Chapter 04 Study Questions

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Chapter 004 Discounted Cash Flow Valuation

1. The interest rate charged per period multiplied by the number of periods per year is called the _____ rate. a. effective annual
b. annual percentage
c. periodic interest
d. compound interest
e. daily interest
Answer: b
Difficulty level: Easy
Topic: ANNUAL PERCENTAGE RATE

2. You are comparing two investment options. The cost to invest in either option is the same today. Both options will provide you with $20,000 of income. Option A pays five annual payments starting with $8,000 the first year followed by four annual payments of $3,000 each. Option B pays five annual payments of $4,000 each. Which one of the following statements is correct given these two investment options? a. Both options are of equal value given that they both provide $20,000 of income. b. Option A is the better choice of the two given any positive rate of return. c. Option B has a higher present value than option A given a positive rate of return. d. Option B has a lower future value at year 5 than option A given a zero rate of return. e. Option A is preferable because it is an annuity due.

Answer: b
Difficulty level: Medium
Topic: UNEVEN CASH FLOWS AND PRESENT VALUE

3. You are comparing two annuities with equal present values. The applicable discount rate is 7.5 percent. One annuity pays $5,000 on the first day of each year for twenty years. How much does the second annuity pay each year for twenty years if it pays at the end of each year? a. $4,651

b. $5,075
c. $5,000
d. $5,375
e. $5,405
Answer: d
Feedback:
Feedback: Because each payment is received one year later, then the cash flow has to equal: Feedback: $5,000 x (1 + .075) = $5,375
Difficulty level: Medium
Topic: ORDINARY ANNUITY VERSUS ANNUITY DUE

4. Martha receives $100 on the first of each month. Stewart receives $100 on the last day of each month. Both Martha and Stewart will receive payments for five years. At an 8% discount rate, what is the difference in the present value of these two sets of payments? a. $32.88

b. $40.00
c. $99.01
d. $108.00
e. $112.50
Answer: a
Feedback:
Difficulty level: Medium
Topic: ORDINARY ANNUITY VERSUS ANNUITY DUE

5. You borrow $149,000 to buy a house. The mortgage rate is 7.5% and the loan period is 30 years. Payments are made monthly. If you pay for the house according to the loan agreement, how much total interest will you pay? a. $138,086

b. $218,161
c. $226,059
d. $287,086
e. $375,059
Answer: c
Feedback:
Feedback: Total interest = ($1,041.83 x 30 x 12) - $149,000 = $226,058.80 = $226,059 (rounded) Difficulty level: Medium
Topic: ORDINARY ANNUITY PAYMENTS AND COST OF INTEREST
6. You estimate that you will have $24,500 in student loans by the time you graduate. The interest rate is 6.5 percent. If you want to have this debt paid in full within five years, how much must you pay each month? a. $471.30

b. $473.65
c. $476.79
d. $479.37
e. $480.40
Answer: d
Feedback:
Difficulty level: Medium
Topic: ORDINARY ANNUITY PAYMENTS AND PRESENT VALUE

7. Your car dealer is willing to lease you a new car for $299 a month for 60 months. Payments are due on the first day of each month starting with the day you sign the lease contract. If your cost of money is 4.9 percent, what is the current value of the lease? a. $15,882.75

b. $15,906.14
c. $15,947.61
d. $16,235.42
e. $16,289.54
Answer: c
Feedback:
Difficulty level: Medium
Topic: ANNUITY DUE PAYMENTS AND PRESENT VALUE

8. Winston Enterprises would like to buy some additional land and build a new factory. The anticipated total cost is $136 million. The owner of the firm is quite conservative and will only do this when the company has sufficient funds to pay cash for the entire expansion project. Management has decided to save $450,000 a month for this purpose. The firm earns 6% compounded monthly on the funds it saves. How long does the company have to wait before expanding its operations? a. 184.61 months

b....
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