Problem 1

Present Value of an Ordinary Annuity. Fill in the missing present values in the following table
for an ordinary annuity:

Number of Annual Interest

Payments or Years Rate Future Value Annuity Present Value
10 6% 0 $ 250.00
20 12% 0 $3,387.88
25 4% 0 $ 600.00
360 1% 0 $2,571.53
 Problem 1 (Answer)

Formula Answer (Rounded final answer to two decimal places)

PV = $250.00  [1 - 1/(1 + 0.06)10]/0.06 = $250.00  7.3601 = $1,840.02
PV = $3,387.88  [1 - 1/(1 + 0.12)20]/0.12 = $3,387.88  7.4694 =
$25,305.58
PV = $600.00  [1 - 1/(1 + 0.04)25]/0.04 = $600.00  15.6221 =
$9,373.25
PV = $2,571.53  [1 - 1/(1 + 0.01)360]/0.01 = $2,571.53  97.2183 =
$249,999.85
 Problem 2

Perpetuities. The Canadian Government has once again decided to

issue a consol (a bond with a never-ending interest payment and no
maturity date). The bond will pay $50 in interest each year (at the end
of the year), but it will never return the principal. The current discount
rate for Canadian government bonds is 6.5%. What should this bond
sell for in the market? What if the interest rate should fall to 4.5%? Rise
to 8.5%? Why does the price go up when interest rates fall? Why does
the price go down when interest rates rise?
 Problem 2 (Answer)

at 6.5%, $50/0.065 = $769.23

at 4.5%, $50/0.045 = $1,111.11
at 8.5%, $50/0.085 = $588.24
 Problem 3
Lottery. A lottery ticket states that you will receive $250 every year for the
next ten years.
a. What is the value of the winning lottery ticket in present value if the
discount rate is 6%, and it is an ordinary annuity?
b. What is the value of the winning lottery ticket in present value if the
discount rate is 6%, and it is an annuity due?
c. What is the difference between the ordinary annuity and annuity due in
parts (a) and (b)?
d. Verify that the difference in part (c) is the difference between the $250
first payment of the annuity due and the discounted final $250 payment of
the ordinary annuity.
 Problem 3 (Answer)
Answer with calculator (settings are P/Y  1, C/Y  1, and END mode).
a.
Input 10 6.0 ? $250 $0
Variables N I/Y PV PMT FV
Output $1,840.02
 Problem 3 (Answer)
Reset calculator to BGN mode.
b.
Input 10 6.0 ? $250 $0
Variables N I/Y PV PMT FV
Output $1,950.42

c. Difference is $1,950.42  $1,840.02  $110.40.

d. Verification with the two different timed payments, first for annuity due and last
for ordinary annuity:
Difference  $250.00  $250.00  1/1.0610
 $250.00  $250.00  0.5584
 $250.00  $139.60  $110.40
 Problem 4

Periodic Interest Rates. In the following table, fill in the periodic rates and the effective annual
rates.

Compounding Periodic Effective

Period APR Per Year Rate Annual Rate
Semiannual 8% 2
Quarterly 9% 4
Monthly 7.5% 12
Daily 4.25% 365
 Problem 4 (Answer)

Compounding Effective
Period APR Per Year Periodic Rate Annual Rate
Semi-Annual 8% 2 4.0% 8.16%
Quarterly 9% 4 2.25% 9.31%
Monthly 7.5% 12 0.625% 7.76%
Daily 4.25% 365 0.01164% 4.34%
 Problem 4 (Answer)
Periodic Rate  APR/(C/Y)  0.08/2  0.04  4.0%
Periodic Rate  APR/(C/Y)  0.09/4  0.0225  2.25%
Periodic Rate  APR/(C/Y)  0.075/12  0.00625  0.625%
Periodic Rate  APR/(C/Y)  0.0425/365  0.0001164384  0.01164%

EAR  (1  Periodic Rate)C/Y  1  1.042  1  1.0816  1  0.0816  8.16%

EAR  (1  Periodic Rate)C/Y  1  1.02254  1  1.0931  1  0.0931  9.31%
EAR  (1  Periodic Rate)C/Y  1  1.0062512  1  1.0776  1  0.0776  7.76%
EAR  (1  Periodic Rate)C/Y  1  1.0001164365  1  1.0434  1  0.0434  4.34%
 Problem 5
Bond Prices: For Problems 1 through 4, use the information given in the following table:

Years to Yield to
Par Value Coupon Rate Maturity Maturity Price
$1,000.00 8% 10 6% ?
$1,000.00 6% 10 8% ?
$5,000.00 9% 20 7% ?
$5,000.00 12% 30 5% ?
 Problem 5 (Answer)
Price the bonds from the above table with annual coupon payments.

Answer: Price  $1,000.00  1/(1.06)10  $80.00 [1 – 1/(1.06)10]/0.06

Price  $1,000.00  0.5584  $80.00  7.3601
Price  $558.39  $588.81  $1,147.20
Price  $1,000.00  1/(1.08)10  $60.00 [1 – 1/(1.08)10]/0.08
Price  $1,000.00  0.4632  $60.00  6.7101
Price  $463.19  $402.60  $865.80
Price  $5,000.00  1/(1.07)20  $450.00 [1 – 1/(1.07)20]/0.07
Price  $5,000.00  0.2584  $450.00  10.5940
Price  $1,292.10  $4,767.30  $6,059.40
Price  $5,000.00  1/(1.05)30  $600.00 [1 – 1/(1.05)30]/0.05
Price  $5,000.00  0.2314  $600.00  15.3725
Price  $1,156.89  $9,223.47  $10,380.36
 Problem 6
Missing Information on Bond. Your broker faxed you the following information about two
semiannual coupon bonds that you are considering as a potential investment. Unfortunately,
your fax machine is blurring some of the items, and all you can read from the fax on the two
different bonds is the following:

IBM Coupon Bond AOL Coupon Bond

Face Value (Par) $1,000 $1,000
Coupon Rate 9.5%
Yield to Maturity 7.5% 9.5%
Years to Maturity 10 20
Price $689.15
 Problem 6 (Answer)
IBM’s Variables: n  10  2  20
r  0.075/2  0.0375
Coupon  $1,000  0.095/2  $47.50
Par value  $1,000
 1 
 1  
1 (1  0.0375)20
IBM’s Price = $1,000   $47.50   
(1  0.0375)20  0.0375 
 
 
IBM’s Price  $1,000  0.4789  $47.50  13.8962  $1,138.96
AOL’s Coupon Rate? This will be a little more difficult, but we can solve first for the
coupon and then backtrack to the coupon rate.

AOL’s Variables: n  20  2  40
r  0.095/2  0.0475
Par Value  $1,000
Price  $689.15
 1 
1  1  (1  0.0475) 40 
$689.15  $1,000   Coupon   
(1  0.0475)40  0.0475 
 
 
 Problem 6 (Answer)
Now we need to isolate the coupon amount on the left-hand side of the equation and we have:
 1 
1 
 (1  0.0475)40  1
Coupon     $689.15  $1,000 
 0.0475  (1  0.0475) 40
 
 
Coupon  (17.7630)  $689.15  $1,000  0.15626  $532.89
Coupon  $532.89/17.7630  $30.00

So if the coupon is $30.00 every six months, the annual interest is $60.00 (2  $30),
and the coupon rate is the annual interest divided by the par value:
Coupon rate  $60.00/$1,000  0.06 or 6%
 Problem 7
Seitz Glassware is trying to determine its growth rate for an annual
cash dividend. Last year’s dividend was $0.25 per share. The target
return rate for the stock is 10%. What is the price of this stock if
a. the annual growth rate is 1%?
b. the annual growth rate is 3%?
c. the annual growth rate is 5%?
d. the annual growth rate is 7%?
e. the annual growth rate is 9%?
 Problem 7 (Answer)
Use the constant growth dividend model with infinite horizon:
Price = Last Dividend * (1 + g)/(r - g)
a. Price = $0.25 X (1.01)/(0.10 - 0.01) = $0.2525/0.09 = $2.81
b. Price = $0.25 X (1.03)/(0.10 - 0.03) = $0.2575/0.07 = $3.68
c. Price = $0.25 X (1.05)/(0.10 - 0.05) = $0.2625/0.05 = $5.25
d. Price = $0.25 X (1.07)/(0.10 - 0.07) = $0.2675/0.03 = $8.92
e. Price = $0.25 X (1.09)/(0.10 - 0.09) = $0.2725/0.01 = $27.25