Chapter 7 Rate of Return Analysis: Single Alternative

Solutions to Problems 7.1 A rate of return of 100% means that the entire investment is lost. 7.2 Balance = 10,000(1.50) 5(2638) = $1810 7.3 (a) Annual payment = [10,000/4 + 10,000(0.10)] = $3500 (b) A = 10,000(A/P,10%,4) = 10,000(0.31547) = $3154.70 7.4 Monthly pmt = 100,000(A/P,0.5%,360) = 100,000(0.00600) = $600 Balloon pmt = 100,000(F/P,0.5%,60) 600(F/A,0.5%,60) = 100,000(1.3489) 600(69.7700) = $93,028 7.5 0 = -150,000 + (33,000 27,000)(P/A,i,30) (P/A,i,30) = 25.0000 i = 1.2% per month (interpolation or Excel) 0 = -400,000 + [(10(200) + 25(50) +70(100)](P/A,i%,48) (P/A,i%,48) = 39.0240 Solve by trial and error or Excel i = 0.88% per month (Excel) 7.7 0 = -30,000 + (27,000 18,000)(P/A,i%,5) + 4000(P/F,i%,5) Solve by trial and error or Excel i = 17.9 % (Excel)

7.6

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7.8 0 = -130,000 49,000(P/A,i%,8) + 78,000(P/A,i%,8) + 1000(P/G,i%,8) + 23,000(P/F,i%,8) Solve by trial and error or Excel i = 19.2% (Excel) 7.9 (100,000 10,000)i = 10,000 i = 11.1% 7.10 0 = -10 4(P/A,i%,3) - 3(P/A,i%,3)(P/F,i%,3) + 2(P/F,i%,1) + 3(P/F,i%,2) + 9(P/A,i%,4)(P/F,i%,2) Solve by trial and error or Excel i = 14.6% (Excel) 7.11 (a) 0 = -(220,000 + 15,000 + 76,000)(A/P,i%,36) + 12,000(2.00 1.05) + 2000 + 100,000(A/F,i%,36) 0 = -(311,000)(A/P,i%,36) + 13,400 + 100,000(A/F,i%,36) Solve by trial and error or Excel i = 3.3% per month (Excel) (b) Nominal per year = 3.3(12) = 39.6% per year Effective per year = (1 + 0.396/12)12 1 = 47.6% per year 7.12 0 = -40 28(P/A, i%,3) + 5(P/F,i%,4) + 15(P/F,i%,5) + 30(P/A,i%,5)(P/F,i%,5 Solve by trial and error or Excel i = 5.2% per year (Excel) 7.13 (a) 0 = -41,000,000 + 55,000(60)(P/A,i%,30) Solve by trial and error or Excel i = 7.0% per year (Excel) (b) 0 = -41,000,000 + [55,000(60) + 12,000(90)](P/A,i%,30) 0 = -41,000,000 + (4,380,000)(P/A,i%,30) Solve by trial and error or Excel i = 10.1% per year (Excel)

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7.14

Cash flow tabulation is below. Note that both series end at the end of month 11. Month 0 1 2 3 4 5 6 7 8 9 10 11 M3Turbo M3Power -7.99 -(14.99 + 10.99) -7.99 0 -7.99 -10.99 -7.99 0 -7.99 -10.99 -7.99 0 -7.99 -10.99 -7.99 0 -7.99 -10.99 -7.99 0 -7.99 -10.99 -7.99 0 Difference -17.99 +7.99 - 3.00 + 7.99 - 3.00 +7.99 -3.00 +7.99 -3.00 +7.99 - 3.00 +7.99

(a) 0 = -17.99 + 7.99(P/F,i%,1) 3.00(P/F,i%,2) + 7.99(P/F,i%,3) 3.00(P/F,i%,4) + ... + 7.99(P/F,i%,9) 3.00(P/F,i%,10) + 7.99(P/F,i%,11) Solve by trial and error or Excel i = 12.2% per month (Excel) (b) Nominal per year = 12.2(12) = 146.4% per year Effective = (1 + 0.122)12 1 = 298% per year 7.15 0 = -90,000(A/P,i%,24) 0.014(6000) + 0.015(6000)(150) 0 = -90,000(A/P,i%,24) + 13,416 Solve by trial and error or Excel i = 14.3% per month (Excel) 7.16 0 = -110,000 + 4800(P/A,i%,60) (P/A,i%,60) = 22.9167 Use tables or Excel i = 3.93% per month (Excel)

7.17 0 = -210 150(P/F,i%,1) + [100(P/A,i%,4) + 60(P/G,i%,4)](P/F,i%,1) Solve by trial and error or Excel i = 24.7% per year (Excel)
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7.18 0 = -450,000 [50,000(P/A,i%,5) 10,000(P/G,i%,5)] + 10,000(P/A,i%,5) +10,000(P/G,i%,5) + 80,000(P/A,i%,7)(P/F,i%,5) Solve by trial and error or Excel i = 2.36% per quarter (Excel) = 2.36(4) = 9.44% per year (nominal) 7.19 0 = -950,000 + [450,000(P/A,i%,5) + 50,000(P/G,i%,5)] )(P/F,i%,10) Solve by trial and error or Excel i = 8.45% per year (Excel) 7.20 10,000,000(F/P,i%,4)(i) = 100(10,000) Solve by trial and error i = 7.49% 7.21 [(5,000,000 200,000)(F/P, i%,5) 200,000(F/A,i%,5)](i) = 1,000,000 Solve by trial and error i = 13.2% 7.22 In a conventional cash flow series, there is only one sign change in the net cash flow. A nonconventional series has more than one sign change. 7.23 Descartes rule uses net cash flows while Norstroms criterion is based on cumulative cash flows. 7.24 (a) three; (b) one; (c) five

7.25 Tabulate net cash flows and cumulative cash flows. Quarter 0 1 2 3 4 5 6 7 8 Expenses -20 -20 -10 -10 -10 -10 -15 -12 -15 Revenue 0 5 10 25 26 20 17 15 2 Net Cash Flow -20 -15 0 15 16 10 2 3 -13 Cumulative -20 -35 -35 -20 -4 +6 +8 +11 -2

(a) From net cash flow column, there are two possible i* values
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(b) In cumulative cash flow column, sign starts negative but it changes twice. Therefore, Norstroms criterion is not satisfied. Thus, there may be up to two i* values. However, in this case, since the cumulative cash flow is negative, there is no positive rate of return value. 7.26 (a) There are two sign changes, indicating that there may be two real-number rate of return values. (b) 0 = -30,000 + 20,000(P/F,i%,1) + 15,000(P/F,i%,2) - 2000(P/F,i%,3) Solve by trial and error or Excel i = 7.43% per year (Excel) 7.27 (a) There are three sign changes, Therefore, there are three possible i* values. (b) 0 = -17,000 + 20,000(P/F,i%,1) - 5000(P/F,i%,2) + 8000(P/F,i%,3) Solve by trial and error or Excel i = 24.4% per year (Excel) 7.28 The net cash flow and cumulative cash flow are shown below. Year 0 1 2 3 4 Expenses, $ -33,000 -15,000 -40,000 -20,000 -13,000 Savings, $ 0 18,000 38,000 55,000 12,000 Net Cash Flow, $ -33,000 +3,000 -2000 +35,000 -1000 Cumulative, $ -33,000 -30,000 -32,000 +3000 +2000

(a) There are four sign changes in net cash flow, so, there are four possible i* values. (b) Cumulative cash flow starts negative and changes only once. Therefore, there is only one positive, real solution. 0 = -33,000 + 3000(P/F,i%,1) - 2000(P/F,i%,2) + 35,000(P/F,i%,3) -1000(P/F,i%,4) Solve by trial and error or Excel i = 2.1% per year (Excel) 7.29 Cumulative cash flow starts negative and changes only once, so, there is only one positive real solution. 0 = -5000 + 4000(P/F,i%,) + 20,000(P/F,i%,4) - 15,000(P/F,i%,5) Solve by trial and error or Excel i = 44.1% per year (Excel)
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7.30

Reinvestment rate refers to the interest rate that is used for funds that are released from a project before the project is over. Tabulate net cash flow and cumulative cash flow values. Year 1 2 3 4 5 6 7 8 9 10 Cash Flow, $ -5000 -5000 -5000 -5000 -5000 -5000 +9000 -5000 -5000 -5000 + 50,000 Cumulative, $ -5,000 -10,000 -15,000 -20,000 -25,000 -30,000 -21,000 -26,000 -31,000 +14,000

7.31

(a) There are three changes in sign in the net cash flow series, so there are three possible ROR values. However, according to Norstroms criterion regarding cumulative cash flow, there is only one ROR value. (b) Move all cash flows to year 10. 0 = -5000(F/A,i,10) + 14,000(F/P,i,3) + 50,000 Solve for i by trial and error or Excel i = 6.3% (c) (Excel)

If Equation [7.6] is applied, all F values are negative except the last one. Therefore, i is used in all equations. The composite ROR (i) is the same as the internal ROR value (i*) of 6.3% per year.

7.32 First, calculate the cumulative CF. Year 0 1 2 3 4 Cash Flow, $1000 -65 30 84 -10 -12 Cumulative CF, $1000 -65 -35 +49 +39 +27

(a) The cumulative cash flow starts out negatively and changes sign only once,
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indicating there is only one root to the equation. 0 = -65 + 30(P/F,i,1) + 84(P/F,i,2) 10(P/F,i,3) 12(P/F,i,4) Solve for i by trial and error or Excel. i = 28.6% per year (Excel)

(b) Apply net reinvestment procedure because reinvestment rate, c, is not equal to i* rate of 28.6% per year: F0 = -65 F1 = -65(1 + i) + 30 F2 = F1(1 + i) + 84 F3 = F2(1 + 0.15) -10 F4 = F3(1 + 0.15) 12 Set F4 = 0 and solve for i by trial and error: F1 = -65 65i + 30 F2 = (-65 65i + 30)(1 + i) + 84 = -65 - 65i + 30 65i 65i2 + 30i +84 = -65i2 100i + 49 F3 = (-65i2 100i + 49)(1.15) 10 = -74.8 i2 115i + 56.4 10 = -74.8 i2 115i + 46.4 F4 = (-74.8 i2 115i + 46.4)(1.15) 12 = -86 i2 132.3i + 53.3 12 = -86 i2 132.3i + 41.3 Solve by quadratic equation, trial and error, or spreadsheet. i = 26.6% per year (Excel) 7.33 Apply net reinvestment procedure. F0 = 3000 F1 = 3000(1 + 0.14) - 2000 = 1420 F2 = 1420(1 + 0.14) + 1000 = 2618.80 F3 = 2618.80(1 + 0.14) 6000 = -3014.57
Chapter 7

F0 < 0; use i F1 < 0; use i F2 > 0; use c(F2 must be > 0 because last two terms are negative) F3 > 0; use c(F3 must be > 0 because last term is negative)

F0 > 0; use c F1 > 0; use c F2 > 0; use c F3 < 0; use i

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F4 = -3014.57(1 + i) + 3800 Set F4 = 0 and solve for i. 0 = -3014.57(1 + i) + 3800 i = 26.1% 7.34 Apply net reinvestment procedure because reinvestment rate, c, is not equal to i* rate of 44.1% per year (from problem 7.29): F0 = -5000 F0 < 0; use i F1 = -5000(1 + i) + 4000 = -5000 5000i + 4000 = -1000 5000i F1 < 0; use i F2 = (-1000 5000i)(1 + i) = -1000 5000i 1000i 5000i2 = -1000 6000i 5000i2 F2 < 0; use i 2 F3 = (-1000 6000i 5000i )(1 + i) = -1000 6000i 5000i2 1000i 6000i2 5000i3 = -1000 7000i 11,000i2 5000i3 F3 < 0; use i 2 3 F4 = (-1000 7000i 11,000i 5000i )(1 + i) + 20,000 = 19,000 8000i 18,000i2 16,000i3 - 5,000i4 F4 > 0; use c 2 3 4 F5 = (19,000 8000i 18,000i 16,000i - 5,000i )(1.15) 15,000 = 6850 9200i 20,700i2 18,400i3 - 5,750i4 Set F5 = 0 and solve for i by trial and error or spreadsheet. i = 35.7% per year 7.35 (a) i = 25,000(0.06)/2 = $750 every six months (b) The bond is due in 22 years, so, n = 22(2) = 44 7.36 i = 10,000(0.08)/4 = $200 per quarter 0 = -9200 + 200(P/A,i%,28) + 10,000(P/F,i%,28) Solve for i by trial and error or Excel i = 2.4% per quarter (Excel) Nominal i/yr = 2.4(4) = 9.6% per year

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7.37 (a) i = 5,000,000(0.06)/4 = $75,000 per quarter After brokerage fees, the City got $4,500,000. However, before brokerage fees, the ROR equation from the Citys standpoint is: 0 = 4,600,000 75,000(P/A,i%,120) - 5,000,000(P/F,i%,120) Solve for i by trial and error or Excel i = 1.65% per quarter (Excel)

(b) Nominal i per year = 1.65(4) = 6.6% per year Effective i per year = (1 + 0.066/4)4 1 = 6.77% per year 7.38 i = 5000(0.04)/2 = $100 per six months 0 = -4100 + 100(P/A,i%,22) + 5,000(P/F,i%,22) Solve for i by trial and error or Excel i = 3.15% per six months 7.39 (Excel)

0 = -9250 + 50,000(P/F,i%,18) (P/F,i%,18) = 0.1850 Solve directly or use Excel i = 9.83% per year (Excel)

7.40

i = 5000(0.10)/2 = $250 per six months 0 = -5000 + 250(P/A,i%,8) + 5,500(P/F,i%,8) Solve for i by trial and error or Excel i = 6.0% per six months (Excel)

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7.41 (a) i = 10,000,000(0.12)/4 = $300,000 per quarter By spending $11 million, the company will save $300,000 every three months for 25 years and will save $10,000,000 at that time. The ROR will be: 0 = -11,000,000 + 300,000(P/A,i%,100) + 10,000,000(P/F,i%,100) i = 2.71% per quarter (Excel) (b) Nominal i per year = 2.71(4) = 10.84% per year FE Review Solutions 7.42 Answer is (d) 7.43 Answer is (c) 7.44 0 = 1,000,000 20,000(P/A,i,24) 1,000,000(P/F,i,24) Solve for i by trial and error or Excel i = 2% per month (Excel) Answer is (b) Answer is (b) 0 = -60,000 + 10,000(P/A,i,10) (P/A,i,10) = 6.0000 From tables, i is between 10% and 11% Answer is (a) 7.47 Answer is (c) 7.48 0 = -50,000 + (7500 5000)(P/A,i,24) + 11,000(P/F,i,24) Solve for i by trial and error or Excel i = 2.6% per month (Excel) Answer is (a) 7.49 0 = -100,000 + (10,000/i) (P/F,i,4) Solve for i by trial and error or Excel i = 9.99%% per year (Excel) Answer is (a)
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7.45 7.46

7.50 i = 4500/50,000 = 9% per year Answer is (c) 7.51 Answer is (d) 7.52 250 = (10,000)(b)/2 b = 5% per year payable semiannually Answer is (c) 7.53 Since the bond is purchased for its face value, the interest rate received by the purchaser is the bond interest rate of 8% per year payable quarterly. This is a nominal interest rate per year. The effective rate per quarter is 2% Answer is (a) 7.54 Answer is (a) 7.55 Since the bond was purchased for its face value, the interest rate received by the purchaser is the bond interest rate of 10% per year payable quarterly. Answers (a) and (b) are correct. Therefore, the best answer is (c).

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Extended Exercise 1 Solution Solution by hand 1. Charles payment = 5000(A/P,10%,3) = 5000(0.402115) = $2010.57 Beginning unrecovered Year balance balance (1) (2) 0 1 $-5000.00 2 -3489.43 3 -1827.80 Total amount Interest (3) = 0.1(2) $-500.00 -348.94 -182.78 $-1031.72 owed (4)=(2)+(3) $-5000.00 -5500.00 -3838.37 -2010.58 (5) $2010.57 2010.57 2010.57 $6031.71 (by formula) Ending unrecovered Payment (6)=(4)+(5) $-5000.00 -3489.43 -1827.80 -0.01* *round-off Jeremys payment = $2166.67 Beginning unrecovered balance Total amount Ending unrecovered Payment (6)=(4)+(5) $-5000.00 -3333.33 -1666.67 0.00

Year Interest owed balance (1) (2) (3) = 0.1(5000) (4)=(2)+(3) (5) 0 $-5000.00 1 $-5000.00 $-500 -5500.00 $2166.67 2 -3333.33 -500 -3833.33 2166.67 3 -1666.67 -500 -2166.67 2166.67 $-1500 $6500.01

Plot year versus column (4) in the form of Figure 71 in the text. 2. Interest Total Solution by computer 1. The following spreadsheets have the same information as the two tables above. The x-y scatter charts are year (column A) versus total owed (column B). (The indicator lines and curves were drawn separately.)
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More for Jeremy Charles Jeremy $1500.00 $1031.72 $468.28 6500.01 6031.71 468.30

2. The second spreadsheet shows that $468.28 more is paid by Jeremy.

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Chapter 7

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Extended Exercise 2 Solution

The spreadsheet above summarizes all answers in $1000. Some cells must be changed to obtain the rate of return values shown in column H. These are described below. 1. Use IRR function in year 4 and add $225 in cell C8 for year 4. i* (sell after 4) = 38.09% With no sale, IRR results in: i* (no sale after 4) = 3.04% 2. Use IRR function with $60 added into cell C11 for year 7. i* (sell after 7) = 17.74% i* (no sale after 7) = 10.95 3. i* (no sale after 10) = 4.84%

4. Use IRR function with $25 added into cell C14 for year 10. i* (charity after 10) = 9.5%
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Case Study Solution

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Chapter 7

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