BFM 1014 FUNDAMENTALS OF FINANCE

Trimester 2, 2016-2017

CHAPTER 5: DISCOUNTED CASH FLOW VALUATION

CRITICAL THINKING AND CONCEPT REVIEW

Concepts Review and Critical Thinking Questions

1. As you increase the length of the time involved, what happens to the present value of an
annuity? What happens to the future value?

Assuming positive cash flows and a positive interest rate, both the present and the future value
will rise.

QUESTIONS AND PROBLEM

3. Havana, Inc has identified an investment project with the following cash flows. If the discount
rate is 8% what is the future value of these cash flows in year 4? What is the future value at an
interest rate of 11% at 24%

Year Cash Flow $

1 1,075
2 1,235
3 1,510
4 1,965

The time line is:

0 1 2 3 4

$1,075 $1,235 $1,510 $1,965

To solve this problem, we must find the FV of each cash flow and sum. To find the FV of a lump
sum, we use:

FV = PV(1 + r)t

FV@8% = $1,075(1.08)3 + $1,235(1.08)2 + $1,510(1.08) + $1,965 = $6,390.49

FV@11% = $1,075(1.11)3 + $1,235(1.11)2 + $1,510(1.11) + $1,965 = $6,632.95

FV@24% = $1,075(1.24)3 + $1,235(1.24)2 + $1,510(1.24) + $1,965 = $7,785.96

Notice, since we are finding the value at Year 4, the cash flow at Year 4 is added to the FV of
the other cash flows. In other words, we do not need to compound this cash flow.

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4. An investment offers $6,700 per year for 15 years, with the first payment occurring 1 year from
now. If the required return is 8%, what is the value of the investment? What would the value
be if the payment occurred for 40 years? For 75 years? Forever?

To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)t]} / r )

0 1 15
…
PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@15 yrs: PVA = $6,700{[1 – (1/1.08)15 ] / .08} = $57,348.51

0 1 40
…
PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@40 yrs: PVA = $6,700{[1 – (1/1.08)40 ] / .08} = $79,894.91

0 1 75
…
PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@75 yrs: PVA = $6,700{[1 – (1/1.08)75 ] / .08} = $83,489.26

To find the PV of a perpetuity, we use the equation:

PV = C / r

0 1 ∞
…
PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PV = $6,700 / .08
PV = $83,750.00

Notice that as the length of the annuity payments increases, the present value of the annuity
approaches the present value of the perpetuity. The present value of the 75-year annuity and
the present value of the perpetuity imply that the value today of all perpetuity payments
beyond 75 years is only $260.74.

10. Curly’s Life Insurance Co. is trying to sell you an investment policy that will pay you and your
heirs $25,000 per year forever. If the required return on this investment is 6%, how much will
you pay for the policy?

The time line is:

0 1 ∞
…

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 PV $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000

This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $25,000 / .06
PV = $416,666.67

12. Find the EAR in each of the following cases:

Stated Rate (APR) Number of times compounded Effective Rate (EAR)

10 % Quarterly
17 Monthly
13 Daily
9 Semiannually

For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.10 / 4)]4 – 1 = .1038, or 10.38%

EAR = [1 + (.17 / 12)]12 – 1 = .1839, or 18.39%

EAR = [1 + (.13 / 365)]365 – 1 = .1388, or 13.88%

EAR = [1 + (.09 / 2)]2 – 1 = .0920, or 9.20%

15. Magnus Credit Corp wants to earn an effective annual return on its consumer loans of 17% per
year. The bank uses daily compounding on its loans. What interest rate is the bank required by
law to report to potential borrowers? Explain why this rate is misleading to an uninformed
borrower.

The reported rate is the APR, so we need to convert the EAR to an APR as follows:

EAR = [1 + (APR / m)]m – 1

APR = m[(1 + EAR)1/m – 1]

APR = 365[(1.17)1/365 – 1] = .1570, or 15.70%

This is deceptive because the borrower is actually paying annualized interest of 17 percent per
year, not the 15.70 percent reported on the loan contract.

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20. You want to buy a new sport coupe for $68,500, and the finance office at the dealership has
quoted you a 5.9% APR loan for 60 months to buy the car. What will your monthly payments
be? What is the effective annual rate on this loan?
The time line is:
0 1 60
…
$65,800 C C C C C C C C C

We first need to find the annuity payment. We have the PVA, the length of the annuity, and the
interest rate. Using the PVA equation:

PVA = C({1 – [1 / (1 + r)t]} / r )

$65,800 = $C[1 – {1 / [1 + (.059/12)]60} / (.059/12)]

Solving for the payment, we get:

C = $65,800 / 51.85018
C = $1,321.11

To find the EAR, we use the EAR equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.059 / 12)]12 – 1
EAR = .0606, or 6.06%

21. One of your customers is delinquent on his account payable balance. You’ve mutually agreed
to a repayment schedule of $500 per month. You will charge 1.4% per month interest on the
overdue balance. If the current balance is $17,340, how long it take for the account to be paid
off?

The time line is:

0 1 t
…
–$17,340 $500 $500 $500 $500 $500 $500 $500 $500 $500

Here we need to find the length of an annuity. We know the interest rate, the PV, and the
payments. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t]} / r )

$17,340 = $500{[1 – (1/1.014)t ] / .014}

Now we solve for t:

1/1.014t = 1 – [($17,340)(.014) / ($500)]

1.014t = 1 / .51448 = 1.94371
t = ln 1.94371 / ln 1.014
t = 47.80 months
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31. You have received a credit card application from Shady Bank Savings and Loan offering an
introductory rate of 1.8% per year, compounded monthly for the first six month, increasing
thereafter to 18% compounded monthly. Assuming you transfer the $10,000 balance from your
existing credit card and make no subsequent payments, how much interest that you owe at the
end of the first year?

The time line is:

0 1 12
…
–$10,000 FV

Here we need to find the FV of a lump sum, with a changing interest rate. We must do this
problem in two parts. After the first six months, the balance will be:

FV = $10,000[1 + (.018/12)]6
FV = $10,090.34

This is the balance in six months. The FV in another six months will be:

FV = $10,090.34[1 + (.18/12)]6
FV = $11,033.21

The problem asks for the interest accrued, so, to find the interest, we subtract the beginning
balance from the principal. The interest accrued is:

Interest = $11,033.21 – 10,000.00

Interest = $1,033.21

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32. You are saving to buy a $195,000 house. There are two competing bank in your area, both
offering certificates of deposit yielding 5.5%. How long will it take your initial $85,000
investment to reach the desired level at First Bank, which pays simple interest? How long at
Second Bank, which compounds interest monthly?

We will calculate the time we must wait if we deposit in the bank that pays simple interest. The
interest amount we will receive each year in this bank will be:

Interest = $85,000(.055)
Interest = $4,675 per year

The deposit will have to increase by the difference between the amount we need by the amount
we originally deposit divided by the interest earned per year, so the number of years it will take
in the bank that pays simple interest is:

Years to wait = ($195,000 – 85,000) / $4,675

Years to wait = 23.53 years

To find the number of years it will take in the bank that pays compound interest, we can use
the future value equation for a lump sum and solve for the periods. Doing so, we find:

0 1 t

…
– $195,000
$85,000

FV = PV(1 + r)t
$195,000 = $85,000 [1 + (.055/12)]t
t = 181.58 months, or 15.13 years