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4. Suppose Goodyear Tire and Rubber Company is considering divesting one of its manufacturing plants. The plant is expected to generate free cash flows of $1.5 million per year, growing at a rate of 2.5% per year. Goodyear has an equity cost of capital of 8.5%, a debt cost of capital of 7%, a marginal corporate tax rate of 35%, and a debt-equity ratio of 2.6. If the plant has average risk and Goodyear plans to maintain a constant debt-equity ratio, what after-tax amount must it receive for the plant for the divestiture to be profitable?

5. Suppose Alcatel-Lucent has an equity cost of capital of 10%, market capitalization of $10.8 billion, and an enterprise value of $14.4 billion. Suppose Alcatel-Lucent’s debt cost of capital is 6.1% and its marginal tax rate is 35%.

a. What is Alcatel-Lucent’s WACC?b. If Alcatel-Lucent maintains a constant debt-equity ratio, what is the value of a project with average risk and the following expected free cash flows?Year0123FCF−1005010070c. If Alcatel-Lucent maintains its debt-equity ratio, what is the debt capacity of the project in part b?

1. What inherent characteristic of corporations creates the need for a system of checks on manager behavior?

2. What are some examples of agency problems?

3. What are the advantages and disadvantages of the corporate organizational structure?

10. Is it necessarily true that increasing managerial ownership stakes will improve firm performance?

11.How can proxy contests be used to overcome a captured board?

12. What is a say-on-pay vote?

13. What are a board’s options when confronted with dissident shareholders?

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You are considering making a movie. The movie is expected to cost $10 million upfront and take a year to make. After that, it is expected to make $5 million when it is released in one year and $2 million per year for the following four years. What is the payback period of this investment? If you require a payback period of two years, will you make the movie? Does the movie have positive NPV if the cost of capital is 10%?

21.

You are deciding between two mutually exclusive investment opportunities. Both require the same initial investment of $10 million. Investment A will generate $2 million per year (starting at the end of the first year) in perpetuity. Investment B will generate $1.5 million at the end of the first year and its revenues will grow at 2% per year for every year after that.

a. Which investment has the higher IRR?b. Which investment has the higher NPV when the cost of capital is 7%?c. In this case, for what values of the cost of capital does picking the higher IRR give the correct answer as to which investment is the best opportunity?

1.

Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $20 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 40% will come from customers who switch to the new, healthier pizza instead of buying the original version.

a. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?b. Suppose that 50% of the customers who will switch from Pisa Pizza’s original pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case?

23. Bauer Industries is an automobile manufacturer. Management is currently evaluating a proposal to build a plant that will manufacture lightweight trucks. Bauer plans to use a cost of capital of 12% to evaluate this project. Based on extensive research, it has prepared the following incremental free cash flow projections (in millions of dollars):

a. For this base-case scenario, what is the NPV of the plant to manufacture lightweight trucks?b. Based on input from the marketing department, Bauer is uncertain about its revenue forecast. In particular, management would like to examine the sensitivity of the NPV to the revenue assumptions. What is the NPV of this project if revenues are 10% higher than forecast? What is the NPV if revenues are 10% lower than forecast?c. Rather than assuming that cash flows for this project are constant, management would like to explore the sensitivity of its analysis to possible growth in revenues and operating expenses. Specifically, management would like to assume that revenues, manufacturing expenses, and marketing expenses are as given in the table for year 1 and grow by 2% per year every year starting in year 2. Management also plans to assume that the initial capital expenditures (and therefore depreciation), additions to working capital, and continuation value remain as initially specified in the table. What is the NPV of this project under these alternative assumptions? How does the NPV change if the revenues and operating expenses grow by 5% per year rather than by 2%?d. To examine the sensitivity of this project to the discount rate, management would like to compute the NPV for different discount rates. Create a graph, with the discount rate on the x-axis and the NPV on the y-axis, for discount rates ranging from 5% to 30%. For what ranges of discount rates does the project have a positive NPV?
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Assume Evco, Inc., has a current price of $50 and will pay a $2 dividend in one year, and its equity cost of capital is 15%. What price must you expect it to sell for right after paying the dividend in one year in order to justify its current price?

4.

Krell Industries has a share price of $22 today. If Krell is expected to pay a dividend of $0.88 this year, and its stock price is expected to grow to $23.54 at the end of the year, what is Krell’s dividend yield and equity cost of capital?

5.

NoGrowth Corporation currently pays a dividend of $2 per year, and it will continue to pay this dividend forever. What is the price per share if its equity cost of capital is 15% per year?

6.

Summit Systems will pay a dividend of $1.50 this year. If you expect Summit’s dividend to grow by 6% per year, what is its price per share if its equity cost of capital is 11%?

7.

Dorpac Corporation has a dividend yield of 1.5%. Dorpac’s equity cost of capital is 8%, and its dividends are expected to grow at a constant rate.

a. What is the expected growth rate of Dorpac’s dividends?
b. What is the expected growth rate of Dorpac’s share price?

12.

Procter & Gamble will pay an annual dividend of $0.65 one year from now. Analysts expect this dividend to grow at 12% per year thereafter until the fifth year. After then, growth will level off at 2% per year. According to the dividend-discount model, what is the value of a share of Procter & Gamble stock if the firm’s equity cost of capital is 8%?

19.

Heavy Metal Corporation is expected to generate the following free cash flows over the next five years:

Year12345FCF ($ millions)5368787582

After then, the free cash flows are expected to grow at the industry average of 4% per year. Using the discounted free cash flow model and a weighted average cost of capital of 14%:

a. Estimate the enterprise value of Heavy Metal.
b. If Heavy Metal has no excess cash, debt of $300 million, and 40 million shares outstanding, estimate its share price.

1.

Suppose Pepsico’s stock has a beta of 0.57. If the risk-free rate is 3% and the expected return of the market portfolio is 8%, what is Pepsico’s equity cost of capital?

3.

Aluminum maker Alcoa has a beta of about 2.0, whereas Hormel Foods has a beta of 0.45. If the expected excess return of the marker portfolio is 5%, which of these firms has a higher equity cost of capital, and how much higher is it?

26.

Unida Systems has 40 million shares outstanding trading for $10 per share. In addition, Unida has $100 million in outstanding debt. Suppose Unida’s equity cost of capital is 15%, its debt cost of capital is 8%, and the corporate tax rate is 40%.

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Suppose the term structure of risk-free interest rates is as shown below:

Term1 year2 years3 years5 years7 years10 years20 yearsRate (EAR, %)1.992.412.743.323.764.134.93a. Calculate the present value of an investment that pays $1000 in two years and $2000 in five years for certain.b. Calculate the present value of receiving $500 per year, with certainty, at the end of the next five years. To find the rates for the missing years in the table, linearly interpolate between the years for which you do know the rates. (For example, the rate in year 4 would be the average of the rate in year 3 and year 5.)*c. Calculate the present value of receiving $2300 per year, with certainty, for the next 20 years. Infer rates for the missing years using linear interpolation. (Hint: Use a spreadsheet.)

31.

What is the shape of the yield curve given the term structure in Problem 29? What expectations are investors likely to have about future interest rates?

2.  Assume that a bond will make payments every six months as shown on the following timeline (using six-month periods):

6.

Suppose a 10-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading for a price of $1034.74.

a. What is the bond’s yield to maturity (expressed as an APR with semiannual compounding)?b. If the bond’s yield to maturity changes to 9% APR, what will the bond’s price be?

7.

Suppose a five-year, $1000 bond with annual coupons has a price of $900 and a yield to maturity of 6%. What is the bond’s coupon rate?

10.

Suppose a seven-year, $1000 bond with an 8% coupon rate and semiannual coupons is trading with a yield to maturity of 6.75%.

a. Is this bond currently trading at a discount, at par, or at a premium? Explain.b. If the yield to maturity of the bond rises to 7% (APR with semiannual compounding), what price will the bond trade for?

28.

The following table summarizes the yields to maturity on several one-year, zero-coupon securities:

SecurityYield (%)Treasury3.1AAA corporate3.2BBB corporate4.2B corporate4.9

 

a. What is the price (expressed as a percentage of the face value) of a one-year, zero-coupon corporate bond with a AAA rating?b. What is the credit spread on AAA-rated corporate bonds?c. What is the credit spread on B-rated corporate bonds?d. How does the credit spread change with the bond rating? Why?

30.

HMK Enterprises would like to raise $10 million to invest in capital expenditures. The company plans to issue five-year bonds with a face value of $1000 and a coupon rate of 6.5% (annual payments). The following table summarizes the yield to maturity for five-year (annual-pay) coupon corporate bonds of various ratings:

RatingAAAAAABBBBBYTM6.20%6.30%6.50%6.90%7.50%a. Assuming the bonds will be rated AA, what will the price of the bonds be?b. How much total principal amount of these bonds must HMK issue to raise $10 million today, assuming the bonds are AA rated? (Because HMK cannot issue a fraction of a bond, assume that all fractions are rounded to the nearest whole number.)c. What must the rating of the bonds be for them to sell at par?d. Suppose that when the bonds are issued, the price of each bond is $959.54. What is the likely rating of the bonds? Are they junk bonds?

1.

The figure below shows the one-year return distribution for RCS stock. Calculate

a. The expected return.

b. The standard deviation of the return.

30.

What does the beta of a stock measure?

35.

Suppose the market risk premium is 5% and the risk-free interest rate is 4%. Using the data in Table 10.6, calculate the expected return of investing in

a. Starbucks’ stock.

b. Hershey’s stock.

c. Autodesk’s stock.

37.

Suppose the market risk premium is 6.5% and the risk-free interest rate is 5%. Calculate the cost of capital of investing in a project with a beta of 1.2.

2.

You own three stocks: 600 shares of Apple Computer, 10,000 shares of Cisco Systems, and 5000 shares of Colgate-Palmolive. The current share prices and expected returns of Apple, Cisco, and Colgate-Palmolive are, respectively, $500, $20, $100 and 12%, 10%, 8%.

a. What are the portfolio weights of the three stocks in your portfolio?b. What is the expected return of your portfolio?c. Suppose the price of Apple stock goes up by $25, Cisco rises by $5, and Colgate-Palmolive falls by $13. What are the new portfolio weights?d. Assuming the stocks’ expected returns remain the same, what is the expected return of the portfolio at the new prices?
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1. (TCO A) Which of the following does NOT always increase a company’s market value?

2. (TCO F) Which of the following statements is correct?

3. (TCO D) Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock?

4. (TCO G) Singal Inc. is preparing its cash budget. It expects to have sales of $30,000 in January, $35,000 in February, and $35,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March?

1. (TCO H) Zervos Inc. had the following data for 2008 (in millions). The new CFO believes (a) that an improved inventory management system could lower the average inventory by $4,000, (b) that improvements in the credit department could reduce receivables by $2,000, and (c) that the purchasing department could negotiate better credit terms and thereby increase accounts payable by $2,000. Furthermore, she thinks that these changes would not affect either sales or the costs of goods sold. If these changes were made, by how many days would the cash conversion cycle be lowered?

2. (TCO C) Bumpas Enterprises purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50. If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its nonfree trade credit? (Assume a 365-day year.)

3. (TCO E) You were hired as a consultant to the Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of common from retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new common stock. What is Quigley’s WACC?

4. (TCO B) A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?

5. (TCO G) Based on the corporate valuation model, Hunsader’s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock’s price per share?

6. TCO G) Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm’s additional funds needed (AFN). The firm is operating at full capacity. Data for use in your forecast are shown below. Based on the AFN equation, what is the AFN for the coming year? Dollars are in millions.

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1. (TCO D) A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. Which is the current stock price? (Points : 10)

2. (TCO D) If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, which is the stock’s expected dividend yield for the coming year? (Points : 10)

3. (TCO D) Carter’s preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, which is its nominal (not effective) annual rate of return? (Points : 10)

4. (TCO E) Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Because new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would reduce its need to issue new common stock? (Points : 10)

5. (TCO E) Duval Inc. uses only equity capital, and it has two equally sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B’s projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? (Points : 10)

6. (TCO D) Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67, P0 = $27.50, and g = 8.00% (constant). Which is the cost of common from retained earnings based on the DCF approach? (Points : 10)

7. (TCO F) Cornell Enterprises is considering a project that has the following cash flow and WACC data. Which is the project’s NPV? Note that a project’s expected NPV can be negative, in which case it will be rejected

8. (TCO F) Simkins Renovations Inc. is considering a project that has the following cash flow data. Which is the project’s IRR? Note that a project’s IRR can be less than the WACC (and even negative), in which case it will be rejected.

9. (TCO F) Masulis Inc. is considering a project that has the following cash flow and WACC data. Which is the project’s discounted payback?

10. (TCO H) Temple Corp. is considering a new project, which has data as shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project’s 3-year life. What is the project’s NPV?

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(TCO A) Which of the following statements is correct?

(TCO G) A security analyst obtained the following information from Prestopino Products’ financial statements.

(TCO G) Beranek Corp. has $410,000 of assets, and it uses no debt—it is financed only with common equity. The new CFO wants to employ enough debt to bring the debt to assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio?

(TCO B) You deposit $1,000 today in a savings account that pays 3.5% interest, compounded annually. How much will your account be worth at the end of 25 years?

(TCO B) Your father paid $10,000 (CF at t = 0) for an investment that promises to pay $750 at the end of each of the next 5 years, then an additional lump sum payment of $10,000 at the end of the fifth year. Which is the expected rate of return on this investment?

(TCO B) Suppose you borrowed $12,000 at a rate of 9.0% and must repay it in four equal installments at the end of each of the next 4 years. How large would your payments be?

(TCO D) Which of the following statements is correct?

(TCO D) Ezzell Enterprises’ noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. Which is their yield to maturity?

(TCO C) Keys Corporation’s 5-year bonds yield 7.00%, and 5-year T-bonds yield 5.15%. The real risk-free rate is r* = 3.0%, the inflation premium for 5-year bonds is IP = 1.75%, the liquidity premium for Keys’ bonds is LP = 0.75% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) × 0.1%, where t = number of years to maturity. Which is the default risk premium (DRP) on Keys’ bonds?

(TCO C) Assume that to cool off the economy and decrease expectations for inflation, the Federal Reserve tightened the money supply, causing an increase in the risk-free rate, rRF. Investors also became concerned that the Fed’s actions would lead to a recession, and that led to an increase in the market risk premium (rM – rRF). Under these conditions, with other things held constant, which of the following statements is most correct?

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(TCO A) Which of the following statements is CORRECT?

  It is generally more expensive to form a proprietorship than a corporation because, with a proprietorship, extensive legal documents are required. Corporations face fewer regulations than sole proprietorships. One disadvantage of operating a business as a sole proprietorship is that the firm is subject to double taxation, at both the firm level and the owner level.One advantage of forming a corporation is that equity investors are usually exposed to less liability than in a regular partnership.If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the amount of his or her investment in the business.

(TCO G) Which of the following statements is CORRECT?

In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash.Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.In the statement of cash flows, depreciation charges are reported as a use of cash.  In the statement of cash flows, a decrease in inventories is reported as a use of cash.

(TCO G) LeCompte Corp. has $312,900 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $620,000, and its net income after taxes was $24,655. Stockholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 15%. What profit margin would LeCompte need in order to achieve the 15% ROE, holding everything else constant?

(TCO B) Suppose a State of New York bond will pay $1,000 10 years from now. If the going interest rate on these 10-year bonds is 5.5%, how much is the bond worth today?

(TCO B) Your father paid $10,000 (CF at t = 0) for an investment that promises to pay $750 at the end of each of the next five years, then an additional lump sum payment of $10,000 at the end of the fifth year. What is the expected rate of return on this investment?

(TCO B) Suppose you borrowed $14,000 at a rate of 10.0% and must repay it in five equal installments at the end of each of the next five years. How much interest would you have to pay in the first year?

(TCO D) A 10-year bond pays an annual coupon, its YTM is 8%, and it currently trades at a premium. Which of the following statements is CORRECT?

(TCO D) Ezzell Enterprises’ noncallable bonds currently sell for $1,165. They have a 15-year maturity, an annual coupon of $95, and a par value of $1,000. What is their yield to maturity?

(TCO C) Niendorf Corporation’s five-year bonds yield 6.75%, and five-year T-bonds yield 4.80%. The real risk-free rate is r* = 2.75%, the inflation premium for five-year bonds is IP = 1.65%, the default risk premium for Niendorf’s bonds is DRP = 1.20% versus zero for T-bonds, and the maturity risk premium for all bonds is found with the formula MRP = (t - 1) x 0.1%, where t = number of years to maturity. What is the liquidity premium (LP) on Niendorf’s bonds?

(TCO C) Other things held constant, if the expected inflation rate decreases and investors also become more risk averse, the Security Market Line would be affected as follows:

 
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In fiscal year 2011, Starbucks Corporation (SBUX) had revenue of $11.70 billion, gross profit of $6.75 billion, and net income of $1.25 billion. Peet’s Coffee and Tea (PEET) had revenue of $372 million, gross profit of $72.7 million, and net income of $17.8 million.

a. Compare the gross margins for Starbucks and Peet’s.

b. Compare the net profit margins for Starbucks and Peet’s.

c. Which firm was more profitable in 2011?

30.

In mid-2012, Apple had cash and short-term investments of $27.65 billion, accounts receivable of $14.30 billion, current assets of $51.94 billion, and current liabilities of $33.06 billion.

a. What was Apple’s current ratio?

b. What was Apple’s quick ratio?

c. What was Apple’s cash ratio?

d. In mid-2012, Dell had a cash ratio of 0.67, a quick ratio of 1.11 and a current ratio of 1.35. What can you say about the asset liquidity of Apple relative to Dell?

31.

See Table 2.5 showing financial statement data and stock price data for Mydeco Corp.

a. How did Mydeco’s accounts receivable days change over this period?

b. How did Mydeco’s inventory days change over this period?

c. Based on your analysis, has Mydeco improved its management of its working capital during this time period?

36.

You are analyzing the leverage of two firms and you note the following (all values in millions of dollars):

DebtBook EquityMarket EquityEBITInterest ExpenseFirm A50030040010050Firm B 80 35 40  8  7a. What is the market debt-to-equity ratio of each firm?b. What is the book debt-to-equity ratio of each firm?c. What is the EBIT/interest coverage ratio of each firm?d. Which firm may have more difficulty meeting its debt obligations? Explain.

42.

For fiscal year 2011, Starbucks Corporation (SBUX) had total revenues of $11.70 billion, net income of $1.25 billion, total assets of $7.36 billion, and total shareholder’s equity of $4.38 billion.

a. Calculate the Starbucks’ ROE directly, and using the DuPont Identity.

b. Comparing with the data for Peet’s in Problem 41, use the DuPont Identity to understand the difference between the two firms’ ROEs.

43.

Consider a retailing firm with a net profit margin of 3.5%, a total asset turnover of 1.8, total assets of $44 million, and a book value of equity of $18 million.

a. What is the firm’s current ROE?

b. If the firm increased its net profit margin to 4%, what would be its ROE?

c. If, in addition, the firm increased its revenues by 20% (while maintaining this higher profit margin and without changing its assets or liabilities), what would be its ROE?

10.

Your firm has identified three potential investment projects. The projects and their cash flows are shown here:

ProjectCash Flow Today ($)Cash Flow in One Year ($)A−1020B 5 5C20−10

Suppose all cash flows are certain and the risk-free interest rate is 10%.

a. What is the NPV of each project?

b. If the firm can choose only one of these projects, which should it choose?

c. If the firm can choose any two of these projects, which should it choose?

3.

Calculate the future value of $2000 in

a. Five years at an interest rate of 5% per year.

b. Ten years at an interest rate of 5% per year.

c. Five years at an interest rate of 10% per year.

d. Why is the amount of interest earned in part (a) less than half the amount of interest earned in part (b)?

4.

What is the present value of $10,000 received

a. Twelve years from today when the interest rate is 4% per year?

b. Twenty years from today when the interest rate is 8% per year?

c. Six years from today when the interest rate is 2% per year?

11.

Suppose you receive $100 at the end of each year for the next three years.

a. If the interest rate is 8%, what is the present value of these cash flows?

b. What is the future value in three years of the present value you computed in (a)?

c. Suppose you deposit the cash flows in a bank account that pays 8% interest per year. What is the balance in the account at the end of each of the next three years (after your deposit is made)? How does the final bank balance compare with your answer in (b)?

12.

You have just received a windfall from an investment you made in a friend’s business. He will be paying you $10,000 at the end of this year, $20,000 at the end of the following year, and $30,000 at the end of the year after that (three years from today). The interest rate is 3.5% per year.

a. What is the present value of your windfall?

b. What is the future value of your windfall in three years (on the date of the last payment)?

27.

Your oldest daughter is about to start kindergarten at a private school. Tuition is $10,000 per year, payable at the beginning of the school year. You expect to keep your daughter in private school through high school. You expect tuition to increase at a rate of 5% per year over the 13 years of her schooling. What is the present value of the tuition payments if the interest rate is 5% per year? How much would you need to have in the bank now to fund all 13 years of tuition?

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