Ch 3 class problems/solutions

Today you will deposit $100,000 into a savings account that pays
5% compound annual interest. Four years from today you will
withdraw R dollars and continue to make additional annual
withdrawals of R dollars until the end of year 9.

How large must R be to leave you with exactly a zero balance after
your final R withdrawal is made at the end of year 9?
 Solution
PVA9 – PVA3 = $100,000
R(PVIFA05, 9) – R(PVIFA05, 3) = $100,000
R(7.108) – R(2.723) = $100,000
R(4.385) = $100,000
R = $100,000/(4.385)
= $22,805.02
Alternative solution:
100,000(FVIF5%,3) = R(PVIFA5%,6)
100,000 x 1.1580 = R x 5.076
R = 115,800/5.076 = $22,813
 Problem
Earl E. Bird decides to start saving for his retirement on his twenty-
first birthday. He plans to invest $2,000 each birthday into a
savings investment earning a 7% compound annual rate of
interest. He will continue this savings program for l0 years and
then stop making payments. But his savings will continue to
compound at 7% for 35 more years, until he retires at age 65.
Ivana Waite also plans to invest $2,000 a year, on each birthday, at
7%, and will do so for a total of 35 years. She begins her
contributions on her thirty-first birthday.
How much will Earl's and Ivana's savings programs be worth at the
retirement age of 65? Who is better off financially at retirement,
and by how much?
 Solution
FV of Earl’s plan = ($2,000) × (FVIFA7%,10) × (FVIF7%,35)
= ($2,000) × (13.816) × (10.677)
= $295,027
FV of Ivana’s plan = ($2,000) × (FVIFA7%, 35)
= ($2,000) × (138.237)
= $276,474
Earl’s investment program is worth ($295,027 – $276,474) =
$18,553 more at retirement than Ivana’s program.
 Problem
When you were born, Aunt Minnie promised to deposit $1,000
in a savings account for you on each of your birthdays,
beginning with your first. The savings account bears a 5%
compound annual rate of interest.
You have just turned 25 and want all the cash. However, it
turns out that (forgetful) Aunt Minnie made no deposits on
your fifth, seventh, and eleventh birthdays.
How much is in the account now - on your twenty-fifth
birthday?
 Solution
First find the future value of a $1,000-a-year ordinary annuity that runs for 25
years. This future value overstates our “true” ending balance because three
$1,000 deposits never occurred. We need to then subtract three future values
from our “trial” ending balance:
(1) the future value of $1,000 compounded for 25 – 5 = 20 years;
(2) the future value of $1,000 compounded for 25 – 7 = 18 years; and
(3) the future value of $1,000 compounded for 25 – 11 = 14 years.
After collecting terms, we get the following:
FV25 = $1,000[(FVIFA5%, 25) – (FVIF5%, 20) – (FVIF5%, 18) – (FVIF5%,14)]
= $1,000[(47.727) – (2.653) – (2.407) – (1.980)]
= $1,000[40.687]
= $40,687
 Problem
Suppose that an investment promises to pay a nominal 9.6%
annual rate of interest
What is the effective annual interest rate on this investment
assuming that interest is compounded
(a) annually?
(b) semiannually?
(c) quarterly?
(d) monthly?
 Solution

Effective annual interest rate = (1 + [i/m])m – 1

a. annually = (1 + [0.096/1])1 – 1 = 0.0960
b. semiannually = (1 + [0.096/2])2 – 1 = 0.0983
c. quarterly = (1 + [0.096/4])4 – 1 = 0.0995
d. monthly = (1 + [0.096/12])12 – 1 = 0.1003
 Problem
You borrow $10,000 at 14% compound annual interest for four
years. The loan is repayable in four equal annual installments
payable at the end of each year.
a. What is the annual payment that will completely amortise
the loan over four years? (Round to the nearest dollar.)
b. Of each equal payment, what is the amount of interest? The
amount of loan principal?
(Hint: In early years, the payment is composed largely of
interest, whereas at the end it is mainly principal.)
 Solution
a. PV0 = $10,000 = R(PVIFA14%, 4) = R(2.914)
Therefore, R = $10,000/2.914 = $3,432 (to the nearest dollar).
Period Instal. Interest Principal loan outstanding
0 -- -- -- $10,000
1 $ 3,432 $1,400 $ 2,032 7,968
2 3,432 1,116 2,316 5,652
3 3,432 791 2,641 3,011
4 3,432 421 3,011 0
$13,728 $3,728 $10,000