Practice Questions - Time Value of Money

1. Suppose you are given permission to extract gold from a gold mine, where
you are entitled to operate on the mine for the next 20 years, over which period
you plan to extract 5,000 ounces of gold every year. The price of gold per
ounce is $300 currently, but it is expected to increase 3% a year. The
appropriate discount rate is 10%. If both the growth rate (price of gold) and the
discount rate go up by 1%, will the present value of gold to be extracted from
this mine increase or decrease?

2. You are thinking of making an investment in a new equipment. The

equipment will generate revenues of $1 million per year for as long as you
maintain it. You expect that the maintenance cost will start at $50,000 per year
and will increase 5% per year thereafter. Assume that all revenue and
maintenance costs occur at the end of the year. You intend to run the equipment
as long as it continues to make a positive cash flow (as long as the cash
generated by the equipment exceeds the maintenance costs). The equipment can
be bought and become operational immediately. If the equipment costs $10
million to acquire, and the interest rate is 6% per year, should you invest in the
equipment?

3. You are thinking of bidding for a piece of art that costs $50,000. A finance
company is proposing the following deal: They will lend you the money, and
you will repay the loan by making the same payment every two years for the
next 20 years (i.e., a total of 10 payments). If the interest rate is 4%, how much
will you have to pay every two years?

4. You are the CEO of a biotech company. Analysts predict that the company’s
earnings will grow at 30% per year for the next five years. After that, as
competition increases, earnings growth is expected to slow to 2% per year and
continue at that level forever. Your company has just announced earnings of
$1,000,000. What is the present value of all future earnings if the interest rate is
8%? (Assume all cash flows occur at the end of the year.)

5. A perpetuity, with its first payment paid immediately, generates $100

annually. Straight after the fifth payment, the perpetuity is exchanged for a 25-
year annuity that would pay $A at the end of the first year. Each subsequent
annual payment will be 8% greater than the preceding payment. The annual
effect rate of interest is 8%. What is $A?

6. Peter puts $500 into a savings account now, which pays interest at a stated
annual interest rate of r which compounded semi-annually. Jack deposits $1000
into a different savings account now, which pays simple interest at an annual
rate r. Peter and Jack receive the same amount of interest during the second
half of the 8th year. Calculate r.

7. John recently bought a house, and he financed it with a $250,000, 30-year

mortgage with an annual interest rate of 7 percent. The mortgage payments are
made at the end of each year. What total dollar amount of the mortgage
payments during the first three years will go towards paying interest?

8. You are lucky and have just own the Powerball Lottery with a jackpot prize
of $200,000,000 (of course, you will continue to attend the Quant class of
MAF). Your prize money will be disbursed to you in 26 equal annual
instalments with the first payment made immediately. You could invest these
payments (as soon as you receive them) in an account with a stated annual
interest rate of 9% with monthly interest compounding. What is the present
value of the payment streams you will receive?

Answers:
1. Increase
2. Yes
3. $7505
4. $51,981,214
5. $54
6. 9.459%
7. $51,931.2
8. $80,978,000