Corporate Finance, 3e (Berk/DeMarzo) Chapter 4 The Time Value of Money 4.1 The Timeline Use the figure for the question(s) below. 1) Whi...

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1) Which of the following statements regarding timelines is FALSE? A) Timelines are an important first step in organizing and then solving a financial problem. B) We refer to a series of cash flows lasting several periods as a stream of cash flows. C) Not every stream of cash flows can be represented on a timeline. D) A timeline is a linear representation of the timing of the (expected) cash flows. Answer: C Diff: 1 Section: 4.1 The Timeline Skill: Conceptual 2) Which of the following statements regarding the timeline is FALSE? A) Date 1 is one year from now. B) The $5000 below date 1 is the payment you will receive at the end of the first year. C) The $5000 below date 2 is the payment you will receive at the beginning of the second year. D) Date 0 represents today. Answer: C Diff: 2 Section: 4.1 The Timeline Skill: Definition 3) Which of the following statements regarding the timeline is FALSE? A) Date 1 is the end of the first year. B) Date 0 is the beginning of the first year. C) The space between date 0 and date 1 represents the time period between two specific dates. D) You will find the timeline most useful in tracking cash flows if you interpret each point on the timeline as a period or interval of time. Answer: D Diff: 2 Section: 4.1 The Timeline Skill: Definition 1 Copyright © 2014 Pearson Education, Inc.

Use the information for the question(s) below. Joe just inherited the family business, and having no desire to run the family business, he has decided to sell it to an entrepreneur. In exchange for the family business, Joe has been offered an immediate payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000 in two years, and $75,000 in three years. The current market rate of interest for Joe is 6%. 4) Draw a timeline detailing Joe's cash flows from the sale of the family business. Answer:

Diff: 2 Section: 4.1 The Timeline Skill: Conceptual 5) You have been offered the following investment opportunity, if you pay $2500 today, you will receive $1000 at the end of each of the next three years. Draw a timeline detailing this investment opportunity. Answer:

Diff: 1 Section: 4.1 The Timeline Skill: Conceptual

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Use the information for the question(s) below. Suppose that a young couple has just had their first baby and they wish to ensure that enough money will be available to pay for their child's college education. Currently, college tuition, books, fees, and other costs, average $12,500 per year. On average, tuition and other costs have historically increased at a rate of 4% per year. 8) Assume that college costs continue to increase an average of 4% per year and that all her college savings are invested in an account paying 7% interest. Draw a timeline that details the amount of money she will need to have in the future four each of her four years of her undergraduate education. Answer: 18 19 20 21 25,322.71 $25,322.71(1.)1 $25,322.71(1.04)2 $25,322.71(1.04)3 Note that the tuition for the first year is calculated as: $12,500(1.04) 18 = $25,322.71 Diff: 2 Section: 4.1 The Timeline Skill: Conceptual 9) Suppose that a young couple has just had their first baby and they wish to insure that enough money will be available to pay for their child's college education. They decide to make deposits into an educational savings account on each of their daughter's birthdays, starting with her first birthday. Assume that the educational savings account will return a constant 7%. The parents deposit $2000 on their daughter's first birthday and plan to increase the size of their deposits by 5% each year. Draw a timeline that details the amount that would be available for the daughter's college expenses on her 18th birthday. Answer:

Diff: 2 Section: 4.1 The Timeline Skill: Analytical

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4.2 The Three Rules of Time Travel 1) Which of the following statements is FALSE? A) The process of moving a value or cash flow forward in time is known as compounding. B) The effect of earning interest on interest is known as compound interest. C) It is only possible to compare or combine values at the same point in time. D) A dollar in the future is worth more than a dollar today. Answer: D Explanation: D) A dollar in the future is worth less than a dollar today. Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Conceptual 2) Which of the following statements is FALSE? A) Finding the present value and compounding are the same. B) A dollar today and a dollar in one year are not equivalent. C) If you want to compare or combine cash flows that occur at different points in time, you first need to convert the cash flows into the same units or move them to the same point in time. D) The equivalent value of two cash flows at two different points in time is sometimes referred to as the time value of money. Answer: A Explanation: A) Finding the present value and discounting are the same. Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Conceptual 3) At an annual interest rate of 7%, the future value of $5,000 in five years is closest to: A) $3,565 B) $6,750 C) $7,015 D) $7,035 Answer: C Explanation: C) FV = PV(1 + i) N = 5000(1.07)5 = 7,012.76 Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Analytical

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6) The ranking of the four alternatives from most valuable to least valuable if the interest rate is 6% per year would be: A) 1, 2, 3, 4 B) 1, 3, 2, 4 C) 4, 3, 1, 2 D) 3, 4, 2, 1 Answer: D Explanation: C) Alternative Year Amount PV Rank 1 2 132 117.4795 4 2 5 160 119.5613 3 3 8 200 125.4825 1 4 10 220 122.8469 2 Diff: 2 Section: 4.2 The Three Rules of Time Travel Skill: Analytical Use the following information to answer the question(s) below. Your great aunt Matilda put some money in an account for you on the day you were born. This account pays 8% interest per year. On your 21st birthday the account balance was $5,033.83. 7) The amount of money that your great aunt Matilda originally put in the account is closest to: A) $600 B) $800 C) $1,000 D) $1,200 Answer: C Explanation: C) PV = FV/(1 + i)N = 5033.83(/1.08)21 = 1,000 Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Analytical 8) The amount of money that would be in the account if you left the money there until your 65th birthday is closest to: A) $29,556 B) $148,780 C) $168,824 D) $748,932 Answer: B Explanation: B) FV = PV(1 + i) N = 5033.83(1.08) (65 - 21) = $148,779.85 Diff: 2 Section: 4.2 The Three Rules of Time Travel Skill: Analytical

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9) Which of the following statements is FALSE? A) The process of moving a value or cash flow backward in time is known as discounting. B) FV =

C) The process of moving a value or cash flow forward in time is known as compounding. D) The value of a cash flow that is moved forward in time is known as its future value. Answer: B Explanation: B) FV = C(1 + r)n Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Conceptual 10) Consider the following time line:

If the current market rate of interest is 8%, then the present value of this timeline is closest to: A) $1000 B) $857 C) $860 D) $926 Answer: B Explanation: B) PV = FV/(1 + r)n = 1000/(1.08)2 = 857.34 or approximately $857 Diff: 1 Section: 4.2 The Three Rules of Time Travel Skill: Analytical

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13) Consider the following timeline:

If the current market rate of interest is 9%, then the present value of this timeline as of year 0 is closest to: A) $492 B) $637 C) $600 D) $400 Answer: A Explanation: A) PV = FV(1 + r)n 100/(1.09) 1 = 91.74 200/(1.09) 2 = 168.34 300/(1.09) 3 = 231.66 Sum = 491.74 which is approximately $492 Diff: 3 Section: 4.2 The Three Rules of Time Travel Skill: Analytical

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14) Consider the following timeline:

If the current market rate of interest is 8%, then the value as of year 1 is closest to: A) $0 B) $1003 C) $540 D) $77 Answer: D Explanation: D) Two part problem: FV = PV(1 + r) n = 500(1.08)1 = $540 PV = FV/(1 + r)n = -500/(1.08)1 = -$463 So the answer is $540 + -$463 = $77 Diff: 2 Section: 4.2 The Three Rules of Time Travel Skill: Analytical 4.3 Valuing a Stream of Cash Flows 1) Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 8%, then the present value of this stream of cash flows is closest to: A) $22,871 B) $21,211 C) $24,074 D) $26,000 Answer: B Explanation: B) PV = 5000/(1.07)1 + 6000/(1.07)2 + 7000/(1.07)3 + 8000/(1.07)4 = $21,210.72 Diff: 2 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical 11 Copyright © 2014 Pearson Education, Inc.

4) Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 10%, then the present value of this stream of cash flows is closest to: A) $674 B) $600 C) $460 D) $287 Answer: C Explanation: C) PV = 100/(1.10)1 + 100/(1.10)2 + 200/(1.10) 3 + 200/(1.10)4 = $460 Diff: 2 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical 5) Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 6%, then the future value of this stream of cash flows is closest to: A) $1,723 B) $1,500 C) $1,626 D) $1,288 Answer: A Explanation: A) FV = 100(1.06)5 + 200(1.06)4 + 300(1.06)3 + 400(1.06)2 + 500(1.06)1 = $1723 Diff: 2 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical

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Use the following timeline to answer the question(s) below. 0

1 $600

2 $1,200

3 $1,800

6) At an annual interest rate of 7%, the future value of this timeline in year 3 is closest to: A) $3,295 B) $3,600 C) $3,770 D) $4,035 Answer: C Explanation: C) FV = PV(1 + i) N = $600(1.07)2 + 1,200(1.07)1 + 1,800 = 3,770.94 Diff: 2 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical 7) At an annual interest rate of 7%, the present value of this timeline in year 0 is closest to: A) $3,080 B) $3,600 C) $3,770 D) $4,035 Answer: A Explanation: A) PV = FV/(1 + i)N = $600/(1.07)1 + 1,200/(1.07)2 + 1,800/(1.07)3 = 3,078.21 Diff: 2 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical 8) At an annual interest rate of 7%, the future value of this timeline in year 2 is closest to: A) $3,080 B) $3,525 C) $3,770 D) $4,035 Answer: B Explanation: B) FV year 2 = $600(1.07)1 + 1,200 + 1,800/(1.07)1 = 3,524.24 Diff: 3 Section: 4.3 Valuing a Stream of Cash Flows Skill: Analytical

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4.4 Calculating the Net Present Value Use the following information to answer the question(s) below. Nielson Motors is considering an opportunity that requires an investment of $1,000,000 today and will provide $250,000 one year from now, $450,000 two years from now, and $650,000 three years from now. 1) If the appropriate interest rate is 10%, then the NPV of this opportunity is closest to: A) ($88,000) B) $88,000 C) $300,000 D) $1,300,000 Answer: B Explanation: B) NPV = -1,000,000 + 250,000/(1.10)1 + 450,000/(1.10) 2 + 650,000/(1.10)3 = 87,528.17 Diff: 2 Section: 4.4 Calculating the Net Present Value Skill: Analytical 2) If the appropriate interest rate is 10%, then Nielson Motors should: A) invest in this opportunity since the NPV is positive. B) not invest in this opportunity since the NPV is positive. C) invest in this opportunity since the NPV is negative. D) not invest in this opportunity since the NPV is negative. Answer: A Explanation: A) NPV = -1,000,000 + 250,000/(1.10)1 + 450,000/(1.10) 2 + 650,000/(1.10)3 = 87,528.17 Invest since positive NPV Diff: 2 Section: 4.4 Calculating the Net Present Value Skill: Analytical 3) If the appropriate interest rate is 15%, then Nielson Motors should: A) invest in this opportunity since the NPV is positive. B) not invest in this opportunity since the NPV is positive. C) invest in this opportunity since the NPV is negative. D) not invest in this opportunity since the NPV is negative. Answer: D Explanation: D) NPV = -1,000,000 + 250,000/(1.15)1 + 450,000/(1.15)2 + 650,000/(1.15)3 = -14,958.49 Do Not Invest since negative NPV Diff: 2 Section: 4.4 Calculating the Net Present Value Skill: Analytical 16 Copyright © 2014 Pearson Education, Inc.

4) Kampgrounds Inc. is considering purchasing a parcel of wilderness land near a popular historic site. Although this land will cost Kampgrounds $400,000 today, by renting out wilderness campsites on this land, Kampgrounds expects to make $35,000 at the end of every year indefinitely. If the appropriate discount rate is 8%, then the NPV of this new wilderness campsite is closest to: A) -$50,000 B) -$37,500 C) $37,500 D) $50,000 Answer: C Explanation: C) NPV = -400,000 + $35,000/.08 = 37,500 Diff: 1 Section: 4.4 Calculating the Net Present Value Skill: Analytical 5) Wyatt oil is considering drilling a new self sustaining oil well at a cost of $1,000,000. This well will produce $100,000 worth of oil during the first year, but as oil is removed from the well the amount of oil produced will decline by 2%, per year forever. If the Wyatt oil's appropriate interest rate is 8%, then the NPV of this oil well is closest to: A) -$250,000 B) $0 C) $250,000 D) $1,000,000 Answer: B Explanation: B) NPV = -1,000,000 + $100,000/(.08 - (-.02)) = $0 Diff: 2 Section: 4.4 Calculating the Net Present Value Skill: Analytical 4.5 Perpetuities and Annuities 1) Which of the following statements regarding perpetuities is FALSE? A) To find the value of a perpetuity one cash flow at a time would take forever. B) A perpetuity is a stream of equal cash flows that occurs at regular intervals and lasts forever. C) PV of a perpetuity =

D) One example of a perpetuity is the British government bond called a consol. Answer: C Explanation: C) PV of a perpetuity =

Diff: 1 Section: 4.5 Perpetuities and Annuities Skill: Conceptual

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5) Which of the following statements is FALSE? A) The difference between an annuity and a perpetuity is that an annuity ends after some fixed number of payments. B) Most car loans, mortgages, and some bonds are annuities. C) A growing perpetuity is a cash flow stream that occurs at regular intervals and grows at a constant rate forever. D) An annuity is a stream of N equal cash flows paid at irregular intervals. Answer: D Explanation: D) annuities are paid at regular intervals. Diff: 2 Section: 4.5 Perpetuities and Annuities Skill: Conceptual 6) Which of the following formulas is INCORRECT? A) PV of a growing annuity = C × B) PV of an annuity = C × C) PV of a growing perpetuity = D) PV of a perpetuity = Answer: A

Explanation: A) PV of a growing annuity = C × Diff: 1 Section: 4.5 Perpetuities and Annuities Skill: Conceptual

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Use the information for the question(s) below. Suppose that a young couple has just had their first baby and they wish to ensure that enough money will be available to pay for their child's college education. Currently, college tuition, books, fees, and other costs, average $12,500 per year. On average, tuition and other costs have historically increased at a rate of 4% per year. 7) Assuming that costs continue to increase an average of 4% per year, tuition and other costs for one year for this student in 18 years when she enters college will be closest to: A) $12,500 B) $21,500 C) $320,568 D) $25,323 Answer: D Explanation: D) FV = PV(1 + i) N = $12,500(1.04) 18 = $25,322.71 Diff: 2 Section: 4.5 Perpetuities and Annuities Skill: Analytical 8) Assuming that college costs continue to increase an average of 4% per year and that all her college savings are invested in an account paying 7% interest, then the amount of money she will need to have available at age 18 to pay for all four years of her undergraduate education is closest to: A) $97,110 B) $107,532 C) $101,291 D) $50,000 Answer: A Explanation: A) This is a two step problem. Step #1 determine the cost of the first year of college. FV = PV(1 + i)N = $12,500(1.04)18 = $25,322.71 Step #2 figure out the value for four years of college. PV of a growing annuity due = C × = $25,322.71 ×

1

(1 + r)

4 1.04 (1 + .07) = $97,110.01 1.07

Diff: 3 Section: 4.5 Perpetuities and Annuities Skill: Analytical

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