E120 Fall 14

Homework 2 Solutions

1. The EAR is 1 +

0.06 12
12

1 = 0.0617 = 6.17%.

This is equivalent to 6%
= 0.5% per month (note that this is only true when we have
12
monthly compounding).
We wish to determine the amount of cash C to put into the bank for 120 months, and
earn a future value of $100000, i.e.
100000 = C (1.005)119 + C (1.005)118 + . . . + C = C 163.8793468 = C = 610.205.

4
2. The EAR is 1 + 0.06
1 = 6.136%.
4
The one-month discount rate is (1 + 0.06136)1/12 1 = 0.49752% per month.
Now we can compare the PVs of these two cash flows
(a) (150K, 0, . . . , 0)
(b) (0, 5K, . . . , 5K)
With r = 0.0049752, the second cash flow has present value of 164, 427.95, so that it
is better to pay the $150K up front.
3. We will use a 3 year period as the benchmark for comparisons.
(a) 5% per year (EAR) for 3 years gives us (1 + 0.05)3 1 = 15.7625% in 3 years.
(b) 2.5% every six months for 3 years gives us (1 + 0.025)6 1 = 15.9693% in 3 years.
(c) 7.5% every 18 months for 3 years gives us (1 + 0.075)2 1 = 15.5625% in 3 years.
(d)

1
%
2

every month for 3 years gives us (1 + 0.005)36 1 = 19.6681% in 3 years.

APR
12

4. The rate for each month is

8%
12

= 23 %.

The compounded rate for a six-month period is 4.06726%.

The cash flow for periods of six-month, lasting for 10 periods (5 years) is (0, 100, 100, . . . , 100),
where the periods are (0, 1, 2, . . . , 10) and r = 4.06726%.
PV =

100
1+r

100
(1+r)2

+ ... +

5. The one-month rate is

100
.
(1+r)10

5.99%
12

= 0.49916% = r.

We look at the cash flow (8000, C, C, . . . , C).

We want P V = 0 = 8, 000 +

C
1+r

+ ... +

After some algebra, we get C = 154.62.

C
.
(1+r)6 0

6. Firstly, the monthly interest rate is

5.25%
12

= 0.4375%.

The cash flow for payments to be made is (800K, C, C, . . . , C) where n = 360, r =

0.004375.
C
C
. . . (1+r)
We want the present value of the above to be 0, so solving 800K 1+r
360 =
0 = C = $4, 417.63.

Mortgage is currently exactly 18 12 years old, and you just made a payment, so that
youve paid 18 12 12 = 222 payments, and there are 360 222 = 138 payments left.
So that the cash flow for the future is (0, C, . . . , C) (with n = 138), and this has
present value (at the time you sold the house for $1M :
C
C
C
1+r
(1+r)
2 . . . (1+r)138 = $456, 931.41. This is how much you still owe the bank
due to the loan you took out.

I assume you use your $1M to pay off the above, leaving you with a net value of
$543, 068.59.
7. Suppose you make a payment of C for 360 months at monthly interest rate of 1%
(assume monthly compounding), then the loan is about
"

360 #
1
1 1.01
C
C
+ ... +
=C
1.01
1.01360
0.01
Now, suppose you make an extra payment of C once every year, starting 6 periods
from now. The value of your payment is:
C
C
C
C
C
+ ... +
+
+
+ ... +
n
6
18
12([n/12]1)+6
1.01
1.01
1.01
1.01
1.01
We want the first expression (no extra payments) to be equal to the second expression
(with extra payments). Plotting with respect to n, we find n 228 or 229.
8. Using the new parameters, here are the two equations that we have to solve simulataneously in L and P :
L=

P
1+0.01

P
(1+0.01)2

L 0.03L 1000 =

+ ... +

P
(1+0.01)240

P
(1+0.01054441)

+ ... +

P
(1+0.01054441)240

Solving yields approximately L = 100, 000, and P = 1101.086.

9. (a) First note that the effective monthly rate rm has to satisfied (1+rm )12 = (1+ 12%
)4 .
4
This gives us rm = 0.9901634%.
Let A denote the montly payment amount, the cash flow we are interested in is:
(0, A, A, . . . , A), where the number of periods is 30 12 = 360.

We want the present value of the above to be $100, 000, hence we must have A
satisfying
A
1+rm

+ ... +

A
(1+rm )360

= $100, 000

Simplifying the left hand side with the geometric series formula, I obtain
98.08387922 A = 100, 000, so that A = 1019.54.
(b) I make the assumption that this month payment has already been made, so that
the cash flow looks like (0, A, . . . , A), where the number of periods is 240. This
tells me the amount that I still owe the loan company (the value at year 10) is
$93, 289.91.
If I make an extra payment of $500 each month, then the new cash flow is (0, A +
500, . . . , A + 500), and we want the present value of this cash flow to be equal
to $93, 289.91. The number of periods in the above cash flow is what we wish to
find.
That is, we want n such that

A+500
1+rm

+ ... +

A+500
(1+rm )n

= $93, 289.91.

Dividing both sides by (A + 500), and use the geometric series formula to simplify
the left hand side, I obtain
1 (1+r1

m )n

rm

= 61.393566711 = n = 95.0204 months, beginning from year 10.