05 TVOM Exercise

Questions: Class exercise 1 TVOM
1. The financial manager at ABC company is considering an investment that requires an initial outlay
of $30,000 and is expected to result in cash inflows of $4,000 at the end of year 1, $7,000 at the end
of years 2 and 3, $10,000 at the end of year 4, $7,000 at the end of year 5, and $9,000 at the end of
year 6.
a. Draw and label a time line depicting the cash flows associated with ABC company’s proposed
investments.
b. Use arrows to demonstrate, on the time line in part a, how compounding to find future value can
be used to measure all cash flows at the end of year 6.
c. Use arrows to demonstrate, on the time line in part b, how discounting to find present value can
be used to measure all cash flows at time zero.
d. Which of the approach- future value or present value-do financial managers rely on most for
decision making? Why?
2. You have $100 to invest. If you can earn 12% interest, about how long does it take for your $100
investment to grow $200? Suppose that the interest rate is just half that, at 6%. At half the interest
rate, does it take twice as long to double your money? Why or why not? How long does it take?
3. You have $1,500 to invest today at 7% interest compounded annually.
a. Find how much you will have accumulated in the account at the end of (1) 3 years, (2) 6 years,
and (3) 9 years.
b. Use your findings in part a to calculate the amount of interest earned in (1) the first 3 years (years
1 to 3), (2) the second 3 years (years 4 to 6), and (3) the third 3 years (years 7 to 9).
c. Compare and contrast your findings in part b. Explain why the amount of interest earned increases
in each succeeding 3-year period
4. As part of your financial planning, you wish to purchase a new car exactly 5 years from today. The
car you wish to purchase costs $14,000 today, and your research indicates that its price will increase
by 2% to 4% per year over the next 5 years.
a. Estimate the price of the car at the end of 5 years if inflation is (1) 2% per year, and (2) 4% per
year.
b. How much more expensive will the car be if the rate of inflation is 4% rather than 2%?
c. Estimate the price of the car if inflation is 2% for the next 2 years and 4% for 3 years after that.
5. You can deposit $10,000 into an account paying 9% annual interest either today or exactly 10
years from today. How much better off will you be at the end of 40 years if you decide to make the
initial deposit today rather than 10 years from today?
6. Alex just got his driver’s license, and he wants to buy a new sports car for $70,000. He has $3,000
to invest as a lump sump today. Peter is a conservative investor and he only invests in safe products.
After approaching different banks, he is offered the following investment opportunities:
1) River Bank’s savings account with and interest rate of 10.8% compounded monthly?
2) First State Bank’s savings account with an interest rate of 11.5% compounded annually.
3) Union Bank’s savings account with an interest rate of 9.3% compounded weekly. How long will it
take for Peter to accumulate enough money to buy the car in each of the above three cases?
7. Jim firmly believes that if he invests his high-school graduation gift of $5,000, he will be able to
triple its value by the time he graduates with a college degree in four years. What rate of return per
year will Jim have to earn on his investment to make this belief come true?
8. Lee has been offered an investment that will pay him $500 three years from today.
a. If his opportunity cost is 7% compounded annually, what value should he place on this
opportunity today?
b. What is the most he should pay to purchase this payment today?
c. If Jim can purchase this investment for less than the amount calculated in part a, what does that
imply about the rate of return that he will earn on the investment?
9. Suppose you want to save money to pay for a down payment on an apartment in 5 years’ time.
One year from now, you will invest your $30,000 year-end bonus for the down payment. If you can
invest at 15% per year, how much interest rate will you receive on your cash in 5 years? If you need
$210,000 for the down payment, and you would like to top-up the remaining amount by investing a
lump sump today, what is the amount you should invest?
10. You just won a lottery that promises to pay you $1,000,000 exactly 10 years from today. Because
the $1,000,000 payment is guaranteed by the state which you live, opportunities exist to sell the
claim today for an immediate single cash payment.
a. What is the least you will sell your claim for if you can earn the following rates of return on similar-
risk investments during the 10-year period?
1)6%
2)9%
3)12%
b. Rework part a under the assumption that the $1,000,000 payment will be received in 15 rather
than 10 years.
c. On the basis of your findings in parts a and b, discuss the effect of both the size of the rate of
return and the time until receipt of payment on the present value of a future sum.
11. In exchange for a $20,000 payment today, a well-known company will allow you to choose one
of the alternatives shown in the following table. Your opportunity cost is 11%.
Alternatives : A B C
Single amount: $28,500 at the end of 3 years $54,000 at the end 9 years $160,000 end of 20yrs
a. Find the value today of each alternative.
b. Are all the alternative acceptable?
c. Which alternative, if any, will you take?
12. At retirement, you would like to have $1,500,000. You would like to save for retirement by
setting aside an equal sum from every monthly paycheck you receive for the next 35 years. You think
you can earn an interest rate of 12%, compounded monthly. How much do you need to save from
every paycheck?
13. You want to borrow $600,000 to buy an apartment, and you can only afford $4,000 a month to
repay the loan. Suppose the bank charges you a fixed interest rate of 4% with monthly
compounding. How long will it take you to pay off the loan?

05 TVOM Exercise

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Questions: Class exercise 1 TVOM

3. You have $1,500 to invest today at 7% interest compounded annually.

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