Homework 3

1.

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 + (.015/12)]6 = $5,037.62

This is the balance in six months. The FV in another six months will be:

FV = $5,037.62[1 + (.18/12)]6 = $5,508.35

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 = $5,508.35 – 5,000.00 = $508.35

2.

Here we are finding the annuity payment necessary to achieve the same FV. The interest rate given is a
12 percent APR, with monthly deposits. We must make sure to use the number of months in the
equation. So, using the FVA equation:

Starting today:

FVA = C[{[1 + (.12/12) ]480 – 1} / (.12/12)]

C = $1,000,000 / 11,764.77 = $85.00

Starting in 10 years:

FVA = C[{[1 + (.12/12) ]360 – 1} / (.12/12)]

C = $1,000,000 / 3,494.96 = $286.13

Starting in 20 years: FVA = C[{[1 + (.12/12) ]240 – 1} / (.12/12)]

C = $1,000,000 / 989.255 = $1,010.86

Notice that a deposit for half the length of time, i.e. 20 years versus 40 years, does not mean that the
annuity payment is doubled. In this example, by reducing the savings period by one-half, the deposit
necessary to achieve the same ending value is about twelve times as large.

3.

Since your salary grows at 4 percent per year, your salary next year will be:

Next year’s salary = $50,000 (1 + .04)

Next year’s salary = $52,000

This means your deposit next year will be:

Next year’s deposit = $52,000(.05)

Since your salary grows at 4 percent, you deposit will also grow at 4 percent. 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 {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t }

PV = $2,600{[1/(.11 – .04)] – [1/(.11 – .04)] × [(1 + .04)/(1 + .11)]40}

PV = $34,399.45

Now, we can find the future value of this lump sum in 40 years. We find:

FV = PV(1 + r) t

FV = $34,366.45(1 + .11)40

FV = $2,235,994.31

This is the value of your savings in 40 years.

4.

We need to use the PVA due equation, that is:

PVAdue = (1 + r) PVA

Using this equation:

PVAdue = $68,000 = [1 + (.0785/12)] × C[{1 – 1 / [1 + (.0785/12)]60} / (.0785/12)

$67,558.06 = $C{1 – [1 / (1 + .0785/12)60]} / (.0785/12)

C = $1,364.99

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.

5.

The payment for a loan repaid with equal payments is the annuity payment with the loan value as the
PV of the annuity. So, the loan payment will be:

PVA = $42,000 = C {[1 – 1 / (1 + .08)5 ] / .08}

C = $10,519.17

The interest payment is the beginning balance times the interest rate for the period, and the principal
payment is the total payment minus the interest payment. The ending balance is the beginning balance
minus the principal payment. The ending balance for a period is the beginning balance for the next
period. The amortization table for an equal payment is:
In the third year, $2,168.71 of interest is paid.

Total interest over life of the loan = $3,360 + 2,787.27 + 2,168.71 + 1,500.68 + 779.20

Total interest over life of the loan = $10,595.86

6.

Price and yield move in opposite directions; if interest rates rise, the price of the bond will fall. This is
because the fixed coupon payments determined by the fixed coupon rate are not as valuable when
interest rates rise—hence, the price of the bond decreases

7.

To find the price of this bond, we need to realize that the maturity of the bond is 10 years. The bond was
issued one year ago, with 11 years to maturity, so there are 10 years left on the bond. Also, the coupons
are semiannual, so we need to use the semiannual interest rate and the number of semiannual periods.
The price of the bond is:

P = $34.50(PVIFA3.7%,20) + $1,000(PVIF3.7%,20) = $965.10

8.

The price of any bond (or financial instrument) is the PV of the future cash flows. Even though Bond M
makes different coupons payments, to find the price of the bond, we just find the PV of the cash flows.
The PV of the cash flows for Bond M is:

PM = $1,100(PVIFA3.5%,16)(PVIF3.5%,12) + $1,400(PVIFA3.5%,12)(PVIF3.5%,28) + $20,000(PVIF3.5%,40)

PM = $19,018.78

Notice that for the coupon payments of $1,400, we found the PVA for the coupon payments, and then
discounted the lump sum back to today.

Bond N is a zero coupon bond with a $20,000 par value, therefore, the price of the bond is the PV of the
par, or:

PN = $20,000(PVIF3.5%,40) = $5,051.45

9.
Resnor, Inc., has an issue of preferred stock outstanding that pays a $5.50 dividend every year in
perpetuity. If this issue currently sells for $108 per share, what is the required return?

R = D/P0 = $5.50/$108 = .0509 or 5.09%

10.

This stock has a constant growth rate of dividends, but the required return changes twice. To find the
value of the stock today, we will begin by finding the price of the stock at Year 6, when both the
dividend growth rate and the required return are stable forever. The price of the stock in Year 6 will be
the dividend in Year 7, divided by the required return minus the growth rate in dividends. So:

P6 = D6 (1 + g) / (R – g) = D0 (1 + g) 7 / (R – g) = $3.50 (1.05)7 / (.10 – .05) = $98.50

Now we can find the price of the stock in Year 3. We need to find the price here since the required
return changes at that time. The price of the stock in Year 3 is the PV of the dividends in Years 4, 5, and
6, plus the PV of the stock price in Year 6. The price of the stock in Year 3 is:

P3 = $3.50(1.05)4 / 1.12 + $3.50(1.05)5 / 1.122 + $3.50(1.05)6 / 1.123 + $98.50 / 1.123

P3 = $80.81

Finally, we can find the price of the stock today. The price today will be the PV of the dividends in Years
1, 2, and 3, plus the PV of the stock in Year 3. The price of the stock today is:

P0 = $3.50(1.05) / 1.14 + $3.50(1.05)2 / (1.14)2 + $3.50(1.05)3 / (1.14)3 + $80.81 / (1.14)3

P0 = $63.47

11.

P0 = $64 = D0 (1 + g) / (R – g)

D0 = $64(.10 – .045) / (1.045)

D0 = $3.37

12.

R = 0%: 3 + ($2,100 / $4,300) = 3.49 years

discounted payback = regular payback = 3.49 years

R = 5%: $4,300/1.05 + $4,300/1.052 + $4,300/1.053 = $11,709.97

$4,300/1.054 = $3,537.62

discounted payback = 3 + ($15,000 – 11,709.97) / $3,537.62 = 3.93 years

R = 19%: $4,300(PVIFA19%,6) = $14,662.04

The project never pays back.

13.
The NPV of a project is the PV of the outflows minus the PV of the inflows. Since the cash inflows are an
annuity, the equation for the NPV of this project at an 8 percent required return is:

NPV = –$138,000 + $28,500(PVIFA8%, 9) = $40,036.31

At an 8 percent required return, the NPV is positive, so we would accept the project.

The equation for the NPV of the project at a 20 percent required return is:

NPV = –$138,000 + $28,500(PVIFA20%, 9) = –$23,117.45

At a 20 percent required return, the NPV is negative, so we would reject the project. We would be
indifferent to the project if the required return was equal to the IRR of the project, since at that required
return the NPV is zero. The IRR of the project is:

0 = –$138,000 + $28,500(PVIFAIRR, 9)

IRR = 14.59%

14.

Here the cash inflows of the project go on forever, which is a perpetuity. Unlike ordinary perpetuity cash
flows, the cash flows here grow at a constant rate forever, which is a growing perpetuity. If you
remember back to the chapter on stock valuation, we presented a formula for valuing a stock with
constant growth in dividends. This formula is actually the formula for a growing perpetuity, so we can
use it here. The PV of the future cash flows from the project is:

PV of cash inflows = C1/(R – g)

PV of cash inflows = $85,000/(.13 – .06) = $1,214,285.71

NPV is the PV of the outflows minus the PV of the inflows, so the NPV is:

NPV of the project = –$1,400,000 + 1,214,285.71 = –$185,714.29

The NPV is negative, so we would reject the project. b. Here we want to know the minimum growth rate
in cash flows necessary to accept the project. The minimum growth rate is the growth rate at which we
would have a zero NPV. The equation for a zero NPV, using the equation for the PV of a growing
perpetuity is:

0 = –$1,400,000 + $85,000/(.13 – g)

Solving for g, we get:

g = .0693 or 6.93%