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Practice problems for Chapter 2: Time value of money

1. You have VND 100 mil, and intend to save the money in a term-deposit
account in 5 years. The bank offered you an interest rate of 14% per annum.
How much money will you get back next 5 years? If:
a. The bank uses the simple interest.
b. The bank uses the compound interest.
2. You invest in a project with an initial investment of $200, and hope to earn
$300 in 3 years. What is your required rate of return?
3. Your term deposit account has a quoted interest of 12%, the term is 1 month.
How much money will you have in 3 years if now you put VND 100 mil into
your account?
4. You take out a loan at an APR of 12% with monthly compounding. What is the
effective annual rate on your loan?
5. A bank quotes a rate of 5.89% with an effective annual interest rate of 6.05%.
Does the bank use annual, quarterly, or monthly compounding?
6. Like question 4 but what is the effective annual rate on your loan if the loan is
continuous compounded?
7. Compute the present value of a $100 cash flow for the following
combinations of discount rates and times:
a. r= 8%, t= 10 years;
b. r= 8%, t= 20 years;
c. i= 4%, t= 10 years;
d. i= 4%, t= 20 years;
8. Compute the future value of a $100 cash flow for the same combinations of
the rates and times as in question 7.
9. You deposit $1000 in your bank account. If the bank pays 4% simple interest,
how much will you accumulate in your account after 10 years? What if the
bank pays compound interest? How much of your earning will be interest on
interest?
10.You will require $700 in 5 years. If you earn 5% interest on your funds, how
much will you need to invest today in order to reach your savings goal?
11.Find the interest rate implied by the following combinations of present and
future values:
Present value
Years
Future value
$400
11
$684
183
4
249
300
7
300
12.Would you rather receive $1,000 a year for 10 years or $800 a year for 15
years if
a. The interest rate is 5%
b. The interest rate is 15%
Why do answers to (a) and (b) differ?

13.What is the present value of the following cash-flow stream if the interest rate
is 6%?
Year
1
2
3

Cash flow
$200
400
300

14.How long will it take for $400 to grow to $1,000 at the interest rate specified?
a. 4%
b. 8%
c. 16%
15.If you earn 6% per year on your bank account, how long will it take an
account with $100 to double to $200?
16.Annuity values
a. What is the present value of a 3-year annuity of $100 if the discount
rate is 6%?
b. What is the present value of the annuity in (a) if you have to wait 2
years instead of 1 year for the first payment?
17.Professors Annuity Corp. offers a lifetime annuity to retiring professors. For a
payment of $80,000 at age 65, the firm will pay the retiring professor $600 a
month until death.
a. If the professors remaining life expectancy is 20 years, what is the
monthly rate on this annuity? What is the effective annual rate?
b. If the monthly interest rate is 0.5%, what monthly annuity payment
can the firm offer to the retiring professor?
18.A store offers two payment plans. Under the installment plan, you pay 25%
down and 25% of the purchase price in each of the next 3 years. If you pay
the entire bill immediately, you can take a 10% discount from the purchase
price. Which is a better deal if you can borrow or lend funds at a 5% interest
rate?
19.Suppose that you will receive annual payments of $10,000 for a period of 10
years. The first payment will be made 4 years from now. If the interest rate is
5%, what is the present value of this steam of payments?
20.How much will $100 grow to if invested at a continuously compounded
interest rate of 10% for 8 years? What if it is invested for 10 years at 8%?
21.Now I have $20,000 in the bank earning interest of 0.5% per month. I need
$30,000 to make a down payment on a house. I can save an additional $100
per month. How long will it take me to accumulate the $30,000?
22.A local bank advertises the following deal: Pay us $100 a year for 10 years
and then we will pay you (or your beneficiaries) $100 a year forever. Is this a
good deal if the interest rate available on other deposit is 6%?
23.A local bank will pay you $100 a year for your lifetime if you deposit $2,500 in
the bank today. If you plan to live forever, what interest rate is the bank
paying?

24.There are two projects with the following cash flows:


Year
0
1
2
3
4

Project A
Project B
-$200
-$200
80
100
80
100
80
100
80
a. If the opportunity cost of capital is 11%, which of these projects is
worth pursuing?
b. Suppose that you can choose only one of these projects. Which would
you choose? The discount rate is still 11%.
c. Which project would you choose if the opportunity cost of capital were
16%?
d. What are the internal rates of return on project A and B?
e. In light of your answers to question b-d, is there any reason to believe
that the project with the higher IRR is the better project?
f. If the opportunity cost of capital is 11%, what is the profitability index
for each project? Does the profitability index rank the project correctly?
25.A project that costs $3,000 to install will provide annual cash flows of $800
for each of the next 6 years. Is this project worth pursuing if the discount rate
is 10%? How high can the discount rate be before you could reject the
project?
26.A proposed nuclear power plant will cost $2.2 billion to build and then will
produce cash flows of $300 million a year for 15 years. After that period (in
year 15), it must be decommissioned at a cost of $900 million. What is
project NPV if the discount rate is 5%? What if it is 18%?
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? Does this alternative change your recommendation in part c?
Explain why or why not.
27.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. On a purely subjective basis, which annuity do you think is more


attractive? Why?
b. Find the future value at the end of year 6 for both annuities.
c. Use your finding in part b to indicate which annuity is more attractive.
Why? Compare your finding to your subjective response in part a.
28.You have a choice of accepting either of two 5-year cash flow streams or
single amounts. One cash flow stream is an ordinary annuity, and the other is
a mixed stream. You may accept alternative A or B either as a cash flow
stream or as a single amount. Given the cash flow stream and single amounts
associated with each (see the following table), and assuming a 9%
opportunity cost, which alternative (A or B) and in which form (cash flow
stream or single amount) would you prefer?

29.Judi Janson wishes to accumulate $8,000 by the end of 5 years by making


equal, annual, end-of-year deposits over the next 5 years. If Judi can earn 7%
on her investments, how much must she deposit at the end of each year to
meet this goal?
30.Hook Industries is considering the replacement of one of its old drill presses.
Three alternative replacement presses are under consideration. The relevant
cash flows associated with each are shown in the following table. The firms
cost of capital is 15%.

a. Calculate the net present value (NPV) of each press.


b. Using NPV, evaluate the acceptability of each press.
c. Rank the presses from best to worst using NPV.
d. Calculate the profitability index (PI) for each press.
e. Rank the presses from best to worst using PI.
31.A precision lathe costs $10,000 and will cost $20,000 a year to operate and
maintain. If the discount rate is 10% and the lathe will last for 5 years. What
is the equivalent annual cost of the tool?
32.A firm can lease a truck for 4 years at a cost of $30,000 annually. It can
instead buy a truck at a cost of $80,000, with annual maintenance expenses
of $10,000. The truck will be sold at the end of 4 years of $20,000. Which is
the better option if the discount rate is 10%?
33.A firm can purchase a fixed asset for a $13,000 initial investment. The asset
generates an annual after-tax cash inflow of $4,000 for 4 years.
a. Determine the net present value (NPV) of the asset, assuming that the firm
has a 10% cost of capital. Is the project acceptable?
b. Determine the maximum required rate of return (closest whole-percentage
rate) that the firm can have and still accept the asset. Discuss this finding in
light of your response in part a.
34.Axis Corp. is considering investment in the best of two mutually exclusive
projects. Project Kelvin involves an overhaul of the existing system; it will cost
$45,000 and generate cash inflows of $20,000 per year for the next 3 years.
Project Thompson involves replacement of the existing system; it will cost
$275,000 and generate cash inflows of $60,000 per year for 6 years. Using an
8% cost of capital, calculate each projects NPV, and make a recommendation
based on your findings.
35.Billabong Tech uses the internal rate of return (IRR) to select projects.
Calculate the IRR for each of the following projects and recommend the best
project based on this measure. Project T-Shirt requires an initial investment of
$15,000 and generates cash inflows of $8,000 per year for 4 years. Project
Board Shorts requires an initial investment of $25,000 and produces cash
inflows of $12,000 per year for 5 years.