Practice Problems

Prof. D. Malueg SOLUTIONS: Present Value 1. Matt is trying to decide whether to go to college. If he starts work right out of high school, he expects to earn $50,000 for each of the next 40 years. Alternatively, he could spend four years in college, during which time he spends $20,000 annually; after graduation he expects to earn $70,000 for each of the next 36 years (note, he retires at the same age under both scenarios). For what interest rates does the present value of the cost/income stream from going to college exceed that associated with starting work immediately? Treat each years costs or income as coming at the beginning of the year. ANSWER. Write the streams of expenses and income as follows: work now college rst 50 20 50 20 50 20 50 20 50 70 ... ... 50 70 Econ 104B

1 Here there are 36 years to the right of the vertical line. Let 1+r denote the annual discount factor when the annual interest rate is 100r% (so r = 0.05 corresponds to a 5% interest rate). Let PDVW denote the present discounted value of the stream starting work now; let PDVC be the corresponding value when going to college rst. Then

PDVW = 50(1 + + 2 + + 39 ) and PDVC = 20(1 + + 2 + 3 ) + 70( 4 + 5 + + 39 ). Therefore, PDVC PDVW = 70(1 + + 2 + 3 ) + 20( 4 + 5 + + 39 ) = 70(1 + + 2 + 3 ) + 20 4 (1 + + 2 + + 35 ) = 70 Therefore, PDVC PDVW 0 70 90 4 + 20 40 0 7 9 4 + 2 40 . You can understand this last expression using a graphing calculator (either on your pocket calculator or your computer. Then zoom in on where the graph crosses the horizontal axis to nd the root of 0 7 9 4 + 2 40 (see the gures on the next page). So we see that the critical discount factor above which college yields the higher discounted valueis = 0.946345. Recalling the denition of , this now implies that the critical interest rate is 1 1 1 0.056697. r = 1 = 0.946345 For interest rates less than r , college yields an income stream with greater present value. 1 4 1 + 20 4 1 36 1 .

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Figure 1: Graph of 7 9 4 + 2 40 .

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Figure 2: Zooming in on the graph of 7 9 4 + 2 40 .

2. Henry needs a car for going to law school. He needs the car for three years. He can buy or lease a new Honda Civic. A lease requires $3000 at the signing and $160 per month for each of the following 36 months. (The rst $160 payment is due one month after signing.) At the end of the lease the car goes back to the dealer. Alternatively, Henry can buy the car for $14,000 in cash; at the end of 36 months he is sure to sell it for $6000. (a) Suppose Henry discounts future costs and benets at 9% per year. Calculate the present discounted value (cost) of each of Henrys options. ANSWER. Note that an annual interest rate of R is converted to a monthly interest rate using the formula 1 + R = (1 + r)12 , so r = (1 + R) 12 1. Therefore, an annual rate of 9% corresponds to a monthly interest rate of r = (1.09) 12 1 0.0072, or 0.72% per month. Let = 1/(1 + r) denote the monthly discount factor. Then PDVlease = 3000 + 160 + 2 + 3 + + 36 = 3000 + 160 1 + + 2 + + 35 = 3000 + 160 $8057.45, using = 1/1.0072 0.9928. Alternatively, PDVbuy = 14, 000 6000 36 $9366.90. So here the lease has the lower present value. (b) Find the monthly discount rate (i.e., personal interest rate) at which Henry would be indierent between the two options. What is this as an annual interest rate? ANSWER. The present values of the two options are equal if and only if 3000 + 160 which is satised if and only if 160(1 36 ) = (11,000 6000 36 )(1 ) 160 160 37 = 11,000 11,000 6000 36 + 6000 37 0 = 11,000 11,160 6000 36 + 6160 37 . The solution to this equation is 0.997553, for a monthly interest rate of r = 1 1 0.00245, 1 36 1 = 14,000 6000 36 , 1 36 1
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which corresponds to an annual interest rate of about 3%. 3

3. Wilma bought a 10-year $1000 bond when the interest rate was 5% per year. So her bond would provide her with $50 at the end of each of ten successive years; and the $1000 is also returned at the end of ten years. She has just collected her seventh annual payment on the bond. Suppose now she wants to sell the bond because she is in need of money sooner than expected. (a) Suppose the interest rate is still 5% and this is expected to continue for the indenite future. How much can she expect to sell her bond for? ANSWER. There are three years left on the bond, with payments of $50 after 1 year and 2 years, with a nal payment of $1050 at the end of three years. With an interest rate of 5% on other investments available, the price of this bond will be P = 50 50 1050 + + = $1000. 2 1.05 (1.05) (1.05)3

(b) Suppose the interest rate has increased to 10% and this is 10% rate is expected to continue for the indenite future. How much can she expect to sell her bond for? ANSWER. Now the bond would sell for P = 50 1050 50 + + = $876.65. 2 1.1 (1.1) (1.1)3