Answers to Problem Set 5

1. (5.24) Determine the capitalized cost of an expenditure of $200,000 at time 0, $25,000 in years 2 through 5,
and $40,000 per year from year 6 on. Use an interest rate of 12% per year.

CC = -200,000 25,000(P/A,12%,4)(P/F,12%,1) [40,000/0.12](P/F,12%,5)

= -200,000 25,000(3.0373)(0.8929) [40,000/0.12])(0.5674)
= $-456,933

2. (5.27) If you want to be able to withdraw 80,000 per year forever beginning 30 years from now, how much
will you have to have in your retirement account (that earns 8% per year interest) in (a) year 29 and (b) year 0?

(a) P29 = 80,000/0.08

= $1,000,000

(b) P0 = 1,000,000(P/F,8%,29)
= 1,000,000(0.1073)
= $107,300

3. (5.30) Compare the following alternatives on the basis of their capitalized cost at an interest rate of 10% per
year.

Petroleum- Based Feedstock Inorganic- Based Feedstock

First cost, $ 250,000 110,000
Annual operating cost, 130,000 65,000
$/year
Annual revenues, 400,000 270,000
$/year
Salvage value, $ 50,000 20,000
Life, years 6 4

CCpetroleum = [-250,000(A/P,10%,6) 130,000 + 400,000

+ 50,000(A/F,10%,6)]/0.10
= [-250,000(0.22961) 130,000 + 400,000
+ 50,000(0.12961)]/0.10
= $2,190,780

CCinorganic = [-110,000(A/P,10%,4) 65,000 + 270,000

+ 20,000(A/F,10%,4)]/0.10
= [-110,000(0.31547) 65,000 + 270,000
+ 20,000(0.21547)]/0.10
= $1,746,077

Petroleum-based alternative has a larger profit.

SO CLEARLY CAPITALIZED COST IS NOT ABOUT COSTS ONLY. IF THERE ARE REVENUES
WHOSE PRESENT VALUE EXCEEDS THAT OF COSTS, CC VALUE WILL BE POSITIVE.
 14. (5.33) Compare the alternatives shown below on the basis of their capitalized costs, using an interest rate 12%
per year, compounded quarterly.

Alternative E Alternative F Alternative G

First cost, $ 200,000 300,000 900,000
Quarterly income $quarter, 30,000 10,000 40,000
Salvage value, $ 50,000 70,000 100,000
Life, years 2 4

CCE = [-200,000(A/P,3%,8) + 30,000 + 50,000(A/F,3%,8)]/0.03

= [-200,000(0.14246) + 30,000 + 50,000(0.11246)]/0.03
= $237,700

CCF = [-300,000(A/P,3%,16) + 10,000 + 70,000(A/F,3%,16)]/0.03

= [-300,000(0.07961) + 10,000 + 70,000(0.04961)]/0.03
= $-347,010

CCG = -900,000 + 40,000/0.03

= $433,333

Select alternative G.

15. (5.47) What is the face value of a municipal bond that has a bond interest rate of 4% per year with semiannual
interest payments of $800?

800 = (V)(0.04)/2
V = $40,000

16. (5.48) What is the bond interest rate on a $20,000 bond that has semiannual interest payments of $1500 and a
20-year maturity date?

1500 = (20,000)(b)/2
b = 15%

17. (5.50) What is the present worth of a $50,000 municipal bond that has an interest rate of 4% per year, payable
quarterly? The bond matures in 15 years, and the market interest rate is 8% per year, compounded quarterly.

I = (50,000)(0.04)/4
= $500 every 3 months

PW = 500(P/A,2%,60) + 50,000(P/F,2%,60)
= 500(34.7609) + 50,000(0.3048)
= $32,620
18. (5.51) General Electric issued 1000 debenture bonds 3 years ago with a face value of $5000 each and a bond
interest rate of 8% per year payable semiannually. The bonds have a maturity date of 20 years from the date they
were issued. If the interest rate in the market place is 10% per year, compounded semiannually, what is the
present worth of one bond to an investor who wishes to purchase it today?

I = 5000(0.08)/2
= $200 every 6 months

PW = 200(P/A,5%,34) + 5000(P/F,5%,34)
= 200(16.1929) + 5000(0.1904)
= $4190.58

19. (6.2) Machine A has a 3-year life with no salvage value. Assume that you were told that the service provided
by these machines would be needed for only 5 years. Alternative A would have to be repurchased and kept for
only 2 years. What would its salvage value have to be after the 2 years in order to make its annual worth the same
as it is for its 3- year life cycle at an interest rate of 10% per year?

Year Alternative A, $ Alternative B, $

0 10,000 20,000
1 7,000 5,000
2 7,000 5,000
3 7,000 5,000
4 5,000
5 5,000

-10,000(A/P,10%,3) 7000 = -10,000(A/P,10%,2) 7000 + S(A/F,10%,2)

-10,000(0.40211) 7000 = -10,000(0.57619) 7000 + S(0.47619)
S = $3656

20. (6.12) Two mutually exclusive projects have the estimated cash flows shown below. Use an annual worth
analysis to determine which should be selected at an interest rate of 10% per year.

Project Q Project R
First cost, $ 42,000 80,000
Annual cost, 6,000 7,000 year 1, increasing
$/year by $1000 per year
Salvage value, $ 0 4,000
Life, years 2 4
AWQ = -42,000(A/P,10%,2) 6000
= -42,000(0.57619) 6000
= $-30,200
AWR = -80,000(A/P,10%,4) [7000 + 1000(A/G,10%,4)] + 4000(A/F,10%,4)
= -80,000(0.31547) [7000 + 1000(1.3812)] + 4000(0.21547)
= $-32,757

Select project Q.
21. (6.15) How much must you deposit in your retirement account starting now and continuing each year through
year 9 (i.e., 10 deposits) if you want to be able to withdraw $80,000 per year forever beginning 30 years from now?
Assume the account earns interest at 10% per year.

Find P in year 29, move back to year 9, and then use A/F for n = 10.

A = [80,000/0.10](P/F,10%,20)(A/F,10%,10)
= [80,000/0.10](0.1486)(0.06275)
= $ 7459.72

22. (6.17) A stockbroker claims she can consistently earn 15% per year on an investors money. If she invests
$20,000 now, $40,000 two years from now, and $10,000 per year through year 11 starting 4 years from now, how
much money can the client withdraw every year forever, beginning 12 years from now, if the stockbroker delivers
what she said and the account earns 6% per year from year 12 forward? Disregard taxes.

First find the value of the account in year 11 and then multiply by i = 6%.

F11 = 20,000(F/P,15%,11) + 40,000(F/P,15%,9) + 10,000(F/A,15%,8)

= 20,000(4.6524) + 40,000(3.5179) + 10,000(13.7268)
= $371,032

A = 371,032(0.06)
= $22,262

23. (6.18) Determine the perpetual equivalent annual worth (in years 1 through infinity) of an investment of
$50,000 at time 0 and $50,000 per year thereafter (forever) at an interest rate of 10% per year.

AW = 50,000(0.10) + 50,000 = $55,000

24. (6.21) A philanthropist working to set up a permanent endowment wants to deposit money each year, starting
now and making 10 more (i.e., 11) deposits, so that money will be available for research related to planetary
colonization. If the size of the first deposit is $1 million and each succeeding one is $100,000 larger than the
previous one, how much will be available forever beginning in year 11, if the fund earns interest at a rate of 10%
per year?

P-1 = 1,000,000(P/A,10%,11) + 100,000(P/G,10%,11)

= 1,000,000(6.4951) + 100,000(26.3963)
= $9,134,730

Amt in yr 10 = 9,134,730(F/P,10%,11)
= 9,134,730(2.8531)
= $26,062,298

AW = 26,062,298(0.10)
= $2,606,230

25. (6.23) A company that manufactures magnetic membrane switches is investigating three production options
that have the estimated cash flows below. (a) Determine which option is preferable at an interest rate of 15% per
year. (b) If the options are independent, determine which are economically acceptable. (All dollar values are in
millions.)
In-house License Contract
First cost, $ 30 2 0
Annual cost, $/year 5 0.2 2
Annual income, $/year 14 1.5 2.5
Salvage value, $ 7
Life, years 10 5

(a) AWin-house = -30(A/P,15%,10) 5 + 14 + 7(A/F,15%,10)

= -30(0.19925) 5 + 14 + 7(0.04925)
= $3.37 ($ millions)

AWlicense = -2(0.15) 0.2 + 1.5

= $1.0 ($ millions)

AWcontract = -2 + 2.5
= $0.5 ($ millions)

Select in-house option.

All three options are acceptable