Additional Solved Problems

Lump Sum Future Value

The Problem
You've received a $40,000 legal settlement. Your great-uncle recommends investing it for retirement in 27-years by rolling over oneyear certificates of deposit (CDs) Your local bank has 3% 1-year CDs How much will your investment be worth? Comment.

Categorization
Your capital gains will be reinvested. There is no cash-flow from the settlement for 27 years, so this is a lump sum problem. There is some uncertainty in the cash flows because interest rate are static for just the first year, but we assume that it will be 3% until you retire If you are unable to shelter your earnings, the IRS will want their cut

Data Extraction
PV = $40,000 i = 3% (or 3% * (1- marginal tax rate)?) n = 27-years FV = ?

Solution by Equation
F ! P(1  i ) n ! 40,000(1  0.03) 27 ! $ 88,851.56

Calculator Solution
N 27 I PV PMT FV 0 ? $88,851.56 3% 40,000

Comments
Your great uncle's a financial idiot Given a 27-year investment, you should either
Invest the money more aggressively to accumulate the money you need to survive, or

Live! Blow the money on that red convertible!

3 Additional Solved Problems

Lump Sum Interest Rate

Problem 1
If you have five years to increase your money from $3,287 to $4,583, at what interest rate should you invest?

Algebraic Solution

F F ! P (1  i ) n i !  1 P 4583 i !  1 ! 0.0687 ! 6.87% 3287

1 5

1 n

Problem 2
An investment you made 12-years ago is today worth its purchase price. It has never paid a dividend. Closer inspection reveals that the share price has been highly periodic, moving from $150 when purchased, to $300 in the next year, to $75 in the next, back to $150, before repeating

Cyclical Price Movement

300 250 200 Price ($) 150 100 50 0 0 2 4 6 Year 8 10 12

12-Year and Average Returns

EndCF  StartCF  Dividends HoldingPeriodReturn ! StartCF 150  150  0 ! !0 150 Compare with Average HPR 1  150 75  300 150  75 300 150  75   .  ! 12 150 300 75 75 1 _ %  75%  100%  -  100%a! 41.67% 100 12

Comments
Here we have the average holding period return being 41.67% per year, while the security has returned you nothing over the whole period! Averages seduce us with their intuitiveness The correct average to have used was the geometric average of return factors, not the arithmetic average of return rates

Averages Must be Meaningful 1

You walk 1 mile at 2 mph and another at 3 mph. What was your average speed? (2+3)/2 = 2.5 mph. NO! The first leg lasts 1/2 hour, and the second leg lasts 1/3 hours, total 5/6 hours. So average speed is 2/(5/6) = 2.4 mph.

Averages Must be Meaningful 2

A little analysis shows that the correct mean for the walker is the harmonic mean The correct mean for the return problem may be shown to be the geometric mean of the (1+return)s The appropriate mean requires thought

Problem 3
In 1066 the First Duke of Oxbridge was awarded a square mile of London for his services in assisting the conquest the England. The 30th Duke wished to live a faster paced life, and sold his holding in 1966 for 5,000,000,000. Examination of original projects cost showed only the entry 1066 a.d.: to repair armor, 5 What was rate of capital appreciation ?

Categorization
We may assume that the Dukes lived quite well from leasing land to their tenants, but we are not interested in the revenue cash flows here, just the capital cash flows There is a present cash flow, a future cash flow, and no annuity payments, so the problem is the return on a lump-sum invested for a number of periods

Data Extraction
PV = 10 FV = 5,000,000,000 n = (1966 - 1066) = 1900 i=?

Solution by Equation
F 1 n! P
1 1900 1 n

F ! P1  i

5000000000  1 n! 5 ! 1.096667999% $ 1.10%

Solution by Calculator
n i PV Pmt FV -5 0 5,000,000,000 1900 ? 1.09666%

Comments
Note that a capital gain of only 1.1% per year results in a huge value over time
Time plus return is very potent

The real issue here is what is missing, namely the revenue streams

Additional Solved Problems

Lump Sum Number of periods

The Problem
How many years would it take for an investment of $9,284 to grow to $22,450 if the interest rate is 7% p.a. ? p.a. = per annum = per year

Categorization
This is a lump sum problem asking for a solution in terms of time. Most of these problems are useful models of reality if expressed in real terms, not nominal terms In any nominal situation, the terminal $22,450 will not be a constant, but will depend on the unknown time We will assume that the numbers and rates are in real terms

Data Extraction
PV = $9,284 FV = $22,450 i = 7% p.a. n=?

Solution by Equation
F ln P n! ln 1  i

F ! P1  i

22,450 ln 9,284 ! 13.05 years n! ln 1  0.07

Additional Solved Problems

Lump Sum Present Value

The Problem
If investment rates are 1% per month, and you have an investment that will produce $6,000 one hundred months from now, how much is your investment worth today?

Categorization
This is the most basic of financial situations, and involves finding the present value of a future payment given no periodic payments The issue of risk is a little fuzzy. It is assumed that the rate given is for the projects risk category

Data Extraction
FV = $6000 PV = ? n = 100 months i = 1%

Solution by Equation

F F ! P(1  i ) P ! ! F * (1  i )  n (1  i ) n 6,000 P! ! $ 2,218.27 100 (1  0.01)

n

Calculator Solution
N 100 I 1% PV PMT FV 6000 ? 0 -2,218.27

Additional Solved Problems

Lump Sum Special Case: Doubling Rule of 72

The Problem
Consider the following simple example:
Sol Cooper Investments have offered you a deal. Invest with them and they will double your investment in 10 years. What interest rate are they offering you? We could solve this using

but this is over-kill

i ! F P  1
n

Data Extraction
Doubling n = 10 i=?

Some Algebra
F ! P1  i
n

F F ln ln P ! P n! ln 1  i i 1 i 3 1 i 5 2 .   2  i 3 2  i 5 2  i

F ln P ! 2  i ln F n$ i 2i P 2 * 2i 2  0.08 2 To double, i $ 8% : n * i $ ln } 0.72 2 1

Solution by Equation
i * n $ 0.72 72 i $ % ! 7.20% 10 Accurate answer 2x i !  1 ! 210  1 ! 7.16% x
1 n 1

The Secret Reveled

Now you have seen the derivation of the rule of 72, you are now able to produce your own personal rules. Example:
The Rule of a Magnitude
To increase your wealth by 10 times, the product of interest and time is 240, that is about (2.08/2)*ln(10) Example, how long will it take to increase your money ten times, given interest rates of 10%? N = 240/10 = 24 years, real answer is 24.16 years

How good is the Rule of 72?

We have derived a rule using approximation methods, but have no idea how accurate it is There are two tests we could apply
we could take some range, and determine the absolute maximum error of the rule in that range we could simply graph the error

Graphs are fun:

Doubling your Money

100.00% 90.00% 80.00% 70.00% 60.00%

Interest

rule algebra

50.00% 40.00% 30.00% 20.00% 10.00% 0.00% 0 5 10 15 20 25 30

Years

Absolute Error
5.00%

0.00% 0 5 10 15 20 25 30

-5.00%

% Error

-10.00%

error
-15.00%

-20.00%

-25.00%

-30.00%

Years

Graph of Rule of 72 Error

The high error in a part of the graph that does not interest us is hiding the error in the part that does. We have two choices
plot absolute error on a log scale truncate the graph and re-scale

Truncation is fun

Absolute Error
0.10% 0.05% 0.00% -0.05% % Error -0.10% -0.15% -0.20% -0.25% -0.30% -0.35% -0.40%
Years 5 10 15 20 25 30

Another Example
You are a stockbroker wishing to persuade a young client to reconsider her $50,000 invested in 3%-CDs. Your client believes that stock mutual funds will return about 12% for the foreseeable future, but is averse to the volatility risks. Her money will remain fully invested for the next 48 years.

Step 1
The first step requires the calculation of how long is required to obtain a single doubling
CDs: 72/3 = 24 years to double Mutual fund: 72/12 = 6 years to double

Step 2
The second step requires the calculation of how many doublings will occur during the lives of the investments
CDs: 48/24 = 2 doublings Mutual fund: 48/6 = 8 doublings

Step 3
The third step calculates the value of the investment in 48 years CDs: 2 doublings of $50,000
= $200,000

Mutual fund: 8 doubling of $50,000

=256 * $50,000 =$12,800,000 in 48 years

Conclusion
We shall discover that her risk is smaller than she imagines, but she will be about 64 times more wealthy if she accepts that risk Using the accurate method, her respective wealths are $206,613 and $11,519,539, The lesson is to start to invest early, and accept some risk

Growth at 3 and 12 %
The following graph shows her wealth increases over 10 years at a 3% and 12%
The graph was cut at 10 years because the 12% rate of growth is so large that it dwarfs the 3% growth, making the graph meaningless

Growth of $50,000 for 10 Years @ 3% and 12%

Ten Years Growth @ 3% & 12%
180000 160000 140000 Value at end of Holding Period

CD

Stock

120000

100000

80000

60000

40000

20000

0 0 1 2 3 4 5 6 Holding Period in Years 7 8 9 10

Log Transformation of Y-Axis

A common way to plot two such cash flows on the same graph is to use a semi-log graph. This prevents scale problems from hiding one of the graphs Note that the two graphs appear to be straight lines, and this is in fact the case

Growth of $50,000 at 3% and 12% for 48 Years (Log Scale)

48 Years Log scale
CD 100000000 Stock Value at end of Holding Period (Log Scale) 10000000

1000000

100000

10000 0 5 10 15 20 25 30 35 40 45 50 Holding Period in Years

What is the use of the Rule?

A significant source of avoidable error in financial calculations results from blindly running the numbers without reviewing them for empirical reasonableness It is a good practice to estimate values before computing them The rule of 72 is one tool that sometimes gives you numerical feel of a problem

 Your reaction to learning the rule of 72 is

Why bother, Ive got the latest and best HP financial calculator.

In a business meeting, the unilateral drawing of a financial calculator has a chilling effect on your opponents flexibility in a negotiation
It is amazing how many real problems you can solve in your head using the rule of 72

Additional Solved Problems

Irregular Cash Flows Backwards Method

The Problem
You have been offered a video business, and estimate that video rental technology will be obsolete in 8 years when cable bandwidths and video compression will permit movie-ondemand. You require a 20% return on this class of risk. The cash flows, starting 1-year from now,are: 90, 110, 140, 140, 130, 90, 70, 30 (thousands of $s)

A Faster Method of Discounting

This is basically a present value of a lump sum repeated 8-times The most straightforward method would be to crunch the answer or use an Excel worksheet A good method to use on a calculator is the following algorithm:

A Faster Method of Discounting (Continued)

Input the last cash flow, and divide by the interest factor to bring it to a year earlier Iterate:
Add this discounted cash flow to the cash flow that is already there, and discount the total for another period by dividing by the interest factor. Stop when you reach the current time Doing this is a lot simpler than it sounds

Data and Computation: Backwards

year 8 7 6 5 4 3 2 1 0 Flow Accumulation $30.00 $30.00 $70.00 $97.27 $90.00 $178.43 $130.00 $292.21 $140.00 $405.64 $140.00 $508.77 $110.00 $572.52 $90.00 $610.47 $554.97 $0.00

Equations
rate RateFactor year 8 7 6 5 4 3 2 1 0 0.1 =1+rate Flow 30 70 90 130 140 140 110 90 0 Accumulation =0 + B8 =C8/RateFactor + B9 =C9/RateFactor + B10 =C10/RateFactor + B11 =C11/RateFactor + B12 =C12/RateFactor + B13 =C13/RateFactor + B14 =C14/RateFactor + B15 =C15/RateFactor + B16

Data and Computation: Traditional

year_ 0 1 2 3 4 5 6 7 8 Sum Flow_ Discounted $0.00 $0.00 $90.00 $81.82 $110.00 $90.91 $140.00 $105.18 $140.00 $95.62 $130.00 $80.72 $90.00 $50.80 $70.00 $35.92 $30.00 $14.00 $554.97

Equations
year_ 0 1 2 3 4 5 6 7 8 Sum Flow_ 0 90 110 140 140 130 90 70 30 Discounted =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =Flow_*(1+rate)^-year =SUM(C19:C27)

Calculator Solution
The computation a BAII+ calculator is 30/1.1+ 70/1.1+ 90/1.1+ 130/1.1+ 140/1.1+ 140/1.1+ 110/1.1+ 90/1.1= The solution is $554.97 Calculators differ in the way they string computations, you may need to add = after the dollar amounts See the savings on computational time!

Comments
It is particularly useful to know the backwards method when the yield curve is not flat. (Use the forward rates). The level of computation savings are even greater in this case

Additional Solved Problems

Deceptive Interest Rates

The Problem
Advertisement:
American Classic Cars! Finance Special! Sprite Conversion! Now Only $15,000! Just $1,000 Down, and 3-years to pay! Only 3% per year! (Compounded monthly with your good credit.)

The Problem (Continued)

Classic Car News has an almost identical car advertised for $9,000, but it needs $3,000 of work to match the condition of the car offered by ACC. What implied rate of interest, (per year, compounded yearly) would you be paying if you purchased the car from ACC?

Explanation
When purchasing from Smart, you are buying a bundle of financing and car To un-bundle the package, you use the cost of acquiring the competing car
Cash value of car = $9,000 + $3,000 = $12,000

Next, determine the cash flows associated with the financed car

Calculator
N 36 I PV PMT FV 0

3%/12 ($15,000 ? -$1,000) -407.14 = 0.25% = $14,000

Analysis Continued
The equivalent value of each cash flow is
$(12,000-1,000) -407.14 -407.14 (36 equal payments in all)

Calculator (Continued)
I PV PMT (monthly) 36 3%/12 = ($15,000? 0.25% $1,000) = -407.14 $14,000 N 36 ? ($12,000- -407.14 1.6419% $1,000) = $11,000 FV 0

True Interest Rates

i ! 1.6419 *12 ! 19.70% p.a. compounded monthly i ! 1.016419  1 ! 21.58% p.a. compounded p.a.
12

The true interest rate on this loan is much higher than that in the advertisement An enterprising lady sold jewelry in a factory where she worked. The people she sold to were poor credit risks. She gave them interest-free loans, one third down. She marked up her prices to cost + 200%. No Risk!

Series of Annuities
The next problem evaluates a project that has a sequence of annuities
The method of solution is to evaluate each annuity to the date one year before its first cash flow, and then to discount these lump sum equivalent amounts to todays date The cash flow feature of a financial calculator may also be used

The Problem
Expected cash flows from a project requiring a 20% return Years Cash Flow Each Year 0 $(20,000,000) 1 to 5 $3,000,000 6 to 30 $2,000,000 31 to 49 $1,000,000 $(2,000,000) 50

Present Values of Components

From 0 1 6 31 50 Rate To 0 5 30 49 50 Amount PV (20,000,000) (20,000,000) 3,000,000 8,971,836 2,000,000 3,976,649 1,000,000 20,404 (2,000,000) (220) (7,031,331)

0.2 Sum

Excel Equations
From 0 1 6 31 50 Rate To 0 5 30 49 50 Amount -20000000 3000000 2000000 1000000 -2000000 PV =Amount/Rate/(1+Rate)^(From-1)*(1-(1/(1+Rate)^(To-From+1))) =Amount/Rate/(1+Rate)^(From-1)*(1-(1/(1+Rate)^(To-From+1))) =Amount/Rate/(1+Rate)^(From-1)*(1-(1/(1+Rate)^(To-From+1))) =Amount/Rate/(1+Rate)^(From-1)*(1-(1/(1+Rate)^(To-From+1))) =Amount/Rate/(1+Rate)^(From-1)*(1-(1/(1+Rate)^(To-From+1))) =SUM(E5:E9)

0.2 Sum

Note
A single lump sum is just a degenerate annuity. The above equations made use of this fact The project is not at all attractive at the given rate At what discount rate does the project become attractive?

Present Value of Project v Rate

50,000,000

40,000,000

Present Value

30,000,000

20,000,000

10,000,000

0.00%
(10,000,000)

5.00%

10.00%

15.00%

20.00%

Discount Rate

The Problem
What is the present value of the following project? The cash flow starts in year 1 $20,000, $20,000, $20,000, $20,000, $20,000, $20,000, $20,000, $15,000, $20,000, $20,000, $20,000, $20,000, $20,000, $20,000, $20,000. The discount rate is 12% p. a.

Analysis
This project is basically an annuity with a hiccup.
Add $5,000 to the hiccup, Evaluate the annuity, and then Subtract the PV of the $5,000

Algebraic Solution
Padj _ ann pmt 1 1  ! 1  i i
n

15

20,000 1 1  ! 1.12 0.12 Ppert ! Padj _ ann  Ppert

! 136,217.29

 5,000 ! 2,019.42 8 1.12 This is the projects value ! $ 134,197.87

The Problem
Mary will retire in 12-years, has $100,000 saved, and will put $12,000 into an account (at the end of every year) until she retires. She will take a $20,000 cruse in year-5. She expects to live 8 years after she retires, and will leave $30,000 to bury her. What will be her retirement income? The bank pays 3%

Key to Solution
After Marys wake, there is no money left. The future value of all her cash flows is the zero. The present value of all cash flows must also be zero We will discount all flows to the current year You may prefer to use Marys retirement or death day as the reference

Solution Outline
0 = 100000 + 12000*PVIFA(3%, 12-years) 20000*PVIF(3%, 5-years) X*PVIFA(3%, 8-years)*PVIF(3%, 12-years) - 30000*PVIF(3%, 20-years)

Solution by Equation

12000 12 0 ! 100000  1  1.03 0.03 X 8 -5 20000*( 1.03 )  1  1.03 * ( 1.03 )-12  0.03 30000*( 1.03 )- 20

int

0 ret

Solution using Excel

-37694

year CF Pert bal 0 100000 1 12000 115000 2 12000 130450 3 12000 146364 4 12000 162754 5 12000 -20000 159637 6 12000 176426 7 12000 193719 8 12000 211531 9 12000 229876 10 12000 248773 11 12000 268236 12 12000 288283 13 -37694 259237 14 -37694 229320 15 -37694 198506 16 -37694 166767 17 -37694 134076 18 -37694 100404 19 -37694 65722 20 -37694 -30000 0

This was set to an arbitrary value, and then solved for

This is set to zero using the Tools Solve function