CHAPTER 2 Time Value of Moneyujelkqlkdwqlkenddkne,m
Transcript of CHAPTER 2 Time Value of Moneyujelkqlkdwqlkenddkne,m
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Future value
Present value
Rates of return
Amortization See:
http://vimeo.com/13310725
Chapter 2Time Value of Money
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Time lines show timing of cash flows.
CF0 CF1 CF3CF2
0 1 2 3i%
Tick marks at ends of periods, so Time 0is today; Time 1 is the end of Period 1;or the beginning of Period 2.
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Time line for a $100 lump sum
due at the end of Year 2.
100
0 1 2 Yeari%
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Time line for an ordinary annuity
of $100 for 3 years.
100 100100
0 1 2 3i%
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Time line for uneven CFs: -$50 at t
= 0 and $100, $75, and $50 at theend of Years 1 through 3.
100 5075
0 1 2 3i%
-50
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Whats the FV of an initial $100
after 3 years if i = 10%?
FV = ?
0 1 2 3
10%
Finding FVs (moving to the righton a time line) is called compounding.
100
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After 1 year:
FV1 = PV + INT1 = PV + PV (i)= PV(1 + i)= $100(1.10)
= $110.00.After 2 years:
FV2 = FV1(1+i) = PV(1 + i)(1+i)
= PV(1+i)2
= $100(1.10)2= $121.00.
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After 3 years:
FV3 = FV2(1+i)=PV(1 + i)2(1+i)
= PV(1+i)3
= $100(1.10)3
= $133.10.
In general,
FVn = PV(1 + i)n.
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Three Ways to Find FVs
Solve the equation with a regular
calculator. Use a financial calculator.
Use a spreadsheet.
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Financial calculator: HP10BII
Adjust display brightness: hold down ONand push + or -.
Set number of decimal places to display:Orange Shift key, then DISP key (inorange), then desired decimal places(e.g., 3).
To temporarily show all digits, hit OrangeShift key, then DISP, then =
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HP10BII (Continued)
To permantly show all digits, hitORANGE shift, then DISP, then . (periodkey)
Set decimal mode: Hit ORANGE shift,then ./, key. Note: many non-UScountries reverse the US use of decimals
and commas when writing a number.
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HP10BII: Set Time Value Parameters
To set END (for cash flows occuring atthe end of the year), hit ORANGE shiftkey, then BEG/END.
To set 1 payment per period, hit 1, thenORANGE shift key, then P/YR
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Financial calculators solve thisequation:
There are 4 variables. If 3 areknown, the calculator will solvefor the 4th.
.0ni1PVnFV
Financial Calculator Solution
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3 10 -100 0
N I/YR PV PMT FV133.10
Heres the setup to find FV:
Clearing automatically sets everythingto 0, but for safety enter PMT = 0.
Set: P/YR = 1, END.
INPUTS
OUTPUT
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Spreadsheet Solution
Use the FV function: see spreadsheet inCh 02 Mini Case.xls.
= FV(Rate, Nper, Pmt, PV)
= FV(0.10, 3, 0, -100) = 133.10
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10%
Whats the PV of $100 due in 3
years if i = 10%
Finding PVs is discounting, and its
the reverse of compounding.
100
0 1 2 3
PV = ?
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Solve FVn
= PV(1 + i )n for PV:
PV = FV1+ i = FV 11+ in n nn
PV = $100 11.10= $100 0.7513 = $75.13. 3
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Financial Calculator Solution
3 10 0 100
N I/YR PV PMT FV-75.13
Either PV or FV must be negative. HerePV = -75.13. Put in $75.13 today, takeout $100 after 3 years.
INPUTS
OUTPUT
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Spreadsheet Solution
Use the PV function: see spreadsheet.
= PV(Rate, Nper, Pmt, FV)
= PV(0.10, 3, 0, 100) = -75.13
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Finding the Time to Double
20%
2
0 1 2 ?
-1 FV = PV(1 + i)n$2 = $1(1 + 0.20)n
(1.2)n = $2/$1 = 2nLN(1.2) = LN(2)
n = LN(2)/LN(1.2)n = 0.693/0.182 = 3.8.
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20 -1 0 2
N I/YR PV PMT FV3.8
INPUTS
OUTPUT
Financial Calculator
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Spreadsheet Solution
Use the NPER function: seespreadsheet.
= NPER(Rate, Pmt, PV, FV)
= NPER(0.10, 0, -1, 2) = 3.8
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Finding the Interest Rate
?%
2
0 1 2 3
-1 FV = PV(1 + i)n$2 = $1(1 + i)3
(2)(1/3) = (1 + i)1.2599 = (1 + i)
i = 0.2599 = 25.99%.
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3 -1 0 2
N I/YR PV PMT FV25.99
INPUTS
OUTPUT
Financial Calculator
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Spreadsheet Solution
Use the RATE function:
= RATE(Nper, Pmt, PV, FV)
= RATE(3, 0, -1, 2) = 0.2599
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Ordinary Annuity
PMT PMTPMT
0 1 2 3
i%
PMT PMT
0 1 2 3i%
PMT
Annuity Due
Whats the difference between an
ordinary annuity and an annuity due?
PV FV 26
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Whats the FV of a 3-year ordinary
annuity of $100 at 10%?
100 100100
0 1 2 310%
110
121FV = 331
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FV Annuity Formula
The future value of an annuity with nperiods and an interest rate of i can befound with the following formula:
.33110.
100
0.10
1)0(1
i
1i)(1PMT
3
n
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Financial calculators solve thisequation:
There are 5 variables. If 4 areknown, the calculator will solvefor the 5th.
.0i
1ni)(1PMTni1PVnFV
Financial Calculator Formula
for Annuities
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3 10 0 -100
331.00
N I/YR PV PMT FV
Financial Calculator Solution
Have payments but no lump sum PV,so enter 0 for present value.
INPUTS
OUTPUT
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Spreadsheet Solution
Use the FV function: see spreadsheet.
= FV(Rate, Nper, Pmt, Pv)
= FV(0.10, 3, -100, 0) = 331.00
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Whats the PV of this ordinaryannuity?
100 100100
0 1 2 310%
90.91
82.6475.13
248.69 = PV
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PV Annuity Formula
The present value of an annuity with nperiods and an interest rate of i can befound with the following formula:
69.24810.
100
0.10
)0(1
11-
i
i)(1
11-
PMT
3
n
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Have payments but no lump sum FV,so enter 0 for future value.
3 10 100 0N I/YR PV PMT FV
-248.69
INPUTS
OUTPUT
Financial Calculator Solution
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Spreadsheet Solution
Use the PV function: see spreadsheet.
= PV(Rate, Nper, Pmt, Fv)
= PV(0.10, 3, 100, 0) = -248.69
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Find the FV and PV if the
annuity were an annuity due.
100 100
0 1 2 310%
100
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PV and FV of Annuity Due
vs. Ordinary Annuity
PV of annuity due:
= (PV of ordinary annuity) (1+i)
= (248.69) (1+ 0.10) = 273.56
FV of annuity due:
= (FV of ordinary annuity) (1+i)
= (331.00) (1+ 0.10) = 364.1
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3 10 100 0
-273.55
N I/YR PV PMT FV
Switch from End to Begin.Then enter variables to find PVA
3=
$273.55.
Then enter PV = 0 and press FV to findFV = $364.10.
INPUTS
OUTPUT
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Excel Function for Annuities Due
Change the formula to:
=PV(10%,3,-100,0,1)
The fourth term, 0, tells the functionthere are no other cash flows. Thefifth term tells the function that it is an
annuity due. A similar function givesthe future value of an annuity due:
=FV(10%,3,-100,0,1)
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What is the PV of this unevencashflow stream?
0
100
1
300
2
300
310%
-50
4
90.91
247.93
225.39-34.15
530.08 = PV
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Financial calculator: HP10BII
Clear all: Orange Shift key, then C Allkey (in orange).
Enter number, then hit the CFj key.
Repeat for all cash flows, in order.
To find NPV: Enter interest rate (I/YR).Then Orange Shift key, then NPV key (inorange).
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Financial calculator: HP10BII (more)
To see current cash flow in list, hit RCLCFj CFj
To see previous CF, hit RCL CFj
To see subseqent CF, hit RCL CFj +
To see CF 0-9, hit RCL CFj 1 (to see CF1). To see CF 10-14, hit RCL CFj .
(period) 1 (to see CF 11).
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Input in CFLO register:
CF0 = 0
CF1 = 100
CF2 = 300
CF3 = 300CF4 = -50
Enter I = 10%, then press NPV button
to get NPV = 530.09. (Here NPV = PV.)
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Spreadsheet Solution
Excel Formula in cell A3:
=NPV(10%,B2:E2)
A B C D E
1 0 1 2 3 42 100 300 300 -50
3 530.09
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Nominal rate (iNom)
Stated in contracts, and quoted by banks andbrokers.
Not used in calculations or shown on time
lines Periods per year (m) must be given. Examples:
8%; Quarterly 8%, Daily interest (365 days)
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Periodic rate (iPer)
iPer= iNom/m, where m is number ofcompounding periods per year. m = 4 forquarterly, 12 for monthly, and 360 or 365 for
daily compounding. Used in calculations, shown on time lines. Examples:
8% quarterly: iPer = 8%/4 = 2%.
8% daily (365): iPer = 8%/365 =0.021918%.
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Will the FV of a lump sum belarger or smaller if we compound
more often, holding the stated I%constant? Why?
LARGER! If compounding is morefrequent than once a year--forexample, semiannually, quarterly,
or daily--interest is earned on interestmore often.
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FV Formula with Different Compounding Periods (e.g.,$100 at a 12% nominal rate with semiannualcompounding for 5 years)
= $100(1.06)10 = $179.08.
FV = PV 1 .+i
m
nNom
mn
FV = $100 1 +0.12
25S
2x5
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FV of $100 at a 12% nominal
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FV of $100 at a 12% nominalrate for 5 years with different
compoundingFV(Annual)= $100(1.12)5 = $176.23.
FV(Semiannual)= $100(1.06)10=$179.08.
FV(Quarterly)= $100(1.03)20 = $180.61.FV(Monthly)= $100(1.01)60 = $181.67.
FV(Daily) = $100(1+(0.12/365))(5x365)
= $182.19.
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Effective Annual Rate (EAR =EFF%)
The EAR is the annual rate which causes PV togrow to the same FV as under multi-periodcompounding Example: Invest $1 for one year at12%, semiannual:
FV = PV(1 + iNom/m)m
FV = $1 (1.06)2 = 1.1236.
EFF% = 12.36%, because $1 invested for oneyear at 12% semiannual compounding wouldgrow to the same value as $1 invested for oneyear at 12.36% annual compounding.
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An investment with monthlypayments is different from one withquarterly payments. Must put on
EFF% basis to compare rates ofreturn. Use EFF% only forcomparisons.
Banks say interest paid daily.Same as compounded daily.
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How do we find EFF% for a nominal rate of12%, compounded semiannually?
EFF% = - 1(1 + )iNommm
= - 1.0(1 + )0.122
2
= (1.06)2
- 1.0= 0.1236 = 12.36%.
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Finding EFF with HP10BII
Type in nominal rate, then Orange Shiftkey, then NOM% key (in orange).
Type in number of periods, then Orange
Shift key, then P/YR key (in orange).
To find effective rate, hit Orange Shift key,then EFF% key (in orange).
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EAR (or EFF%) for a Nominal
Rate of of 12%
EARAnnual = 12%.
EARQ = (1 + 0.12/4)4 - 1 = 12.55%.
EARM = (1 + 0.12/12)12 - 1 = 12.68%.
EARD(365) = (1 + 0.12/365)365 - 1 = 12.75%.
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Can the effective rate ever be
equal to the nominal rate?
Yes, but only if annual compounding isused, i.e., if m = 1.
If m > 1, EFF% will always be greater
than the nominal rate.
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When is each rate used?
iNom: Written into contracts, quoted
by banks and brokers. Notused in calculations or shownon time lines.
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iPer: Used in calculations, shown ontime lines.
If iNom has annual compounding,then iPer = iNom/1 = iNom.
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(Used for calculations if and only ifdealing with annuities wherepayments dont match interestcompounding periods.)
EAR = EFF%: Used to comparereturns on investmentswith different payments
per year.
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Amortization
Construct an amortization schedule
for a $1,000, 10% annual rate loanwith 3 equal payments.
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Step 1: Find the requiredpayments.
PMT PMTPMT
0 1 2 310%
-1,000
3 10 -1000 0INPUTS
OUTPUTN I/YR PV FVPMT
402.11
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Step 2: Find interest charge forYear 1.
INTt = Beg balt (i)INT1 = $1,000(0.10) = $100.
Step 3: Find repayment of principal inYear 1.
Repmt = PMT - INT= $402.11 - $100= $302.11.
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Step 4: Find ending balance after
Year 1.
End bal = Beg bal - Repmt
= $1,000 - $302.11 = $697.89.
Repeat these steps for Years 2 and 3to complete the amortization table.
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Interest declines. Tax implications.
BEG PRIN ENDYR BAL PMT INT PMT BAL
1 $1,000 $402 $100 $302 $698
2 698 402 70 332 3663 366 402 37 366 0
TOT 1,206.34 206.34 1,000
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$
0 1 2 3
402.11Interest
302.11
Level payments. Interest declines becauseoutstanding balance declines. Lender earns10% on loan outstanding, which is falling.
Principal Payments
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Amortization tables are widely used--for home mortgages, auto loans,business loans, retirement plans,
and so on. They are very important! Financial calculators (and
spreadsheets) are great for setting
up amortization tables.
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On January 1 you deposit $100 in anaccount that pays a nominal interestrate of11.33463%, with daily
compounding (365 days).How much will you have on October1, or after 9 months (273 days)?(Days given.)
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iPer = 11.33463%/365
= 0.031054% per day.
FV=?
0 1 2 273
0.031054%
-100
Note: % in calculator, decimal in equation.
FV = $100 1.00031054= $100 1.08846 = $108.85.273273
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273 -100 0
108.85
INPUTS
OUTPUT
N I/YR PV FVPMT
iPer = iNom/m
= 11.33463/365= 0.031054% per day.
Enter i in one step.Leave data in calculator.
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Whats the value at the end ofYear 3 of the following CF stream
if the quoted interest rate is 10%,compounded semiannually?
0 1
100
2 35%
4 5 6 6-mos.periods
100 100
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Payments occur annually, butcompounding occurs each 6 months.
So we cant use normal annuityvaluation techniques.
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1st Method: Compound Each CF
0 1
100
2 35%
4 5 6
100 100.00110.25121.55331.80
FVA3 = $100(1.05)4 + $100(1.05)2 + $100
= $331.80.
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Could you find the FV with afinancial calculator?
Yes, by following these steps:
a. Find the EAR for the quoted rate:
2nd Method: Treat as an Annuity
EAR = (1 + ) - 1 = 10.25%.0.1022
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3 10.25 0 -100INPUTS
OUTPUT
N I/YR PV FVPMT
331.80
b. Use EAR = 10.25% as the annual ratein your calculator:
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Whats the PV of this stream?
0
100
15%
2 3
100 100
90.70
82.2774.62247.59
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You are offered a note which pays$1,000 in 15 months (or 456 days)for $850. You have $850 in a bankwhich pays a 6.76649% nominal rate,
with 365 daily compounding, whichis a daily rate of 0.018538% and anEAR of 7.0%. You plan to leave themoney in the bank if you dont buy
the note. The note is riskless.Should you buy it?
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3 Ways to Solve:
1. Greatest future wealth: FV2. Greatest wealth today: PV3. Highest rate of return: Highest EFF%
iPer= 0.018538% per day.
1,000
0 365 456 days
-850
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1. Greatest Future Wealth
Find FV of $850 left in bank for15 months and compare withnotes FV = $1,000.
FVBank = $850(1.00018538)456
= $924.97 in bank.
Buy the note: $1,000 > $924.97.
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456 -850 0
924.97
INPUTS
OUTPUT
N I/YR PV FVPMT
Calculator Solution to FV:
iPer = iNom/m= 6.76649%/365= 0.018538% per day.
Enter iPer in one step.
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2. Greatest Present Wealth
Find PV of note, and comparewith its $850 cost:
PV = $1,000/(1.00018538)456= $918.95.
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456 .018538 0 1000
-918.95
INPUTS
OUTPUT
N I/YR PV FVPMT
6.76649/365 =
PV of note is greater than its $850cost, so buy the note. Raises yourwealth.
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Find the EFF% on note andcompare with 7.0% bank pays,which is youropportunity cost of
capital:
FVn = PV(1 + i)n
$1,000 = $850(1 + i)456
Now we must solve fori.
3. Rate of Return
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456 -850 0 1000
0.035646%per day
INPUTS
OUTPUT
N I/YR PV FVPMT
Convert % to decimal:
Decimal = 0.035646/100 = 0.00035646.
EAR = EFF% = (1.00035646)365 - 1= 13.89%.
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Using interest conversion:
P/YR = 365NOM% = 0.035646(365) = 13.01
EFF% = 13.89
Since 13.89% > 7.0% opportunity cost,buy the note.
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Brain Teaser Home work (submit
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Brain Teaser Home work (submitto Jernej)
Melissa wants to save money to meet two objectives.First, she would like to be able to retire 20 years from now and
have a retirement income of $30,000 per year for 30 years.
Second, she would like to purchase a car 5 years from now at an
estimated cost of $20,000. She can afford to save only $6,000 per
year for the first 10 years. Melissa expects to earn 8% per year
from investments over the next 50 years. What must be her
minimum annual savings from years 11 through 20 to meet herobjectives?