Problem set 1

1. A firm has an estimated pension liability of $1.5 million due 27 years from today.
If the firm can invest in a risk-free security with an interest rate of 8 percent, how
much must the firm invest today to be able to make the $1.5 million payment?

2. You have won the Florida state lottery. Lottery officials offer you the choice of
the following alternative payouts:

Alternative 1: $10,000,000 one year from now.

Alternative 2: $20,000,000 five years from now.

Which alternative should you choose if the discount rate is:

a. 0 percent?

b. 10 percent?

c. 20 percent?

d. What discount rate makes the two alternatives equally attractive to you?

3. You are selling your house. The Smiths have offered you $ 115,000.They will pay
you immediately. The Joneses have offered you $150,000, but they cannot pay
you until three years from today. The interest rate is 10 percent. Which offer
should you choose?

4. Ann Woodhouse wants to invest in raw land. She expects to own the property for
10 years and to sell it at the end of the 10th year for $5 million. There are no other
cash flows. What is the most she would be willing to pay for the property if the
appropriate discount rate is 12 percent?

5. You wish to purchase a new convertible 12 years from today. At that time, the car
will cost $80,000.You currently have $10,000 to invest. What rate of interest must
your investment earn so that you can pay for the car?

6. What is the present value of an annuity of $2,000 per year, with the first cash flow
received three years from today and the last one received 22 years from today?
Use a discount rate of 8 percent.

7. On January I, Jack Ferguson signed a three-year contract to work for a computer

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8. Nancy Ferris bought a building for $120,000. She paid 15 percent down and
agreed to pay the balance in 20 equal, end-of-year, installments. What are the
equal installments if the annual interest rate is 10 percent?

Type: Intermediate

9. Your younger brother has come to you for advice. He is about to enter college and
has two options open to him. His first option is to study engineering. If he does
this, his undergraduate degree would cost him $12,000 a year for four years.
Having obtained his undergraduate degree, he would need to gain two years of
practical experience. He would earn $20,000 in the first year and he would earn
$25,000 in the second year. He would then need to obtain his master's degree,
which will cost $15,000 a year for two years. After completion of his master's
degree, he will be fully qualified as an engineer and can earn $40,000 per year for
25 years. His other alternative is to study accounting. If he does this, he would
pay $13,000 a year for four years and then he would earn $31,000 per year for 30
years.

a. The effort involved in the two careers is the same, so he is only interested
in the earnings that the jobs provide. All earnings and costs are paid at the
end of the year.

b. What advice would you give him if the market interest rate is 5 percent?

c. A day later he comes back and says that he took your advice, but in fact,
the market interest rate was 6 percent. Has your brother made the right
choice?

10. Ian Krassner wants to save money to meet two objectives. First, he wants to
retire with a retirement income of $300,000 per year for 20 years. The first
retirement payment will occur 31 years from today. Second, he would like to
purchase a cabin in the mountains 10 years from today at an estimated cost of
$350,000. He can afford to save only $40,000 at the end of each year for the first
10 years. He expects to earn 7 percent per year on his savings. Assuming he saves
the same amount each year, what must Ian save annually at the end of year 11
through year 30 to meet his objectives?

11. Mr. Moore is 35 years old today and is beginning to plan for his retirement. He
wants to set aside an equal amount at the end of each of the next 25 years so that
he can retire at age 60. He expects to live to the maximum age of 80 and wants to
be able to withdraw $25,000 per year from the account on his 61st through 80th
birthdays. The account is expected to earn 10 percent per annum for the entire
period of time. Determine the size of the annual deposits that must be made by
Mr. Moore.

12. What is the effective annual rate for a 15% annual rate with monthly
compounding?

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 13. What is the present value of Rs 3400 to be received 3 years from now if the
required return is 11% pa compounded continuously?

14. What is the future value 1.5 years from now if the present value is 900 and the
expected return is 12% pa compounded quarterly?

15. What are the monthly installments on a 3 year Rs. 10000 loan if the interest rate is
10% pa compounded annually?

16. What is the present value of 500 every year forever with the first payment 2 years
from today, if the required return is 12% pa.

17. Sarah Buchwalter bought a $15,000 Honda Civic with 20 percent down and
financed the rest with a four-year loan at an 8% APR, compounded monthly.
What is her monthly payment if she makes the first payment one month after the
purchase?

18. Paladin Enterprises manufactures printing presses for small-town newspapers that
are often short of cash. To accommodate these customers, Paladin offers the
following payment terms:

i. 1/3 on delivery

ii. 1/3 after six months

iii. 1/3 after 18 months

What discount is implied by the terms from Paladin's point of view if it can invest
excess funds at 8% compounded quarterly?

The Littleton Sentinel is a typically cash-poor newspaper considering one of Paladin's

19. What are the monthly mortgage payments on a 30-year loan for $150,000
at 12% PA compounded annually? Construct an amortization table for the
first six months of the loan.

20. The Tower family wants to make a home improvement that is expected to
cost $60,000. They want to fund as much of the cost as possible with a
home equity loan, but can afford payments of only $600 per month. Their
bank offers equity loans at 12% compounded monthly for a maximum
term of 10 years. How much cash do they need as a down payment?

(Collected from different textbooks)

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Q. no Answer
1 -₹ 1,87,780.23
2 @0 % Alt 2
@10% Alt 2
@20% Alt 1
Indifference rate = 18.92%
3 The offer of Smith's since 115,000 > 112697.22
4 ₹ 1609866.183
5 18.92%
6 16834.96
7 174276.93
8 -₹ 11,980.88
9 AT 5% - Go for Engineering total benefits = 352535.15
At 6% Go for Accounting total benefits =292947.73
10 Annual savings during t =11 to 20 is 58396.23
11 Annual saving = 2164.16
12 16.08%
13 2444.34
14 1074.65
15 320.65
16 3720.24
17 292.96
18 a) 5.03%
b) 7.40%
19 EMI=1472.47
20 18179.69