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E120

Homework 3 Solutions
1.
1000(1 1/(1 + 7%))100
7%
= 14269.25

PV =

2.
PV =

X
i=1

1
(1 + 8%)5i

1
(1 + 8%)5 1

= 2.13
i.e., the present value of your gift is $2.13 million.
3. (a) The cash flow is (0, 1200, 1200, . . . , 1200), where n = 18.
The amount I have to pay (at year 12) is P V =
$12993.12.

1200
1+0.06

1200
1.062

+ ... +

1200
1.0618

1200
1.062

+ ... +

1200
1.0610

(b) The cash flow is (0, 1200, 1200, . . . , 1200), where n = 10.
The amount I have to pay (at year 20) is P V =
$8832.10.

1200
1+0.06

(c) The cash flow is (1200, 1200, 1200, . . . , 1200), where n = 18.
1200
1200
1200
The amount I have to pay (at year 12) is P V = 1200 + 1+0.06
+ 1.06
2 + . . . + 1.0618 =
$14193.12.

4. First note that the savings in year 1 is 1000, in year 2 is 1000 0.98, in year 3 is
1000 0.982 , etc.



10000.98
10000.982
1000
0.98
0.98 2
Then P V = 1000
+
+
+.
.
.
=

1
+
+
+
.
.
.
= 14285.71.
1.05
1.052
1.053
1.05
1.05
1.05
5. Note that we want the PV of this cash flow to be 0: (50000, 0, x, 0, x, . . . , 0, x).
P V = 50000 +

x
1.042

x
1.044

+ ... +

x
1.0420

= 0.

Solving, I get x = 7505.34.


6. We want n so that
200K +

25K
25K
25K
+
+ ... +
>0
2
1.05 1.05
1.05n

Using the geometric series to simplify terms; after some algebraic manipulations, we
obtain n > 10.47.
So another 11 (or more) joyous years on Earth is preferable.
7.

a. Suppose the monthly rate is rm . Then


24
X
i=1

500
= 10000
(1 + rm )i

1 1/(1 + rm )24 = 20rm


rm = 1.513%
Therefore the equivalent EAR is
EARa = (1 + rm )1 2 1 = 19.747%
b.
2
X
i=1

6050
= 10000
(1 + EARb )i

1 1/(1 + EARb )2 = 20EARb


EARb = 13.707%
Option B is preferred since the implied EAR of option B is lower.
Remark
In this problem, the EARs you calculated are the implied EARs for the given
pay back options. Therefore if you use the implied EAR to calculate the present
value of that corresponding cash flow, you always get the same number - the initial
loan you take. That is actually how you compute the implied EAR. Hence we can
not really compare the options by their present value by using their own implied
EAR. Taking the one with lower implied EAR is the simplest way to answer this
question because you would like to pay lower interest rate to the bank. Or, you
can use the same interest rate (the rate you think fair) to discount both cash flows
and choose the one with lower present value. Then the answer is not unique. It
depends on the fair rate you choose. If it is close to 0, then option A might be
preferred.
8. The cash flow is (1000, 100, 100, . . .).
PV of this cash flow is 0, so we must have 1000 +

100
1+r

100
(1+r)2

+ . . . = 0.

Simplifying the above using the geometric series formula, and solve for r, I get r = 0.1.

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