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Tutorial 2 Solutions

This document contains solutions to 4 questions regarding financial calculations: 1) It calculates the annual rate of return for two investments with different time horizons and payoffs. Investment A has a higher 8.21% return. 2) It evaluates lottery payout options at different discount rates, showing that higher discount rates reduce the present value of future cash flows. 3) It calculates the present value of an annuity with payments starting in 5 years and lasting 20 years at an 8% interest rate as $14,433.11. 4) It determines the annual deposit or lump sum amount needed to fund $10,000 annual withdrawals for 10 years starting at retirement based on an 8% rate

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Faryal
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178 views

Tutorial 2 Solutions

This document contains solutions to 4 questions regarding financial calculations: 1) It calculates the annual rate of return for two investments with different time horizons and payoffs. Investment A has a higher 8.21% return. 2) It evaluates lottery payout options at different discount rates, showing that higher discount rates reduce the present value of future cash flows. 3) It calculates the present value of an annuity with payments starting in 5 years and lasting 20 years at an 8% interest rate as $14,433.11. 4) It determines the annual deposit or lump sum amount needed to fund $10,000 annual withdrawals for 10 years starting at retirement based on an 8% rate

Uploaded by

Faryal
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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P2P-Tutorial One Solutions

Question 1
You are comparing two investments. Both require a $2500 initial investment. Investment A
returns $4700 in eight years. Investment B pays $5650 in 12 yrs. Which of these investments
has the higher return?

Answers

Investment A

t
FV =PV ( 1+r )
8
4700=2500 ( 1+r )

Divide both sides by 2500

4700 = 1.88 = (1 + r )8
2500

Find 1/8 which is 0.125

Take both sides to the power of 1/8 or 0.125


1/ 8
1.88 [ ( 1 + r )8 ] 1/ 8

1.0821 = (1 + r ) 1

=1+r

subtract 1 from both sides

1.0821 – 1 = 0.0821 = r

r = 8.21%

1
Investment B

t
FV =PV ( 1+r )
12
5650=2500 ( 1+r )

Divide both sides by 2500

5650 = 2.26 = (1 + r )12


2500

Find 1/12 which is 0.08333

Take both sides to the power of 1/12 or 0.083333


1/ 12
2.26 = [ ( 1 + r )12 ] 1/ 12

1.0703 = (1 + r ) 1

=1+r

subtract 1 from both sides

1.0703 – 1 = r

r = 0.0703 = 7.03%

Question 2
You have won the lottery and lottery officials offer you the choice of the following
alternative payouts:

Alternative1: $10 K one year from now

Alternative 2: $20 K five years from now

Which one would you choose if the discount rate is:

(a) 0%
(b) 10%
(c) 20%

2
Answers

PV = FV = FV (1 + r )-t
(1 + r )t

r =0 r = 0.1 (10%) r = 0.2 (20%)

10 000 10 000 10 000


(1 + r )1 (1 + r )1 (1 + r )1

10 000 10 000 10 000


1 1.1 1.2

=10 000 = 9090.91 = 8333.33

20 000 20 000 20 000


(1 + r )5 (1 + r )5 (1 + r )5

20 000 20 000 20 000


15 (1 .1 )5 (1 .2 )5

20 000 20 000 20 000


1 1.61051 2.48832

= 20 000  = 12 418.43  = 8 037.55 

This question shows that the bigger the discount rate, the less valuable in today’s money
terms are the cash flows to be received in the future.

3
Question 3
What is the present value of cash flows of $2000 per year, with the first cash flow received 5
years from today and the last one 24 years from today (a total of $40,000)? Use an 8%
interest rate.

Answer

DEFERRED ANNUITY cash flows start after PERIOD 1

0 1 2 3 4 5 6 7……………22 23 24

C = 2 000 t = 20 payments to
At end of period 5 end of period 24

Note: C = 2 000 is received at the end of each of the t = 20 periods

r = 8% or 0.08

1−( 1+r )−t


PV =C [r ]
This shows the present value of the annuity AT THE START OF THE PERIOD IN WHICH
THE FIRST CASH FLOWS OCCUR.

Note: The START = The END


of PERIOD 5 of PERIOD 4

1−( 1+r )−t


PV =C [r ]
1−( 1 .08 )−20
PV 4 =2000 [ 0. 08 ]
1−0 . 21455
PV4
=2000
[ 0. 08 ]
PV4 = 19 636.25

0 1 2 3 4

4
At Period 0 (today) PV0 = 19 636.25 = 19 636 .25
(1 + r )4 (1 .08 )4

= 14 433.11

Question 4
This is a classic retirement problem. A timeline will help in solving it. Your friend is
celebrating his 35th birthday today and wants to start saving for his anticipated retirement at
age 65. He wants to be able to withdraw $10k from his savings account on each birthday for
10 years following his retirement; the first withdrawal will be on his 66 th birthday. Your
friend intends to invest his money in the local savings bank, which offers 8% interest per
year. He wants to make equal, annual payments on each birthday in a new savings account he
will establish for his retirement fund.

a) If he starts making these deposits on his 36 th birthday and continues to make deposits
until he is 65 (the last deposit will be on his 65th birthday), what amount must he
deposit annually to be able to make the desired withdrawals on retirement?
b) Suppose your friend has just inherited a large sum of money. Rather than making
equal payments, he has decided to make one lump-sum payment on his 36 th birthday
to cover his retirement needs. What amount would he have to deposit?

Answer
Pension withdrawal annuity
0 1 2 3 4 5 6 7 8 9 10
35 36 37 ………………………64 65 66 67 68 69 7 0 71 72 73 74 75

0 1 2 29 30

PART A

Step 1: Find the PV of the Pension withdrawal annuity at age 65 yrs.

1−( 1+r )−t


PV =C [ r ] C = 10 000 t = 10 r = 8% or 0.08

1−( 1.08 )−10


PV 65=10000 [
0 .08 ]
= 67 100 .81

Step 2: Use the PV (age 65 yrs) of the pension withdrawal annuity as the FV of the
payments annuity.

5
( 1+r )t −1
FV =C [ r ]
We must find C

( 1+r )t −1 ( 1+r )t −1
Take
FV =C
r [ ] and divide both sides by
[ r ]
C = FV
( 1+r )t −1
[ r ]
= 67 100.81
( 1 .08 )30 −1
[ 0 . 08 ]
= 67 100.81
113.28321

= 592.33

PART B

For 1 LUMP SUM on the 36th birthday, we use:

PV = FV = FV (1 + r )-t
(1 + r ) t

= 67 100.81 (1.08)-29 (Why 29 Not 30)

= 67 100.81 ( 0.107328)

= 7 201.76

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