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suggestedProblems_ch06_sol.doc

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Department
Business
Course Code
BUSI 2504
Professor
Robert Riordan

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CHAPTER 6 DISCOUNTED CASH FLOW VALUATION Learning Objectives LO1 How to determine the future and present value of investments with multiple cash flows. LO2 How loan payments are calculated and how to find the interest rate on a loan. LO3 How loans are amortized or paid off. LO4 How interest rates are quoted (and misquoted). Answers to Concepts Review and Critical Thinking Questions 2. (LO1) Assuming positive cash flows, both the present and the future values will rise. 4. (LO1) It’s deceptive, but very common. The basic concept of time value of money is that a dollar today is not worth the same as a dollar tomorrow. The deception is particularly irritating given that such lotteries are usually government sponsored! 6. (LO1) The better deal is the one with equal installments. Solutions to Questions and Problems NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem. Basic 2. (LO1) To find the PVA, we use the equation: PVA = C({1 – [1/(1 + r)] } / r ) At a 5 percent interest rate: 8 [email protected]%: PVA = $7,000{[1 – (1/1.05) ] / .05 } = $45,242.49 [email protected]%: PVA = $9,000{[1 – (1/1.05) ] / .05 } = $38,965.29 And at a 22 percent interest rate: 8 [email protected]%: PVA = $7,000{[1 – (1/1.22) ] / .22 } = $25,334.87 [email protected]%: PVA = $9,000{[1 – (1/1.22) ] / .22 } = $25,772.76 Notice that the PV of cash flow X has a greater PV at a 5 percent interest rate, but a lower PV at a 22 percent interest rate. The reason is that X has greater total cash flows. At a lower interest rate, the total cash flow is more important since the cost of waiting (the interest rate) is not as great. At a higher interest rate, Y is more valuable since it has larger cash flows. At the higher interest rate, these bigger cash flows early are more important since the cost of waiting (the interest rate) is so much greater. 3. (LO1) To solve this problem, we must find the FV of each cash flow and add them. To find the FV of a lump sum, we use: S6-1 FV = PV(1 + r) t [email protected]% = $700(1.08) + $950(1.08) + $1,200(1.08) + $1,300 = $4,585.88 3 2 [email protected]% = $700(1.11) + $950(1.11) + $1,200(1.11) + $1,300 = $4,759.84 3 2 [email protected]% = $700(1.24) + $950(1.24) + $1,200(1.24) + $1,300 = $5,583.36 Notice we are finding the value at Year 4, the cash flow at Year 4 is simply added to the FV of the other cash flows. In other words, we do not need to compound this cash flow. 4. (LO1) To find the PVA, we use the equation: t PVA = C({1 – [1/(1 + r)] } / r ) 15 [email protected] yrs: PVA = $4,600{[1 – (1/1.08) ] / .08} = $39,373.60 [email protected] yrs: PVA = $4,600{[1 – (1/1.08) ] / .08} = $54,853.22 75 [email protected] yrs: PVA = $4,600{[1 – (1/1.08) ] / .08} = $57,320.99 To find the PV of a perpetuity, we use the equation: PV = C / r PV = $4,600 / .08 = $57,500.00 Notice that as the length of the annuity payments increases, the present value of the annuity approaches the present value of the perpetuity. The present value of the 75 year annuity and the present value of the perpetuity imply that the value today of all perpetuity payments beyond 75 years is only $179.01. 5. (LO1) Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Using the PVA equation: PVA = C({1 – [1/(1 + r)] } / r ) PVA = $28,000 = $C{[1 – (1/1.0825) ] / .0825} We can now solve this equation for the annuity payment. Doing so, we get: C = $28,000 / 8.43035 = $3,321.33 6. (LO1) To find the PVA, we use the equation: PVA = C({1 – [1/(1 + r)] } / r ) PVA = $65,000{[1 – (1/1.085) ] / .085} = $366,546.89 8. (LO1) Here we have the FVA, the length of the annuity, and the interest rate. We want to calculate the annuity payment. Using the FVA equation: FVA = C{[(1 + r) – 1] / r} 10 $80,000 = $C[(1.065 – 1) / .065] We can now solve this equation for the annuity payment. Doing so, we get: C = $80,000 / 13.49442 = $5,928.38 S6-2 10. (LO1) Here we have the quarterly annuity payment, the length of the annuity in years, and the interest rate compounded monthly. We want to calculate the PVA for an annuity due. We must first calculate the quarterly interest rate. At 5% compounded monthly, the quarterly rate is: 3 r = (1 + .05/ 12) – 1 = .01255 = 1.26% Six years is 24 quarters. Using the PVA equation for an ordinary annuity: t PVA = C({1 – [1/(1 + r)] } / r) PVA = $1,059{[1 – (1/1.0126) ] / .0126} We can now solve this equation for the annuity payment. Doing so, we get the PVA: PVA = $21,827.68 Annuity due value = Ordinary annuity value x (1+r): PVA due = $21,827.68 x (1 + .0126) = $22,101.61 12. (LO1) Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. Using the PV of a perpetuity equation: PV = C / r $280,000 = $20,000 / r We can now solve for the interest rate as follows: r = $20,000 / $280,000 = .0714 or 7.14% 14. (LO4) Here we are given the EAR and need to find the APR. Using the equation for discrete compounding: m EAR = [1 + (APR / m)] – 1 We can now solve for the APR. Doing so, we get: 1/m APR = m[(1 + EAR) – 1] EAR = .1220 = [1 + (APR / 2)] – 12 APR = 2[(1.1220) – 1]2 = .1185 or 11.85% EAR = .0940 = [1 + (APR / 12)] – 112 APR = 12[(1.0940) 1/12– 1] = .0902 or 9.02% 52 1/52 EAR = .0860 = [1 + (APR / 52)] – 1 APR = 52[(1.0860) – 1] = .0826 or 8.26% Solving the continuous compounding EAR equation: q EAR = e – 1 We get: APR = ln(1 + EAR) APR = ln(1 + .2380) APR = .2135 or 21.35% S6-3 16. (LO4) The reported rate is the APR, so we need to convert the EAR to an APR as follows: EAR = [1 + (APR / m)] – 1 m 1/m APR = m[(1 + EAR) – 1] APR = 365[(1.14) 1/36– 1] = .1311 or 13.11% This is deceptive because the borrower is actually paying annualized interest of 14% per year, not the 13.11% reported on the loan contract. 18. (LO1) For this problem, we simply need to find the FV of a lump sum using the equation: FV = PV(1 + r) t It is important to note that compounding occurs daily. To account for this, we will divide the interest rate by 365 (the number of days in a year, ignoring leap year), and multiply the number of periods by 365. Doing so, we get: FV in 5 years = $6,000[1 + (.084/365)] 5(365= $9,131.33 10(365) FV in 10 years = $6,000[1 + (.084/365)] = $13,896.86 FV in 20 years = $6,000[1 + (.084/365)] 20(36= $32,187.11 20. (LO4) The APR is simply the interest rate per period times the number of periods in a year. In this case, the interest rate is 25 percent per month, and there are 12 months in a year, so we get: APR = 12(25%) = 300% To find the EAR, we use the EAR formula: EAR = [1 + (APR / m)] – 1 m 12 EAR = (1 + .25) – 1 = 1,355.19% Notice that we didn’t need to divide the APR by the number of compounding periods per year. We do this division to get the interest rate per period, but in this problem we are already given the interest rate per period. 22. (LO3) Here we need to find the length of an annuity. We know the interest rate, the PV, and the payments. Using the PVA equation: PVA = C({1 – [1/(1 + r)] } / r) t $17,000 = $300{[1 – (1/1.009) ] / .009} Now we solve for t: t 1/1.009 = 1 – {[($17,000)/($300)](.009)} 1/1.009 = 0.49 t 1.009 = 1/(0.49) = 2.0408 t = ln 2.0408 / ln 1.009 = 79.62 months 23. (LO4) Here we are trying to find the interest rate when we know the PV and FV. Using the FV equation: FV = PV(1 + r) $4 = $3(1 + r) S6-4 r = 4/3 – 1 = 33.33% per week The interest rate is 33.33% per week. To find the APR, we multiply this rate by the number of weeks in a year, so: APR = (52)33.33% = 1,733.33% And using the equation to find the EAR: m EAR = [1 + (APR / m)] – 1 EAR = [1 + .3333] – 1 = 3,139,166.15,% 24. (LO1) Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. Using the PV of a perpetuity equation: PV = C / r $63,000 = $1,200 / r We can now solve for the interest rate as follows: r = $1,200 / $63,000 = .0190 or 1.90% per month The interest rate is 1.90% per month. To find the APR, we multiply this rate by the number of months in a year, so: APR = (12)1.90% = 22.86% And using the equation to find an EAR: m EAR = [1 + (APR / m)] – 1 EAR = [1 + .0190] – 1 = 25.41% 26. (LO1) In the previous problem, the cash flows are monthly and the compounding period is monthly. This assumption still holds. Since the cash flows are annual, we need to use the EAR to calculate the future value of annual cash flows. It is important to remember that you have to make sure the compounding periods of the interest rate times with the cash flows. In this case, we have annual cash flows, so we need the EAR since it is the true annual interest rate you will earn. So, finding the EAR: EAR = [1 + (APR / m)] – 1 12 EAR = [1 + (.10/12)] – 1 = .1047 or 10.47% Using the FVA equation, we get: t FVA = C{[(1 + r) – 1] / r} FVA = $3,000[(1.1047 – 1) / .1047] = $539,686.21 27. (LO1) The cash flows are simply an annuity with four payments per year for four years, or 16 payments. We can use the PVA equation: t PVA = C({1 – [1/(1 + r)] } / r) PVA = $1,500{[1 – (1/1.0075) ] / .0075} = $22,536.47 28. (LO1) The cash flows are annual and the compounding period is quarterly, so we need to calculate the EAR to make the interest rate comparable with the timing of the cash flows. Using the equation for the EAR, we get: EAR = [1 + (APR / m)] – 1 S6-5 EAR = [1 + (.11/4)] – 1 = .1146 or 11.46% And now we use the EAR to find the PV of each cash flow as a lump sum and add them together: 2 4 PV = $900 / 1.1146 + $850 / 1.1146 + $1,140 / 1.1146 = $2,230.20 Intermediate 30. (LO4) The total interest paid by First Simple Bank is the interest rate per period times the number of periods. In other words, the interest by First Simple Bank paid over 10 years will be: .06(10) = .6 First Complex Bank pays compound interest, so the interest paid by this bank will be the FV factor of $1, or: 10 (1 + r) Setting the two equal, we get: 10 (.06)(10) = (1 + r) – 1 1/10 r = 1.6 – 1 = .0481 or 4.81% 32. (LO2) Here we need to find the FV of a lump sum, with a changing interest rate. We must do this problem in two parts. After the first six months, the balance will be: FV = $5,000 [1 + (.025/12)] = $5,062.83 This is the balance in six months. The FV in another six months will be: FV = $5,062.83 [1 + (.17/12)] = $5,508.70 The problem asks for the interest accrued, so, to find the interest, we subtract the beginning balance from the FV. The interest accrued is: Interest = $5,508.70 – 5,000.00 = $508.70 34. (LO1) We need to find the FV of a lump sum in one year and two years. It is important that we use the number of months in compounding since interest is compounded monthly in this case. So: 12 FV in one year = $1(1.0108) = $1.14 FV in two years = $1(1.0108) = $1.29 There is also another common alternative solution. We could find the EAR, and use the number of years as our compounding periods. So we will find the EAR first: EAR = (1 + .0108) – 1 = .1376 or 13.76% Using the EAR and the number of years to find the FV, we get: FV in one year = $1(1.1376) = $1.14 FV in two years = $1(1.1376) = $1.29 S6-6 Either method is correct and acceptable. We have simply made sure that the interest compounding period is the same as the number of periods we use to calculate the FV. 36. (LO2) Since we are looking to triple our money, the PV and FV are irrelevant as long as the FV is three times as large as the PV. The number of periods is four, the number of quarters per year. So: (12/3) FV = $3 = $1(1 + r) r = .3160 or 31.60% 38. (LO1) We can use the present value of a growing perpetuity equation to find the value of your deposits today. Doing so, we find: PV = {C /(r – g)}{[1 – [(1 + g)/(1 + r)]} t PV = {$1,000,000/(.09 – .05)}{[1 – [(1 + .05)/(1 + .09)] } 25 PV = $15,182,293.68 40. (LO1) The relationship between the PVA and the interest rate is: PVA falls as r increases, and PVA rises as r decreases FVA rises as r increases, and FVA falls as r decreases The present values of $7,000 per year for 10 years at the various interest rates given are: [email protected]% = $7,000{[1 – (1/1.10) ] / .10}0 = $43,011.97 10 [email protected]% = $7,000{[1 – (1/1.05) ] / .05} = $54,052.14 [email protected]% = $7,000{[1 – (1/1.15) ] / .15}0 = $35,131.38 41. (LO2) Here we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for the number of payments. Using the FVA equation: t FVA = $20,000 = $225[{[1 + (.09/12)] – 1 } / (.09/12)] Solving for t, we get: t 1.0075 = 1 + [($20,000)/($225)](.09/12) t = ln 1.66667 / ln 1.0075 = 68.37 payments 42. (LO2) Here we are given the PVA, number of periods, and the amount of the annuity. We need to solve for the interest rate. Using the PVA equation: PVA = $55,000 = $1,120[{1 – [1 / (1 + r)] }/ r]0 To find the interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial and error. If you use trial and error, remember that increasing the interest rate lowers the PVA, and increasing the interest rate decreases the PVA. Using a spreadsheet, we find: r = 0.682% The APR is the periodic interest rate times the number of periods in the year, so: APR = 12(0.682%) = 8.18% 44. (LO2) The amount of principal paid on the loan is the PV of the monthly payments you make. So, the present value of the $1,100 monthly payments is: S6-7 PVA = $1,100[(1 – {1 / [1 + (.068/12)]} ) / (.068/12)] = $168,731.02 The monthly payments of $1,100 will amount to a principal payment of $168,731.02. The amount of principal you will still owe is: $220,000 – 168,731.02 = $51,268.98 This remaining principal amount will increase at the interest rate on the loan until the end of the loan period. So the balloon payment in 30 years, which is the FV of the remaining principal will be: 360 Balloon payment = $51,268.98 [1 + (.068/12)] = $392,025.82 46. (LO1) To solve this problem, we simply need to find the PV of each lump sum and add them together. It is important to note that the first cash flow of $1 million occurs today, so we do not need to discount that cash flow. The PV of the lottery winnings is: 2 3 4 $1,000,000 + $1,400,000/1.09 + $1,800,000/1.09 + $2,200,000/1.09 + $2,600,000/1.09 + $3,000,000/1.09 + $3,400,000/1.09 + $3,800,000/1.09 + $4,200,000/1.09 + $4,600,000/1.09 + 9 $5,000,000/1.09 = $19,733,830.26 47. (LO4) Here we are finding interest rate for an annuity cash flow. We are given the PVA, number of periods, and the amount of the annuity. We need to solve for the number of payments. We should also note that the PV of the annuity is not the amount borrowed since we are making a down payment on the warehouse. The amount borrowed is: Amount borrowed = 0.80($2,400,000) = $1,920,000 Using the PVA equation: PVA = $1,920,000 = $13,000[{1 – [1 / (1 + r)] }/ r]360 Unfortunately this equation cannot be solved to find the interest rate using algebra. To find the interest rate, we need to solve this equation on a financial calculator, using a spreadsheet, or by trial and error. If you use trial and error, remember that increasing the interest rate lowers the PVA, and increasing the interest rate decreases the PVA. Using a spreadsheet, we find: r = 0.598% The APR is the monthly interest rate times the number of months in the year, so: APR = 12(0.598%) = 7.17% And the EAR is: EAR = (1 + .00598) – 1 = .0742 or 7.42% 48. (LO1) The profit the firm earns is just the PV of the sales price minus the cost to produce the asset. We find the PV of the sales price as the PV of a lump sum: PV = $145,000 / 1.13 = $100,492.27 And the firm’s profit is: Profit = $100,492.27 – 94,000.00 = $6,492.27 S6-8 To find the interest rate at which the firm will break even, we need to find the interest rate using the PV (or FV) of a lump sum. Using the PV equation for a lump sum, we get: 3 $94,000 = $145,000 / ( 1 + 1/3 r = ($145,000 / $94,000) – 1 = .1554 or 15.54% 50. (LO1) This question is asking for the present value of an annuity, but the interest rate changes during the life of the annuity. We need to find the present value of the cash flows for the last eight years first. The PV of these cash flows is: 96 PVA = 21,500 [{1 – 1 / [1 + (.10/12)] } / (.10/12)] = $98,852.23 Note that this is the PV of this annuity exactly seven years from today. Now we can discount this lump sum to today. The value of this cash flow today is: PV = $98,852.23 / [1 + (.13/12)] = $39,985.62 Now we need to find the PV of the annuity for the first seven years. The value of these cash flows today is: PVA = $1,500 [{1 – 1 / [1 + (.13/12)] } / (.13/12)] = $82,453.99 1 The value of the cash flows today is the sum of these two cash flows, so: PV = $39,985.62 + 82,453.99 = $122,439.62 52. (LO1) To find the value of the perpetuity at t = 7, we first need to use the PV of a perpetuity equation. Using this equation we find: PV = $5,000 / .057 = $87,719.30 Remember that the PV of a perpetuity (and annuity) equations give the PV one period before the first payment, so, this is the value of the perpetuity at t = 14. To find the value at t = 7, we find the PV of this lump sum as: 7 PV = $87,719.30 / 1.057 = $59,507.30 54. (LO1) The cash flows in this problem are semiannual, so we need the effective semiannual rate. The interest rate given is the APR, so the monthly interest rate is: Monthly rate = .10 / 12 = .00833 To get the semiannual interest rate, we can use the EAR equation, but instead of using 12 months as the exponent, we will use 6 months. The effective semiannual rate is: Semiannual rate = (1.00833) – 1 = .0511 or 5.11% We can now use this rate to find the PV of the annuity. The PV of the annuity is: PVA @ t = 9: $6,000{[1 – (1 / 1.0511) ] / .0511} = $46,094.33 Note, this is the value one period (six months) before the first payment, so it is the value at t = 9. So, the value at the various times the questions asked for uses this value 9 years from now. 8 PV @ t = 5: $46,094.33 / 1.0511 = $30,949.21 S6-9 Note, you can also calculate this present value (as well as the remaining present values) using the number of years. To do this, you need the EAR. The EAR is: EAR = (1 + .0083) – 1 = .1047 or 10.47% So, we can find the PV at t = 5 using the following method as well: PV @ t = 5: $46,094.33 / 1.1047 = $30,949.21 The value of the annuity at the other times in the problem is: PV @ t = 3: $46,094.33 / 1.0511 12 = $25,360.08 PV @ t = 3: $46,094.33 / 1.1047 6 = $25,360.08 18 PV @ t = 0: $46,094.33 / 1.0511 = $18,810.58 PV @ t = 0: $46,094.33 / 1.1047 9 = $18,810.58 56. (LO1) We need to use the PVA due equation, that is: PVA due= (1 + r) PVA Using this equation: 60 PVA due= $61,000 = [1 + (.0815/12)] × C[{1 – 1 / [1 + (.0815/12)] } / (.0815/12) $60,588.50 = $C{1 – [1 / (1 + .0815/12) ]} / (.0815/12) C = $1,232.87 Notice, when we find the payment for the PVA due, we simply discount the PV of the annuity due back one period. We then use this value as the PV of an ordinary annuity. 58. (LO3) This amortization table calls for equal principal payments of $7,200 per year. The interest payment is the beginning balance times the interest rate for the period, and the total payment is the principal payment plus the interest payment. The ending balance for a period is the beginning balance for the next period. The amortization table for an equal principal reduction is: Beginning Total Interest Principal Ending Year Balance Payment Payment Payment Balance 1 $36,000.00 $10,440.00 $3,240.00 $7,200.00 $28,800.00 2 28,800.00 9,792.00 2,592.00 7,200.00 21,600.00 3 21,600.00 9,144.00 1,944.00 7,200.00 14,400.00 4 14,400.00 8,496.00 1,296.00 7,200.00 7,200.00 5 7,200.00 7,848.00 648.00 7,200.00 0.00 In the third year, $1,944 of interest is paid. Total interest over life of the loan = $3,240 + 2,592 + 1,944 + 1,296 + 648 = $9,720 Notice that the total payments for the equal principal reduction loan are lower. This is because more principal is repaid early in the loan, which reduces the total interest expense over the life of the loan. Challenge S6-10 60. (LO1) To answer this question, we should find the PV of both options, and compare them. Since we are purchasing the car, the lowest PV is the best option. The PV of the leasing is simply the PV of the lease payments, plus the $1. The interest rate we would use for the leasing option is the same as the interest rate of the loan. The PV of leasing is: 12(3) PV = $1 + $380{1 – [1 / (1 + .08/12) ]} / (.08/12) = $12,127.49 The PV of purchasing the car is the current price of the car minus the PV of the resale price. The PV of the resale price is: 12(3) PV = $15,000 / [1 + (.08/12)] = $11,808.82 The PV of the decision to purchase is: $28,000 – 11,808.82 = $16,191.18 In this case, it is cheaper to lease the car than buy it since the PV of the leasing cash flows is lower. To find the breakeven resale price, we need to find the resale price that makes the PV of the two options the same. In other words, the PV of the decision to buy should be: $28,000 – PV of resale price = $12,127.49 PV of resale price = $15,872.51 The resale price that would make the PV of the lease versus buy decision is the FV of this value, so: Breakeven resale price = $15,872.51[1 + (.08/12)] 12(3= $20,161.86 62. (LO1) a. Calculating the monthly interest rate: r = .109/12 = .00908 = 0.91% Using the PVA equation to find the monthly payments: PVA = $17,679 - $2,500 - $1,000 = C[{1 – [1 / (1 + r)] }/ r] 48 PVA = $14,179 = C[{1 – [1 / (1 + .0091)] }/ .0091] Solving for the monthly payment: C = $365.78 Now calculate the PV of this option with an annual discount rate of 9%: The monthly interest rate = .09 / 12 = .0075 = 0.75% 48 PV = $2,500 + $365.78[{1 – [1 / (1 + .0075)] }/ .0075] PV = $2,500 + $14,698.79 = $17,198.79 b. Calculating the monthly interest rate: r = .015/12 = .00125 = 0.13% Using the PVA equation to find the monthly payments: S6-11 48 PVA = $17,679 - $2,500 = C[{1 – [1 / (1 + r)] }/ r] PVA = $14,179 = C[{1 – [1 / (1 + .0013)] }/ .0013] Solving for the monthly payment: C = $326.01 Now calculate the PV of this option with an annual discount rate of 9%: The monthly interest rate = .09 / 12 = .0075 = 0.75% PV = $2,500 + $326.01[{1 – [1 / (1 + .0075)] }/ .0075] PV = $2,500 + $13,100.64 = $15,600.64 Option b is the better deal. 63. (LO4)
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