LO 0-6 Time and Value of Money Part 2

Question 1

Assuming a 6% discount rate which choice is better:
Choice A: Get $500 today
Choice B: Receive $600 in 2 years
Choice C: Receive $300 today, $200 in 2 years, $60 in 3 years

Answer 1

Choice A: 500 , 561.8 and $595.51

Choice B: 600/1.06 = 566

Choice C:
300 + (200/1.06^2) + (60/1.03^2) = 548.54

So Choice B

Question 2

You have the opportunity to pay $2,000 to invest in a company. You estimate that this company will earn a total of $12,000 during its life. You expect the company to pay all of these earnings to you as a dividend 12 years from today. Currently, the risk-free rate is 6% but this investment is really risky and you feel that a 16% discount rate is appropriate. Given your assumptions, should you make this investment? Assume that no other investments are available to you.

Answer 2

12,000/(1+16%)^12 = 2,021.55

Question 3

You have the opportunity to pay $2,000 to invest in a company. You estimate that this company will earn a total of $10,000 during its life. You expect the company to pay all of these earnings to you as a dividend 10 years from today. Currently, the risk-free rate is 6% but this investment is really risky and you feel that a 14% discount rate is appropriate. How much would you earn from this investment in today’s dollars (i.e. present value)? Round to the nearest dollar.

Answer 3

First, you calculate the present value of this investment (i=0.14, n=10, FV=10,000), which gives you $2,697.

Next, if you recall, the initial investment was $2000. You have to do one more step to get the amount earned, 2,697 - 2,000 = $697,

Question 4

You are considering purchasing a bond. The bond will pay you $100 at the end of each year for three years. At the end of the third year, the bond will also pay you back its $1,000 face value. Assuming a 10% discount rate, how much is this bond worth today? Round to the nearest dollar.

Answer 4

Face Value of the Bond:
(1000/(1.1^3)= $248.68

PV = 100/(1.1^1) + 100/(1.1^2)+100/(1.1^3) = $751.31

=$248.68 + $751.31 = approx. $1,000

Question 5

if interest rates go up then:

• asset prices are unaffected
• asset prices go down
• asset prices go up

Answer 5

-asset prices go down

Question 6

You are considering purchasing a bond. The bond will pay you $100 at the end of each year for three years. At the end of the third year, the bond will also pay you back its $1,000 face value. Assuming an 8% discount rate, how much is this bond worth today? Round to the nearest dollar.

Answer 6

The present value of the bond consists of two parts:

1. Present value of $1,000 face value. PV = $1,000/(1+0.08)^3 = 793.83
2. Present value of $100 interest payment at the end of each year for 3 years. PV = $100/(1+0.08)^3 +$100/(1+0.08)^2 +100/(1+0.08) = 79.38+85.73+92.59=257.7

In total, 793.83 +257.7 = $1,052 is how much the bond is worth today.

Question 7

You have two investment options:

Option A
You can purchase $2,000 of stock in a company. You estimate that this company will earn a total of $10,000 during its life. You expect the company to pay all of these earnings to you as a dividend 10 years from today. Currently, the risk-free rate is 1% but this investment is really risky and you feel that a 14% discount rate is appropriate.

Option B
You can purchase $2,000 worth of bonds. The bond will pay you $250 at the end of each year for three years. At the end of the third year, the bond will also pay you back its $2,000 face value. You feel that this is a very safe investment and a 2% discount rate is appropriate.
Which investment has the highest present value?
Option A value is 2697
Option B value is 2605

Answer 7

Option A Value is
lifetime =100

10000/(1 + 1%)^100 = $3,697

Option B Value is
1. Present value of $2,000 face value. PV = $2,000/(1+2%)^3 = $1,884.64

2. Present value:
   PV= 250/(1 + 2%)^1 + 250/(1 + 2%)^2 + 250/(1 + 2%)^3 = $720.97

=$1,884.64 + $720.97 - $2,000 = $604

Choice A

Question 8

In order to value a bond, you estimate?

• future cash payments
• timing of future payments
• discount rate
• all of the above

Answer 8

-discount rate

Question 9

discount rate is everything

Answer 9

critically important as it determines everything

Question 10

when discount rates go down

Answer 10

present value goes up

Question 11

when discount rates go up

Answer 11

present values go down

Question 12

to value a bond is to

Answer 12

estimate a discount rate

Question 13

the more uncertain the payout (riskier the investment)

Answer 13

the higher the discount rate

Question 14

stocks and bonds don’t use a risk free rate of return because

Answer 14

payout is not guaranteed with stocks

Question 15

the riskier the investment the _____ the discount rate

Answer 15

higher

Question 16

risk free rate affects

Answer 16

all asset prices

Question 17

no asset safer than

Answer 17

a US Treasury

Question 18

US Treasury determines

Answer 18

all other interest rates

Question 19

if treasury rates are high then you have

Answer 19

high interest rates and vice versa

Question 20

the lowest rate will be

Answer 20

US Treasury

Question 21

everything builds up

Answer 21

risk free rate

Question 22

companies investing in future earnings benefit more from _____ interest rates

Answer 22

low

Question 23

when payments far out into the future

Answer 23

benefit from lower interest rates

this benefits new corporations as they boost in value once the rate drops

Question 24

interest rates drop

Answer 24

asset price goes up

Question 25

rates go up

Answer 25

asset prices go down