FIN515 Unit 2 Learning Activity Solutions

4-3. Calculate the future value of $2,000 in:

a. 5 years at an interest rate of 5% per year.
b. 10 years at an interest rate of 5% per year.
c. 5 years at an interest rate of 10% per year.
d. Why is the amount of interest earned in part a less than half the amount of interest earned in
part b?
a. Timeline
0 1 2 5

2000 FV = ?
FV5 = 2, 000 ´1.055 = 2,552.56
b. Timeline
0 1 2 10

2000 FV = ?
FV10 = 2, 000 ´1.0510 = 3, 257.79
c. Timeline
0 1 2 5

2000 FV = ?
FV5 = 2,000 ´1.15 = 3, 221.02
d. It is less than half because in the last 5 years, you get interest on the interest earned in the first
5 years, as well as interest on the original $2,000.

4-4. What is the present value of $10,000 received

a. 12 years from today when the interest rate is 4% per year?
b. 20 years from today when the interest rate is 8% per year?
c. 6 years from today when the interest rate is 2% per year?
a. Timeline
0 1 2 3 12

PV = ? 10,000
 10, 000
PV = 12
= 6, 245.97
1.04
b. Timeline
0 1 2 3 20

PV = ? 10,000
10, 000
PV = 20
= 2,145.48
1.08
c. Timeline
0 1 2 3 4 5 6

PV = ? 10,000
10, 000
PV = 6
= 8, 879.71
1.02

4-5. Your brother has offered to give you either $5000 today or $10,000 in 10 years. If the interest rate
is 7% per year, which option is preferable?
Timeline
0 1 2 3 4 10

PV = ? 10,000
10, 000
PV = 10
= 5, 083.49
1.07
So the $10,000 in 10 years is preferable because it is worth more.

4-6. Consider the following alternatives.

i. $100 received in 1 year
ii. $200 received in 5 years
iii. $300 received in 10 years
a. Rank the alternatives from most valuable to least valuable if the interest rate is 10% per year.
b. What is your ranking if the interest rate is only 5% per year?
c. What is your ranking if the interest rate is 20% per year?
a. Option ii > Option iii > Option i
 rate 10%
Amount Years PV
100 1 90.9090909
200 5 124.184265
300 10 115.662987

b. Option iii > Option ii > Option i

rate 5%
Amount Years PV
100 1 95.2380952
200 5 156.705233
300 10 184.173976

c. Option i > Option ii > Option iii

rate 20%
Amount Years PV
100 1 83.33333
200 5 80.37551
300 10 48.45167

4-8. Your daughter is currently 8 years old. You anticipate that she will be going to college in 10 years.
You would like to have $100,000 in a savings account to fund her education at that time. If the
account promises to pay a fixed interest rate of 3% per year, how much money do you need to put
into the account today to ensure that you will have $100,000 in 10 years?
Timeline
0 1 2 3 10

PV = ? 100,000
100, 000
PV= 10
= 74, 409.39
1.03

4-9. You are thinking of retiring. Your retirement plan will pay you either $250,000 immediately on
retirement or $350,000 five years after the date of your retirement. Which alternative should you
choose if the interest rate is
a. 0% per year?
b. 8% per year?
c. 20% per year?
Timeline: Same for all parts
0 1 2 3 4 5

PV = ? 350,000
 350, 000
a. PV = 5
= 350, 000
1.0
You should take the $350,000.
350, 000
b. PV = 5
= 238, 204
1.08
You should take the $250,000.
350, 000
c. PV = = 140, 657
5
1.2
You should take the $250,000.
4-14. You have been offered a unique investment opportunity. If you invest $10,000 today, you will receive $500
1 year from now, $1,500 2 years from now, and $10,000 10 years from now.
a. What is the NPV of the opportunity if the interest rate is 6% per year? Should you take the
opportunity?
b. What is the NPV of the opportunity if the interest rate is 2% per year? Should you take it now?
Timeline
0 1 2 3 10

-10,000 500 1,500 10,000

500 1, 500 10, 000

a. NPV = -10, 000 + + +
2 10
1.06 1.06 1.06
= -10, 000 + 471.70 + 1, 334.99 + 5, 583.95 = -2, 609.36
Because the NPV < 0, don’t take it.

500 1, 500 10, 000

b. NPV = -10, 000 + + +
2 10
1.02 1.02 1.02
= -10, 000 + 490.20 + 1, 441.75 + 8, 203.48 = 135.43
Since the NPV > 0, take it.

4-19. What is the present value of $1,000 paid at the end of each of the next 100 years if the interest rate is 7%
per year?
Timeline
0 1 2 3 100

1,000 1,000 1,000 1,000

The cash flows are a 100-year annuity, so use the annuity formula.

1, 000 æ 1 ö
PV = ç1 - 100 ÷
= 14, 269.25.
0.07 è 1.07 ø

4-36. You are thinking of purchasing a house. The house costs $350,000. You have $50,000 in cash that you can
use as a down payment on the house, but you need to borrow the rest of the purchase price. The bank is
offering a 30-year mortgage that requires annual payments and has an interest rate of 7% per year. What
will your annual payment be if you sign up for this mortgage?
Timeline (From the perspective of the bank)
0 1 2 3 30

–300,000 C C C C

300, 000
C= = $24,176
1 æ1 - 1 ö
ç 30 ÷
0.07 è 1.07 ø
4-38. You have just made an offer on a new home and are seeking a mortgage. You need to borrow
$600,000.
a. The bank offers a 30-year mortgage with fixed monthly payments and an interest rate of 0.5% per
month. What is the amount of your monthly payment if you take this loan?
b. Alternatively, you can get a 15-year mortgage with fixed monthly payments and an interest rate of
0.4% per month. How much would your monthly payments be if you take this loan instead?

a. Note that a 30-year loan has 30 × 12 = 360 monthly payments. Here is the timeline.
1 2 360

P = 600,000 –C –C –C
We can solve for the loan payment using the following formula.

P 600, 000
C= =
1æ 1 ö 1 æ 1 ö
ç1 - ÷ ç1 - ÷
r çè (1 + r ) N ÷
ø 0.005 çè (1.005 )360 ÷
ø
= $3597.30

Or, use the annuity calculator.

b. Note that a 15-year loan has 15 × 12 = 180 monthly payments. Here is the timeline.
1 2 180

P = 600,000 –C –C –C
We can solve for the loan payment using the following formula.

P 600, 000
C= =
1æ 1 ö 1 æ 1 ö
ç1 - ÷ ç1 - ÷
r çè (1 + r ) N ÷
ø 0.004 çè (1.004 )360 ÷
ø
= $4682.49

Or, use the annuity calculator.

4-A.1. Your grandmother bought an annuity from Rock Solid Life Insurance Company for $200,000 when she
retired. In exchange for the $200,000, Rock Solid will pay her $25,000 per year until she dies. The interest
rate is 5%. How long must she live after the day she retired to come out ahead (that is, to get more in value
than what she paid in)?
Timeline.
 0 1 2 3 N

–200,000 25,000 25,000 25,000 25,000

She breaks even when the NPV of the cash flows is zero. The value of N that solves this is as follows.

25, 000 æ 1 ö
NPV = -200, 000 + ç1 - N ÷
=0
0.05 è (1.05 ) ø
1 200, 000 ´ 0.05
Þ 1- = = 0.4
(1.05 ) N
25, 000
1 1
= 0.6 Þ (1.05 ) =
N

(1.05 ) N
0.6

log (1.05 ) = log ç

N æ 1 ö
÷
è 0.6 ø
N log (1.05 ) = - log ( 0.6 )
- log ( 0.6 )
N=
log (1.05 )
= 10.5.
So if she lives 10.5 or more years, she comes out ahead.

Berk, J., & DeMarzo, P. (2014). Corporate Finance. Boston, MA: Pearson.