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QUESTION 2

A magazine publisher offers its customers three option on subscriptions:

Option A: $50 today for three years.

Option B: A two-year rate of $38 paid immediately, followed by a one-year rate of $17 paid

at the beginning of the third year.

Option C: $17 paid at the beginning of each of the three years.

a) From the perspective of the company, which option is best if the company’s opportunity cost of funds is 8%? Explain.

b) From the perspective of the subscriber, which option is best in terms of minimizing the cost of subscription if the subscriber’s opportunity cost of funds is 5%? Explain.

QUESTION 3

Bart Simpson, now age 10, wants to be able to buy a really cool new car when he turns 16. His really cool car costs $15,000 today, and its cost is expected to increase 3% annually. Bart wants to make one deposit today (he can sell his original collection of The Spiderman comic books) into an account paying 8% annually in order to buy his dream car. How much will Bart’s car cost? And how much does Bart have to save today in order to buy this car at age 16?

QUESTION 4

Lisa Simpson is planning to attend college when she graduates from high school 7 years from now. She anticipates that she will need an amount of $35,770.97 for her 4-year college to pay for tuition and fees, and have some spending money. Lisa has made an arrangement with her father to do the household chores if her dad deposits $3,500 at the end of each year for the next 7 years in a bank account paying 8 percent interest. Will there be enough money in the account for Lisa to pay for her college expenses?

Answer 1

QUESTION 2

a]

From the company perspective, the best option is that with the highest present value.

Present value = cash flow / (1 + cost of funds)^{number of years}

Option A

present value = $50. This is the present value, and does not need to be discounted as it is received today.

Option B

present value = $38 + ($17 / (1 + 8%)¹) = $53.74

Option C

present value = $17 + ($17 / (1 + 8%)²) + ($17 / (1 + 8%)³) = $47.32

Option B is best as it has the highest present value

b]

From the subscriber perspective, the best option is that with the lowest present value.

Present value = cash flow / (1 + cost of funds)^{number of years}

Option A

present value = $50. This is the present value, and does not need to be discounted as it is received today.

Option B

present value = $38 + ($17 / (1 + 5%)¹) = $53.19

Option C

present value = $17 + ($17 / (1 + 5%)²) + ($17 / (1 + 5%)³) = $48.61

Option C is best as it has the lowest present value