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Problems

7-1 A woman went to the Beneficla1Loan Company and borrowed $3000 She must pay $1 19 67
at the end of each month for the next thuty months
11
a. Calculate the nominal annual interest rate she 1s paylng to within *O 15%
b. What effective annual Interest rate 1s she paymg?

1'

7-2 For the diagram shown, compute the interest rate to within %%.

7-3 Helen is buying a $12,375 automobile with a $3000 down payment, followed by 36 monthly
payments of $325 each. The down payment is paid immediately, and the monthly payments are due
at the end of each month. What nominal annual interest rate is Helen paying? What effective interest
rate? (Answers: 15%; 16.08%)
7-4 Consider the following cash flow:
Year
0
I

2
3
4

Cmhflow
-$500
+200
+I50
+I00
+so

Compute the rate of return represented by the cash flow.

7-5
benefits.

For the diagram below, compute the interest rate at which the costs are equivalent to the

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9-L

Chapter 7 Rate Of Return Analysis

a $5 sales commission). What nominal annual rate of retum would you receive if you purchased the
bond now and held it to maturity twenty years hence? ( A w e r : 6.6%)

7-1 1 One aspect of obtaining a college education is the prospect of improved future earnings,
compared to non-college graduates. Sharon Shay estimates that a college education has a $28,000
equivalent cost at graduation. She believes the benefits of her education will occur throughout forty
years of employment. She thinks she will have a $3000-per-year higher income during the fust ten
years out of college, compared to a non-college graduate. During the subsequent ten years, she projects
an annual income that is $6000-per-year higher. During the last twenty years of employment, she
estimates an annual salary that is $12,000 above the level of the non-college graduate. Assuming her
estimates are correct, what rate of return will she receive as a result of her investment in a college
education?
7-12 An investor purchased a one-acre lot on the outskirts of a city for $9000 cash. Each year he
paid $80 of property taxes. At the end of four years, he sold the lot. After deducting his selling
expenses, the investor received $15,000. What rate of return did he receive on his investment?
(Answer: 12.92%)
7-1 3 A popular reader's digest offers a lifetime subscription to the magazine for $200. Such a
subscription may be given as a gift to an infant at birth (the parents can read it in those early years),
or taken out by an individual for himself. Normally, the magazine costs $12.90 per year.
Knowledgeable people say it probably will continue indefmitely at this $12.90 rate. What rate of
return would be obtained if a life subscription were purchased for an infant, rather than paying $ 12.90
per year beginning immediately? You may make any reasonable assumptions, but the compound
interest factors must be correctly used.
7-14 On April 2,1988, an engineer buys a $1000 bond of an American airline for $875. The bond
pays 6% on its principal amount of $1000, half in each of its April 1 and October 1 semi-annual
payments; it will repay the $1000 principal sum on October 1,2001. What nominal rate of return wiil
the engineer receive fi-om the bond if he holds it to its maturity (on October 1, 200 I)?
(Answer: 7.5%)
7-15 The cash price of a machine tool is $3500. The dealer is willing to accept a $1200 down
payment and 24 end-of-month monthly payments ofS110 each. At what effective interest rate are these
terms equivalent? (Annver: 14.4%)
7-16 A local bank makes automobile loans. It charges 4% per year in the following manner: if
$3600 is borrowed to be repaid over a three-year period, the bank interest charge is $3600 x 0.04 x
3 years = $432. The bank deducts the $432 of interest from the $3600 loan and gives the customer
$3 168 in cash. The customer must repay the loan by paying 'h6 of $3600, or $100, at the end of each
month for 36 months. What nominal annual interest rate is the bank actually charging for this loan?
7-1 7 Upon graduation every engineer must decide whether or not to go on to graduate school.
Estimate the costs of going full time to the university to obtain a Master of Science degree. Then
estimate the resulting costs and benefits. Combine the various consequences into a cash flow table and
compute the rate of retum. Non-fmancial benefits are probably relevant here too.

Problems

265

is to choose one of two alternatives:


Alternative 1: $2000 cash.
Alternat~ve2 $150 cash now plus $100 per month for twenty months beglnnmg
the fmt day of next month.

a. At what rate of return are the two altematlves equivalent?


b. If Frank th~nksthe rate of return in a is too low, which alternative should he select?
, pay $35
7-19 A man buys a table saw at a local store for $175 He may e~therpay cash for ~ tor
now and $12 64 a month for twelve months beglnnmg thirty days hence If the man chooses the tune
payment plan, what 1s the nomlnal annual mterest rate he will be charged? (Answer 15%)
I

j
r

7-20 An investment of $5000 in Biotech common stock proved to be very profitable. At the end
of three years the stock was sold for $25,000. What was the rate of return on the investment?
7-21 A man owns a corner lot He must dec~dewhlch of several altematlves to select In trying to
obtam a desirable return on h ~ mvestment
s
After much study and calculat~on,he dec~desthat the two
best alternat~vesare

First cost
Annual property taxes
Amual income
Life of building, in years
Salvage value

Build
gas station
$80,000
3,000
11,000
20
0

Build so$
ice cream stand

$120,000
5,000
16,000
20
0

If the owner wants a mmunum attractwe rate of return on his Investment of 6%. whlch of the two
alternatives would you recommend to hlm?
!

7-22

Two alternatlves are as follows.


Year

0
1

2
3

A
-32000
1800
+800
+goo

B
-52800
+I100
+I100
+I 100

If 5% 1s cons~deredthe minunum attractive rate of return, which alternative should be selected?

7-23 The Southern GUN Copper Company operates a large mlne m a South Amer~cancountry
A legislator m the Nat~onalAssembly s a ~ dIn a speech that most of the capital for the mmlng
operatlon was prov~dedby loans from the World Bank,m fact, Southern GUN has only $500,000 of
~ t own
s
money actually mvested m the property The cash flow for the mlne 1s

Chapter 7 Rate Of Return Analysis

Year
0
1

2
3
4
5
6
7

Cashjrow
$0.5 million investment
3.5 million profit
0.9 million profit
3.9 million profit
8.6 million profit
4.3 million profit
3.1 million profit
6.1 million profit

The legislator divided the $30.4 million total profit by the $0.5 million investment. This produced,
he said, a 6080% rate of return on the investment. Southern GUN claims their actual rate of return
is much lower. They ask you to compute their rate of return.

7-24

Two alternatives are being considered:

, Q>i

First cost
Uniform annual benefit
Useful life, in years

B
$5000

$9200
1850

' <

1750

If the minimum attractive rate of return is 7%, which alternative should be selected?

7-25 pan has decided it is time to purchase a new battery for her car. Her choices are:
Z~PP~
First cost
Guarantee period, in months

f56

Kicko
$90

12

24

Jean believes the batteries can be expected to last only for the guarantee period. She does not want
to invest extra money in a battery unless she can expect a 50% rate of return. If she plans to keep her
present car another two years, which battery should she buy?

e d~agrarnbelow, compute the rate of return on the $3810 mvestment

n =dmty

3810

7-27

Consider the following cash flow:


Year

0
1
2
3

i
i

tC

Cashflow
-$400
0
+200
+150
+loo
+50

Wnte one equation, with I as the only unknown, for the cash flow. In the equatlon you are not
compound mterest factors. (You may use as many other factors
more than two smale
- .payment
wish.) Then solve your equation f i r i.

7-28

Compute the rate of return for the following cash flow to withm %%
Year

29

Cashflow

For the following diagram, compute the rate of retum.

25

use
YOU

168

7-30

Chapter 7 Rate Of Return Analysis


Solve the cash flow below for the rate of return to within 0.5%.
Year

7-31

Cashflow

For the cash flow below, compute the rate of return


Year

7-32

Cashflow

Compute the rate of return for the following cash flow to within 0.5%.
Year

Cash flow

0
1
2
3
4
5

-5640
0
100
200
300
300

(Answer: 9.3Yo)

7-33 Consider two mutually exclusive alternatives:


Year

0
1
2
3
4

-5100
35
35
35
35

-$50.0
16.5
16.5
16.5
16.5

If the minimum attractive rate of return is lo%, which alternative should be selected?

Problems

269

Consider these two mutually exclusive alternatives:


Year
o

1
2
3
4

-353
B
17
17
17
17

-$SO
A
17
17
17
17

At a MARR of lo%, which alternative should be selected? (Annver: A )

7-35 Two mutually exclusive alternatives are being considered. Both have a ten-year useful
life. IF the MARR is go?, which alternative is preferred?
B

Initial cost
Uniform annual benefit

6100.00
19.93

$50.00
11.93

7-36 Two alternatives are being considered:


B

A
Initial cost
Uniform annual benefit
Useful life, in years

$9200
1850
8

$5000
1750
4

Base your computations on a MARR of 7% and an eight-year analysis period. If identical


replacement is assumed, which alternative should be selected?

7-37

Two invesfment opportunities are as follows:

First cost
Uniform annual benefit
End-of-useful-life salvage value
Useful life, in years

$150
25
20
15

$100
22.25
0
10

At the end of ten years, Alt. B is not replaced. Thus, the comparison is 15 years ofA vs. 10 years of
B. If the MARR is lo0?,which alternative should be selected?

7-38 An insurance company is offering to sell an annuity for $20,000 cash. In return they will
guarantee to pay the purchaser 20 annual end-of-year payments, with the fust payment amounting
to $1 100. Subsequent payments will increase at a uniform 10% rate each year (second payment is
$1210; third payment is $133 1, and so on). What rate of return will the purchaser receive if he buys
the annuity?

~ 7 0

7-39

Chapter 7 Rate Of Return Analysis


Consider hvo mutually exclusive alternatives:

Year

If the MARR is 8%. which alternative should be selected?

7-40 A bank proudly announces that they have changed theu Interest computation method to
contmuous compoundmg Now $2000 left m the bank for nme years wlll double to $4000
a.

What nomlnal merest rate, compounded contmuously, are they paymg?

b. What effectlve mterest rate are they paymg?

7-41 Fifteen families live in Willow Canyon. Although several water wells have been drilled,
none has produced water. The residents take turns driving a water truck to a fue hydrant in a nearby
town. They fill the truck with water and then haul it to a storage tank in Willow Canyon. Last year
it cost $3180 in truck fuel and maintenance costs. This year the residents are seriously considering
spending $100,000 to install a pipeline from the nearby town to their storage tank. What rate of return
would the Willow Canyon residents receive on their new water supply pipeline if the pipeline is
considered to last:
a.

forever?

b.

100 years?

c.

50 years?

d. Would you recommend that the pipeline be installed? Explain.

7-42 Compute the rate of return for the following cash flow.
Year

Cashjlow

7-43 Jan purchased 100 shares of Peach Computer stock for $18 per share, plus a $45 brokerage
commission. Every six months she received a 50 cents per share dividend from'peach. At the end of
two years, just after receiving the fourth dividend, she sold the stock for $23 per share, and paid a
$58 brokerage commission from the proceeds. What annual rate of rehlrn did she receive on her
investment?

Problems

271

1 he Diagonal Stamp Co., which sells used postage stamps to collectors, advertises that theu
. ~ g price
e
has increased from $1 to $5 in the last five years. Thus, they say, investors would have
received a 100% rate of return each year if they had purchased stamps from Diagonal.

a.

To check their calculations, compute the annual rate of return.

b.

Why is your computed rate of return less than 100%?

7-45 An mvestor purchased 100 shares of Omega common stock for $9000. He held the stock
for nlne years. For the fmt four years he received annual end-of-year dividends of $800. For the next
four years he received annual dividends of $400. He received no dividend for the n~nthyear. At the
I end of the nmth year he sold hls stock for $6000. What rate of return did he receive on his
investment?
!

7-46 You spend $100 and In return receive two payments of S 1 0 9 4 . 6 k n e at the end of three
years and the other at the end of six years. Calculate the resulting rate of return.

L 747 A mine is for sale for $240,000. It is believed the mine will produce a profit of $65,000 the

fint year, but the profit will decline $5000 a year after that until it becomes zero and the mine is
worthless. What rate of return would this produce for the purchaser of the mine?

7-48

Two mutually exclusive alternat~vesare being considered.


Year

-12500

-56000

+746

+I664

+746

+I664

+746

+I664

If the minimum attractive rate of return is 8%, which alternative should be selected?
Solve the problem by

a. Present worth analysis

b. Annual cash flow analysis


c. Rate of return analysis

7-49 Fred, our cat, just won the local feline lottery to the tune of 3000 cans of "9-Lives" cat food
(assorted flavors). A local grocer offers to take the 3000 cane and in return, supply Fred with 30
cans a month for the next 10 years. What rate of return, in terms of nominal annual rate, will Fred
realize on this deal? (Compute to nearest .01%)

172
7-50

Chapter 7 Rate Of Return Analysis

-3

The following advertisement appeared in the Wall Street Journal on Thursday, F~~~

9,1995.

"There's nothing quiet like the Seville SmartLease. Seville SLS

$0 down, 5599* a month136 months."

capitalized cost of $39,264 for total monthly payments of $21,564.


a 1995 Seville SLS: $43,658 MSRP including destination charge.
insurance extra. Option to purchase at lease end for $27,854. Mileage c
36,000 miles.

a. Set up the cash flows and

6.Determine the interest rate (nominal and effective) for the lease.

7-51 After

I5 years of working for one employer, you transfer to a new job. During

account for your retirement (a fringe benefit), and you contributed a matching amount e

money you take out, but the other half will be lost as far as you are concerned. In
can give up $15,000 today for the sake of getting now the other $15,000. Othenvi
thirty five years more to get the accumulated value of the entire fund. Which al
attractive? Explain your choice.

7-52 A contractor is considering whether to purchase a new machine for his layout
to lease one. Purchasing a new machine will cost $12,000 with a salvage value of $12
of the machine's useful life of 8 years. On the other hand, leasing one requires an
analysis, which alternative should the contractor be advised to accept. The cash flows are
below.

63000

5000

3000

3000

3000

3000

3000
3000

at is the internal rate o f return for this investment?


ould this investment be accepted if the your other options have a rate of return o f 12%?

$3000 loan terms

52000 loan terms

$1000 loan terms

Chapter 7 Rate Of Return Analysis

.4

7-55 A fmance company is using the "Money by Mail" offer shown in problem 7-54 above.
Calculate the yearly nominal ROR received by the company if a customer chooses the $3000 loan,
but declines the credit insurance.

7-56A new machlne can be purchased today for $300.000 The annual revenue from the machme
1s calculated to be $67,000 and the equipment will last 10 years. Expect the maintenance and
operatmg costs to be $3000 a year and mcrease $600 per year The salvage value of the machine
will be $20,000 What is the rate of return for t h ~ machme?
s

7-57 Two hazardous environment facilities are being evaluated, with the projected life of each
facility being 10 years. The cash flows for each facil~tyare:
Alternative
A

$615,000

$300,000

Maintenance &

10,000

25,000

Annual benefit

158,000

92,000

Salvage value

65,000

-5,000

F i t cost

The company uses a MARR of 15%. Using rate of return analysis, which alternative should be
selected?

7-58 Al Larson asked a bank to lend him money on January Ist, based on the following
repayment plan: the fmt payment would be $2 on February 28th, with subsequent monthly payments
increasing by $2 a montb on an arithmetic gradient. (The March 3 1st payment would be $4; the April
30th payment would beS6,and so on.) The payments are to continue for eleven years, making a total
of 132 payments.
a.

Compute the total amount of money Al will pay the bank, based on the
proposed repayment plan.

b. If the bank charges interest at 12% nominal per year, compounded monthly,
how much would it be willing to lend A1 on the proposed repayment plan?

'

I1

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