Managerial Finance

(4-2) What is an opportunity cost rate? How is this rate used in discounted cash
flow analysis,
and where is it shown on a time line? Is the opportunity rate a single number that is
used
to evaluate all potential investments?
Opportunity cost rate is rate of return that investor could earned on an alternative investment of similar risk.
An opportunity cost is the difference in return between an investment that has chosen for investment and one that is
inevitably gave up. For example, if a person invests in equity and get 3% return over a period of time then by
investing his/her money on stock that person gave up the opportunity of another investment. Lets assume a treasury
bond yielding 5%. In the above situation that persons opportunity costs are 2% (5% - 3%) (Tatum, September
2010).
Opportunity cost rate is used as an interest rate (discounting factor) to calculate present value of future cash flow. To
compute present value, future value is divided by (1 + r) in each year. Therefore, in time line opportunity cost is
shown in between two cash flows.
No the opportunity cost is not the single number that is used in all situation. As per the risk associated with
investment the alternatives as well as opportunity cost will be different.

(4-5) Would you rather have a savings account that pays 5% interest compounded
semiannually or
one that pays 5% interest compounded daily? Explain.
I would rather have a saving account that pays 5% interest compounded daily than compounded semiannually
because effective rate of semiannual interest rate is 5.063% while effective rate of daily compounding is 5.13%.
Calculation of interest compounded semiannually
= (1+ Inom )M - 1.0
M
= (1 + 0.05/2)2 - 1
= (1.025)2 - 1
= 1.050625 - 1
= 5.063%
Calculation of interest compounded daily
= (1+ Inom )M - 1.0
M
= (1 + 0.05/365)365 - 1
= (1.0001369)365 - 1
= 1.05126 - 1
= 5.13%

(4-1) If you deposit $10,000 in a bank account that pays 10% interest annually,
how much will
be in your account after 5 years?

10000*(1.1)^5 = 16105.1
(4-2) What is the present value of a security that will pay $5,000 in 20 years if
securities of equal
risk pay 7% annually?

Future Value =
Years
=
Discount %
=

$5,000
20
7%

Use the following equation to calculate present value:

Present Value =
=
=
=

Future Value X (Present Value Interest Factor (PVIF) )

$5,000
X (1/1.07) ^ 20 years
$5,000 X 0.258
$1,290

(4-6) What is the future value of a 7%, 5-year ordinary annuity that pays $300 each
year? If this
were an annuity due, what would its future value be?
Annuity: $1725.22 Annuity Due: $ 1845.99
the formula of the future value of a ordinary annuity is here http://www.getobjects.com/Components/Finance/TVM/fva.html
You may use table - http://www.principlesofaccounting.com/ART/fv.pv.tables/fvofordinaryannuity.htm
$300*5.75074 = $1725
C
C
C

S = R(((1 + i)n - 1) / i) *(1 + i)

S = $1725 * 1.07
S = $1846

(4-7) An investment will pay $100 at the end of each of the next 3 years, $200 at
the end of Year
4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of
equal
risk earn 8% annually, what is this investments present value? Its future value?
Here's the Present Value Calculation:
Year 1 $100 / (1.0 + .08) = $ 92.59
Year 2 $100 / (1.0 + .08)^2 = $ 85.73
Year 3 $100 / (1.0 + .08)^3 = $ 79.38
Year 4 $200 / (1.0 + .08)^4 = $147.01
Year 5 $300 / (1.0 + .08)^5 = $204.17
Year 6 $500 / (1.0 + .08)^6 = $315.08
Total PV = $923.98
Here's the Future Value calculation:
(Note: since the payment is at the end of each year, the payment for year 1 will compound for only 5 years, the
payment for year 2 will compound for 4 years, and so on)
Year 1 $100 X (1.0 + .08)^5 = $146.93
Year 2 $100 X (1.0 + .08)^4 = $136.05
Year 3 $100 X (1.0 + .08)^3 = $125.97
Year 4 $200 X (1.0 + .08)^2 = $233.28
Year 5 $300 X (1.0 + .08)^1 = $324.00
Year 6 $500 X (1.0 + .08)^0 = $500.00
Total FV = $1,466.23

(4-8) You want to buy a car, and a local bank will lend you $20,000. The loan would
be fully
amortized over 5 years (60 months), and the nominal interest rate would be 12%,
with
interest paid monthly. What is the monthly loan payment? What is the loans EFF%?
PMT = $444.89 EAR = (1 + .01)12 -1 = 12.68%

(4-16) Find the amount to which $500 will grow under each of the following
conditions.
a. N = 5 I = 12 PV = -500 PMT = 0 FV = ?FV = $881.17
b. N = 10 I = 6 PV = -500 PMT = 0 FV = ?FV = $895.42
c. N = 20 I = 3 PV = -500 PMT = 0 FV = ?FV = $903.06
d. N = 60 I = 1 PV = -500 PMT = 0 FV = ?FV = $908.35

(4-17) Find the present value of $500 due in the future under each of the following
conditions.
The nominal rate is the APR
This means that the semiannual rate is 6%
The quarterly rate is 3%
And the monthly rate is 1%
The differences occur because under these conditions the EAR (the effective annual rate) is going to be different for
each case.
Semi annual compounding: EAR = 1.06^2 - 1 = 12.36%
Quarterly compounding EAR = 1.03^4 - 1 = 12.55%
Monthly compounding EAR = 1.01^12 - 1 = 12.6825%

(4-18) Find the future values of the following ordinary annuities.

a. N = 10 I = 6 PV = 0 PMT = -400 FV = $5272.32
b. a. N = 20 I = 3 PV = 0 PMT = -400 FV = $5374.07
c. The annuity in part b earns more because the money is on deposit for a longer period of time and so earns more
interest. Also, because compounding is more frequent, more interest is earned on interest.

(4-19) Universal Bank pays 7% interest, compounded annually, on time deposits.

Regional Bank
pays 6% interest, compounded quarterly.
a. Assuming $100 Deposit:
Universal Bank: N = 1; I1YR = 7; PV = -100; FV = 107
Effective Rate = ((107-100))/100) = .07 or 7%
Regional Bank: N = 4; I1YR = 6/4 = 1.5; PV = -100; FV = 106.136
Effective Rate = 6.136%
You would invest in Universal because the effective rate is higher.
b. If funds must be left on deposit until the end of the compounding period (1
year for Universal and 1 quarter for Regional) and you think there is a high
probability that you will make a withdrawal during the year, the Regional account

might be preferable. If you withdraw 364 days after depositing money in Universal
you would receive no interest, however if you were to have deposited with Regional
you would have received 3 quarterly interest payments.
(4-22) Washington-Pacific invested $4 million to buy a tract of land and plant some
young pine
trees. The trees can be harvested in 10 years, at which time W-P plans to sell the
forest at
an expected price of $8 million. What is W-Ps expected rate of return?
(Final value Initial investment)/Initial investment
(8-4)/4
4/4
1 = 100%
(4-25) While Mary Corens was a student at the University of Tennessee, she
borrowed $12,000
in student loans at an annual interest rate of 9%. If Mary repays $1,500 per year,
then how
long (to the nearest year) will it take her to repay the loan?
Amount of loan = $12,000
I1YR = 9
PV = -12,000
PMT = 1,500
N = 14.77 years or about 15 years (unless she has a rich uncle).
(4-28) Assume that you inherited some money. A friend of yours is working as an
unpaid intern at a
local brokerage firm, and her boss is selling securities that call for 4 payments of
$50 (1
payment at the end of each of the next 4 years) plus an extra payment of $1,000 at
the end of
Year 4. Your friend says she can get you some of these securities at a cost of $900
each. Your
money is now invested in a bank that pays an 8% nominal (quoted) interest rate but
with
quarterly compounding. You regard the securities as being just as safe, and as
liquid, as your
bank deposit, so your required effective annual rate of return on the securities is the
same as
that on your bank deposit. You must calculate the value of the securities to decide
whether
they are a good investment. What is their present value to you?
With I=8% => EFF%= (1+8%/4)^4 1 = 8.24%

8.24%

50

50

50

1050

PV1,2,3= 50* (1-(1.0824)^-3)/.0824 = 128.29

PV4=1050/(1+.0824)^4=764.87
=> PV=128.29+764.87=$893.16