Module 4 Exercises

1. Future value

James has 4,000 to invest in a savings account at 5% interest compounded annually.

a. Find out the compound value in the account after (1) 2 years (2) 6 years and (3) 10 years.

Present value 4000

Interest rate 0.05
Future value after 2 years 4,410.00
Future value after 6 years 5,360.38
Future value after 10 years 6,515.58

Excel command: FV(0.05, number of years, 0, -4000, 0)

b. Use your findings in a. to calculate the amount of interest earned in the first 2 years
(years 1 to 2), (2) the next 4 years (years 3 to 6) and (3) the last 4 years (years 7 to 10)

Interest earned in Amount of earnings

Years 1 to 2 410.00
Years 3 to 6 950.38
Years 7 to 10 1,155.20

Interest earned in years 1 to 2 = Future value after 2 years – Present value

Interest earned in years 3 to 6 = Future value after 6 years – Future value after 2 years
Interest earned in years 7 to 10 = Future value after 10 years – Future value after 6 years

c. Compare your findings in part b. Why does the amount of interest earned increase in each
succeeding period?

The amount of interest earned in part b. increases in each succeeding period. This is because
the interest rate is applied on both the principal and the previously earned interest. As more
interest accumulates over the periods, the amount of money the interest rate is being applied to
grows. Therefore, the amount of earnings rises in each succeeding period.

2. Time value

Isabella wishes to purchase a Nissan GTR. The car costs $85,000 today and after completing her
graduation, she has secured a well-paying job and is able to save for the car. The price trend
indicates that its price will increase by 4% to 6% every year. Isabella wants to save enough to
buy the car in 5 years from today.

a. Estimate the price of the car in 5 years if the price increases by (1) 3% per year and (2)
6% per year
 Annual price increase rate Price of the car in 5 years, $
0.03 98,538.30
0.06 113749.17

Excel command: FV(annual price rate increase, 5, 0, -85000, 0)

b. How much more expensive will the car be if the price increases by 6% rather than 3%?

The car will be approximately $15,210.88 more expensive.

3. Time value

You can deposit 10,000 into an account paying 9% annual interest either today or exactly 10
years from today. How much better off will you be in 40 years from now if you decide to make
the initial deposit today rather than 10 years from today?

We assume that the interest is compounded annually.

Deposit when now 10 years from now

Years in deposit 40 30
Future value 314,094.20 132,676.78

Excel command: FV(0.09, years in deposit, 0, -10000, 0)

Difference in FV = 181,417.42

I will be approximately 181,417.42 better off in 40 years from now if I decide to make the initial
deposit today rather than 10 years from today.

4. Cash flow investment decision

Tom Alexander has an opportunity to purchase any of the investments shown in the following
table. The purchase price, the amount of the single cash inflow and its year of receipt are given
for each investment. Which purchase recommendations would you make, assuming that Tom can
earn 10% on his investments?

Investment Price, $ Single cash flow, $ Years of receipt

A 18,000 30,000 5
B 600 3,000 20
C 3,500 10,000 10
D 1,000 15,000 40

We assume that the interest is compounded annually.

Investment Present Value, $ Recommendation

A 18,627.64 Purchase
 B 445.93 Do not purchase
C 3,855.43 Purchase
D 331.42 Do not Purchase

Excel command: -PV(0.1, years of receipt, 0, single cash flow, 0)

Investment Future Value, $ Recommendation

A 28,989.18 Purchase
B 4,036.50 Do not purchase
C 9,078.10 Purchase
D 45,259.26 Do not Purchase

Excel command: FV(0.1, years of receipt, 0,-purchase price, 0)

We would recommend purchasing investments A and C because their purchase prices are lower
than their present values. The same recommendations could be given if we take a look at the
calculated future value since for both A and C, their future value is less than the single cash flow.
This means that the investment will yield a higher return.

5. Calculating deposit needed

Peter put $6,000 in an account earning 4% annually. After 4 years, he made another deposit into
the same account. At the end of 6 years the account balance is $13,000. What was the amount
deposited at the end of year 4?

Let A be the amount deposited at the end of year 4.

13,000 = (6,000 * (1 + 0.04) ^ 4 + A) * (1 + 0.04) ^ 2

A = {13,000 / [(1 + 0.04) ^ 2]} – 6,000 * (1 + 0.04) ^ 4 = 5,000.08

The amount deposited at the end of year 4 is approximately $5,000.08.

6. Retirement planning

Jill Smith, a 22-year old university graduate has just landed her first job and has planned to retire
at age 62. She has decided to deposit $5,000 at the end of every year in an individual savings
account (ISA) which is tax-free for British citizens and gives 5% per annum return.

a. If Jull continues to make end-of-year $5,000 deposits into the ISA, how much will she
have accumulated in 40 years when she turns 62?

Excel command: FV(0.05, 40, -5000, 0, 0)

She will have accumulated approximately $603,998.87.

 b. If Jill decides to wait until age 32 to begin making deposits into the ISA, how much will
she have accumulated when she retires after 30 years?

Excel command: FV(0.05, 30, -5000, 0, 0)

She will have accumulated approximately $332,194.24.

c. Using your findings in part 1 and b, discuss the impact of delaying deposits into the ISA
for 10 years on the amount accumulated by the end of the period

Delaying deposits into the ISA for 10 years decreases the amount accumulated by the end of
the period by approximately $271,804.63, which is approximately 45% of the amount
accumulated at the end of 40 years. This is a significant impact considering that 10 years is only
25% of 40 years, yet just a 25% time delay resulted into approximately a 45% opportunity cost.
From the perspective of a 30-year deposit accumulation, Jill will earn 81.82% more than the
amount at the end of 30 years if she does not delay.

d. Rework parts a and b assuming that Jill makes all deposits at the beginning, rather than
the end of the year. Discuss the effect of beginning of year deposits on the future value
accumulated by the end of Jill’s sixty-second year.

Deposit when Future value of Annuity Due Surplus over that of Ordinary Annuity
Now 634,198.81 30,199.94
When Jill turns 32 348,803.95 16,609.71

Excel command: FV(0.05, years in deposit, -5000, 0, 1)

Percent increase over ordinary annuity = Surplus over that of Ordinary Annuity / Future value of
Ordinary Annuity
Percent decrease over annuity due = Surplus over that of Ordinary Annuity / Future value of
Annuity Due

Shifting to beginning-of-year from end-of-year deposits increases the future value

accumulated by the end of Jill’s sixty-second year by 5% for both parts a. and b. The effect of
shifting is less pronounced than the impact of delaying. From the perspective of annuity due,
shifting to ordinary annuity decreases the future value by 4.76%.

7. Perpetuities

Suppose you have been offered an investment opportunity that will pay you at $500 at the end of
every year, starting 1 year from now and continuing forever. Assume the relevant discount rate is
6%.
a. What is the maximum amount you will pay for this investment?

Present value of perpetuity = Cash flow at the end of each year / discount rate
= 500 / 6%
The maximum amount I will pay for this investment is approximately $8,333.33.

b. What would you pay if the first cash flow from this investment comes immediately, and
the following cash payments $500 after 1 year thereafter?

8,333.33 + 500 = 8,833.33

I would pay approximately $8,833.33.

c. Suppose the first cash flow from this investment is 4 years from now; that is, the first
payment will be made at the end of the fourth year and will continue every year
thereafter. How much is this worth to you today?

Present value at the start of year 4 = 500 / 6%

Present value at the start of year 1 = (500 / 6%) / (1 + 6%)^4

It is worth approximately $6,600.78.

8. Present value: Mixed Streams

Consider the mixed streams of cash flows shown in the following table:

Year A Cash Flows, $ B Cash flows, $

0 -50,000 10,000
1 40,000 20,000
2 30,000 30,000
3 20,000 40,000
4 10,000 -50,000
Total 50,000 50,000

a. Find the present value of each stream using a 5% discount rate.

Cash Flows Present value, $

A 40,809.90
B 49,676.88

Excel command:
Cash flow at the end of year 0 + NPV(0.05, cash flows at the ends of years 1 to 4)

b. Compare the calculated present values and discuss them in light of the undiscounted cash
flows totaling $50,000 in each case. Is there some discount rate at which the present
values of the two streams would equal?
 The present value of cash flow A is lower than that of cash flow B. Since the undiscounted
cash flows totals $50,000 in each case, cash flow A gives a higher present value growth than
cash flow B. The discount rate at which the present values of the two streams would equal is 0%.

9. Changing compounding frequency

Using annual, semiannual and quarterly compounding periods for each of the following, (1)
calculate the future value if $10,000 is deposited initially and (2) determine the effective annual
rate (EAR).
a. At 12% annual interest for 5 years

Compounding Period Future Value EAR, %

Annual 17,623.42 12
Semiannual 17,908.48 12.36
Quarter 18,061.11 12.55

Excel commands:
FV(0.12 / number of periods in a year, 5 * number of periods in a year, 0, -10000, 0)
EFFECT(0.12, number of periods in a year)

b. At 15% annual interest for 8 years

Compounding Period Future Value EAR, %

Annual 30,590.23 15
Semiannual 31,807.93 15.56
Quarter 32,480.25 15.87

Excel commands:
FV(0.15 / number of periods in a year, 8 * number of periods in a year, 0, -10000, 0)
EFFECT(0.15, number of periods in a year)

c. At 18% annual interest for 11 years

Compounding Period Future Value EAR, %

Annual 61,759.26 18
Semiannual 66,586.00 18.81
Quarter 69,361.23 19.25

Excel commands:
FV(0.18 / number of periods in a year, 11 * number of periods in a year, 0, -10000, 0)
EFFECT(0.18, number of periods in a year)

10. Payback period

Quick Profit Entry is considering a capital expenditure that requires an initial investment of
$84,000 and returns after after-tax cash inflows of $7,000 per year for 20 years. The firm has a
maximum acceptable payback period of 8 years.

a. Determine the payback period for this project

Payback period = 84,000 / 7,000 = 12 years

b. Should Quick Profit accept the project? Explain.

Quick Profit should reject the project because the payback period of the project exceeds its
maximum acceptable payback period. This means the project will not generate sufficient cash
flows to recoup the initial outlay on the investment within 8 years.

11. Net Present Value

The BM Group is considering replacement of one of its car-manufacturing robot lines. Three
alternative replacement robot lines are under consideration. The relevant cash flows associated
with each line are shown in the following table. The cost of capital is 15%.

Cash flows in EUR

Year Robot line A Robot line B Robot line C
0 -850,000 -600,000 -1,500,000
1 150,000 120,000 800,000
2 150,000 140,000 300,000
3 150,000 160,000 200,000
4 150,000 180,000 200,000
5 150,000 200,000 200,000
6 150,000 250,000 300,000
7 150,000 - 400,000
8 150,000 - 500,000

a. Calculate the net present value (NPV) of each line.

Excel command:
cash flow at the end of year 0 + NPV(0.15, cash inflows at the end of years 1 to 8)

Robot line NPV in EUR

A -176,901.77
B 25,843.37
C 211,308.50

b. Using NPV, evaluate the acceptability of each line

Accept robot lines B and C because their NPVs are greater than 0. Reject robot line A
because its NPV is less than 0.
 c. Rank the lines from best to worst using NPV

C>B>A

d. Calculate the profitability index (PI) for each line

PI = PV of cash inflows / absolute value of initial cash outflow

Robot line PI
A 0.79
B 1.04
C 1.14

e. Rank the lines from best to worst, using PI.

C>B>A

12. Economic Value Added

Assume Project X costs $860,000 initially and will generate cash flows in perpetuity of
$320,000. The firm’s cost of capital is 12%
a. Calculate the project’s NPV

NPV = (perpetual cash flow / discount rate) – initial cost

= ($320,000 /12%) – $860,000 = $1,806,666.67

b. Calculate the annual EVA in a typical year

Annual EVA = perpetual cash flow – (initial cost * cost of capital)

= $320,000 – ($860,000 * 12%) = $216,800

c. Calculate the overall project EVA and compare to your answers in part a.

Overall EVA = $216,800 / 12% = $1,806,666.67

The overall EVA and the NPV produced the same value.

13. Internal Rate of Return

Ocean Pacific Restaurants is evaluating two mutually exclusive projects for expanding the
seating capacity at the restaurant. The following table shows the relevant cash flows for the
projects. The firm’s cost of capital is 4%.

Year Project A Cash Flows, $ Project B Cash Flows, $

 0 -980,000 -363,000
1 150,000 110,000
2 170,000 98,000
3 220,000 93,000
4 270,000 82,000
5 340,000 67,000

a. Calculate the IRR to the nearest whole percent for each of the projects

Excel command: IRR(cash flows at the ends of years 0 to 5)

Project A B
IRR, % 5 8

b. Assess the acceptability of each project based on the IRRs found in part a.

Both projects are accepted because their IRRs are greater than the firm’s cost of capital.

c. Which project, on this basis, is preferred?

Project B is preferred because it has a higher IRR.

14. Payback, NPV and IRR

Woolworths Ltd. Is evaluating the feasibility of investing $1,000,000 in a new store in Sydney,
having a 5-year life. The firm has estimated the cash inflows from the proposed store, as shown
in the following table. The firm has an 8% cost of capital.

Year Project A Cash Flows, $

1 100,000
2 200,000
3 300,000
4 400,000
5 500,000

a. Calculate the payback period for the proposed investment

Let p be the payback period.

100,000 p (p + 1) / 2 = 1,000,000
p = -5 or p = 4

Therefore, p = 4 years.

b. Calculate the net present value (NPV) for the proposed investment
Excel command: NPV(0.08, cash flows at the ends of years 1 to 5) – 1,000,000

NPV = $136,513.57

c. Calculate the internal rate of return (IRR), rounded to the nearest whole percent, for the
proposed investment.

Excel command: IRR(cash flows at the ends of years 0 to 5)

IRR = 12%

d. Evaluate the acceptability of investing in the store using NPV and IRR? What
recommendation would you make relative to the implementation of the project? Why?

The investment should be accepted because NPV > $0 and IRR > cost of capital. We recommend
reinvesting the cash inflows at the IRR or a higher interest rate so the investment would be more
valuable than what the NPV indicates.