Format: True/False. Learning Objective: LO 3

Transcription

1 Parrino/Fundamentals of Corporate Finance, Test Bank, Chapter 6 1.Calculating the present and future values of multiple cash flows is relevant only for individual investors. 2.Calculating the present and future values of multiple cash flows is relevant for businesses only. 3.In computing the present and future value of multiple cash flows, each cash flow is discounted or compounded at a different rate. 4.The present value of multiple cash flows is greater than the sum of those cash flows. Learning Objective: LO 3 5.When you pay the same amount every month as your insurance premium for a term life policy for a period of five years, the stream of cash flows is called a perpetuity. Page 1

2 6.When you pay the same amount every month on your car loan for a period of three years, the stream of cash flows is called an annuity. Learning Objective: LO 3 7.In today's financial markets, the best example of a perpetuity is the common stock issued by firms. Learning Objective: LO 3 8.Since the issuers of preferred stock promise to pay investors a fixed dividend, usually quarterly, forever, these are the most important perpetuities in the financial markets. Learning Objective: LO 3 9.The present value of a perpetuity is the promised constant cash payment divided by the interest rate (i). 10.In ordinary annuities, cash flows occur at the beginning of each period. Page 2

3 11.In an annuity due, cash flows occur at the beginning of each period. 12.The lease payments by a business on a warehouse rental are an example of an annuity due. 13.The present value of an annuity due is less than the present value of an ordinary annuity. 14.The present value of an annuity due is equal to the present value of an ordinary annuity. 15.The future value of an annuity due is greater than the future value of an ordinary annuity. Page 3

4 16.The future value of an annuity due is equal to the future value of an ordinary annuity. Learning Objective: LO 4 17.Cash flow streams that increase at a constant rate over time are called growing annuities or growing perpetuities. Learning Objective: LO 4 18.A fertilizer manufacturing company enters into a contract with a county parks and recreation department that calls for the company to sell 10 percent more of its best lawn feed every year for the next five years. If they also agree to maintain the total price as constant over the contract period, this growth in revenue is an example of a growing perpetuity. Learning Objective: LO 4 19.You have received news about an inheritance that will pay you $5,000 next year. Beginning the following year, your inheritance will increase by 5 percent every year forever. This is a growing perpetuity. Page 4

5 Learning Objective: LO 4 20.Trey Hughes opened a pizza place last year. He expects to increase his revenue from last year by 7 percent every year for the next 10 years. This is an example of a growing annuity. Learning Objective: LO 5 21.The APR is the annualized interest rate using compound interest. Learning Objective: LO 5 22.The APR is defined as the simple interest charged per period multiplied by the number of periods per year. Learning Objective: LO 5 23.The correct way to annualize an interest rate is to compute the effective annual interest rate. Learning Objective: LO 5 24.The correct way to annualize an interest rate is to compute the annual percentage rate (APR). Page 5

6 Learning Objective: LO 5 25.The effective annual interest rate (EAR) is defined as the annual growth rate that takes compounding into account. Learning Objective: LO 5 26.The EAR is the true cost of borrowing and lending. Learning Objective: LO 5 27.The quoted interest rate is by convention a simple annual interest rate, such as the APR. Learning Objective: LO 5 28.The quoted interest rate is by definition a simple annual interest rate, such as the EAR. Learning Objective: LO 5 29.The Truth-in-Lending Act and the Truth-in-Savings Act require by law that the APR Page 6

7 be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents. Learning Objective: LO 5 30.Only the APR or some other quoted rate should be used as the interest rate factor for present or future value calculations. 31.To solve future value problems with multiple cash flows involves which of the following steps? A) First, draw a time line to make sure that each cash flow is placed in the correct time period. B) Second, calculate the future value of each cash flow for its time period. C) Third, add up the future values. D) All of the above are necessary steps. Ans: D 32.Which one of the following steps is NOT involved in solving future value problems? A) First, draw a time line to make sure that each cash flow is placed in the correct time period. B) Second, discount each cash flow for its time period. C) Third, add up the values. D) All of the above are necessary steps. 33.To solve present value problems with multiple cash flows involves which of the Page 7

8 following steps? A) First, draw a time line to make sure that each cash flow is placed in the correct time period. B) Second, calculate the present value of each cash flow for its time period. C) Third, add up the present values. D) All of the above are necessary steps. Ans: D 34.Which one of the following steps is NOT involved in solving present value problems? A) First, draw a time line to make sure that each cash flow is placed in the correct time period. B) Second, compound each cash flow for its time period. C) Third, add up the values. D) All of the above are necessary steps. Level of Difficulty: easy 35.Calculating the present and future values of multiple cash flows is relevant A) for businesses only. B) for individuals only C) for both individuals and businesses. D) none of the above. Ans: C 36.In computing the present and future value of multiple cash flows, A) each cash flow is discounted or compounded at the same rate. B) each cash flow is discounted or compounded at a different rate. C) earlier cash flows are discounted at a higher rate. D) later cash flows are discounted at a higher rate. Page 8

9 37.In computing the present and future value of multiple cash flows, A) earlier cash flows are discounted at a lower rate. B) each cash flow is discounted or compounded at the same rate. C) earlier cash flows are discounted at a higher rate. D) none of the above. 38.The present value of multiple cash flows is A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows. D) none of the above. Ans: C 39.The future value of multiple cash flows is A) greater than the sum of the cash flows. B) equal to the sum of all the cash flows. C) less than the sum of the cash flows D) none of the above. 40.If your investment pays the same amount at the end of each year for a period of six years, the cash flow stream is called A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) none of the above. 41.If your investment pays the same amount at the beginning of each year for a period of 10 Page 9

10 years, the cash flow stream is called A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) none of the above. Ans: C 42.If your investment pays the same amount at the end of each year forever, the cash flow stream is called A) a perpetuity. B) an ordinary annuity. C) an annuity due. D) none of the above. 43.Cash flows associated with annuities are considered to be A) an uneven cash flow stream. B) a cash flow stream of the same amount (a constant cash flow stream). C) a mix of constant and uneven cash flow streams. D) none of the above. 44.Which ONE of the following statements is true about amortization? A) Amortization refers to the way the borrowed amount (principal) is paid down over the life of the loan. B) With an amortized loan, each loan payment contains some payment of principal and an interest payment. C) A loan amortization schedule is just a table that shows the loan balance at the beginning and end of each period, the payment made during that period, and how much of that payment represents interest and how much represents repayment of principal. D) All of the above are true. Ans: D Page 10

11 45.Which one of the following statements is NOT true about amortization? A) Amortization refers to the way the borrowed amount (principal) is paid down over the life of the loan. B) With an amortized loan, each loan payment contains some payment of principal and an interest payment. C) With an amortized loan, a smaller proportion of each month's payment goes toward interest in the early periods. D) A loan amortization schedule is just a table that shows the loan balance at the beginning and end of each period, the payment made during that period, and how much of that payment represents interest and how much represents repayment of principal. Ans: C 46.Which one of the following statements is true about amortization? A) With an amortized loan, a bigger proportion of each month's payment goes toward interest in the early periods. B) With an amortized loan, a bigger proportion of each month's payment goes toward interest in the later periods. C) With an amortized loan, a smaller proportion of each month's payment goes toward interest in the early periods. D) None of the above. 47.The annuity transformation method is used to transform A) a present value annuity to a future value annuity. B) a present value annuity to an annuity due. C) an ordinary annuity to an annuity due. D) a perpetuity to an annuity. Ans: C Learning Objective: LO 3 Page 11

12 48.A firm receives a cash flow from an investment that will increase by 10 percent annually for an infinite number of years. This cash flow stream is called A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Learning Objective: LO 3 49.Your investment in a small business venture will produce cash flows that increase by 15 percent every year for the next 25 years. This cash flow stream is called A) an annuity due. B) a growing perpetuity. C) an ordinary annuity. D) a growing annuity. Ans: D Learning Objective: LO 5 50.Which one of the following statements is TRUE about the effective annual rate (EAR)? A) The effective annual interest rate (EAR) is defined as the annual growth rate that takes compounding into account. B) The EAR conversion formula accounts for the number of compounding periods and, thus, effectively adjusts the annualized interest rate for the time value of money. C) The EAR is the true cost of borrowing and lending. D) All of the above are true. Ans: D Learning Objective: LO 5 51.The true cost of borrowing is the A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) periodic rate. Page 12

13 Learning Objective: LO 5 52.The true cost of lending is the A) annual percentage rate. B) effective annual rate. C) quoted interest rate. D) none of the above. Learning Objective: LO 5 53.Which one of the following statements is NOT true? A) The APR is the appropriate rate to do present and future value calculations. B) The EAR is the appropriate rate to do present and future value calculations. C) The EAR is the true cost of borrowing and lending. D) The EAR takes compounding into account. Learning Objective: LO 5 54.Which one of the following statements is NOT true? A) The Truth-in-Lending Act was passed by Congress to ensure that the true cost of credit was disclosed to consumers. B) The Truth-in-Savings Act was passed to provide consumers an accurate estimate of the return they would earn on an investment. C) The above two pieces of legislation require by law that the APR be disclosed on all consumer loans and savings plans. D) All of the above are true statements. Ans: D Learning Objective: LO 5 55.Which one of the following statements is NOT true? A) The correct way to annualize an interest rate is to compute the effective annual interest rate (EAR). B) The APR is the annualized interest rate using simple interest. C) The correct way to annualize an interest rate is to compute the annual percentage rate (APR). D) You can find the interest rate per period by dividing the quoted annual rate by the Page 13

14 Ans: number of compounding periods. C 56.FV of multiple cash flows: Chandler Corp. is expecting a new project to start producing cash flows, beginning at the end of this year. They expect cash flows to be as follows: $643,547 $678,214 $775,908 $778,326 $735,444 If they can reinvest these cash flows to earn a return of 8.2 percent, what is the future value of this cash flow stream at the end of five years? (Round to the nearest dollar.) A) $3,889,256 B) $4,227,118 C) $5,214,690 D) $4, 809,112 FV5 $643,547(1.082) $678, 214(1.082) $775,908(1.082) $778,326(1.082) $735, $882, $859, $908, $842, $735, 444 $4,227, FV of multiple cash flows: Stiglitz, Inc., is expecting the following cash flows starting at the end of the year $113,245, $132,709, $141,554, and $180,760. If their opportunity cost is 9.6 percent, find the future value of these cash flows. (Round to the nearest dollar.) Page 14

15 A) $644, B) $732,114 C) $685,312 D) $900, FV of multiple cash flows: Tariq Aziz will receive from his investment cash flows of $3,125, $3,450, and $3, 800. If he can earn 7.5 percent on any investment that he makes, what is the future value of his investment cash flows at the end of three years? (Round to the nearest dollar.) A) $11,120 B) $10,944 C) $10,812 D) $12,770 Page 15

16 FV $3,125(1.075) $3, 450(1.075) $3,800 $3, $3, $3,800 $11, FV of multiple cash flows: Shane Matthews has invested in an investment that will pay him $6,200, $6,450, $7,225, and $7,500 over the next four years. If his opportunity cost is 10 percent, what is the future value of the cash flows he will receive? (Round to the nearest dollar.) A) $27,150 B) $29,900 C) $30,455 D) $31,504 Ans: D FV $6, 200(1.10) $6, 450(1.10) $7, 225(1.10) $7,500 $8, $7, $7, $7,500 $31, FV of multiple cash flows: International Shippers, Inc., have forecast earnings of $1, 233,400, $1,345,900, and $1,455,650 for the next three years. What is the future value of these earnings if the firm's opportunity cost is 13 percent? (Round to the nearest dollar.) A) $4,214,360 B) $4,551,446 C) $3,900,865 D) $4,875,212 Page 16

17 Ans: B FV $1, 233, 400(1.13) $1,345,900(1.13) $1, 455, 650 $1,574, $1,520,867 $1, 455, 650 $4,551, PV of multiple cash flows: Jack Stuart has loaned money to his brother at an interest rate of 5.75 percent. He expects to receive $625, $650, $700, and $800 at the end of the next four years as complete repayment of the loan with interest. How much did he loan out to his brother? (Round to the nearest dollar.) A) $2,713 B) $2,250 C) $2,404 D) $2,545 Ans: C $625 $650 $700 $800 n = 4; i=5.75% Page 17

18 $625 $650 $700 $800 PV (1.0575) (1.0575) (1.0575) (1.0575) $ $ $ $ $2, PV of multiple cash flows: Ferris, Inc., has borrowed from their bank at a rate of 8 percent and will repay the loan with interest over the next five years. Their scheduled payments, starting at the end of the year are as follows $450,000, $560,000, $750,000, $875,000, and $1,000,000. What is the present value of these payments? (Round to the nearest dollar.) A) $2,735,200 B) $2,615,432 C) $2431,224 D) $2,815,885 Ans: D $450, 000 $560, 000 $750, 000 $875, 000 $1, 000, 000 PV (1.08) (1.08) (1.08) (1.08) (1.08) $416, $480, $595, $643, $680, $2,815, PV of multiple cash flows: Hassan Ali has made an investment that will pay him $11,455, $16,376, and $19,812 at the end of the next three years. His investment was to fetch him a return of 14 percent. What is the present value of these cash flows? (Round to the nearest dollar.) A) $33,124 B) $36,022 Page 18

19 C) $41,675 D) $39,208 $11, 455 $16,376 $19,812 PV 2 3 (1.14) (1.14) (1.14) $10, $12, $13, $36, PV of multiple cash flows: Ajax Corp. is expecting the following cash flows $79,000, $112,000, $164,000, $84,000, and $242,000 over the next five years. If the company s opportunity cost is 15 percent, what is the present value of these cash flows? (Round to the nearest dollar.) A) $429,560 B) $414,322 C) $480,906 D) $477,235 Page 19

20 $79, 000 $112, 000 $164, 000 $84, 000 $242, 000 PV (1.15) (1.15) (1.15) (1.15) (1.15) $68, $84, $107, $48, $120, $429, PV of multiple cash flows: Pam Gregg is expecting cash flows of $50,000, $75,000, $125,000, and $250,000 from an inheritance over the next four years. If she can earn 11 percent on any investment that she makes, what is the present value of her inheritance? (Round to the nearest dollar.) A) $361,998 B) $309,432 C) $412,372 D) $434,599 $50, 000 $75, 000 $125, 000 $250, 000 PV (1.11) (1.11) (1.11) (1.11) $45, , $91, $164, $361, Present value of an annuity: Transit Insurance Company has made an investment in another company that will guarantee it a cash flow of $37,250 each year for the next five years. If the company uses a discount rate of 15 percent on its investments, what is the present value of this investment? (Round to the nearest dollar.) A) $101,766 B) $124,868 Page 20

21 C) $251,154 D) $186,250 Annual payment = PMT = $37,250 No. of payments = n = 5 Required rate of return = 15% Present value of investment = PVA (1 ) n i PVAn PMT i 1 1 (1.15) 5 $37, 250 $37, $124, Present value of an annuity: Herm Mueller has invested in a fund that will provide him a cash flow of $11,700 for the next 20 years. If his opportunity cost is 8.5 percent, what is the present value of this cash flow stream? (Round to the nearest dollar.) A) $234,000 B) $132,455 C) $110,721 D) $167,884 Ans: C Page 21

22 PVA n 1 1 (1 ) n i PMT i 1 1 (1.085) 20 $11, 700 $11, $110, Present value of an annuity: Myers, Inc., will be making lease payments of $3, for a 10-year period, starting at the end of this year. If the firm uses a 9 percent discount rate, what is the present value of this annuity? (Round to the nearest dollar.) A) $23,250 B) $29,000 C) $25,000 D) $20,000 Ans: C Page 22

23 PVA n 1 1 (1 ) n i PMT i 1 1 (1.09) 10 $3, $3, $24, Present value of an annuity: Lorraine Jackson won a lottery. She will have a choice of receiving $25,000 at the end of each year for the next 30 years, or a lump sum today. If she can earn a return of 10 percent on any investment she makes, what is the minimum amount she should be willing to accept today as a lump-sum payment? (Round to the nearest hundred dollars.) A) $750,000 B) $334,600 C) $212,400 D) $235,700 Ans: D Page 23

24 70.Present value of an annuity: Craymore Tech is expecting cash flows of $67,000 at the end of each year for the next five years. If the firm's discount rate is 17 percent, what is the present value of this annuity? (Round to the nearest dollar.) A) $214,356 B) $241,653 C) $278,900 D) $197,776 Page 24

25 71.Future value of an annuity: Carlos Menendez is planning to invest $3,500 every year for the next six years in an investment paying 12 percent annually. What will be the amount he will have at the end of the six years? (Round to the nearest dollar.) A) $21,000 B) $28,403 C) $24,670 D) $26,124 Page 25

26 72.Future value of an annuity: Jayadev Athreya has started on his first job. He plans to start saving for retirement early. He will invest $5,000 at the end of each year for the next 45 years in a fund that will earn a return of 10 percent. How much will Jayadev have at the end of 45 years? (Round to the nearest dollar.) A) $2,667,904 B) $3,594,524 C) $1,745,600 D) $5,233,442 Page 26

27 73.Future value of an annuity: You plan to save $1,250 at the end of each of the next three years to pay for a vacation. If you can invest it at 7 percent, how much will you have at the end of three years? (Round to the nearest dollar.) A) $3,750 B) $3,918 C) $4,019 D) $4,589 Ans: C Page 27

28 74.Future value of an annuity: Zhijie Jiang is saving to buy a new car in four years. She will save $5,500 at the end of each of the next four years. If she invests her savings at 6.75 percent, how much will she have after four years? (Round to the nearest dollar.) A) $22,000 B) $23,345 C) $27,556 D) $24,329 Ans: D Page 28

29 75.Future value of an annuity: Terri Garner will invest $3,000 in an IRA for the next 30 years starting at the end of this year. The investment will earn 13 percent annually. How much will she have at the end of 30 years? (Round to the nearest dollar.) A) $897,598 B) $912,334 C) $748,212 D) $1,233,450 Page 29

30 76.Computing annuity payment: Maricela Sanchez needs to have $25,000 in five years. If she can earn 8 percent on any investment, what is the amount that she will have to invest every year at the end of each year for the next five years? (Round to the nearest dollar.) A) $5,000 B) $4,261 C) $4,640 D) $4,445 Page 30

31 77.Computing annuity payment: Jane Ogden wants to save for a trip to Australia. She will need $12,000 at the end of four years. She can invest a certain amount at the beginning of each of the next four years in a bank account that will pay her 6.8 percent annually. How much will she have to invest annually to reach her target? (Round to the nearest dollar.) A) $3,000 B) $2,980 C) $2,538 D) $2,711 Ans: C Page 31

32 78.Computing annuity payment: Jackson Electricals has borrowed $27,850 from its bank at an annual rate of 8.5 percent. It plans to repay the loan in eight equal installments, beginning in a year. What is its annual loan payment? (Round to the nearest dollar.) A) $4,708 B) $5,134 C) $4,939 D) $4,748 Ans: C PVA n = $27,850 n = 8; i = 8.5% Present value of annuity = PVA = $27,850 Return on investment = i = 8.5% Payment required to meet target = PMT Page 32

33 Using the PVA equation: 1 1 (1 ) n i PVAn PMT i PMT $27,850 $27, (1.085) $4, Each payment made by Jackson Electricals will be $4,938.66, starting at the end of next year. 79.Computing annuity payment: John Harper has borrowed $17,400 to pay for his new truck. The annual interest rate on the loan is 9.4 percent, and the loan needs to be repaid in four payments. What will be his annual payment if he begins his payment beginning now? (Round to the nearest dollar.) A) $5,229 B) $5,450 C) $4,850 D) $4,953 Ans: D PVA n = $17,400 n = 4; i = 9.4% Present value of annuity = PVA = $17,400 Return on investment = i = 9.4% Payment required to meet target = PMT Type of annuity = Annuity due Using the PVA equation: Page 33

34 = $4, Each payment made by John Harper will be $4,952.53, starting today. 80.Computing annuity payment: Trevor Smith wants to have a million dollars at retirement, which is 15 years away. He already has $200,000 in an IRA earning 8 percent annually. How much does he need to save each year, beginning at the end of this year to reach his target? Assume he could earn 8 percent on any investment he makes. (Round to the nearest dollar.) A) $13,464 B) $14,273 C) $10,900 D) $16,110 Retirement investment target in 15 years = $1,000,000 Amount invested in IRA account now = PV = $200,000 Return earned by investment = i = 8% Value of current investment in 15 years = FV FV15 PV (1 i) $200, 000(1.08) $634, Balance of money needed to buy car = $1,000,000 -$634, =$365, = FVA Payment needed to reach target = PMT Page 34

35 n (1 i) 1 FVA PMT i FVA $365, $365, PMT n 15 1 (1 i) (1.08) i 0.08 $13, Learning Objective: LO 3 81.Perpetuity: Your father is 60 years old and wants to set up a cash flow stream that would be forever. He would like to receive $20,000 every year, beginning at the end of this year. If he could invest in account earning 9 percent, how much would he have to invest today to receive his perpetual cash flow? (Round to the nearest dollar.) A) $222,222 B) $200,000 C) $189,000 D) $235,200 Annual payment needed = PMT = $20,000 Investment rate of return = i = 9% Term of payment = Perpetuity Present value of investment needed = PV PMT $20, 000 PV of Perpetuity i 0.09 $222, Learning Objective: LO 3 82.Perpetuity: A lottery winner was given a perpetual payment of $11, 444. She could invest the cash flows at 7 percent. What is the present value of this perpetuity? (Round to the nearest dollar.) A) $112,344 B) $163,486 C) $191,708 D) $201,356 Annual payment needed = PMT = $11,444 Investment rate of return = i = 7% Page 35

36 Term of payment = Perpetuity Present value of investment needed = PV PMT $11, 444 PV of Perpetuity i 0.07 $163, Learning Objective: LO 3 83.Perpetuity: Roger Barkley wants to set up a scholarship at his alma mater. He is willing to invest $500,000 in an account earning 10 percent. What will be the annual scholarship that can be given from this investment? (Round to the nearest dollar.) A) $5,000 B) $500,000 C) $50,000 D) None of the above Ans: C Annual payment needed = PMT Present value of investment = PVA = $500,000 Investment rate of return = i = 10% Term of payment = Perpetuity = $50,000 Learning Objective: LO 3 84.Perpetuity: Chris Collinge has funded a retirement investment with $250,000 earning a return of 5.75 percent. What is the value of the payment that he can receive in perpetuity? (Round to the nearest dollar.) A) $12,150 B) $15,250 C) $14,375 D) $14,900 Ans: C Annual payment needed = PMT Present value of investment = PVA = $250,000 Investment rate of return = i = 5.75% Page 36

37 Term of payment = Perpetuity PMT PV of Perpetuity i PMT PV of Perpetuity i $250, $14,375 Learning Objective: LO 3 85.Perpetuity: Jeff Conway wants to receive $25,000 in perpetuity and will invest his money in an investment that will earn a return of 13.5 percent annually. What is the value of the investment that he needs to make today to receive his perpetual cash flow stream? (Round to the nearest dollar.) A) $640,225 B) $252,325 C) $144,350 D) $185,185 Ans: D Annual Payment needed = PMT = $25,000 Investment rate of return = i = 13.5% Term of payment = Perpetuity Present value of investment needed = PV PMT $25, 000 PV of Perpetuity i $185, Annuity due: You plan to save $1,400 for the next four years, beginning now, to pay for a vacation. If you can invest it at 6 percent, how much will you have at the end of four years? Round to the nearest dollar. A) $6,124 B) $5,618 C) $4,019 D) $6,492 Ans: D Page 37

38 $1,400 $1,400 $1,400 $1,400 n = 4; i = 6% n (1 i) FVA PMT (1 i) i 4 (1.06) 1 $1, 400 (1.06) 0.06 $1, $6, Annuity due: Mark Holcomb has a five-year loan on which he will make annual payments of $2,235, beginning now. If the interest rate on the loan is 8.3 percent, what is the present value of this annuity? (Round to the nearest dollar.) A) $9,588 B) $8,854 C) $8,612 D) $9, Page 38

39 $2,235 $2,235 $2,235 $2,235 $2,235 n = 5; i = 8.3% Annual payment = PMT = $2,235 No. of payments = n = 5 Required rate of return = 8.3% Present value of investment = PVA (1 ) n i PVA PMT (1 i) i 1 1 (1.083) 5 $2, 235 (1.083) $2, $9, Annuity due: Jenny Abel is investing $2,500 today and will do so at the beginning of each of the next six years for a total of seven payments. If her investment can earn 12 percent, how much will she have at the end of seven years? (Round to the nearest dollar.) A) $25,223 B) $28,249 C) $31,127 D) $29, PMT PMT PMT PMT PMT n = 7; i = 12% Present value of annuity = PVA Return on investment = i = 9.4% Payment required to meet target = $2,500 Type of annuity = Annuity due Page 39

40 n (1 i) FVA PMT (1 i) i 7 (1.12) 1 $2,500 (1.12) 0.12 $2, $28, Annuity due: Your inheritance will pay you $100,000 a year for five years beginning now. You can invest it in a CD that will pay 7.75 percent annually. What is the present value of your inheritance? (Round to the nearest dollar.) A) $399,356 B) $401,916 C) $433,064 D) $467,812 Ans: C $100,000 $100,000 $100,000 $100,000 $100,000 n = 5; i = 7.75% Annual payment = PMT = $100,000 No. of payments = n = 5 Required rate of return = 7.75% Present value of investment = PVA (1 ) n i PVA PMT (1 i) i 1 1 (1.0775) 5 $100, 000 (1.0775) $100, $433, Page 40

41 Learning Objective: LO 4 90.Growing perpetuity: Jack Benny is planning to invest in an insurance company product. The product will pay $10,000 at the end of this year. Thereafter, the payments will grow annually at a 3 percent rate forever. Jack will be able to invest his cash flows at a rate of 6.5 percent. What is the present value of this investment cash flow stream? (Round to the nearest dollar.) A) $326,908 B) $312,766 C) $285,714 D) $258,133 Ans: C Cash flow at t=1 = CF 1 = $10,000 Annual growth rate = g = 3% Discount rate = i = 6.5% Present value of growing perpetuity = PVA CF1 $10, 000 PVA ( i g) ( ) $285, Learning Objective: LO 4 91.Growing perpetuity: Norwood Investments is putting out a new product. The product will pay out $25,000 in the first year, and after that the payouts will grow by an annual rate of 2.5 percent forever. If you can invest the cash flows at 7.5 percent, how much will you be willing to pay for this perpetuity? (Round to the nearest dollar.) A) $312,000 B) $233,000 C) $250,000 D) $500,000 Ans: D Cash flow at t=1 = CF 1 = $25,000 Annual growth rate = g = 2.5% Discount rate = i = 7.5% Present value of growing perpetuity = PVA CF1 $25, 000 PVA ( i g) ( ) $500,000 Page 41

42 Learning Objective: LO 4 92.Growing annuity: Hill Enterprises is expecting tremendous growth from its newest boutique store. Next year the store is expected to bring in net cash flows of $675,000. The company expects its earnings to grow annually at a rate of 13 percent for the next 15 years. What is the present value of this growing annuity if the firm uses a discount rate of 18 percent on its investments? (Round to the nearest dollar.) A) $6,448,519 B) $6,750,000 C) $7,115,449 D) $5,478,320 Time of growth = n = 15 years Next year's expected net cash flow = CF 1 = $675,000 Expected annual growth rate = g = 13% Firm's required rate of return = i = 18% Present value of growing annuity = PVA n =$13,500,000 x = $6,448, Learning Objective: LO 4 93.Growing annuity: Wilbon Corp. is evaluating whether it should take over the lease of an ethnic restaurant in Manhattan. The current owner had originally signed a 25-year lease, of which 16 years still remain. The restaurant has been growing steadily at a 7 percent growth for the last several years. Wilbon Corp. expects the restaurant to continue to grow at the same rate for the remaining lease term. Last year, the restaurant brought in net cash flows of $310,000. If the firm evaluates similar investments at 15 percent, what is the present value of this investment? (Round to the nearest dollar.) A) $2, B) $2,838,182 C) $3,109,460 D) $2,709,124 Time for lease to expire = n = 16 years Last year's net cash flow = CF 0 = $310,000 Page 42

43 Expected annual growth rate = g = 7% Firm's required rate of return = i = 15% Expected cash flow next year = CF 1 = $310,000(1 + g) = $310,000(1.07) = $331,700 Present value of growing annuity = PVA n n 16 CF 1 1 g $331, PVAn 1 1 ( i g) 1 i ( ) 1.15 $4,146, $2,838, Learning Objective: LO 5 94.Effective annual rate: Desire Cosmetics borrowed $152,300 from a bank for three years. If the quoted rate (APR) is percent, and the compounding is daily, what is the effective annual rate (EAR)? (Round to one decimal place.) A) 11.75% B) 14.3% C) 12.5% D) 11.6% Ans: C Loan amount = PV = $152,300 Interest rate on loan = i = 11.75% Frequency of compounding = m = 365 Effective annual rate = EAR m i EAR m % Learning Objective: LO 5 95.Effective annual rate: Largent Supplies Corp. has borrowed to invest in a project. The loan calls for a payment of $17,384 every month for three years. The lender quoted Largent a rate of 8.40 percent with monthly compounding. At what rate would you discount the payments to find amount borrowed by Largent? (Round to two decimal places.) A) 8.40% B) 8.73% C) 8.95% D) None of the above. Page 43

44 Loan amount = PV Interest rate on loan = i = 8.4% Frequency of compounding = m = 12 Effective annual rate = EAR m 1 12 i EAR m % To discount present or future value of cash flows, the most appropriate rate is the EAR, that is, 8.73 percent. Format: Essay 96.How is an annuity due different from the ordinary annuity? Ans: When constant cash flows are received or paid at the end of each period for a length of time, we have an ordinary annuity. If the same cash flows happen at the beginning of each period, we call it an annuity due. Cash flows received at the beginning of each period earn interest for an extra period compared to cash flows received at the end of each period for an investment of the same time frame. Thus, annuity dues have higher values than ordinary annuities. Format: Essay Learning Objective: LO 5 97.The annual percentage rate (APR) is not the appropriate rate to do present or future value calculations. Explain this statement. Ans: The APR is the annualized interest rate using simple interest. In other words, the APR is the simple interest charged per period multiplied by the number of periods per year. However, the APR ignores the impact of compounding on cash flows. This makes it an inappropriate discount rate for doing present and future value calculations. An appropriate rate for such calculations is the effective annual rate (EAR). Format: Essay Learning Objective: LO 5 98.What was the purpose behind the passage of the two consumer protection acts discussed in this chapter? Ans: In 1968, Congress passed the Truth-in-Lending Act to ensure that all borrowers receive meaningful information about the cost of credit so they can make intelligent economic decisions. The act applies to all lenders that extend credit to consumers, and it covers credit card loans, auto loans, home mortgage loans, home equity loans, home improvement loans, and some small business loans. Similar legislation, the so-called Truth-in-Savings Act, applies to consumer savings Page 44

45 vehicles such as consumer certificates of deposits (CDs). These two pieces of legislation require by law that the APR be disclosed on all consumer loans and savings plans and that it be prominently displayed on advertising and contractual documents. Page 45