Question 1
Suppose you were the recipient of an annuity for coming in second place in a beauty contest. The annuity pays you $6,000 per year for the rest of your life. However, you decide that “It’s my money and I need it now!”, and you want to sell the financial instrument.
a) What is the fair market value of the annuity if the market interest rate is 7.50%?
b) What is the fair market value of the annuity if the market interest rate were 3.25% instead?
Question 2
Suppose you are having lunch with your friend, and he drunkenly declares that he will give you $250,000 in ten (10) years. You take him up on his offer, but instead, say you will take the present value of that money today.
a) If the interest rate is 12%, how much will your friend have to pay you today?
b) If the interest rate is 2.75% instead, how much will your friend have to pay you today?
Question 3
Suppose you enter into a tournament to play Quidditch against other teams. In order for you to play, you must pay $3,750 today to the organization that hosts the tournament. The top prize for winning is structured so that you will receive $6,500 one year from now, $4,250 three years from now, $2,500 five years from now, and $9,125 seven years from now.
a) If the market interest rate is 5%, what is the present value of this stream of payments? Draw the timeline when providing your calculations, as well.
b) What is the net present value if you win the tournament? Would this be considered a good, bad, or neutral deal for you? Explain your reasoning.