Time Value of 6 Money Chapter

LEARNING OB ECTIVE!

After reading this chapter, students should be able to:

Convert time value of money (TVM) problems from words to time lines !"plain the relationship future and present value between compounding and discounting, between

Calculate the future value of some beginning amount, and find the present value of a single payment to be received in the future #olve for time or interest rate, given the other three variables in the TVM e$uation %ind the future value of a series of e$ual, periodic payments (an annuity) as well as the present value of such an annuity !"plain the difference between an ordinary annuity and an annuity due, and calculate the difference in their values Calculate the value of a perpetuity &emonstrate how to find the present and future values of an uneven series of cash flows &istinguish among the following interest rates: 'ominal (or (uoted) rate, )eriodic rate, and !ffective (or !$uivalent) Annual *ate+ and properly choose between securities with different compounding periods #olve time value of money problems that involve fractional time periods Construct loan amorti,ation partially-amorti,ed loans schedules for both fully-amorti,ed and

Learning Objectives: 6 - 1

LECT#RE !#GGE!TION!

.e regard Chapter / as the most important chapter in the boo0, so we spend a good bit of time on it .e approach time value in three ways %irst, we try to get students to understand the basic concepts by use of time lines and simple logic #econd, we e"plain how the basic formulas follow the logic set forth in the time lines Third, we show how financial calculators and spreadsheets can be used to solve various time value problems in an efficient manner 1nce we have been through the basics, we have students wor0 problems and become proficient with the calculations and also get an idea about the sensitivity of output, such as present or future value, to changes in input variables, such as the interest rate or number of payments #ome instructors prefer to ta0e a strictly analytical approach and have students focus on the formulas themselves 1thers prefer to use the )resent Value Tables, which have for many years been supplied with the te"t 2n both cases, the argument is made that students treat their calculators as 3blac0 bo"es,4 and that they do not understand where their answers are coming from or what they mean .e disagree .e thin0 that our approach shows students the logic behind the calculations as well as alternative approaches, and because calculators are so efficient, students can actually see the significance of what they are doing better if they use a calculator .e also thin0 it is important to teach students how to use the type of technology (calculators and spreadsheets) they must use when they venture into the real world 2n the past, the biggest stumbling bloc0 to many of our students has been time value, and the biggest problem there has been that they did not 0now how to use their calculator when we got into time value Therefore, we strongly encourage students to get a calculator early, learn to use it, and bring it to class so they can wor0 problems with us as we go through the lectures 1ur urging, plus the fact that we can now provide relatively brief, course-specific manuals for the leading calculators, has reduced if not eliminated the problem 1ur research suggests that the best calculator for the money for most students is the 5)-678 %inance and accounting ma9ors might be better off with a more powerful calculator, such as the 5)-6:8 .e recommend these two for people who do not already have a calculator, but we tell them that any financial calculator that has an 2** function will do .e also tell students that it is essential that they wor0 lots of problems, including the end-of-chapter problems .e emphasi,e that this chapter is critical, so they should invest the time now to get the material down .e stress that they simply cannot do well with the material that follows without having this material down cold Cost of capital and capital budgeting ma0e little sense, and one certainly cannot wor0 problems in these areas, without understanding time value of money first %or other suggestions about the lecture, please see the 3;ecture #uggestions4 in Chapter <, where we describe how we conduct our classes &A=# 1' C5A)T!*: > 1% ?@ &A=# (?7-minute periods)

Lecture Suggestions: 6 - "

AN!%ER! TO EN&-O'-C(A)TER *#E!TION!

/-6

The opportunity cost rate is the rate of interest one could earn on an alternative investment with a ris0 e$ual to the ris0 of the investment in $uestion This is the value of i in the TVM e$uations, and it is shown on the top of a time line, between the first and second tic0 mar0s 2t is not a single rate--the opportunity cost rate varies depending on the ris0iness and maturity of an investment, and it also varies from year to year depending on inflationary e"pectations (see Chapter ?) True The second series is an uneven payment stream, but it contains an annuity of A>77 for @ years The series could also be thought of as a A677 annuity for 67 years plus an additional payment of A677 in =ear <, plus additional payments of AB77 in =ears B through 67 True, because of compounding effects--growth on growth The following e"ample demonstrates the point The annual growth rate is i in the following e$uation: A6(6 C i)67 D A< The term (6 C i)67 is the %V2% for i percent, 67 years follows: .e can find i as

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Esing a financial calculator input ' D 67, )V D -6, )MT D 7, %V D <, and 2 D F #olving for 2 you obtain : 6@ percent Viewed another way, if earnings had grown at the rate of 67 percent per year for 67 years, then !)# would have increased from A6 77 to A< ?G, found as follows: Esing a financial calculator, input ' D 67, 2 D 67, )V D -6, )MT D 7, and %V D F #olving for %V you obtain A< ?G This formulation recogni,es the 3interest on interest4 phenomenon /-> /-? %or the same stated rate, daily compounding is best 3interest on interest 4 =ou would earn more

%alse 1ne can find the present value of an embedded annuity and add this )V to the )Vs of the other individual cash flows to determine the present value of the cash flow stream The concept of a perpetuity implies that payments forever %V ()erpetuity) D )V ()erpetuity)(6 C i) D will be received

/-/

Answers and Solutions: 6 - $

!OL#TION! TO EN&-O'-C(A)TER )ROBLEM!

/-6

7 67K H )V D 67,777

6 H

< H

B H

> H

? H %V? D F

%V? D A67,777(6 67)? D A67,777(6 /67?6) D A6/,67? 67 Alternatively, with a financial calculator enter the following: 2 D 67, )V D -67777, and )MT D 7 #olve for %V D A6/,67? 67 /-< 7 :K H )V D F ? H 67 H 6? H <7 H %V<7 D ?,777 ' D <7, 2 D :, )MT D 7, ' D ?,

.ith a financial calculator enter the following: and %V D ?777 #olve for )V D A6,<G< 67 /-B 7 / ?K H )V D 6 < D 6(6 7/?)n .ith a financial calculator enter the following: 7, and %V D < #olve for ' D 66 76 I 66 years /-> n D F H %Vn D <

2 D / ?, )V D -6, )MT D

Esing your financial calculator, enter the following data: 2 D 6<+ )V D -><6@7 ?B+ )MT D -?777+ %V D <?7777+ ' D F #olve for ' D 66 2t will ta0e 66 years for John to accumulate A<?7,777 7 i D F H )V D <?7,777 6@ H D 6,777,777

/-?

%V6@

.ith a financial calculator enter the following: ' D 6@, )V D -<?7777, )MT D 7, and %V D 6777777 #olve for 2 D @ 76K I @K /-/ 7 :K H 6 H B77 < H B77 B H B77 > H B77 ? H B77 %VA? D F

Answers and Solutions: 6 - +

/-:

.ith a financial calculator enter the following: and )MT D B77 #olve for %V D A6,:<? << 7 :K 6 < B > ? H H H H H H B77 B77 B77 B77 B77

' D ?, 2 D :, )V D 7,

.ith a financial calculator, switch to 38!L4 and enter the following: ' D ?, 2 D :, )V D 7, and )MT D B77 #olve for %V D A6,@>? GG &onMt forget to switch bac0 to 3!'&4 mode /-@ 7 @K H )V D F Esing a financial calculator, enter the following: C%7 C%6 C%> C%? C%/ and D D D D D 2 7 677, '9 D B <77 ('ote B77 ('ote ?77 ('ote D @ #olve 6 H 677 < H 677 B H 677 > H <77 ? H B77 / H ?77 %V D F

calculator will show C%< on screen ) calculator will show C%B on screen ) calculator will show C%> on screen ) for ')V D AG<B G@

To solve for the %V of the cash flow stream with a calculator that doesnMt have the '%V 0ey, do the following: !nter ' D /, 2 D @, )V D -G<B G@, and )MT D 7 #olve for %V D A6,>// <> =ou can chec0 this as follows: 7 @K H 6 H 677 < H 677
(6 7@)> (6 7@)?

B H 677
(6 7@)
B

> H <77
(6 7@)<

? H B77 (6

/ H 7@) ?77 B<> <BB 6<? 6B/ 6>/ A6,>//

77 <@ G: 7? GB <B

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Esing a financial calculator, enter the following: -<7777, and %V D 7 #olve for )MT D A>>> @G !A* D 6 +

' D /7, 2 D 6, )V D

i 'om m

- 6 7

D (6 76)6< - 6 7 D 6< /@K Alternatively, using a financial calculator, enter the following: '1MK D 6< and )N=* D 6< #olve for !%%K D 6< /@<?K *emember to change bac0 to )N=* D 6 on your calculator Answers and Solutions: 6 - ,

Answers and Solutions: 6 - 6

/-67

6GG:F H -/

6GG@ H

6GGG H

<777 H

<776 H

<77< H 6< (in millions)

.ith a calculator, enter ' D ?, )V D -/, )MT D 7, %V D 6<, and then solve for 2 D 6> @:K b The calculation described in the $uotation fails to ta0e account of the compounding effect 2t can be demonstrated to be incorrect as follows: A/,777,777(6 <7)? D A/,777,777(< >@@B) D A6>,G<G,@77, which is greater than A6< million Thus, the annual growth rate is less than <7 percent+ in fact, it is about 6? percent, as shown in )art a /-66 7D F i 6 H < H B H > H ? H / H : H @ H G H 67 H @ (in millions)

H ->

.ith a calculator, enter ' D 67, )V D ->, )MT D 7, %V D @, and then solve for 2 D : 6@K /-6< 7i D F H @?,777 6 < B > H H H H -@,<:B ?G -@,<:B ?G -@,<:B ?G -@,<:B ?G B7 H -@,<:B ?G

.ith a calculator, enter ' D B7, )V D @?777, )MT D -@<:B ?G, %V D 7, and then solve for 2 D GK /-6B a 7 :K H )V D F 6 H -67,777 < H -67,777 B H -67,777 > H -67,777 Then

.ith a calculator, enter ' D >, 2 D :, )MT D -67777, and %V D 7 press )V to get )V D ABB,@:< 66 b 6

At this point, we have a B-year, : percent annuity whose value is A</,<>B 6/ =ou can also thin0 of the problem as follows: ABB,@:<(6 7:) - A67,777 D A</,<>B 7>

< /-6> 7 6<K H

Oero after the last withdrawal 6 H 6,<?7 < H 6,<?7 B H 6,<?7 > H 6,<?7 ? H 6,<?7 / H F %V D 67,777

Answers and Solutions: 6 - -

.ith a financial calculator, get a 3ballpar04 estimate of the years by entering 2 D 6<, )V D 7, )MT D -6<?7, and %V D 67777, and then pressing the ' 0ey to find ' D ? G> years This answer assumes that a payment of A6,<?7 will be made G>N677th of the way through =ear ? 'ow find the %V of A6,<?7 for ? years at 6< percent+ it is A:,G>6 7/ Compound this value for 6 year at 6< percent to obtain the value in the account after / years and before the last payment is made+ it is A:,G>6 7/(6 6<) D A@,@GB GG Thus, you will have to ma0e a payment of A67,777 - A@,@GB GG D A6,67/ 76 at =ear /, so the answer is: it will ta0e / years, and A6,67/ 76 is the amount of the last payment

/-6?

Contract 6:

)V D D

AB , 777 , 777 AB , 777 , 777 AB , 777 , 777 AB , 777 , 777 + + + < B > 6 6 (6 6) (6 6) (6 6)
A<,:<:,<:< :B C A<,>:G,BB@ @> C A<,<?B,G>> >7 C

A<,7>G,7>7 B: D AG,?7G,?G/ B> Esing your financial calculator, enter the following data: C%7 D 7+ C%6-> D B777777+ 2 D 67+ ')V D F #olve for ')V D AG,?7G,?G/ B> Contract <:
AB,>6?,7/: <@

)V D D

A< , 777 , 777 AB, 777 , 777 A>, 777 , 777 A?, 777 , 777 + + + < B > 6 67 (6 67) (6 67) (6 67)
A6,@6@,6@6 @< C A<,>:G,BB@ @> C AB,77?,<?G <7 C

D A67,:6:,@>: 6> Alternatively, using your financial calculator, enter the following data: C%7 D 7+ C%6 D <777777+ C%< D B777777+ C%B D >777777+ C%> D ?777777+ 2 D 67+ ')V D F #olve for ')V D A67,:6:,@>: 6> Contract B: )V D

A: , 777 , 777 A6, 777 , 777 A6, 777 , 777 A6, 777 , 777 + + + < B > 6 67 (6 67) (6 67) (6 67)

D A/,B/B,/B/ B/ C A@</,>>/ <@ C A:?6,B6> @7 C A/@B,76B >/ D A@,/<>,>67 G7 Alternatively, using your financial calculator, enter the following data: C%7 D 7+ C%6 D :777777+ C%< D 6777777+ C%B D 6777777+ C%> D 6777777+ 2 D 67+ ')V D F #olve for ')V D A@,/<>,>67 G7 Contract < gives the $uarterbac0 the highest present value+ therefore, he should accept Contract < /-6/ )V D A677N7 7: D A6,><@ ?: )V D A677N7 6> D A:6> <G

.hen the interest rate is doubled, the )V of the perpetuity is halved /-6: 7 <K > @ 6< 6/

Answers and Solutions: 6 - .

H H )V D F 7

H 7

H 7

H ?7

H 7

H 7

H 7

H ?7

H 7

H 7

H 7

H ?7

H 7

H 7

H H 7 6,7?7

i)!* D @KN> D <K The cash flows are shown on the time line above .ith a financial calculator enter the following cash flows into your cash flow register: C% 7 D 7, C%6-B D 7, C%> D ?7, C%?-: D 7, C%@ D ?7, C%G-66 D 7, C%6< D ?7, C%6B - 6? D 7, C%6/ D 67?7+ enter 2 D <, and then press the ')V 0ey to find )V D A@GB 6/ /-6@ This can be done with a calculator by specifying an interest rate of ? percent per period for <7 periods with 6 payment per period ' 2 )V %V D D D D 67 < D <7 67KN< D ? -67777 7

#olve for )MT D A@7< >B #et up an amorti,ation table: )eriod 6 < 8eginning 8alance A67,777 77 G,/G: ?: )ayment A@7< >B @7< >B 2nterest A?77 77 >@> @@ AG@> @@ )ayment of )rincipal AB7< >B !nding 8alance AG,/G: ?:

=ou can also wor0 the problem with a calculator having an amorti,ation function %ind the interest in each /-month period, sum them, and you have the answer !ven simpler, with some calculators such as the 5)-6:8, 9ust input < for periods and press 2'T to get the interest during the first year, AG@> @@ The 5)-678 does the same thing /-6G A6,777,777 loan P 6? percent, annual )MT, ?-year amorti,ation .hat is the fraction of )MT that is principal in the second yearF %irst, find )MT by using your financial calculator: ' D ?, 2N=* D 6?, )V D -6777777, and %V D 7 #olve for )MT D A<G@,B6? ?? Then set up an amorti,ation table: =ear 6 < 8eginning 8alance A6,777,777 77 @?6,/@> >? )ayment A<G@,B6? ?? <G@,B6? ?? 2nterest A6?7,777 77 6<:,:?< /: )rincipal A6>@,B6? ?? 6:7,?/< @@ !nding 8alance

A@?6,/@> >? /@6,6<6 ?:

%raction that is principal D A6:7,?/< @@NA<G@,B6? ?? D 7 ?:6@ D ?: 6@K I ?: <K Answers and Solutions: 6 - /

/-<7

8egin with a time line:

7 6 < B > ? B H / : > H @ G 67 ? H @ H 6/ 6: G H 6@ 6G 67 H <7 /-

mos 7 6 < /K H H H H H H 677 677 677 677 677 %VA =ears H H

#ince the first payment is made today, we have a ?-period annuity due The applicable interest rate is 6<KN< D /K %irst, we find the %VA of the annuity due in period ? by entering the following data in the financial calculator: ' D ?, 2 D 6<N< D /, )V D 7, and )MT D -677 #etting the calculator on 38!L,4 we find %VA (Annuity due) D A?G: ?B 'ow, we must compound out for 6? semiannual periods at / percent A?G: ?B b 7 6 BK H H )MT )MT <7 Q ? D 6? periods P /K < H )MT B H )MT > H )MT ? H

A6,>B< 7< >7 $uarters H %V D 6,>B< 7<

The time line depicting the problem is shown above 8ecause the payments only occur for ? periods throughout the >7 $uarters, this problem cannot be immediately solved as an annuity problem The problem can be solved in two steps: 6 &iscount the A6,>B< 7< bac0 to the end of (uarter ? to obtain the )V of that future amount at (uarter ? 2nput the following into your calculator: ' D B?, 2 D B, )MT D 7, %V D 6>B< 7<, and solve for )V at (uarter ? )V D A?7@ G< < Then solve for )MT using the value solved in #tep 6 as the %V of the five-period annuity due The )V found in step 6 is now the %V for the calculations in this step Change your calculator to the 8!L2' mode 2nput the following into your calculator: ' D ?, 2 D B, )V D 7, %V D ?7@ G<, and solve for )MT D AGB 7: /-<6 5ere we want to have the same effective annual rate on the credit e"tended as on the ban0 loan that will be used to finance the credit e"tension %irst, we must find the !A* D !%%K on the ban0 loan !nter '1MK D 6?, )N=* D 6<, and press !%%K to get !A* D 6/ 7@K 'ow recogni,e that giving B months of credit is e$uivalent to $uarterly compounding--interest is earned at the end of the $uarter, so it is available to earn interest during the ne"t $uarter Therefore, enter )N=* D >, !%%K D !A* D 6/ 7@K, and press '1MK to find the nominal rate of 6? 6G percent (&onMt forget to change your calculator bac0 to )N=* D 6 )

Answers and Solutions: 6 - 10

Therefore, if you charge a 6? 6G percent nominal rate and give credit for B months, you will cover the cost of the ban0 loan Alternative solution: .e need to find the effective annual rate (!A*) the ban0 is charging first Then, we can use this !A* to calculate the nominal rate that you should $uote your customers 8an0 !A*: !A* D (6 C i'omNm)m - 6 D (6 C 7 6?N6<)6< - 6 D 6/ 7@K

Answers and Solutions: 6 - 11

'ominal rate you should $uote customers: 6/ 7@K 6 6/7@ 6 7B@7 i'om /-<< D D D D (6 C i'omN>)> - 6 (6 C i'omN>)> 6 C i'omN> 7 7B@7(>) D 6? 6GK

2nformation given: 6 < .ill save for 67 years, then receive payments for <? years .ants payments of A>7,777 per year in todayMs dollars for first payment only *eal income will decline 2nflation will be ? percent Therefore, to find the inflated fi"ed payments, we have this time line: 7?K H >7,777 ? H 67 H %V D F

!nter ' D 67, 2 D ?, )V D ->7777, )MT D 7, and press %V to get %V D A/?,6?? :G B 5e now has A677,777 in an account that pays @ percent, annual compounding .e need to find the %V of the A677,777 after 67 years !nter ' D 67, 2 D @, )V D -677777, )MT D 7, and press %V to get %V D A<6?,@G< ?7 5e wants to withdraw, or have payments of, A/?,6?? :G per year for <? years, with the first payment made at the beginning of the first retirement year #o, we have a <?-year annuity due with )MT D /?,6?? :G, at an interest rate of @ percent (The interest rate is @ percent annually, so no ad9ustment is re$uired ) #et the calculator to 38!L4 mode, then enter ' D <?, 2 D @, )MT D /?6?? :G, %V D 7, and press )V to get )V D A:?6,6/? B? This amount must be on hand to ma0e the <? payments #ince the original A677,777, which grows to A<6?,@G< ?7, will be available, we must save enough to accumulate A:?6,6/? B? - A<6?,@G< ?7 D A?B?,<:< @? The A?B?,<:< @? is the %V of a 67-year ordinary annuity The payments will be deposited in the ban0 and earn @ percent interest Therefore, set the calculator to 3!'&4 mode and enter ' D 67, 2 D @, )V D 7, %V D ?B?<:< @?, and press )MT to find )MT D AB/,G>G /6 8egin with a time line: 7 @K H 6 :? )V D F 6 H 6 :?

>

/-<B

6G H 6 :?

<7 H (in millions)

Answers and Solutions: 6 - 1"

2t is important to recogni,e that this is an annuity due since payments start immediately Esing a financial calculator input the following after switching to 8!L2' mode: ' D <7, 2 D @, )MT D 6:?7777, %V D 7, and solve for )V D A6@,??/,<GG b 7 @K H 6 :? 6 H 6 :?

6G H 6 :?

<7 H (in millions) %V D F

2t is important to recogni,e that this is an annuity due since payments start immediately Esing a financial calculator input the following after switching to 8!L2' mode: ' D <7, 2 D @, )V D 7, )MT D 6:?7777, and solve for %V D A@/,>G7,66B c 7 @K H )V D F Esing a financial calculator input the following: ' D <7, 2 D @, )MT D 6:?7777, %V D 7, and solve for )V D A6:,6@6,:?@ 7 @K H 6 H 6 :?

6 H 6 :?

6G H 6 :?

<7 H 6 :?

(in millions)

6G H 6 :?

<7 H 6 :? %V D F

(in millions)

Esing a financial calculator input the following: ' D <7, 2 D @, )V D 7, )MT D 6:?7777, and solve for %V D A@7,7@B,>B@ /-<> a 8egin with a time line: >7 6<K H >6 H ?,777

/> H ?,777

/? H ?,777

Esing a financial calculator input the following: ' D <?, 2 D 6<, )V D 7, )MT D ?777, and solve for %V D A///,//G B? b >7 6<K H >6 H ?,777

/G H ?,777

:7 H ?,777 %V D F

Esing a financial calculator input the following:

Answers and Solutions: 6 - 1$

' D B7, 2 D 6<, )V D 7, )MT D ?777, and solve for %V D A6,<7/,//B ><

Answers and Solutions: 6 - 1+

/-<?

8egin with a time line: 7 6 < B > ? 6<NB6N76 6<NB6N7< 6<NB6N7B 6<NB6N7> 6<NB6N7? 6<NB6N7/ 76N76N7: :K H H H H H H H B>,777 B/,777 B:,7@7 B@,6G< >7 BG,BB@ 6: >7,?6@ B< >6,:BB @: 677,777 <7,777 )V D F #tep 6: #tep <: Calculate the )V of the lost bac0 pay: AB>,777(6 7:) C AB/,777 D A:<,B@7 Calculate the )V of future salary (<77B - <77:): C%7 D 7 C%6 D B/,777(6 7B) D B:7@7 77 C%< D B/,777(6 7B)< D B@6G< >7 C%B D B/,777(6 7B)B D BGBB@ 6: C%> D B/,777(6 7B)> D >7?6@ B< C%? D B/,777(6 7B)? D >6:BB @: 2 D : #olve for ')V D A6/7,:G6 ?7 8ecause the costs for pain and suffering and court costs are already on a present value basis, 9ust add to the )V of costs found in #teps 6 and < )V D A:<,B@7 C A6/7,:G6 ?7 C A677,777 C A<7,777 D AB?B,6:6 ?7

#tep B:

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8egin with a time line: 7 H :K 6 H ?,777 < H ?,?77 B H /,7?7 %V D F

Ese a financial calculator to calculate the present value of the cash flows and then determine the future value of this present value amount: #tep 6: C%7 D C%6 D C%< D C%B D 2 D #olve 7 ?777 ??77 /7?7 : for ')V D A6>,>6? >6

#tep <:

2nput the following data: ' D B, 2 D :, )V D -6>>6? >6, )MT D 7, and solve for %V D A6:,/?G ?7

Answers and Solutions: 6 - 1,

/-<:

8egin with a time line: 7 GK H -B>7 >/@G 6 H ?7

? H ?7

/ H )MT

6? H )MT

This security is essentially two annuities and the present value of the security is the sum of the present values for each of the two annuities Esing a financial calculator solve as follows: #tep 6: &etermine the present value of the first annuity: 2nput ' D ?, 2 D G, )MT D ?7, %V D 7, and solve for )V D A6G> >@</ Calculate the present value of the second annuity: AB>7 >/@G - A6G> >@</ D A6>? G@/B Calculate the value of the second annuity as of =ear ?: 2nput ' D ?, 2 D G, )V D -6>? G@/B, )MT D 7, and solve for %V D A<<> /6@7 #tep >: Calculate the payment amount of the second annuity: 2nput ' D 67, 2 D G, )V D -<<> /6@7, %V D 7, and solve for )MT D AB? 77 6 H < H <7 B H > H <7 ? H / H <7 : H @ (trs H <7 %V D F

#tep <: #tep B:

/-<@

7 6 :?K H

To solve this problem two steps are needed %irst, determine the present value of the cash flow stream #econd, calculate the future value of this present value Esing a financial calculator input the following: C%7 D 7+ C%6 D 7+ C%< D <7+ C%B D 7+ C%> D <7+ C%? D 7+ C%/ D <7+ C%: D 7+ C%@ D <7+ 2 D :N> D 6 :?+ and then solve for ')V D A:B >7@< Calculate the future value of this ')V amount: 2nput ' D @, 2 D 6 :?, )V D -:B >7@<, )MT D 7, and solve for %V D A@> B> /-<G a Esing the information given in the problem, you can solve for the length of time re$uired to reach A6 million 2 D @+ )V D B7777+ )MT D ?777+ %V D -6777777+ and then solve for ' D B6 :6G/ Therefore, it will ta0e !ri0a B6 :< years to reach her investment goal b Again, you can solve for the length of time re$uired to reach A6 million

Answers and Solutions: 6 - 16

2 D G+ )V D B7777+ )MT D ?777+ %V D -6777777+ and then solve for ' D <G 6?/: 2t will ta0e Ratherine <G 6/ years to reach her investment goal The difference in time is B6 :< - <G 6/ D < ?/ years c Esing the B6 :6G/ year target, you can solve for the re$uired payment ' D B6 :6G/+ 2 D G+ )V D B7777+ %V D -6777777+ then solve for )MT D B,B/@ 77 2f Ratherine wishes to reach the investment goal at the same time as !ri0a, she can contribute as little as AB,B/@ every year /-B7 a 2f Crissie e"pects a :K annual return upon her investments: 6 payment 67 payments ' D 67 2 D : )MT D G?77777 %V D 7 )V D //,:<>,7<? B7 payments ' D B7 2 D : )MT D ??77777 %V D 7 )V D /@,<>G,:<:

)V D /6,777,777

Crissie should accept the B7-year payment option as it carries the highest present value (A/@,<>G,:<:) b 2f Crissie e"pects an @K annual return upon her investments: 6 payment 67 payments ' D 67 2 D @ )MT D G?77777 %V D 7 )V D /B,:>?,::B B7 payments ' D B7 2 D @ )MT D ??77777 %V D 7 )V D /6,G6:,@7@

)V D /6,777,777

Crissie should accept the 67-year payment option as it carries the highest present value (A/B,:>?,::B) c 2f Crissie e"pects a GK annual return upon her investments: 6 payment 67 payments ' D 67 2 D G )MT D G?77777 %V D 7 )V D /7,G/:,:>@ B7 payments ' D B7 2 D G )MT D ??77777 %V D 7 )V D ?/,?7?,7G:

)V D /6,777,777

Crissie should accept the lump-sum payment option as it carries the highest present value (A/6,777,777) Answers and Solutions: 6 - 1-

/-B6

Esing the information given in the problem, you can solve for the ma"imum car price attainable %inanced for >@ months ' D >@ 2 D 6 (6<KN6< D 6K) )MT D B?7 %V D 7 )V D 6B,<G7 @G %inanced for /7 months ' D /7 2 D 6 )MT D B?7 %V D 7 )V D 6?,:B> </

=ou must add the value of the down payment to the present value of the car payments 2f financed for >@ months, Jarrett can afford a car valued up to A6:,<G7 @G (A6B,<G7 @G C A>,777) 2f financing for /7 months, Jarrett can afford a car valued up to 6G,:B> </ (A6?,:B> </ C A>,777) /-B< a Esing the information given in the problem, you can solve for the length of time re$uired to eliminate the debt 2 D < (<>KN6<)+ )V D B7? >>+ )MT D -67+ %V D 7+ and then solve for ' D >: //B@ 8ecause #imon ma0es payments on his credit card at the end of the month, it will re$uire >@ months before he pays off the debt b %irst, you should solve for the present value of the total payments made through the first >: months ' D >:+ 2 D <+ )MT D -67+ %V D 7+ and then solve for )V D B7< @/?@ This represents a difference in present values of payments of A< ?:>< (AB7? >> - AB7< @/?@) 'e"t, you must find the value of this difference at the end of the >@th month ' D >@+ 2 D <+ )V D -< ?:><+ )MT D 7+ and then solve for %V D / /?G/ Therefore, the >@th and final payment will be for A/ // c 2f #imon ma0es monthly payments of AB7, we can solve for the length of time re$uired before the account is paid off 2 D <+ )V D B7? >>+ )MT D -B7+ %V D 7+ and then solve for ' D 66 >G:@ .ith AB7 monthly payments, #imon will only need 6< months to pay off the account d %irst, we must find out what the final payment will be if AB7 payments are made for the first 66 months

Answers and Solutions: 6 - 1.

' D 66+ 2 D <+ )MT D -B7+ %V D 7+ and then solve for )V D <GB /7?> This represents a difference in present values of payments of A66 @B>/ (AB7? >> - A<GB /7?>) 'e"t, you must find the value of this difference at the end of the 6<th month ' D 6<+ 2 D <+ )V D -66 @B>/+ )MT D 7+ and then solve for %V D 6? 77G6 Therefore, the 6<th and final payment will be for A6? 76 The difference in total payments can be found to be: S(>: A67) C A/ //T - S(66 AB7) C A6? 76T D A6B6 /? /-BB Esing the information given in the problem, you can solve for the return on the investment ' D ?+ )V D -6B77+ )MT D >77+ %V D 7+ and then solve for 2 D 6/ B<K /-B> a 7 /K H -?77 7 /K H -?77 7 H )V D 7 H )V D /K F /K F < H < H < H < H B H B H B H B H > H > H > H > H ? H ? H ? H ? H 6 H %V D F 6 H 6 H ?77 6 H

A?77(6 7/) D A?B7 77 < H %V D F

A?77(6 7/)< D A?/6 @7

c d

A?77(6N6 7/) D A>:6 :7 < H ?77 / H / H / H / H : H : H : H : H A?77(6N6 7/)< D A>>? 77

/-B?

7 /K 6 H H -?77 7 6 6<K H H -?77 7 /K 6 H H )V D F 7 6 6<K H H )V D F

@ H @ H @ H @ H

G H G H

67 H A?77(6 7/)67 D A@G? >< %V D F 67 H A?77(6 6<)67 D A6,??< G< %V D F G H G H 67 H A?77N(6 7/)67 D A<:G <7 ?77 67 H 6,??< G7 Answers and Solutions: 6 - 1/

A6,??< G7N(6 6<)67 D A>GG GG A6,??< G7N(6 7/)67 D A@/: 6B The present value is the value today of a sum of money to be received in the future %or e"ample, the value today of A6,??< G7 to be received 67 years in the future is about A?77 at an interest rate of 6< percent, but it is appro"imately A@/: if the interest rate is / percent Therefore, if you had A?77 today and invested it at 6< percent, you would end up with A6,??< G7 in 67 years The present value depends on the interest rate because the interest rate determines the amount of interest you forgo by not having the money today /-B/ a F H >77

:K H -<77

.ith a financial calculator, enter 2 D :, )V D -<77, )MT D 7, and %V D >77 Then press the ' 0ey to find ' D 67 <> 1verride 2 with the other values to find ' D : <:, > 6G, and 6 77 b 67K H -<77 H -<77 d H -<77 /-B: a 7 67K 6 H H >77 6@K F H >77 F H >77 F H >77 < H >77 B H >77 !nter: 2 D 67, )V D -<77, )MT D 7, and %V D >77 ' D : <: !nter: 2 D 6@, )V D -<77, )MT D 7, and %V D >77 ' D > 6G !nter: 2 D 677, )V D -<77, )MT D 7, and %V D >77 ' D 6 77 > H >77 ? H >77 / H >77 : H >77 @ H >77 G H >77 67 H >77 %V D F

.ith a financial calculator, enter ' D 67, 2 D 67, )V D 7, and )MT D ->77 Then press the %V 0ey to find %V D A/,B:> G: b 7 ?K H 6 H <77 < H <77 B H <77 > H <77 ? H <77 %V D F

.ith a financial calculator, enter ' D ?, 2 D ?, )V D 7, and )MT D -<77 Then press the %V 0ey to find %V D A6,67? 6B c 7 7K H 6 H >77 < H >77 B H >77 > H >77 ? H >77 %V D F

Answers and Solutions: 6 - "0

.ith a financial calculator, enter ' D ?, 2 D 7, )V D 7, and )MT D ->77 Then press the %V 0ey to find %V D A<,777 d To solve )art d using a financial calculator, repeat the procedures discussed in )arts a, b, and c, but first switch the calculator to 38!L4 mode Ma0e sure you switch the calculator bac0 to 3!'&4 mode after wor0ing the problem 6 767K 6 H H >77 >77 < H >77 B H >77 > H >77 ? H >77 / H >77 : H >77 @ H >77 G 67 H H >77 %V D F

.ith a financial calculator on 8!L, enter: 7, and )MT D ->77 %V D A:,76< >: < 7?K H <77 6 H <77 < H <77 B H <77 > ? H H <77 %V D F

' D 67, 2 D 67, )V D

.ith a financial calculator on 8!L, enter: and )MT D -<77 %V D A6,6/7 B@ B 7 7K H >77 6 H >77 < H >77 B H >77 > H >77 ? H %V D F

' D ?, 2 D ?, )V D 7,

.ith a financial calculator on 8!L, enter: and )MT D ->77 %V D A<,777 /-B@ The general formula is )VAn D )MT()V2%Ai,n) a 7 67K 6 H H )V D F >77 < H >77 B H >77 > H >77 ? H >77 / H >77 : H >77 @ H >77

' D ?, 2 D 7, )V D 7,

G H >77

67 H >77

.ith a financial calculator, simply enter the 0nown values and then press the 0ey for the un0nown !nter: ' D 67, 2 D 67, )MT D ->77, and %V D 7 )V D A<,>?: @B b 7 ?K H )V D F 6 H <77 < H <77 B H <77 > H <77 ? H <77 ' D ?, 2 D ?, )MT D -<77, and ? H >77 ' D ?, 2 D 7, )MT D ->77, and Answers and Solutions: 6 - "1

.ith a financial calculator, enter: %V D 7 )V D A@/? G7 c 7 7K H )V D F 6 H >77 < H >77 B H >77 > H >77

.ith a financial calculator, enter: %V D 7 )V D A<,777 77

7 67K 6 H H >77 >77 )V D F

< H >77

B H >77

> H >77

? H >77

/ H >77

: H >77

@ H >77

G H >77

67 H

<

.ith a financial calculator on 8!L, enter: ->77, and %V D 7 )V D A<,:7B /6 7 ?K 6 < B > ? H H H H H H <77 <77 <77 <77 <77 )V D F .ith a financial calculator on 8!L, enter: -<77, and %V D 7 )V D AG7G 6G

' D 67, 2 D 67, )MT D

' D ?, 2 D ?, )MT D

7 7K H >77 )V D F

6 H >77

< H >77

B H >77

> H >77

? H

.ith a financial calculator on 8!L, enter: ->77, and %V D 7 )V D A<,777 77 /-BG a Cash #tream A 7@K 6 < B > H H H H H )V D F 677 >77 >77 >77

' D ?, 2 D 7, )MT D

? H B77

Cash #tream 8 7@K 6 < B > H H H H H )V D F B77 >77 >77 >77

? H 677

.ith a financial calculator, simply enter the cash flows (be sure to enter C%7 D 7), enter 2 D @, and press the ')V 0ey to find ')V D )V D A6,<?6 <? for the first problem 1verride 2 D @ with 2 D 7 to find the ne"t )V for Cash #tream A *epeat for Cash #tream 8 to get ')V D )V D A6,B77 B< b )VA D A677 C A>77 C A>77 C A>77 C AB77 D A6,/77 )V8 D AB77 C A>77 C A>77 C A>77 C A677 D A6,/77

/->7

These problems can all be solved using a financial calculator by entering the 0nown values shown on the time lines and then pressing the 2 button a 7 i D F H C:77 6 H -:>G ' D 6, )V D :77, )MT D 7, and

.ith a financial calculator, enter: %V D -:>G 2 D :K b 7 i D F H -:77 6 H C:>G

Answers and Solutions: 6 - ""

.ith a financial calculator, enter: %V D :>G 2 D :K c 7 i D F H C@?,777 67 H -<76,<<G

' D 6, )V D -:77, )MT D 7, and

.ith a financial calculator, enter: and %V D -<76<<G 2 D GK d 7 i D F 6 H H CG,777 -<,/@> @7 < H -<,/@> @7

' D 67, )V D @?777, )MT D 7, > H -<,/@> @7 ? H -<,/@> @7

B H -<,/@> @7

.ith a financial calculator, enter: -</@> @7, and %V D 7 2 D 6?K /->6 a 7 6<K H -?77 6 H < H B H > H ? H %V D F

' D ?, )V D G777, )MT D

.ith a financial calculator, enter ' D ?, 2 D 6<, )V D -?77, and )MT D 7, and then press %V to obtain %V D A@@6 6: b 7 /K H -?77 6 H < H B H > H ? H / H : H @ H G H 67 H %V D F

!nter the time line values into a financial calculator to obtain %V D A@G? ><

i 7 6< Alternatively, %Vn D )V D A?77 6 + 6 + m < D A?77(6 7/)67 D A@G? ><

c 7 BK H -?77 > H @ H 6< H 6/ H <7 H %V D F

mn

< (?)

!nter the time line values into a financial calculator to obtain %V D AG7B 7/

7 6< Alternatively, %Vn D A?77 6 C >

d 7 6K H -?77 6< H <> H B/ H >@ H

>(?)

D A?77(6 7B)<7 D AG7B 7/ /7 H F

!nter the time line values into a financial calculator to obtain %V D AG7@ B?

Answers and Solutions: 6 - "$

7 6< Alternatively, %Vn D A?77 6 C 6<

/->< a 7 /K H )V D F < H > H / H @ H

6<(?)

D A?77(6 76)/7 D AG7@ B?

67 H ?77

!nter the time line values into a financial calculator to obtain )V D A<:G <7 Alternatively, )V
6 D %Vn 6 C i m
mn

6 D A?77 6 C 7 6< <

<(?)

6 D A?77 6 7/
b 7 BK H )V D F > H @ H 6< H

67

D A<:G <7 <7 H ?77

6/ H

!nter the time line values into a financial calculator to obtain )V D A<:/ @>
6 Alternatively, )V D A?77 6 C 7 6< >
> (?)

6 D A?77 6 7B

<7

D A<:/ @>

7 6K H )V D F

6 H

< H

6< H ?77

!nter the time line values into a financial calculator to obtain )V D A>>B :<
6 Alternatively, )V D A?77 6 C 7 6< 6<
6< (6)

6 D A?77 6 76

6<

D A>>B :<

/->B

7 /K H

6 H ->77

< H ->77

B H ->77

G H ->77

67 H ->77 %V D F

!nter ' D ? < D 67, 2 D 6<N< D /, )V D 7, )MT D ->77, and then press %V to get %V D A?,<:< B< b 'ow the number of periods is calculated as ' D ? > D <7, 2 D 6<N> D B, )V D 7, and )MT D -<77 The calculator solution is A?,B:> 7:

Answers and Solutions: 6 - "+

The solution assumes that the nominal interest rate is compounded at the annuity period c The annuity in )art b earns more because some of the money is on deposit for a longer period of time and thus earns more interest Also, because compounding is more fre$uent, more interest is earned on interest

Answers and Solutions: 6 - ",

/->>

%irst City 8an0: #econd City 8an0:

!ffective rate D :K

!ffective rate D 6 +

7 7/ - 6 7 D (6 76?)> Q 6 7 > D 6 7/6> Q 6 7 D 7 7/6> D / 6>K

>

.ith a financial calculator, you can use the interest rate conversion feature to obtain the same answer =ou would choose the %irst City 8an0 b 2f funds must be left on deposit until the end of the compounding period (6 year for %irst City and 6 $uarter for #econd City), and you thin0 there is a high probability that you will ma0e a withdrawal during the year, the #econd City account might be preferable %or e"ample, if the withdrawal is made after 67 months, you would earn nothing on the %irst City account but (6 76?)B Q 6 7 D > ?:K on the #econd City account Ten or more years ago, most ban0s and #U;s were set up as described above, but now virtually all are computeri,ed and pay interest from the day of deposit to the day of withdrawal, provided at least A6 is in the account at the end of the period .ith a financial calculator, enter ' D ?, 2 D 67, )V D -<?777, and %V D 7, and then press the )MT 0ey to get )MT D A/,?G> G> Then go through the amorti,ation procedure as described in your calculator manual to get the entries for the amorti,ation table =ear 6 < B > ? )ayment A /,?G> G> /,?G> G> /,?G> G> /,?G> G> /,?G> GBV AB<,G:> /G 2nterest A<,?77 77 <,7G7 ?6 6,/>7 7/ 6,6>> ?@ ?GG ?> A:,G:> /G *epayment of )rincipal A >,7G> G> >,?7> >B >,G?> @@ ?,>?7 B/ ?,GG? BG A<?,777 77 *emaining 8alance A<7,G7? 7/ 6/,>77 /B 66,>>? :? ?,GG? BG 7

/->?

VThe last payment must be smaller to force the ending balance to ,ero b c 5ere the loan si,e is doubled, so the payments also double in si,e to A6B,6@G @: The annual payment on a A?7,777, 67-year loan at 67 percent interest would be A@,6B: <: 8ecause the payments are spread out over a longer time period, each payment is lower but more interest must be paid on the loan The total interest paid on the 67-year loan is AB6,B:< :7 versus interest of A6?,G>G B: on the ?-year loan

Answers and Solutions: 6 - "6

/->/

Esing your financial calculator, input the following data: ' D B7 6< D B/7+ 2 D @N6< D 7 ///:+ )V D -6<?777+ %V D 7+ )MT D F #olve for )MT D AG6: <6 After finding the monthly mortgage payment, use the amorti,ation feature of your calculator to find interest and principal repayments during the year and the remaining mortgage balance as follows: 6 2')ET 6< AM1*T D A G,G/< <B (2nterest) D A 6,7>> <G ()rincipal) D A6<B,G?? :6 (8alance) Total mortgage payments made during the first year e$uals 6< AG6: <6 D A66,77/ ?< )ortion of first year mortgage payments that go towards interest e$uals AG,G/< <BNA66,77/ ?< D G7 ?6K

After finding the monthly mortgage payment, use the amorti,ation feature of your calculator to find interest and principal payments during the first five years and the remaining mortgage balance as follows: 6 2')ET /7 AM1*T D A >@,@/G // (2nterest) D A /,6/< /@ ()rincipal) D A66@,@B: B< (8alance) The remaining mortgage balance after ? years will be A66@,@B: B<

Esing your financial calculator, input the following data: ' D B7 6< D B/7+ 2 D @N6< D 7 ///:+ )MT D 6<77+ %V D 7+ )V D F #olve for )V D A6/B,?>7 6G 2f the Jac0sons are willing to have a A6,<77 monthly mortgage payment, the can borrow A6/B,?>7 6G today

/->: O: 8: a

7 H -><< >6 -6,777 77

H 7 @7

H 7 @7

G H 7 @7

67 H 6,777 77 6,7@7 77

.ith a financial calculator, for O, enter ' D 67, )V D -><< >6, )MT D 7, %V D 6777, and press 2 to get 2 D G 77K %or 8, enter ' D 67, )V D -6777, )MT D @7, %V D 6777, and press 2 to get 2 D @K (Alternatively, enter the values e"actly as shown on the time line in the C% register, and use the 2** 0ey to obtain the same answer ) .ith a calculator, for the 3,ero coupon bond,4 enter ' D 67, 2 D /, )MT D 7, %V D 6777, and press )V to get the value of the security today, Answers and Solutions: 6 - "-

A??@ BG percentage %or the then press percentage c

The profit would be A??@ BG - A><< >6 D A6B? G@, and the profit would be A6B? G@NA><< >6 D B< <K 3coupon bond,4 enter ' D 67, 2 D /, )MT D @7, %V D 6777, and )V to get )V D A6,6>: <7 The profit is A6>: <7, and the profit is 6> :< percent

5ere we compound cash flows to obtain a 3terminal value4 at =ear 67, and then find the interest rate that e$uates the TV to the cost of the security There are no intermediate cash flows with #ecurity O, so its TV is A6,777, and, as we saw in )art a, G percent causes the )V of A6,777 to e$ual the cost, A><< >6 %or #ecurity 8, we must compound the cash flows over 67 years at / percent !nter ' D 67, 2 D /, )V D 7, )MT D @7, and then press %V to get the %V of the 67-year annuity of A@7 per year: %V D A6,7?> >/ Then add the A6,777 to be received at =ear 67 to get TV8 D A<,7?> >/ Then enter ' D 67, )V D -6777, )MT D 7, %V D <7?> >/, and press 2 to get 2 D : >:K #o, if the firm buys #ecurity O, its actual return will be G percent regardless of what happens to interest rates--this security is a ,ero coupon bond that has ,ero reinvestment rate ris0 5owever, if the firm buys the @ percent coupon bond, and rates then fall, its 3true4 return over the 67 years will be only : >: percent, which is an average of the old @ percent and the new / percent The value of #ecurity O would fall from A><< >6 to AB<6 G:, so a loss of A677 >>, or <B @ percent, would be incurred The value of #ecurity 8 would fall to A::B GG, so the loss here would be A<</ 76, or << / percent of the A6,777 original investment The percentage losses for the two bonds is close, but only because the ,eroMs original return was G percent versus @ percent for the coupon bond The 3actual4 or 3true4 return on the ,ero would remain at G percent, but the 3actual4 return on the coupon bond would rise from @ percent to G 6: percent due to reinvestment of the A@7 coupons at 6< percent %irst, determine the annual cost of college The current cost is A6<,?77 per year, but that is escalating at a ? percent inflation rate: College =ear 6 < B > Current Cost A6<,?77 6<,?77 6<,?77 6<,?77 =ears from 'ow ? / : @ 2nflation Ad9ustment (6 7?)? (6 7?)/ (6 7?): (6 7?)@ Cash *e$uired A6?,G?> 6/,:?6 6:,?@G 6@,>/@

/->@

'ow put these costs on a time line: 6B H 6> H 6? H 6/ H 6: H 6@ 6G <7 <6 H H H H -6?,G?> Q6/,:?6 Q6:,?@G Q6@,>/@

Answers and Solutions: 6 - ".

5ow much must be accumulated by age 6@ to provide these payments at ages 6@ through <6 if the funds are invested in an account paying @ percent, compounded annuallyF .ith a financial calculator enter: C%7 D 6?G?>, C%6 D 6/:?6, C%< D 6:?@G, C%B D 6@>/@, and 2 D @ #olve for ')V D A/6,<7> >6 Thus, the father must accumulate A/6,<7> by the time his daughter reaches age 6@ b #he has A:,?77 now (age 6B) to help achieve that goal %ive years hence, that A:,?77, when invested at @ percent, will be worth A66,7<7: A:,?77(6 7@)? D A66,7<7 c The father needs to accumulate only A/6,<7> - A66,7<7 D A?7,6@> The 0ey to completing the problem at this point is to reali,e the series of deposits represent an ordinary annuity rather than an annuity due, despite the fact the first payment is made at the beginning of the first year The reason it is not an annuity due is there is no interest paid on the last payment that occurs when the daughter is 6@ Esing a financial calculator, ' D /, 2 D @, )V D 7, and %V D -?76@> )MT D A/,@>7 @? I A/,@>6

Answers and Solutions: 6 - "/

!)REA&!(EET )ROBLEM

/->G

The detailed solution for the spreadsheet problem is available both on the instructorMs resource C&-*1M and on the instructorMs side of #outh-.esternMs web site, http:NNbrigham swlearning com

Spreadsheet Problem: 6 - $0

INTEGRATE& CA!E

'ir1t National Ban2 Time Value of Mone Anal sis

6-50 ASSUME THAT YOU ARE NEARING GRADUATION AND THAT YOU HAVE APPLIED FOR A JOB WITH A LOCAL BANK, FIRST NATIONAL BANK. COVERS SEVERAL FINANCIAL ANALYSIS TECHNI!UES. TEST ADDRESSES TIME VALUE OF MONEY ANALYSIS. ANSWERING THE FOLLOWING !UESTIONS. A. DRAW TIME LINES FOR "#$ A %#00 LUMP SUM CASH FLOW AT THE END OF YEAR &, "&$ AN ORDINARY ANNUITY OF %#00 PER YEAR FOR ' YEARS, AND "'$ AN UNEVEN CASH FLOW STREAM OF -%50, %#00, %(5, AND %50 AT THE END OF YEARS 0 THROUGH '. ANSWER) S#51. #/-6 T5*1EL5 #/-> 5!*! T A T2M! ;2'! 2# A L*A)52CA; T5! T2CR AS PART OF THE BANKS THE FIRST SECTION OF THE SEE HOW YOU WOULD DO BY EVALUATION PROCESS, YOU HAVE BEEN ASKED TO TAKE AN E AMINATION THAT

*!)*!#!'TAT21' T5AT 2# E#!& T1 #51. T5! T2M2'L 1% CA#5 %;1.# 6 2# T5! !'& 1% T5! %2*#T =!A*, 1* 6 =!A* %*1M T1&A=+ A'& #1 1' 7 H 7 H 7 H -?7 iK 6 H 6 H 677 6 H 677 < H 677 < H 677 < H :? =!A* ;EM) #EM CA#5 %;1. B H A''E2T= 677

MA*R# *!)*!#!'T !'& 1% )!*21&# (1%T!' =!A*#), #1 T2M! 7 2# T1&A=+ T2M!

iK

iK

B H E'!V!' CA#5 %;1. #T*!AM ?7

A ;EM) #EM 2# A #2'L;! %;1.+ %1* !WAM);!, A A677 2'%;1. 2' =!A* <, A# #51.' 2' T5! T1) T2M! ;2'! A' A''E2T= 2# A #!*2!# 1% !(EA; CA#5 %;1.# 1CCE**2'L 1V!* !(EA; 2'T!*VA;#, A# 2;;E#T*AT!& 2' T5! M2&&;! T2M! ;2'!

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B.

#. WHAT IS THE FUTURE VALUE OF AN INITIAL %#00 AFTER ' YEARS IF IT IS INVESTED IN AN ACCOUNT PAYING #0 PERCENT, ANNUAL COMPOUNDING*

ANSWER)

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B.

&. WHAT IS THE PRESENT VALUE OF %#00 TO BE RECEIVED IN ' YEARS IF THE APPROPRIATE INTEREST RATE IS #0 PERCENT, ANNUAL COMPOUNDING*

ANSWER)

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C.

WE SOMETIMES NEED TO FIND HOW LONG IT WILL TAKE A SUM OF MONEY "OR ANYTHING ELSE$ TO GROW TO SOME SPECIFIED AMOUNT. WILL IT TAKE SALES TO DOUBLE* FOR E AMPLE, IF A COMPANYS SALES ARE GROWING AT A RATE OF &0 PERCENT PER YEAR, HOW LONG

ANSWER)

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OPTIONAL !UESTION A FARMER CAN SPEND %60+ACRE TO PLANT PINE TREES ON SOME MARGINAL LAND. THE E PECTED REAL RATE OF RETURN IS , PERCENT, AND THE E PECTED INFLATION RATE IS 6 PERCENT. WHAT IS THE E PECTED VALUE OF THE TIMBER AFTER &0 YEARS* ANSWER) %V<7 D A/7(6 C 7 7> C 7 7/)<7 D A/7(6 67)<7 D A>7B /? )!* AC*! .! C1E;& 5AV! A#R!&: / )!*C!'T 51. ;1'L .1E;& 2T TAR! A/7 T1 L*1. T1 A>7B /?,

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D.

WHAT IS THE DIFFERENCE BETWEEN AN ORDINARY ANNUITY AND AN ANNUITY DUE* WHAT TYPE OF ANNUITY IS SHOWN BELOW* OTHER TYPE OF ANNUITY* 0 # #00 & #00 ' #00 HOW WOULD YOU CHANGE IT TO THE

ANSWER)

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E.

#. WHAT IS THE FUTURE VALUE OF A '-YEAR ORDINARY ANNUITY OF %#00 IF THE APPROPRIATE INTEREST RATE IS #0 PERCENT, ANNUAL COMPOUNDING*

ANSWER)

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E.

&. WHAT IS THE PRESENT VALUE OF THE ANNUITY* S#51. #/-6> 5!*! T 7 H G7 @< :? <>@ G6 /> 6B /@ 5!*! .! E#!& T5! ;EM) #EM 67K 6 H 677 < H 677 B H 677

ANSWER)

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E.

'. WHAT WOULD THE FUTURE AND PRESENT VALUES BE IF THE ANNUITY WERE AN ANNUITY DUE*

ANSWER)

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F.

WHAT IS THE PRESENT VALUE OF THE FOLLOWING UNEVEN CASH FLOW STREAM* THE APPROPRIATE INTEREST RATE IS #0 PERCENT, COMPOUNDED ANNUALLY. 0 0 # #00 & '00 ' '00 , -50 YEARS

ANSWER)

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G. ANSWER)

WHAT ANNUAL INTEREST RATE WILL CAUSE %#00 TO GROW TO %#&5..( IN ' YEARS* S#51. #/-6G 5!*! T 7 H -677 6 H < H B H

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H.

A &0-YEAR OLD STUDENT WANTS TO BEGIN SAVING FOR HER RETIREMENT. PLAN IS TO SAVE %' A DAY. EVERY DAY SHE PLACES %' IN A DRAWER.

HER

AT THE

END OF EACH YEAR, SHE INVESTS THE ACCUMULATED SAVINGS "%#,0.5$ IN AN ONLINE STOCK ACCOUNT THAT HAS AN E PECTED ANNUAL RETURN OF #& PERCENT. #. IF SHE KEEPS SAVING IN THIS MANNER, HOW MUCH WILL SHE HAVE ACCUMULATED BY AGE 65* ANSWER) S#51. #/-<7 A'& #/-<6 5!*! T 2% #5! 8!L2'# #AV2'L T1&A=, A'& #T2CR# T1 ' D >?, 2 D

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&. IF A ,0-YEAR OLD INVESTOR BEGAN SAVING IN THIS MANNER, HOW MUCH WOULD HE HAVE BY AGE 65* ANSWER) S#51. #/-<< 5!*! T T52# (E!#T21' &!M1'#T*AT!# T5! )1.!* 1% C1M)1E'& T5! >7-=!A* 1;& 2'V!#T1* .2;; 5AV! #AV!& 1';=

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'. HOW MUCH WOULD THE ,0-YEAR OLD INVESTOR HAVE TO SAVE EACH YEAR TO ACCUMULATE THE SAME AMOUNT AT AGE 65 AS THE &0-YEAR OLD INVESTOR DESCRIBED ABOVE* ANSWER) S#51. #/-<B 5!*! T ALA2', T52# (E!#T21' &!M1'#T*AT!# T5! )1.!* 1% T5! >7-=!A* 1;& 2'V!#T1* .2;; 5AV! T1 .2T5 A

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I.

#. WILL THE FUTURE VALUE BE LARGER OR SMALLER IF WE COMPOUND AN INITIAL AMOUNT MORE OFTEN THAN ANNUALLY, FOR E AMPLE, EVERY 6 MONTHS, OR SEMIANNUALLY, HOLDING THE STATED INTEREST RATE CONSTANT* WHY*

ANSWER)

S#51. #/-<> 5!*! T

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I.

&. DEFINE "A$ THE STATED, OR !UOTED, OR NOMINAL, RATE, "B$ THE PERIODIC RATE, AND "C$ THE EFFECTIVE ANNUAL RATE "EAR$.

ANSWER)

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I.

'. WHAT IS THE EFFECTIVE ANNUAL RATE CORRESPONDING TO A NOMINAL RATE OF #0 PERCENT, COMPOUNDED SEMIANNUALLY* DAILY* COMPOUNDED !UARTERLY* COMPOUNDED

ANSWER)

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I.

,. WHAT IS THE FUTURE VALUE OF %#00 AFTER ' YEARS UNDER #0 PERCENT SEMIANNUAL COMPOUNDING* !UARTERLY COMPOUNDING* E'&!* #!M2A''EA; C1M)1E'&2'L, T5! A677 2#

ANSWER)

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#!M2A''EA;;=: (EA*T!*;=: J. RATE* ANSWER)

A677(6 67<?)B D A6B> 76 A677(6 67B@)B D A6B> >G

WHEN WILL THE EFFECTIVE ANNUAL RATE BE E!UAL TO THE NOMINAL "!UOTED$

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K.

#. WHAT IS THE VALUE AT THE END OF YEAR ' OF THE FOLLOWING CASH FLOW STREAM IF THE !UOTED INTEREST RATE IS #0 PERCENT, COMPOUNDED SEMIANNUALLY* 0 & #00 , #00 6 #00 PERIODS

ANSWER)

S#51. #/-B6 T5*1EL5 #/-BB 5!*! T 7 H ?K 6 H 677 < H 677 B H 677 667 6<6 ABB6 77 <? D A677(6 7?)< ?? D A677(6 7?)> @7

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K.

&. WHAT IS THE PV OF THE SAME STREAM* S#51. #/-B> 5!*! T 7 H A G7 @< :> A<>: :7 <: /< ?G ?K 6 H 677 )V D 677(6 7?)-> < H 677 B H 677

ANSWER)

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T1 E#! A %2'A'C2A; CA;CE;AT1*, 2')ET ' D B, 2 D 67 <?, )MT D 677, %V D 7, A'& T5!' )*!## T5! )V R!= T1 %2'& )V D A<>: ?G K. '. IS THE STREAM AN ANNUITY* T5! )A=M!'T #T*!AM 2# A' A''E2T= 2' T5! #!'#! 1% C1'#TA'T AM1E'T# AT *!LE;A* 2'T!*VA;#, 8ET T5! 2'T!*VA;# &1 '1T C1**!#)1'& .2T5 T5! C1M)1E'&2'L )!*21&# T52# R2'& 1% #2TEAT21' 1CCE*# 1%T!' 2' T52#

ANSWER)

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K.

,. AN IMPORTANT RULE IS THAT YOU SHOULD NEVER SHOW A NOMINAL RATE ON A TIME LINE OR USE IT IN CALCULATIONS UNLESS WHAT CONDITION HOLDS* THINK OF ANNUAL COMPOUNDING, WHEN /N01 2 EAR 2 /PER.$ "HINT) WHAT WOULD BE WRONG

WITH YOUR ANSWER TO PARTS K"#$ AND K"&$ IF YOU USED THE NOMINAL RATE, #0 PERCENT, RATHER THAN THE PERIODIC RATE, /N01+& 2 #03+& 2 53* ANSWER) i'om CA' 8! E#!& 2' T5! CA;CE;AT21'# 1';= .5!' A''EA; C1M)1E'&2'L 2% T5! '1M2'A; *AT! 1% 67 )!*C!'T .!*! E#!& T1 &2#C1E'T T5!

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L.

#. CONSTRUCT AN AMORTI4ATION SCHEDULE FOR A %#,000, #0 PERCENT, ANNUAL COMPOUNDING LOAN WITH ' E!UAL INSTALLMENTS. &. WHAT IS THE ANNUAL INTEREST E PENSE FOR THE BORROWER, AND THE ANNUAL INTEREST INCOME FOR THE LENDER, DURING YEAR &*

ANSWER)

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M.

M1#T %2'A'C2A; CA;CE;AT1*# 5AV! AM1*T2OAT21' %E'CT21'# 8E2;T 2'

SUPPOSE A HOUSE IS ON THE MARKET FOR %&50,000, AND A BANK AGREES TO LEND THE POTENTIAL HOME BUYER %&&0,000 SECURED BY A MORTGAGE ON THE HOUSE. THUS, THE BUYER MUST COME UP WITH %'0,000 TO COMPLETE THE FOR PURPOSES OF THIS !UESTION, IGNORE ANY ADDITIONAL SUPPOSE THE BUYER HAS ONLY %(,500 CASH, AND THE SELLER A FACE VALUE OF TRANSACTION. CLOSING COSTS.

AGREES TO TAKE A NOTE WITH THE FOLLOWING TERMS)

%&&,500, A (.5 PERCENT ANNUAL INTEREST RATE, AND PAYMENTS AT THE END OF THE YEAR BASED ON A &0-YEAR AMORTI4ATION SCHEDULE, BUT WITH THE LOAN MATURING AT THE END OF THE #0TH YEAR. #. WHAT IS THE BALLOON PORTION OF THE PAYMENT DUE AT THE END OF THE #0 TH YEAR* ANSWER) S#51. #/->< T5*1EL5 #/->> 5!*! T CA;CE;AT!& 8!;1.: ' D <7+ 2 D : ?+ )V D -<<?77+ A'& %V D 7 I A<,<7: 7: #1;V! %1* )MT D A<,<7: 7:>B 8A#!& E)1' T5! ;1A' 2'%1*MAT21', T5!

51M! 8E=!* ME#T MAR! A''EA; )A=M!'T# 1% A<,<7: 7: 1' T5! ;1A' A#

!ntegrated "ase: 6 - ++

NOW, WE NEED TO FIND THE REMAINING BALANCE OF THE LOAN AT THE END OF #0 YEARS. IF WE USE THE AMORTI4ATION FEATURE OF THE CALCULATOR, WE CAN FIND THAT THE BALLOON PAYMENT IS %#5,#,..5,. # INPUT #0 AMORT #,,(&0.&500 (,'50.,6'0 #5,#,..5'(0 6 %#5,#,..5,.

2 "INTEREST$ 2 "PRINCIPAL$ 2 "BALANCE$

M.

&. WHAT IS THE TOTAL PAYMENT THAT WILL BE DUE AT THE END OF THE #0TH YEAR* T1TA; )A=M!'T D A<,<7: 7: C A6?,6>G ?> D A6:,B?/ /6

ANSWER)

!ntegrated "ase: 6 - +,