FNCE10002 Principles of Finance Semester 1, 2018
FNCE10002 Principles of Finance
Semester 1, 2018
Introduction to Financial Mathematics II
Tutorial Questions for Week 2
This tutorial is divided into two parts. The answers to the questions in Part I need to be submitted at the
beginning of your tutorial. All answers must be handwritten and in original (photocopies/emails will
not be accepted). Please follow the instructions on the Tutorial Hand-in Sheet available on the LMS via
the Tutorials link. The answers to the questions in Part II do not need to be submitted and will be
discussed in your tutorial. Please make sure that you have worked through these questions as well and
are prepared to discuss them if called upon by your tutor.
Note that questions flagged as “PEQ” are past exam questions that I’ve used in subjects that are similar
in scope to this subject, while those flagged as “TXT” are sourced from the textbook. Detailed answers
to the questions in Part II will only be provided in tutorials. Brief answers may be provided via the LMS
after a time lag. This policy is in place to ensure that you attend your tutorials regularly and receive
timely feedback from your tutor. If you are unsure of any answer you should check with your tutor, a pit
stop tutor, online tutor or me.
Part I: Answers to be Submitted to Your Tutor
A. Problems
PEQ
A1. You have just won the First Annual Prime Minister Look-Alike contest and have been offered
the following alternative ways of receiving the prize money. Assume that each alternative is
riskfree (that is, the cash flows are certain to occur) and the interest rate is 8% per annum.
a) $140,000 at the end of year 3.
b) $28,000 at the end of each of the next 5 years with the first cash flow occurring at the end
of year 1.
c) $9,000 at the end of each year in perpetuity with the first cash flow occurring at the end of
year 1.
d) $12,000 at the end of each year in perpetuity with the first cash flow occurring at the end
of year 4.
Assuming end-of-the-year cash flows, which is the best way to receive the prize money? Show
all your calculations.
A2. Your mate in mechanical engineering has invented a money machine. The main drawback of
the machine is that it is slow because it takes one year to manufacture $100. However, once
built, the machine will last forever and will require no maintenance. The machine can be built
Tutorial Questions for Week 2 1
FNCE10002 Principles of Finance Semester 1, 2018
immediately (year 0), and it will cost $1,000 to build. Your mate wants to know if he should
invest the money to construct it. If the interest rate is 9.5% per annum what should he do? How
would your answer change if the machine takes one year to build? (Hint: Use a timeline to help
you visualize the cash flows.)
A3. Refer to the case study “No Latte for You!” covered in class. We made the simplifying
assumption that the cost of a latte would not increase over time. Now assume that you drink a
$4 latte a day and over the month the cost is $80. Assume that the cost of the latte is expected
to increase at a rate of 6% per annum, or 0.5% per month forever. As before, you choose to
forgo your daily latte and instead invest this (now growing) amount at the end of each month
in an investment fund that earns an interest rate of 12% p.a. What is the value of your growing
investment at the end of: (a) 10 years and (b) 50 years? What are the present values of your
investments? Round your final answers to the nearest dollar.
Part II: Submission of Answers Not Required
B. Multiple Choice Questions
For each question pick the most reasonable response based only on the information provided.
PEQ
B1. You friend just seen the following advertisement at her local bank: “Deposit $40,000 today and
receive $2,000 every year growing at a constant annual rate forever.” Assume the bank pays an
interest rate of 8% per annum and the first cash flow you receive from the bank is at the end of
year 1. The implied annual growth rate in these cash flows in closest to:
a) –3%.
b) 3%.
c) 5%.
d) 8%.
PEQ
B2. Assume that you are 25 years old and decide to start saving for your retirement. You plan to
save $5,000 at the end of each year (so the first deposit will be made one year from now), and
will make the last deposit when you retire at age 65. Suppose you can earn 8% per annum on
your retirement savings. The amount you will have saved for your retirement is closest to:
a) $1,194,706.
b) $1,295,283.
c) $1,398,905.
d) $1,403,905.
TXT
B3. Consumer Insurance, Inc. sells extended warranties on appliances that provide coverage after
the manufacturers’ warranties expire. An analyst for the company forecasts that the company
will have to pay warranty claims of $5 million per year for three years, with the first costs
expected to occur four years from today. The company wants to set aside a lump sum today to
cover these costs and money invested today will earn an interest rate of 10% per annum.
Assuming end-of-the-year cash flows, the amount that the company needs to invest today is
closest to:
a) $3,756,574.
b) $9,342,044.
c) $11,907,834.
d) $12,434,260.
Tutorial Questions for Week 2 2
FNCE10002 Principles of Finance Semester 1, 2018
PEQ
B4. An investor expects to receive $20,000 over the next four years where the cash flows are to be
received at the beginning of each year. If the interest rate is 6% p.a. compound annually the
future value of these cash flows at the end of year 4 is closest to:
a) $69,302.
b) $73,460.
c) $87,492.
d) $92,742.
B5. You are thinking of building a new machine that will save you $1,000 in the first year. The
machine will then begin to wear out so that these savings will decline at a rate of 2% per annum
forever. If the interest rate is 5% per annum, the present value of the savings is closest to:
a) $14,000.
b) $14,286.
c) $20,000.
d) $33,333.
C. Problems
TXT
C1. Ed Lowman, the 20-year-old star opening batsman of his university cricket team, is approached
about skipping his last two years of his four-year university degree and entering the professional
cricket sports industry. Ed expects that his cricket career will be over by the time he is 32 years
old. Talent scouts for regional cricket teams estimate that Ed could receive a signing bonus of $1
million today, along with a five-year contract for $3 million per year (payable at the end of each
year). They further estimate that he could negotiate a contract for $5 million per year for the
remaining seven years of his career. The scouts believe, however, that Ed will be a better selection
for the Australian Test team if he improves by playing two more years of university cricket. If he
stays at university, he is expected to receive a $2 million signing bonus in two years, along with
a five-year contract for $5 million per year. After that, the scouts expect Ed to obtain a five-year
contract for $6 million per year to take him into retirement. Assume that Ed can earn a 10% per
annum return over this time. Should Ed stay or go? (Hint: Use a timeline to help you visualize
the cash flows.)
PEQ
C2. You work for a pharmaceutical company that has developed a new drug. The patent on the drug
will last 17 years. You expect that the drug’s profits will be $2 million in its first year (that is,
end of year 1) and that this amount will grow at a rate of 5% per annum until the patent expires.
Once the patent expires, other pharmaceutical companies will be able to produce the same drug
and competition will likely drive profits to zero. Assume that the interest rate is 10% per annum.
(Hint: Use a timeline to help you visualize the cash flows.)
a) Calculate the present value of the profits from the new drug.
b) What perpetually growing profits (in year 1) would give you the same present value as that
calculated in part (a)?
Tutorial Questions for Week 2 3