Chapter 05 - Introduction to Valuation: The Time Value of Money

CHAPTER 5
INTRODUCTION TO VALUATION: THE
TIME VALUE OF MONEY
Answers to Concepts Review and Critical Thinking Questions

1. The four parts are the present value (PV), the future value (FV), the discount rate (r), and the life of
the investment (t).

2. Compounding refers to the growth of a dollar amount through time via reinvestment of interest
earned. It is also the process of determining the future value of an investment. Discounting is the
process of determining the value today of an amount to be received in the future.

3. Future values grow (assuming a positive rate of return); present values shrink.

4. The future value rises (assuming it’s positive); the present value falls.

5. It would appear to be both deceptive and unethical to run such an ad without a disclaimer or
explanation.

6. It’s a reflection of the time value of money. TMCC gets to use the $24,099. If TMCC uses it wisely,
it will be worth more than $100,000 in 30 years.

7. This will probably make the security less desirable. TMCC will only repurchase the security prior to
maturity if it is to its advantage, i.e., interest rates decline. Given the drop in interest rates needed to
make this viable for TMCC, it is unlikely the company will repurchase the security. This is an
example of a “call” feature. Such features are discussed at length in a later chapter.

8. The key considerations would be: (1) Is the rate of return implicit in the offer attractive relative to
other, similar risk investments? and (2) How risky is the investment; i.e., how certain are we that we
will actually get the $100,000? Thus, our answer does depend on who is making the promise to
repay.

9. The Treasury security would have a somewhat higher price because the Treasury is the strongest of
all borrowers.

10. The price would be higher because, as time passes, the price of the security will tend to rise toward
$100,000. This rise is just a reflection of the time value of money. As time passes, the time until
receipt of the $100,000 grows shorter, and the present value rises. In 2019, the price will probably be
higher for the same reason. We cannot be sure, however, because interest rates could be much
higher, or TMCC’s financial position could deteriorate. Either event would tend to depress the
security’s price.

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Chapter 05 - Introduction to Valuation: The Time Value of Money

Solutions to Questions and Problems

NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.

Basic

1. The simple interest per year is:

$64,000 × .07 = $4,480

So after 9 years you will have:

$4,480 × 9 = $40,320 in interest.

The total balance will be $64,000 + 40,320 = $104,320

With compound interest we use the future value formula:

FV = PV(1 + r)t
FV = $64,000(1.07)9 = $117,661.39

The difference is:

$117,661.39 – 104,320 = $13,341.39

2. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

FV = $2,250(1.13)11 = $ 8,630.69
FV = $8,752(1.09)7 = $ 15,999.00
FV = $76,355(1.12)14 = $373,155.46
FV = $183,796(1.06)8 = $292,942.90

3. To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

PV = $15,451 / (1.07)13 = $ 6,411.62

PV = $51,557 / (1.13)4 = $31,620.87
PV = $886,073 / (1.14)29 = $19,825.71
PV = $550,164 / (1.09)40 = $17,515.89

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Chapter 05 - Introduction to Valuation: The Time Value of Money

4. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1

FV = $297 = $240(1 + r)4; r = ($297 / $240)1/4 – 1 = 0.0547, or 5.47%

FV = $1,080 = $360(1 + r)18; r = ($1,080 / $360)1/18 – 1 = 0.1472, or 14.72%
FV = $185,382 = $39,000(1 + r)19; r = ($185,382 / $39,000)1/19 – 1 = 0.0855, or 8.55%
FV = $531,618 = $38,261(1 + r)25; r = ($531,618 / $38,261)1/25 – 1 = 0.1110, or 11.10%

5. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

FV = $1,389 = $560(1.09)t; t = ln($1,389/ $560) / ln 1.09 = 10.54 years

FV = $1,821 = $810(1.10)t; t = ln($1,821/ $810) / ln 1.10 = 8.50 years
FV = $289,715 = $18,400(1.17)t; t = ln($289,715 / $18,400) / ln 1.17 = 17.56 years
FV = $430,258 = $21,500(1.15)t; t = ln($430,258 / $21,500) / ln 1.15 = 21.44 years

6. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($300,000 / $65,000)1/18 – 1 = .0887, or 8.87%

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Chapter 05 - Introduction to Valuation: The Time Value of Money

7. To find the length of time for money to double, triple, etc., the present value and future value are
irrelevant as long as the future value is twice the present value for doubling, three times as large for
tripling, etc. To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

The length of time to double your money is:

FV = $2 = $1(1.065)t
t = ln 2 / ln 1.065 = 11.01 years

The length of time to quadruple your money is:

FV = $4 = $1(1.065)t
t = ln 4 / ln 1.065 = 22.01 years

Notice that the length of time to quadruple your money is twice as long as the time needed to double
your money (the difference in these answers is due to rounding). This is an important concept of
time value of money.

8. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($283,400 / $200,300)1/10 – 1 = .0353, or 3.53%

9. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

t = ln ($190,000 / $40,000) / ln 1.048 = 33.23 years

10. To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = $575,000,000 / (1.068)20 = $154,256,257.63

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Chapter 05 - Introduction to Valuation: The Time Value of Money

11. To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = $1,000,000 / (1.09)80 = $1,013.63

12. To find the FV of a lump sum, we use:

FV = PV(1 + r)t
FV = $50(1.041)108 = $3,833.97

13. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($1,350,000 / $150)1/115 – 1 = .0824, or 8.24%

To find the FV of the first prize in 2040, we use:

FV = PV(1 + r)t
FV = $1,350,000(1.0824)30 = $14,516,947.05

14. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($125,000 / $1)1/115 – 1 = .1074, or 10.74%

15. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($10,311,500 / $12,377,500)1/4 – 1 = – 4.46%

Notice that the interest rate is negative. This occurs when the FV is less than the PV.

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Chapter 05 - Introduction to Valuation: The Time Value of Money

Intermediate

16. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1

a. PV = $100,000 / (1 + r)30 = $24,099

r = ($100,000 / $24,099)1/30 – 1 = .0486, or 4.86%

b. PV = $42,380 / (1 + r)11 = $24,099

r = ($42,380 / $24,099)1/11 – 1 = .0527, or 5.27%

c. PV = $100,000 / (1 + r)19 = $42,380

r = ($100,000 / $42,380)1/19 – 1 = .0462, or 4.62%

17. To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = $190,000 / (1.12)9 = $68,515.90

18. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

FV = $5,000(1.11)45 = $547,651.21

FV = $5,000(1.11)35 = $192,874.26

Better start early!

19. We need to find the FV of a lump sum. However, the money will only be invested for six years, so
the number of periods is six.

FV = PV(1 + r)t
FV = $15,000(1.071)6 = $22,637.48

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 Chapter 05 - Introduction to Valuation: The Time Value of Money

20. To answer this question, we can use either the FV or the PV formula. Both will give the same answer
since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

t = ln($85,000 / $15,000) / ln(1.11) = 16.62

So, the money must be invested for 16.62 years. However, you will not receive the money for
another two years. From now, you’ll wait:

2 years + 16.62 years = 18.62 years

Calculator Solutions

1.
Enter 9 7% $64,000
N I/Y PV PMT FV
Solve for $117,661.39

$117,661.39 – 104,320 = $13,341.39

2.
Enter 11 13% $2,250
N I/Y PV PMT FV
Solve for $8,630.69

Enter 7 9% $8,752
N I/Y PV PMT FV
Solve for $15,999.00

Enter 14 12% $76,355

N I/Y PV PMT FV
Solve for $373,155.46

Enter 8 6% $183,796
N I/Y PV PMT FV
Solve for $292,942.90

3.
Enter 13 7% $15,451
N I/Y PV PMT FV
Solve for $6,411.62

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 Chapter 05 - Introduction to Valuation: The Time Value of Money

Enter 4 13% $51,557

N I/Y PV PMT FV
Solve for $31,620.87

Enter 29 14% $886,073

N I/Y PV PMT FV
Solve for $19,825.71

Enter 40 9% $550,164
N I/Y PV PMT FV
Solve for $17,515.89

4.
Enter 4 $240 $297
N I/Y PV PMT FV
Solve for 5.47%

Enter 18 $360 $1,080

N I/Y PV PMT FV
Solve for 6.29%

Enter 19 $39,000 $185,382

N I/Y PV PMT FV
Solve for 8.55%

Enter 25 $38,261 $531,618

N I/Y PV PMT FV
Solve for 11.10%

5.
Enter 9% $560 $1,389
N I/Y PV PMT FV
Solve for 10.54

Enter 10% $810 $1,821

N I/Y PV PMT FV
Solve for 8.50

Enter 17% $18,400 $289,715

N I/Y PV PMT FV
Solve for 17.56

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 Chapter 05 - Introduction to Valuation: The Time Value of Money

Enter 15% $21,500 $430,258

N I/Y PV PMT FV
Solve for 21.44

6.
Enter 18 $65,000 $300,000
N I/Y PV PMT FV
Solve for 8.87%

7.
Enter 6.5% $1 $2
N I/Y PV PMT FV
Solve for 11.01

Enter 6.5% $1 $4

N I/Y PV PMT FV
Solve for 22.01

8.
Enter 10 $200,300 $283,400
N I/Y PV PMT FV
Solve for 3.53%

9.
Enter 4.80% $40,000 $190,000
N I/Y PV PMT FV
Solve for 33.23

10.
Enter 20 6.8% $575,000,000
N I/Y PV PMT FV
Solve for $154,256,257.63

11.
Enter 80 9% $1,000,000
N I/Y PV PMT FV
Solve for $1,013.63

12.
Enter 108 4.10% $50
N I/Y PV PMT FV
Solve for $3,833.97

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 Chapter 05 - Introduction to Valuation: The Time Value of Money

13.
Enter 115 $150 $1,350,000
N I/Y PV PMT FV
Solve for 8.24%

Enter 30 8.24% $1,350,000

N I/Y PV PMT FV
Solve for $14,516,947.05

14.
Enter 115 $1 ±$125,000
N I/Y PV PMT FV
Solve for 10.74%

15.
Enter 4 $12,377,500 $10,311,500
N I/Y PV PMT FV
Solve for –4.46%

16. a.
Enter 30 $24,099 $100,000
N I/Y PV PMT FV
Solve for 4.86%

16. b.
Enter 11 $24,099 $42,380
N I/Y PV PMT FV
Solve for 5.27%

16. c.
Enter 19 $42,380 $100,000
N I/Y PV PMT FV
Solve for 4.62%

17.
Enter 9 12% $190,000
N I/Y PV PMT FV
Solve for $68,515.90

18.
Enter 45 11% $5,000
N I/Y PV PMT FV
Solve for $547,651.21

Enter 35 11% $5,000

N I/Y PV PMT FV
Solve for $192,874.26

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 Chapter 05 - Introduction to Valuation: The Time Value of Money

19.
Enter 6 7.10% $15,000
N I/Y PV PMT FV
Solve for $22,637.48

20.
Enter 11% $15,000 $85,000
N I/Y PV PMT FV
Solve for 16.62

From now, you’ll wait 2 + 16.62 = 18.62 years

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