EF216 - Tutorial 1 Solutions

1. If you invest $100 at an interest rate of 15%, how much will you have at the end
of eight years?

Ct = PV × (1 + r)t
C8 = $100 × 1.158
C8 = $305.90

2. In the 5 years preceding the end of 2016, the price of Amazon shares rose by 34%
a year. If you had invested $ 100 in Amazon at the beginning of this period, how
much you have by the end of the period?

Ct = PV × (1 + r)t
C2016 = $100 × 1.345
C2016 = $432.04

3. Discount factors
a. If the present value of $139 is $125, what is the discount factor?
b. If that $139 is received in year 5, what is the interest rate?

a. PV = Ct × DFt
DFt = $125 / $139
DFt = .8993

b. Ct = PV × (1 + r)t
$139 = $125 × (1+r)5
r = [$139/$125](1/5) – 1 = 0.0215 or 2.15%

4. Lofting Snodbury is considering investing in a new boring machine. It is expected

to produce the following cash flows:
Year 1 2 3 4 5 6 7 8 9 10
Cash flows 50 57 75 80 85 92 92 80 68 50
If the cost of capital is 12%. What is the PV of cashflows?

𝐶
𝑃𝑉 = ∑10 𝑡
𝑡=0 (1.12)𝑡

PV = $50,000 / 1.12 + $57,000 / 1.122 + $75,000 / 1.123 + $80,000 / 1.124 +

$85,000 / 1.125 + $92,000 / 1.126 + $92,000 / 1.127 + $80,000 / 1.128 + $68,000 / 1.129

+ $50,000 / 1.1210

PV = $403,696.15
5. A factory costs $800,000. You reckon that it will produce an inflow after operating
costs of $170,000 a year for 10 years. If the opportunity cost of capital is 14%, what
is the present value of cashflows from the factory? What will the factory be worth
at the end of five years?
a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})
PV = $170,000 × ((1 / .14) – {1 / [.14(1.14)10]})
PV = $886,739.66

b. After five years, the factory’s value will be the present value of the five remaining
year’s of cash flows.
PV = $170,000 × ((1 / .14) – {1 / [.14(1.14)(10 – 5)]})
PV = $583,623.76

6. You have just read an advertising stating, “Pay us $100 a year for 10 years and we
will pay you $100 a year thereafter in perpetuity.” If this is a fair deal, what is the
rate of interest?

One way to approach this problem is to solve for the present value of:

(1) $100 per year for 10 years, and

(2) $100 per year in perpetuity, with the first cash flow at year 11.

If this is a fair deal, these present values must be equal, and thus we can solve for the
interest rate (r).

The present value of $100 per year for 10 years is:

PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $100 × ((1 / r) – {1 / [r(1 + r)10]})

The present value, as of year 0, of $100 per year forever, with the first payment in year 11, is:
PV = (C / r) / (1 + r)t

PV = ($100 / r) / (1 + r)10

Equating these two present values, we have:

$100 × ((1 / r) – {1 / [r(1 + r)10]}) = ($100 / r) / (1 + r)10

Using trial and error or algebraic solution, we find that r = 7.18%.

7. Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He
wishes to invest $20,000 in an annuity that will make a level payment at the end of
each year until his death. If the interest rate is 8%. What income can Mr. Basset
to receive each year?
C = PVA / ((1 / r) – {1 / [r(1 + r)t]})
C = $20,000 / ((1 / .08) – {1 / [.08(1 + .08)12]})
C = $2,653.90

8. The $40 million lottery prize that you have just won actually pays out $2 million a
year for 20 years. The interest rate is 8%.
a. If the first payment comes after 1 year, what is the present value of your
winnings?
b. What is the present value if the first payment comes immediately?

a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $2.0 million × ((1 / .08) – {1 / [.08(1.08)20]})
PV = $19.64 million
b. If each cashflow arrives one year earlier, then you can simply compound the PV calculated in
part a by (1+r)→ $19.64 million × (1.08) = $21.21 million

9. A bank loan requires you to pay $70,000 at the end of each of the next eight years.
The interest rate is 8%.
a. What is the present value of these payments?
b. Calculate for each year the loan balance that remaining outstanding, the
interest payment on the loan and the reduction in the loan balance.

a. Using the annuity formula:

PV = $70,000 × ((1 / .08) – {1 / [.08(1 + .08)8]})
PV = $402,264.73

b. The amortization table follows:

Year Beg Bal. Payment Interest (8%) Loan Red. Ending Bal.
1 $ 402,265 $ (70,000) $ (32,181) $ (37,819) $ 364,446
2 364,446 (70,000) (29,156) (40,844) 323,602
3 323,602 (70,000) (25,888) (44,112) 279,490
4 279,490 (70,000) (22,359) (47,641) 231,849
5 231,849 (70,000) (18,548) (51,452) 180,397
6 180,397 (70,000) (14,432) (55,568) 124,829
7 124,829 (70,000) (9,986) (60,014) 64,815
8 64,815 (70,000) (5,185) (64,815) -

10. You are quoted an interest rate of 6% on an investment of $10 million. What is
the value of your investment after four years if interest is compounded
a. Annually?
b. Monthly?
c. Continuously?
 a. Ct = PV × (1 + r)t
Ct = $10,000,000 x (1.06)4
Ct = $12,624,770

b. Ct = PV × [1+ (r / m)mt
Ct = $10,000,000 × [1 + (.06 / 12)]12 × 4
Ct = $12,704,892

b. Ct = PV × ert
Ct = $10,000,000 × e.06 × 4
Ct = $12,712,492

11. The continuous compounded interest rate is 12%.

a. You invest $1,000 at this rate. What is the investment worth after five
years?
b. What is the PV of $5 million to be received in eight years?
c. What is the PV of a continuous streams of cash flows, amounting to $2,000
per year, starting immediately and continuing for 15 years?

a. FV = C × ert
FV = $1,000 × e.12 x 5
FV = $1,822.12

b. PV = C / ert
PV = $5,000,000 / e.12 × 8
PV = $1,914,464

c. PV = C (1 / r – 1 / rert)
PV = $2,000 (1 / .12 – 1 / .12e .12 x 15)

PV = $13,911.69