Additional exercises on Time Value

1. You run a construction firm. You have just won a contract to construct a government
office building. It will take one year to construct it, requiring an investment of $9.78
million today and $5 million in one year. The government will pay you $22.5 million
upon the building’s completion. Suppose the cash flows and their times of payment
are certain, and the risk-free interest rate is 11%.
a. What is the NPV of this opportunity?
b. How can your firm turn this NPV into cash today?
2. Suppose the risk-free interest rate is 3.9%.
a. Having $500 today is equivalent to having what amount in one year?
b. Having $500 in one year is equivalent to having what amount today?
c. Which would you prefer, $500 today or $500 in one year? Does your answer depend
on when you need the money? Why or why not?
3. You have an investment opportunity in Japan. It requires an investment of $1.06
million today and will produce a cash flow of ¥106 million in one year with no risk.
Suppose the risk-free interest rate in the United States is 4.7%, the risk-free interest
rate in Japan is 2.9%, and the current competitive exchange rate is ¥110 per dollar.
What is the NPV of this investment? Is it a good opportunity?
4. Your firm has a risk-free investment opportunity where it can invest $161,000 today
and receive $178,000 in one year. For what level of interest rates is this project
attractive?
5. You have decided to take your daughter skiing in Utah. The best price you have been
able to find for a roundtrip air ticket is $364. You notice that you have 20,000 frequent
flier miles that are about to expire, but you need 25,000 miles to get her a free ticket.
The airline offers to sell you 5000 additional miles for $0.04 per mile.
a. Suppose that if you don’t use the miles for your daughter’s ticket they will become
worthless. What should you do?
b. What additional information would your decision depend on if the miles were not
expiring? Why?
6. You have just taken out a five-year loan from a bank to buy an engagement ring. The
ring costs $6000. You plan to put down $2000 and borrow $4000. You will need to
make annual payments of $1250 at the end of each year. Show the timeline of the loan
from your perspective. How would the timeline differ if you created it from the bank’s
perspective?
7. You currently have a four-year-old mortgage outstanding on your house. You make
monthly payments of $2000. You have just made a payment. The mortgage has 26
years to go (i.e., it had an original term of 30 years). Show the timeline from your
perspective. How would the timeline differ if you created it from the bank’s
perspective?
Suppose you receive $100 at the end of each year for the next three years.
a. If the interest rate is 7%, what is the present value of these cash flows?
b. What is the future value in three years of the present value you computed in (a)?
c. Suppose you deposit the cash flows in a bank account that pays 7% interest per year.
What is the balance in the account at the end of each of the next three years (after your
deposit is made)? How does the final bank balance compare with your answer in (b)?
8. You have just received a windfall from an investment you made in a friend’s business.
He will be paying you $32,049 at the end of this year, $64,098 at the end of the
following year, and $96,147at the end of the year after that (three years from today).
The interest rate is 12.9% per year.
a. What is the present value of your windfall?
b. What is the future value of your windfall in three years (on the date of the last
payment)?
9. You have a loan outstanding. It requires making five annual payments at the end of
the next five years of $4000 each. Your bank has offered to restructure the loan so that
instead of making five payments as originally agreed, you will make only one final
payment at the end of the loan in five years. If the interest rate on the loan is 5.63%,
what final payment will the bank require you to make so that it is indifferent between
the two forms of payment?
10. You work for a pharmaceutical company that has developed a new drug. The patent
on the drug will last 17 years. You expect that the drug’s profits will be $4 million in
its first year and that this amount will grow at a rate of 6% per year for the next 17
years. Once the patent expires, other pharmaceutical companies will be able to
produce the same drug and competition will likely drive profits to zero. What is the
present value of the new drug if the interest rate is 8% per year?
11. Your oldest daughter is about to start kindergarten at a private school. Tuition is
$30,000 per year, payable at the beginning of the school year. You expect to keep your
daughter in private school through high school. You expect tuition to increase at a rate
of 3% per year over the years of her schooling. What is the present value of the tuition
 payments if the interest rate is 3% per year? How much would you need to have in the
bank now to fund all 13 years of tuition?
12. A rich aunt has promised you $2000 one year from today. In addition, each year after
that, she has promised you a payment (on the anniversary of the last payment) that is
7% larger than the last payment. She will continue to show this generosity for 20
years, giving a total of 20 payments. If the interest rate is 7%, what is her promise
worth today?
13. A rich aunt has promised you $2000 one year from today. In addition, each year after
that, she has promised you a payment (on the anniversary of the last payment) that is
7% larger than the last payment. She will continue to show this generosity for 20
years, giving a total of 20 payments. If the interest rate is 7%, what is her promise
worth today?
14. Ten years ago Diana Torres wrote what has become the leading Tort textbook. She has
been receiving royalties based on revenues reported by the publisher. These revenues
started at $1 million in the first year, and grew steadily by 5% per year. Her royalty
rate is 15% of revenue. Recently, she hired an auditor who discovered that the
publisher had been underreporting revenues. The book had actually earned 10% more
in revenues than had been reported on her royalty statements.
a. Assuming the publisher pays an interest rate of 4% on missed payments, how much
money does the publisher owe Diana?
b. The publisher is short of cash, so instead of paying Diana what is owed, the publisher
is offering to increase her royalty rate on future book sales. Assume the book will
generate revenues for an additional 20 years and that the current revenue growth will
continue. If Diana would otherwise put the money into a bank account paying interest of
3%, what royalty rate would make her indifferent between accepting an increase in the
future royalty rate and receiving the cash owed today.
15. Your brother has offered to give you $100, starting next year, and after that growing at
3% for the next 20 years. You would like to calculate the value of this offer by
calculating how much money you would need to deposit in the local bank so that the
account will generate the same cash flows as he is offering you. Your local bank will
guarantee a 6% annual interest rate so long as you have money in the account.
a. How much money will you need to deposit into the account today?
b. Using an Excel spreadsheet, show explicitly that you can deposit this amount of money
into the account, and every year withdraw what your brother has promised, leaving the
account with nothing after the last withdrawal.
16. You have an investment opportunity that requires an initial investment of $9500 today
and will pay $10,500 in one year. What is the IRR of this opportunity?
17. Suppose you invest $3500 today and receive $9500 in five years.
a. What is the IRR of this opportunity?
b. Suppose another investment opportunity also requires $3500 upfront, but pays an equal
amount at the end of each year for the next five years. If this investment has the same
IRR as the first one, what is the mount you will receive each year?
18. You are shopping for a car and read the following advertisement in the newspaper:
“Own a new Spitfire! No money down. Four annual payments of just $18,000.” You
have shopped around and know that you can buy a Spitfire for cash for $61,200. What
is the interest rate the dealer is advertising (what is the IRR of the loan in the
advertisement)? Assume that you must make the annual payments at the end of each
year.
19. A local bank is running the foll//mowing advertisement in the newspaper: “For just
$4000 we will pay you $280 forever!” The fine print in the ad says that for a $4000
deposit, the bank will pay $280 every year in perpetuity, starting one year after the
deposit is made. What interest rate is the bank advertising (what is the IRR of this
investment)?
20. You are considering purchasing a warehouse. The cost to purchase the warehouse is
$492,000. Renting the equivalent space costs $19,700 per year. If the annual interest
rate is 5.6%, at what rate must rental cost increase each year to make the cost of
renting comparable to purchasing?
21. Many academic institutions offer a sabbatical policy. Every seven years a professor is
given a year free of teaching and other administrative responsibilities at full pay. For a
professor earning $100,000 per year who works for a total of 42 years, what is the
present value of the amount she will earn while on sabbatical if the interest rate is 6%
(EAR)?
22. You have found three investment choices for a one-year deposit: 9% APR
compounded
monthly, 10% APR compounded annually, and 8% APR compounded daily. Compute the
EAR for each investment choice. (Assume that there are 365 days in the year.)
23. You are considering moving your money to new bank offering a one-year CD that
pays an APR of 2% with monthly compounding. Your current bank’s manager offers
to match the rate you have been offered. The account at your current bank would pay
interest every six months. How much interest will you need to earn every six months
to match the CD?
24. Your bank account pays interest with an EAR of 5%. What is the APR quote for this
account based on semiannual compounding? What is the APR with monthly
compounding?
25. Suppose the interest rate is 6.8% APR with monthly compounding. What is the
present value of an annuity that pays $108 every six months for six years?
26. You can earn $38 in interest on a $1000 deposit for eight months. If the EAR is the
same regardless of the length of the investment, determine how much interest will you
earn on a $1000 deposit for 9 months ; 1 year ; 1.6 years.
27. Suppose you invest $101 in a bank account, and five years later it has grown to
$136.14.
What APR did you receive if the interest was compounded semiannually?
What APR did you receive if the interest was compounded monthly?
28. Your son has been accepted into college. This college guarantees that your son’s
tuition will not increase for the four years he attends college. The first $8500 tuition
payment is due in six months. After that, the same payment is due every six months
until you have made a total of eight payments. The college offers a bank account that
allows you to withdraw money every six months and has a fixed APR of 8%
(semiannual) guaranteed to remain the same over the next four years. How much
money must you deposit today if you intend to make no further deposits and would
like to make all the tuition payments from this account, leaving the account empty
when the last payment is made?
29. You make monthly payments on your mortgage. It has a quoted APR of 10%
(monthly compounding).
What percentage of the outstanding principal do you pay in interest each month?
30. Capital One is advertising a 60-month, 6.61% APR motorcycle loan. If you need to
borrow $11,000 to purchase your dream Harley Davidson, what will your monthly
payment be?
31. Oppenheimer Bank is offering a 30-year mortgage with an EAR of 5.5%. If you plan
to borrow $170,000, what will your monthly payment be?
32. You have decided to refinance your mortgage. You plan to borrow whatever is
outstanding on your current mortgage. The current monthly payment is $1991 and you
have made every payment years and eight months old. You have just made your
monthly payment. The mortgage interest rate is 5.537% (APR). How much do you
owe on the mortgage today?
33. You have just sold your house for $1,100,000 in cash. Your mortgage was originally a
30-year mortgage with monthly payments and an initial balance of $750,000. The
mortgage is currently exactly 18.5 years old, and you have just made a payment. If the
interest rate on the mortgage is 5.25% (APR), how much cash will you have from the
sale once you pay off the mortgage?