Worksheet

1. Assume you deposit $10,000 today in an account that pays 6 percent interest. How
much will you have in five years?
2. Suppose you have just celebrated your 19th birthday. A rich uncle has set up a trust
fund for you that will pay you $150,000 when you turn 30. If the relevant discount
rate is 9 percent, how much is this fund worth today?
3. You’ve been offered an investment that wills double your money in 10 years. What
rate of return are you being offered? Check your answer using the Rule of 72.
4. You’ve been offered an investment that will pay you 9 percent per year. If you invest
$15,000, how long until you have $30,000? How long until you have $45,000?
5. Assume the total cost of a college education will be $200,000 when your child enters
college in 18 years. You presently have $15,000 to invest. What annual rate of interest
must you earn on your investment to cover the cost of your child’s college education?
6. Your coin collection contains 50 1952 silver dollars. If your parents purchased them
for their face value when they were new, how much will your collection be worth
when you retire in 2067, assuming they appreciate at a 3 percent annual rate?
7. Delia Martin has $10,000 that she can deposit in any of three savings accounts for a 3-year
period. Bank A compounds interest on an annual basis, bank B compounds interest twice each
year, and bank C compounds interest each quarter. All three banks have a stated annual
interest rate of 4%.
a. What amount would Ms. Martin have at the end of the third year, leaving all
interest paid on deposit, in each bank?
b. What effective annual rate (EAR) would she earn in each of the banks?
c. On the basis of your findings in parts a and b, which bank should Ms. Martin deal
with? Why?
d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds interest
continuously, how much would Ms. Martin have at the end of the third year?
e. Does this alternative change your recommendation in part c? Explain why or why
not
8. Ramesh Abdul wishes to choose the better of two equally costly cash flow streams: annuity X
and annuity Y. X is an annuity due with a cash inflow of $9,000 for each of 6 years. Y is an
ordinary annuity with a cash inflow of $10,000 for each of 6 years. Assume that Ramesh can
earn 15% on his investments.
a. Find the future value at the end of year 6, FVA6, for both annuity X and annuity Y.
b. Use your finding in part b to indicate which annuity is more attractive. Why?
9. An insurance agent is trying to sell you an immediate-retirement annuity, which for a single
amount paid today, will provide you with $12,000 at the end of each year for the next 25
years. You currently earn 9% on low-risk investments comparable to the retirement annuity.
Ignoring taxes, what is the most you would pay for this annuity?
10. A retirement home at Deer Trail Estates now costs $85,000. Inflation is expected to cause this
price to increase at 6% per year over the 20 years before C. L. Donovan retires. How large an
equal annual end-of-year deposit must be made each year into an account paying an annual
interest rate of 10% for Donovan to have the cash to purchase a home at retirement?
11. Joan Messineo borrowed $15,000 at a 14% annual rate of interest to be repaid over 3 years.
The loan is amortized into three equal annual end-of-year payments. a. Calculate the annual
end-of-year loan payment. b. Prepare a loan amortization schedule showing the interest and
principal breakdown of each of the three loan payments. c. Explain why the interest portion of
each payment declines with the passage of time.
12. Nova Products has a 5-year maximum acceptable payback period. The firm is considering the
purchase of a new machine and must choose between two alternative ones. The first machine
requires an initial investment of $14,000 and generates annual after-tax cash inflows of
$3,000 for each of the next 7 years. The second machine requires an initial investment of
$21,000 and provides an annual cash inflow after taxes of $4,000 for 20 years.
a) Determine the payback period for each machine.
b) Which machine should the firm accept? Why?
c) Do the machines in this problem illustrate any of the weaknesses of using payback?
Discuss.
13. Calculate the net present value (NPV) for the following 20-year projects. Comment on the
acceptability of each. Assume that the firm has an opportunity cost of 14%.
a. Initial investment is $10,000; cash inflows are $2,000 per year.
b. Initial investment is $25,000; cash inflows are $3,000 per year.
c. Initial investment is $30,000; cash inflows are $5,000 per year.
14. Simes Innovations, Inc., is negotiating to purchase exclusive rights to manufacture and market
a solar-powered toy car. The car’s inventor has offered Simes the choice of either a one-time
payment of $1,500,000 today or a series of 5 year-end payments of $385,000.
a. If Simes has a cost of capital of 9%, which form of payment should the
company choose?
b. What yearly payment would make the two offers identical in value at a cost
of capital of 9%?
c. Would your answer to part a of this problem be different if the yearly
payments were made at the beginning of each year? Show what difference,
if any, that change in timing would make to the present value calculation.
d. The after-tax cash inflows associated with this purchase are projected to
amount to $250,000 per year for 15 years. Will this factor change the firm’s
decision about how to fund the initial investment?
15. Lahey Industries has outstanding a $1,000 par-value bond with an 8% coupon interest
rate. The bond has 12 years remaining to its maturity date.
a. If interest is paid annually, find the value of the bond when the required
return is (1) 7%, (2) 8%, and (3) 10%?
b. Indicate for each case in part a whether the bond is selling at a discount, at a
premium, or at its par value.
c. Using the 10% required return, find the bond’s value when interest is paid
semi-annually.
16. Elliot Enterprises’ bonds currently sell for $1,150, have an 11% coupon interest rate
and a $1,000 par value, pay interest annually, and have 18 years to maturity.
a. Calculate the bonds’ yield to maturity (YTM).
b. Compare the YTM calculated in part a to the bonds’ coupon interest rate, and use a
comparison of the bonds’ current price and their par value to explain this difference.
17. Complex Systems has an outstanding issue of $1,000- par-value bonds with a 12%
coupon interest rate. The issue pays interest annually and has 16 years remaining to its
maturity date.
a. If bonds of similar risk are currently earning a 10% rate of return, how
much should the Complex Systems bond sell for today
b. If the required return were at 12% instead of 10%, what would the current
value of Complex Systems’ bond be? Contrast this finding with your findings
in part a and discuss.
18. Midland Utilities has outstanding a bond issue that will mature to its $1,000 par value
in 12 years. The bond has a coupon interest rate of 11% and pays interest annually.
a. Find the value of the bond if the required return is (1) 11%, (2) 15%, and (3) 8%.
b. Plot your findings in part a on a set of “required return (x axis)–market value of
bond (y axis)” axes.
c. Use your findings in parts a and b to discuss the relationship between the coupon
interest rate on a bond and the required return and the market value of the bond
relative to its par value.
19. Assuming that the rates of return associated with a given asset investment are
normally distributed and that the expected return, k, is 18.9% and the coefficient of
variation, CV, is .75, answer the following questions.
a. Find the standard deviation of returns, k.
b. Calculate the range of expected return outcomes associated with the following
probabilities of occurrence: (1) 68%, (2) 95%, (3) 99%.
c. Draw the probability distribution associated with your findings in parts a and b.
20. Douglas Keel, a financial analyst for Orange Industries, wishes to estimate the rate of
return for two similar-risk investments, X and Y. Keel’s research indicates that the
immediate past returns will serve as reasonable estimates of future returns. A year
earlier, investment X had a market value of $20,000, investment Y of $55,000. During
the year, investment X generated cash flow of $1,500 and investment Y generated
cash flow of $6,800. The current market values of investments X and Y are $21,000
and $55,000, respectively.
a. Calculate the expected rate of return on investments X and Y using the most
recent year’s data.
b. Assuming that the two investments are equally risky, which one should Keel
recommend? Why?
21. Joe Martinez, a U.S. citizen living in Brownsville, Texas, invested in the common
stock of Telmex, a Mexican corporation. He purchased 1,000 shares at 20.50 pesos
per share. Twelve months later, he sold them at 24.75 pesos per share. He received no
dividends during that time.
a. What was Joe’s investment return (in percentage terms) for the year, on the basis
of the peso value of the shares?
b. The exchange rate for pesos was 9.21 pesos per $US1.00 at the time of the
purchase. At the time of the sale, the exchange rate was 9.85 pesos per $US1.00.
Translate the purchase and sale prices into $US.
c. Calculate Joe’s investment return on the basis of the $US value of the shares.
 d. Explain why the two returns are different. Which one is more important to Joe?
Why?
22. Swift Manufacturing must choose between two asset purchases. The annual rate of
return and the related probabilities given in the following table summarize the firm’s
analysis to this point.

Project 257 Project 432

Rate of return Probability Rate of return Probability
(%)
-10 0.01 10 0.05
10 0.04 15 0.10
20 0.05 20 0.10
30 0.1 25 0.15
40 0.15 30 0.20
45 0.30 35 0.15
50 0.15 40 0.10
60 0.1 45 0.10
70 0.05 50 0.05
80 0.04
100 0.01
For each project, compute:

a.

(1) The range of possible rates of return.

(2) The expected value of return.
(3) The standard deviation of the returns.
(4) The coefficient of variation of the returns.

b. Which project would you consider less risky? Why?

23. The inflation rate in the United States is projected at 3 percent per year for the next
several years. The German inflation rate is projected to be 5 percent during that time.
The exchange rate is currently DM 1.66. Based on relative PPP, what is the expected
exchange rate in two years?
24. Suppose the rate of inflation in Germany will run about 3 percent higher than the U.S.
inflation rate over the next several years. All other things being the same, what will
happen to the deutsche mark versus dollar exchange rate?
25. The exchange rate for the Australian dollar is currently A$1.40. This exchange rate is
expected to rise by 10 percent over the next year.
a. Is the Australian dollar expected to get stronger or weaker?
b. What do you think about the relative inflation rates in the United States and
Australia?
c. What do you think about the relative nominal interest rates in the United States
and Australia? Relative real rates?
26. Suppose the Japanese yen exchange rate is ¥115 = $1, and the British pound
exchange rate is £1 = $1.65.
a. What is the cross-rate in terms of yen per pound?
b. Suppose the cross-rate is ¥160 £1. Is there an arbitrage opportunity here? If there
is, explain how to take advantage of the mispricing