? 19. Lucky Lynn has a choice between receiving $1,000 from her great uncle one year from today or $900 from her great aunt today. She believes she could invest the $900, at a one-year return of 12%. ‘a. What is the future value of the gift from her great uncle upon receipt? From her great aunt? b. Which gift should she choose? ¢. How does your answer change if you believed she could invest the $900 from her ‘great aunt at only 10%? At what rate is she indifferent? 20, As manager of short-term projects, ou are trying to decide whether or not to invest in a short-term project that pays one cash flow of $1,000 one year from today. The total cost of the project is $950. Your alternative investment is to deposit the money in a one-year bank certificate of deposit, which will pay 4% compounded annually. a, Assuming the cash flow of $1,000 is guaranteed (there sno risk you will not re- ceive it), what would be a logical discount rate to use to determine the present value of the cash flows of the project? b. What is the present value of the project if you discount the cash flow at 4% per year? What is the net present valuc of that investment? Should you invest in the project? e What would you do if the bank increases its quoted rate on one-year CDs to 85%? 4. At what bank one-year CD rate would you be indifferent between the two in- vestments? 21. Calculate the net present value of the following cash flows: You invest $2,000 today and receive $200 one year from now, $800 two years from now, and $1,000 a year for 10 years starting four years from now. Assume that the interest rate is 8%. 22, Your cousin has asked for your advice on whether or not to buy a bond for $995, which will make one payment of $1,200 five years from today, or invest in a local bank account, .. What isthe internal rate of return on the bond's cash flows? What additional in formation do you need to make a choice? 1b. What advice would you give her if you learned the bank is paying 3.5% per year for five years (compounded annually)? ¢. How would your advice change if the bank were paying 5% annually for five years? If the price of the bond were $900 and the bank pays 5% annually? 23, You and your sister have just inherited $300 and a savings bond from your great ‘grandfather who had left them in a safe deposit box. Because you are the oldest, you get to choose whether you want the cash or the bond.’The bond has only four years left to maturity at which time it will pay the holder $500. a. If you took the $300 today and invested it at an interest rate 6% per year, how long (in years) would it take for your $300 to grow to $500? (Hint: You want to solve for n or number of periods) Given these circumstances, which are you go- ing to choose? b. Would your answer change if you could invest the $300 at 10% per year? At 15% per year? What other decision rules could you use to analyze this decision?140 PART IL Time and Resource Allocation 24, Suppose you have three personal loans outstanding to your friend Elizabeth. A pay- ‘ment of $1,000 is due (oday, a $500 payment is due one year from now, and a $250 payment is due two years from now. You would like to consolidate the three loans, into one, with 36 equal monthly payments, beginning one month from today. AS- sume the agreed interest rate is 8% (effective annual rate) per year. ‘a. What is the annual percentage rate you will be paying? b. How large will the new monthly payment be? As CEO of ToysRFun, you are offered the chance to participate, without initial charge, ina project that produces cash flows of $5,000 at the end of the first period, $4,000 at the end of the next period, and a loss of $11,000 at the end of the third and final year. a, What is the net present value if the relevant discount rate (the company’s cost of capital) is 10%? b. Would you accept the offer? € What is the internal rate of return? Can you explain why you would reject a project that has an internal rate of return greater than its cost of capital? 25. 26. You must pay a creditor $6,000 one year from now, $5,000 two years from now, $4,000 three years from now, $2,000 four years from now, and a final $1,000 five years irom now. You would like to restructure the loan into five equal annual pay- ‘ments due at the end of each year. I the agreed interest rate is 6% compounded an- nnually, what is the payment? 27, Find the future value of the following ordinary annuities (payments begin one year from today and all interest rates compound annually) a. $100 per year for 10 years at 9% b. $500 per year for 8 years at 15%. . $800 per year for 20 years at 7%. a. $1,000 per year for 5 years at 0%. ©. Now find the present values of the annuities in a-d. £. What is the relationship between present values and future values? 28. Suppose you will need $50,000 ten years from now. You plan to make seven equal annual deposits beginning three years from today in an account that yields 11% compounded annually, How large should the annual deposit be? Suppose an investment offers $100 per year for five years at 5% beginning one year from today. ‘a, What isthe present value? How does the present value calculation change if one additional payment is added today? 'b, What is the future value of this ordinary annuity? How does the future value change if one additional payment is added today? 29. 30. You are trying to decide whether to buy a car for 4.0% APR for the full $20,000 pur- chase price over three years or receive $1,500 cash back and finance the rest at a bank rate of 9.5%. Both loans have monthly payments over three years Which should you choose? 31. You are looking to buy a sports car costing $23,000. One dealer is offering a special reduced financing rate of 2.9% APR on new car purchases for three year loans, with monthly payments. A second dealer is offering a cash rebate. Any customer taking the cash rebate would, of course, be ineligible for the special loan rate and would, have to borrow the balance of the purchase price from the local bank at the 9% an- nual rate. How large must the cash rebate be on this $23,000 car to entice a customer away from the dealer who is offering the special 2.9% financing? Show proof that investing $475.48 today at 10% allows you to withdraw $150 at the end of each of the next four years and have nothing remainingCHAPTER 4 The Time Value of Money and Discounted Cash Flow Analysis. 141 33. As pension manager, you are considering investing in a preferred stock, which pays $5,000,000 per year forever beginning one year from now. If your alternative in- vestment choice is yielding 10% per year, what is the present value of this invest- ment? What is the highest price you would be willing to pay for this investment? If ‘you paid this price, what would be the dividend yield on this investment? 34, A new lottery game offers a choice for the grand prize winner. You can either re- ceive a lump sum of $1,000,000 immediately or an annuity of $100,000 per year for- ever, with the first payment roday. (If you die, your estate will still continue to receive payments) If the relevant interest rate is 9.5% compounded annually, what is the difference in value between the two prizes? 35. Find the future value of a $1,000 lump-sum investment under the following com- pounding periods: (Hint: Either figure out effective annual rate or change number Of periods and interest rate as compounding period shortens.) a. 7% compounded annually for 10 years. b. 7% compounded semiannually for 10 years ¢. 7% compounded monthly for 10 years. d. 7% compounded daily for 10 years. €. 7% compounded continuously for 10 years. Sammy Jo charged $1,000 worth of merchandise one year ago on her MasterCard, which has a stated interest rate of 18% APR compounded monthly. She made 12 regular monthly payments of $50, at the end of each month, and refrained from us- ing the card for the past year. How much does she still owe? 37. Suppose you are considering borrowing $120,000 to finance your dream house. The annual percentage rate is 9% and payments are made monthly. a, Ifthe mortgage has a 30-year amortization schedule, what are the monthly pay- ments? b, What effective annual rate would you be paying! Tow do your answers to parts a and b change ifthe loan anvortires over 15 years rather than 30? 38. Suppose last year you took out the loan described in problem 33a. Now interest rates have declined to 8% per year. Assume there will be no refinancing fees. ‘a, What is the remaining balance of your current mortgage after 12 payments? (Hint: Look for future value.) b, What would be your payment if you refinanced your mortgage at the lower rate for 29 years? Exchange Rates and the Time Value of Money 39. The exchange rate between the pound sterling and the dollar is currently $1.50 per pound, the dollar interest rate is 7% per year.and the pound interest rate is 9% per year. You have $100,000 in a one-year account that allows you to choose between, either currency, and it pays the corresponding interest rate. a. If you expect the dollar/pound exchange rate to be $1.40 per pound a year from now and are indifferent to risk, which currency should you choose? b. What is the break-even value of the dollar/pound exchange rate one year from now? Real versus Nominal Interest Rates 40, The interest rate on conventional 10-year Treasury bonds is 7% per year and the in- terest rate on 10-year TIPS (Treasury inflation-protected securities) is 3.5% per year. You have $10,000 to invest in one of them. a. If you expect the average inflation rate to be 4% per year, which bond offers the higher expected rate of return? b. Which would you prefer to investi142° PARTI APPENDIX Time and Resource Allocation 41. You are 20 years from retirement, and expect to live another 20 years after retire ment. If you start saving now, how much will you be able to withdraw each year for every dollar per year that you save, assuming an effective annual interest rate of: a 0,15, 2%, 346, 3.5%. 4%, 656, 8%, and 109%? b. How would your answer change if you expect the rate of inflation to be 4% per year? eS TERRIER EIR Adjusting a Mortgage for Points Many banks offer mortgages that include points. Points are essentially an extra fee paid to the bank up front. Thus, if you take out a three-year $10,000 mortgage with two points, you have to pay 2% of the mortgage amount to the bank at inception. In other words, instead of getting $10,000 at the beginning from the bank, you re- ally only get $9,800. Let us see what points do to the actual interest rate on a mort gage. Suppose you take out the three-year, $10,000 (two points) mortgage from the bank at a stated APR of 12% with monthly payments. This corresponds to a monthly interest rate of 1%. ‘The first step is to compute the actual payment that the bank requires each month. This is done based on the total amount of the mortgage, $10,000. n i Pv ag PMT Result 36 1 10,000 0 1 PMT = $332.14 “The PV of the mortgage is not really $10,000, but only $9,800. Thus, together with the monthly payments of $332.14, we can compute the monthly interest rate: n i pv wv PMT Result 1.117S7% 36 2 9.800 0 -33214 ‘This monthly interest rate corresponds to an APR of 12 X 1.11757% = 13.41%. ‘Thus, when one bank offers you an APR of 13% on the preceding three-year mortgage and charges no points and a second bank offers you an APR of 12% with two points, you now know which bank offers the better deal. (Hint: It is not the sec- ond bank.)