FNAN 303

Solutions to lecture problems – time value of money, part 3

Lecture Problem 1-a

If Landon invests $4,000 in 2 years in an account that is expected to earn 5.8 percent per
year, and he expects to invest $3,000 in the same account in 4 years, then how much money
will Landon have in his account in 7 years?

The future value of multiple cash flows at different points in time is the sum of the future values of each
individual cash flow, so find the future values of each of the two investments and add them up.

Time 0 1 2 3 4 5 6 7
Invest 4,000 3,000
Future value ?

Investment made in 2 years

If Landon plans to make an investment in 2 years, then in 7 years, which is the point in time of
interest, it will have been invested for 5 years

In 7 years, which is 5 years after investing $4,000 at an expected rate of return of 5.8 percent per year
in 2 years, Landon would have FV7 = $4,000 × (1.058)7-2 = $4,000 × (1.058)5 = $5,302.59

Mode is not relevant, since PMT = 0

Enter 5 5.8 -4,000 0
N I% PV PMT FV
Solve for 5,302.59

Investment made in 4 years

If Landon plans to make an investment in 4 years, then in 7 years, which is the point in time of
interest, it will have been invested for 3 years

In 7 years, which is 3 years after investing $3,000 at an expected rate of return of 5.8 percent per year
in 4 years, Landon would have FV7 = $3,000 × (1.058)7-4 = $3,000 × (1.058)3 = $3,552.86

Mode is not relevant, since PMT = 0

Enter 3 5.8 -3,000 0
N I% PV PMT FV
Solve for 3,552.86

Final step
Add up the two future values to determine how much money Landon will have in 7 years from
the 2 investments: $5,302.59 + $3,552.86 = $8,855.45

Short version
FVt = [C0 × (1+r)t] + [C1 × (1+r)t-1] + … + [Ct-1 × (1+r)1] + [Ct]

In this case, FV7 = [C2 × (1+r)7-2] + [C4 × (1+r)7-4]

= [4,000 × (1.058)5] + [3,000 × (1.058)3]
= 5,302.59 + 3,552.86 = 8,855.45

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Solutions to lecture problems – time value of money, part 3

Lecture Problem 1-b

If CJ invested $5,000 today in an account that is expected to earn 8.0 percent per year, and he
expects to make another investment in the same account in 2 years, then how much money
does CJ expect to invest in 2 years if he expects to have $15,000 in his account in 6 years?

The future value of multiple cash flows at different points in time is the sum of the future values of each
individual cash flow, so find the future values of today’s investment, then find the future value of the
investment made in 2 years, and then find the actual amount of the investment made in 2 years.

Time 0 1 2 3 4 5 6
Invest 5,000 ?
Future value 15,000

Future value of today’s investment

If CJ made an investment today, then in 6 years, which is the point in time of interest, it will
have been invested for 6 years

6 years after investing $5,000 at an expected rate of return of 8.0 percent per year, CJ would
have FV6 = $5,000 × (1.080)6 = $7,934.37

Mode is not relevant, since PMT = 0

Enter 6 8.0 -5,000 0
N I% PV PMT FV
Solve for 7,934.37

Future value of investment made in 2 years

If CJ expects to have $15,000 in his account in 6 years
And if the investment made today is expected to be worth $7,934.37 in 6 years, then
Then the investment made in 2 years will be worth $15,000 – $7,934.37 = $7,065.63 in 6 years

Investment made in 2 years

In general, FVt = Ck × (1+r)t-k
In this case for the investment made in 2 years, FV 6 = C2 × (1+r)6-2 = C2 × (1+r)4
We know FV6 = 7,065.63, r = .080, and t = 4

So 7,065.63 = C2 × (1.080)4
So C2 = 7,065.63 / (1.080)4
= $5,193.45

Mode is not relevant, since PMT = 0

Enter 4 8.0 0 7,065.63
N I% PV PMT FV
Solve for -5,193.45

If CJ invests $5,000 today and $5,193.45 in 2 years from today, and if he expects to earn 8
percent per year, then he will have $15,000 in 6 years from today

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Solutions to lecture problems – time value of money, part 3
Confirm
FV6 = [C0 × (1+r)6] + [C2 × (1+r)4] = [5,000 × (1.08)6] + [5,193.45 × (1.08)4]
= 7,934.37 + 7,065.63 = 15,000 ☺
=======================================

Lecture Problem 2
How much will Emilia have when she retires if she retires in 7 years, invests $30,000 per
year for 7 years, and she makes her first annual contribution in 1 year from today to an
account that earns 9.0 percent per year?

Time 0 1 2 3 4 5 6 7
Pmt # 1 2 3 4 5 6 7
CF 0 30,000 30,000 30,000 30,000 30,000 30,000 30,000
FV ?

The cash flows that are made reflect an annuity, so we want to find the future value of
an annuity

END Mode
Enter 7 9.0 0 -30,000
N I% PV PMT FV
Solve for 276,013

She would have $276,013 when she retires

=================================

Lecture Problem 3-a

How much will Emilia have when she retires if she retires in 7 years, invests $30,000 per
year for 7 years, and she makes her first annual contribution immediately to an account that
earns 9.0 percent per year?

Time 0 1 2 3 4 5 6 7
Pmt # 1 2 3 4 5 6 7
CF 30,000 30,000 30,000 30,000 30,000 30,000 30,000 0
FV ?

The cash flows that are made reflect an annuity due, so we want to find the future value
of an annuity due

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Solutions to lecture problems – time value of money, part 3
BEGIN Mode
Enter 7 9.0 0 -30,000
N I% PV PMT FV
Solve for 300,854

She would have $300,854 when she retires

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Lecture Problem 3-b

How much will Emilia have when she retires if she retires in 7 years, invests $30,000 per
year for 7 years, and she makes her first annual contribution today to an account that earns
9.0 percent per year and currently has $20,000 in it?

From the timeline, we can see that the cash flows reflect a 7-period annuity plus a cash
flow of $20,000 today
Time 0 1 2 3 4 5 6 7
Reg pmt # 1 2 3 4 5 6 7 7
CF 30,000 + 30,000 30,000 30,000 30,000 30,000 30,000
20,000
FV ?

Future value of investment = FV of the 7-period annuity due + FV of the CF of $20,000

today

In one step
BEGIN Mode
Enter 7 9.0 -20,000 -30,000
N I% PV PMT FV
Solve for 337,415

In two steps
FV of the 7-period annuity due
BEGIN Mode
Enter 7 9.0 0 -30,000
N I% PV PMT FV
Solve for 300,854

FV in 7 years of a cash flow of $20,000 today

FVt = C0 × (1+r)t
C0 = 20,000
r = .090
t=7
FV7 = 20,000 × (1.090)7 = 36,561

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Solutions to lecture problems – time value of money, part 3
Mode is not relevant, since PMT = 0
Enter 7 9.0 -20,000 0
N I% PV PMT FV
Solve for 36,561

Future value of investment = FV of the 7-period annuity + FV of the CF of $20,000 today

= 300,854 + 36,561 = $337,415

She would have $337,415 when she retires

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Lecture Problem 3-c

How much will Emilia have when she retires if she retires in 7 years, invests $30,000 per
year for 7 years, and she makes her first annual contribution in 1 year from today to an
account that earns 9.0 percent per year and also makes a special “extra” investment of
$20,000 in 2 years?

From the timeline, we can see that the cash flows reflect a 7-period annuity plus a cash
flow of $20,000 in 2 years
Time 0 1 2 3 4 5 6 7
Pmt # 1 2 3 4 5 6 7
CF 0 30,000 30,000 30,000 30,000 30,000 30,000 30,000
+ 20,000
FV ?

Future value of investment

= FV of the 7-period annuity + FV of the CF of $20,000 in 2 years

Can not be solved in 1 step in the financial calculator, because

1) There are 7 regular, fixed payments
2) The extra payment is not made at time 0, but at time 2, so it compounds for 5 periods

FV of the 7-period annuity

END Mode
Enter 7 9.0 0 -30,000
N I% PV PMT FV
Solve for 276,013

FV of a cash flow of $20,000 in 2 years from today

FVt = Ck × (1+r)t-k
k=2
Ck = 20,000
r = .090
t=7–2=5
FV7 = 20,000 × (1.090)7-2 = 20,000 × (1.090)5 = 30,772
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Solutions to lecture problems – time value of money, part 3

Mode is not relevant, since PMT = 0

Enter 5 9.0 -20,000 0
N I% PV PMT FV
Solve for 30,772

Future value of investment = FV of the 7-period annuity + FV of the CF of $20,000 in 2 years

= 276,013 + 30,772 = $306,785

She would have $306,785 when she retires

=====================================

Lecture Problem 4
How many payments can Franklin expect to receive in retirement? He expects to earn 7.6 percent in
his retirement account. He plans to save $22,000 per year in his retirement account for 5 years, with
his first savings contribution to his retirement account expected today. In retirement, Franklin plans
to withdraw $31,000 per year for as long as he can, with his first retirement payment received in 5
years.

Step 1: find how much money Franklin will have in 5 years

Step 2: find how many payments can be produced by the amount of money expected in 5 years

Time period 0 1 2 3 4 5 6 7 … 5+N-2 5+N-1 5+N

Contribution # 1 2 3 4 5
Contribution amt 22k 22k … 22k 22k
Future value ?A
Re-time 0 1 2 … N-2 N-1 N
Present value ?A
Withdrawal # 1 2 3 … N-1 N
Withdrawal amount 31k 31k 31k … 31k 31k

Step 1: find how much money Franklin will have in 5 years (denoted by ?A)
If the first investment is made today and the last investment is made in 4 years, then the amount
of money accumulated in 5 years can be found by finding the future value of a 5-year annuity
due, since the first payment will be made today, there will be 5 expected payments, and all
expected payments will be equal.

BEGIN mode
Enter 5 7.6 0 -22,000
N I% PV PMT FV
Solve for 137,771

Franklin expects to have $137,771 saved for retirement in 5 years

Step 2: find how many payments can be produced by the amount of money expected in 5 years
The first withdrawal is made in 5 years, which is immediately after he retires. At retirement,
Franklin expects to have $137,771. To find how many payments can be produced, we need to

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FNAN 303
Solutions to lecture problems – time value of money, part 3
find the number of payments for an annuity due with annual payments of $31,000, a present
value of $137,771, and a discount rate of 7.6%. It is an annuity due, since the first payment
occurs at the “new” reference point, which is in 5 years.

Note that the “new” time 0 equals the “original” time 5, since there are 5 savings contributions
in part 1 (N = 5 from part 1).

BEGIN mode
Enter 7.6 -137,771 31,000 0
N I% PV PMT FV
Solve for 5.14

Franklin can expect to receive 5.14 payments of $31,000 in retirement

================================

Lecture Problem 5-a

Vijay wants to retire with $1,000,000. How much does Vijay need to save each year for 10
years if he wants to retire in exactly 10 years, can earn 9.25 percent on his savings, makes his
first contribution to savings later today, and saves an equal amount each year?

Time 0 1 2 3 4 5 6 7 8 9 10
Pmt # 1 2 3 4 5 6 7 8 9 10
CF ? ? ? ? ? ? ? ? ? ?
FV 1,000,000

The cash flows that Vijay will save reflect a 10-period annuity due. We want to find the
annual payment that is necessary for the annuity due to have a future value of
$1,000,000.

BEGIN Mode
Enter 10 9.25 0 1,000,000
N I% PV PMT FV
Solve for -59,532

Vijay would need to save $59,532 per year to have $1 million in 10 years

--------------------------------------------------------

Lecture Problem 5-b

Vijay wants to retire with $1,000,000. How much does Vijay need to save each year for 10
years if he wants to retire in exactly 10 years, can earn 12.3 percent on his savings, starts
saving in exactly 1 year, saves an equal amount each year, and has $40,000 in his account
today?
Time 0 1 2 3 4 5 6 7 8 9 10
Pmt # 0 1 2 3 4 5 6 7 8 9 10

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FNAN 303
Solutions to lecture problems – time value of money, part 3
CF 40k ? ? ? ? ? ? ? ? ? ?

Vijay has $40,000 today that will increase in value over 10 years (from today until 10 years from
today). The cash flows that Vijay will save reflect a 10-period ordinary annuity. We want to find
the annual payment that is necessary for the annuity to have a future value of the following:
$1,000,000 minus the amount that the $40,000 will compound to in 10 years.

Steps: 1) Find the amount that the $40,000 will compound to in 10 years
2) Find the amount that the annuity must be worth in 10 years
3) Find the payment needed to produce the amount from step 2

1) Find the amount that the $40,000 will compound to in 10 years

FVt = Ck × (1+r)t-k
In this case, k = 0, so FVt = C0 × (1+r)t where t = 10, C0 = 40,000, and r = .123
FV10 = 40,000 × (1.123)10 = 127,602

Mode is not relevant since PMT = 0

Enter 10 12.3 -40,000 0
N I% PV PMT FV
Solve for 127,602

2) Find the amount that the annuity must be worth in 10 years

If Vijay needs $1,000,000 and the $40,000 in his account today will compound to $127,602, then the
annual savings payments must grow to 1,000,000 – 127,602 = $872,398

3) Find the payment needed to produce the amount from step 2

END Mode
Enter 10 12.3 0 872,398
N I% PV PMT FV
Solve for -48,997

Vijay would need to save $48,997 per year to have $1 million in 10 years

Since N = 10 for the initial savings and N = 10 for the annuity, the payment can be found in 1 step
In one step
In END mode, -FV is the future value with a return of I% of a cash flow of PV at time 0 and fixed
cash flows of PMT at times 1 through N. Therefore, we can solve for the retirement savings
payment that Vijay needs to make in one step with a financial calculator

END Mode
Enter 10 12.3 -40,000 1,000,000
N I% PV PMT FV
Solve for -48,997

Vijay would need to save $48,997 per year to have $1 million in 10 years

--------------------------------------------------------

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FNAN 303
Solutions to lecture problems – time value of money, part 3

Lecture Problem 5-c

How much does Vijay need to save each year for 9 years as a regular savings payment if he
wants to retire in exactly 9 years with $1,000,000, can earn 14.6 percent on his savings, starts
making regular savings payments in exactly 1 year, and saves an equal amount each year with
one exception, which is that in 2 years, he plans to make an extra contribution of $30,000 to
savings?

Time 0 1 2 3 4 5 6 7 8 9
Pmt # 0 1 2 3 4 5 6 7 8 9
CF 0 ? ? + 30k ? ? ? ? ? ? ?

Vijay expects to make an extra payment of $30,000 in 2 years that will increase in value over 7
years (from 2 years from today until 9 years from today). The cash flows that Vijay will save
regularly reflect a 9-period ordinary annuity. We want to find the annual payment that is
necessary for the annuity to have a future value of the following: $1,000,000 minus the amount
that the $30,000 will compound in 7 years (from 2 years from today to 9 years from today)

Steps: 1) Find the amount that the $30,000 received in 2 years will compound to in 9 years
2) Find the amount that the annuity must compound to in 9 years
3) Find the payment needed to produce the amount from step 2

1) Find the amount that the $30,000 received in 2 years will compound to in 9 years
FVt = Ck × (1+r)t-k
In this case, k = 2, t = 9, t – k = 9- 2 = 7, C2 = 30,000, and r = .146
FV9 = 30,000 × (1.146)9-2 = 30,000 × (1.146)7 = 77,878

Mode is not relevant since PMT = 0

Enter 7 14.6 -30,000 0
N I% PV PMT FV
Solve for 77,878

2) Find the amount that the annuity must compound to in 9 years

If Vijay needs $1,000,000 and the $30,000 that he receives and saves in 2 years will compound to
77,878, then the annual savings payments must compound to 1,000,000 – 77,878 = 922,122

3) Find the payment needed to produce the amount from step 2

END Mode
Enter 9 14.6 0 922,122
N I% PV PMT FV
Solve for -55,880

In addition to saving $30,000 in 2 years, Vijay would need to save $55,880 per year to have $1
million in 9 years

==============================

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FNAN 303
Solutions to lecture problems – time value of money, part 3

Lecture Problem 6-a

How many regular savings contributions must Vijay make to retire with $1,000,000, if he
saves $10,000 per year, begins saving today, and can earn 6.5 percent per year on his
savings?

The cash flows that Vijay will save reflect an annuity due with $10,000 annual
payments. We want to find the number of annuity due payments that are necessary for
the annuity due to have a future value of $1,000,000.

BEGIN Mode
Enter 6.5 0 -10,000 1,000,000
N I% PV PMT FV
Solve for 31.13

Vijay would need to make 31.13 payments to reach $1 million

--------------------------------------------------------

Lecture Problem 6-b

How many regular savings contributions must Vijay make to retire with $1,000,000, if he
currently has $120,000 saved, saves $10,000 per year, begins saving today, and can earn 6.5
percent per year on his savings?

The cash flows that Vijay will save reflect an annuity due with $10,000 annual
payments. We want to find the number of annuity due payments that are necessary for
the annuity due to have a future value of $1,000,000 (less the future value of the
$120,000 currently saved).

BEGIN Mode
Enter 6.5 -120,000 -10,000 1,000,000
N I% PV PMT FV
Solve for 22.41

Vijay would need to make 22.41 payments to reach $1 million

====================================

Lecture Problem 7-a

If Vijay wants to retire in 25 years with $1,000,000 and can save $10,000 annually for 25
years with his first savings contribution made in 1 year, then what annual return does he need
to earn?

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FNAN 303
Solutions to lecture problems – time value of money, part 3
The cash flows that Vijay will save reflect a 25-period ordinary annuity with $10,000
annual payments. We want to find the rate of return that is necessary for the annuity
to have a future value of $1,000,000.

END Mode
Enter 25 0 -10,000 1,000,000
N I% PV PMT FV
Solve for 10.11

Vijay must earn 10.11% per year to have $1 million in 25 years

--------------------------------------------------------

Lecture Problem 7-b

If Vijay has $80,000 currently saved, wants to retire in 25 years with $1,000,000, and can
save $10,000 annually for 25 years with his first savings contribution made in 1 year, then
what annual return does he need to earn?

The cash flows that Vijay will save reflect a 25-period ordinary annuity with $10,000
annual payments. We want to find the rate of return that is necessary for the annuity
to have a future value of $1,000,000 (less the future value of the $80,000 currently
saved).

END Mode
Enter 25 -80,000 -10,000 1,000,000
N I% PV PMT FV
Solve for 6.64

Vijay must earn 6.64% per year to have $1 million in 25 years

=====================================

Lecture Problem 8

How much does Patty need to donate to a trust each year for 6 years to have exactly enough
in the trust to be able to make scholarship payments of $10,000 per year forever? The first
annual $10,000 scholarship payment will be made in 7 years from today. To fund the trust,
Patty plans to make equal annual savings donations to the trust for 6 years. Her first donation
to the trust will be made in one year from today. The expected return for the trust is 18.2
percent per year.

Step 1: Determine how much savings needs to be accumulated to pay for the annual scholarship
Step 2: Determine how much needs to be saved each year (?B) to accumulate the amount
identified in step 1

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Solutions to lecture problems – time value of money, part 3
Time 0 1 2 3 4 5 6 7 8 9 10 …
Re-time 0 1 2 3 4 …
Payment # 1 2 3 4 …
Scholarship pmt 10k 10k 10k 10k …
Present value ?A
Time 0 1 2 3 4 5 6 7 8 9 10 …
Payment # 1 2 3 4 5 6
Donation pmt ?B ?B ?B ?B ?B ?B
Future value ?A

Step 1: Determine how much savings needs to be accumulated to pay for the annual scholarship
Note that the “new time 0” for this step is time 6, since there are savings donations for 6 years

The scholarship payments reflect a fixed perpetuity with payments of $10,000 and a discount
rate of 18.2%. Therefore, the present value of this fixed perpetuity as of 6 years from now,
which is 1 year before the first payment, can be found as C/r. The present value is the amount
needed one year before the scholarship payments start to pay the annual scholarships of
$10,000 forever.

As of 6 years from today, PV6 = C/r = 10,000 / .182 = $54,945

Patty needs to accumulate $54,945 as of 6 years from today

Step 2: Determine how much needs to be saved each year (?B) to accumulate the amount identified in
step 1
If Patty donates a fixed amount of money for 6 years with her first donation in 1 year from
today and her last in 6 years from today, then the amount that she needs to save each year to
accumulate $54,945 in 6 years is the annual payment associated with a 6-period annuity with a
future value of 54,945.

END mode
Enter 6 18.2 0 54,945
N I% PV PMT FV
Solve for -5,789.97

Patty needs to save $5,789.97 per year to have $54,945 in 6 years, which would fund
scholarships forever

========================================

Lecture Problem 9

Which loan (A, B, or C) would a borrower prefer, if all 3 loans involve receiving $1,670
today and then paying back the original principal and all accrued interest in 1 year from
today?
Loan A if it has an interest rate of 10.32 percent compounded monthly?
Loan B if it has an interest rate of 10.44 percent compounded quarterly?
Loan C if it has an interest rate of 10.48 percent compounded semi-annually?

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Solutions to lecture problems – time value of money, part 3
To answer this question, find and compare the EARs of the loans. Loans with lower
EAR have lower costs, all else equal, because EAR reflects the true cost of a loan.
Therefore, a loan with a lower EAR would be preferred to a comparable loan with a
higher EAR.

For all 3 loans, because no other information is given about the relevant period for the
interest rate, we assume that the given interest rate is an APR

EAR = [(1 + periodic rate)# of periods in a year] – 1

= [(1 + (APR ÷ # periods in a year))# of periods in a year] – 1

Loan A
Periodic rate = APR ÷ # of periods in a year = .1032 / 12 = .0086 = 0.86%
EAR = (1.0086)12] – 1
= 1.1082 – 1
= .1082 = 10.82%

Loan B
Periodic rate = APR ÷ # of periods in a year = .1044 / 4 = .0261 = 2.61%
EAR = (1.0261)4] – 1
= 1.1086 – 1
= .1086 = 10.86%

Loan C
Periodic rate = APR ÷ # of periods in a year = .1048 / 2 = .0524 = 5.24%
EAR = (1.0524)2] – 1
= 1.1075 – 1
= .1075 = 10.75%

===============================

Lecture Problem 10

What is the EAR of an investment with an expected return of 4.26 percent compounded
continuously?

With continuous compounding:

EAR
= eAPR – 1
= e0.0426 – 1
= 1.0435 – 1
= .0435 = 4.35%

==================================

Lecture Problem 11-a

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Solutions to lecture problems – time value of money, part 3

How much will you have in 10 years if you save $175 per month for 10 years, your first
savings contribution is in one month, and your expected return is 9.00 percent?

Timeline tip for FNAN 303: if cash flows reflect an annuity, annuity due, or perpetuity,
then the timeline period equals the period associated with the cash flows. In this case,
the cash flows reflect an annuity with monthly payments, so the timeline period is 1
month

Since no time period is associated with the expected return, we assume that it is an APR

N = 10 years × 12 months per year = 120 months

PMT = -175 = monthly cash flows (negative since it is an outflow into savings)

I% = monthly expected return

= .0900 per year / 12 months per year = .0075 = 0.75% monthly rate

PV = 0, since no initial savings or extra contribution made today

END Mode
Enter 120 0.75 0 -175
N I% PV PMT FV
Solve for 33,865

You would have $33,865 in 10 years

--------------------------------------------------------

Lecture Problem 11-b

What is the value of an investment that is scheduled to pay you $10,000 in 5 years and that
has an expected return of 8.60 percent, compounded semi-annually?

Timeline tip for FNAN 303: rate is given for a year and compounding occurs semi-
annually, so the timeline period equals a half year

Time period 0 1yr 2yrs 3yrs 4yrs 5yrs

Time period 0 1 2 3 4 5 6 7 8 9 10
Cash flow 10,000
Present value ?

We want the semi-annual rate

The rate of 8.6 percent for the year is assumed to be an APR

The semi-annual rate = 8.60 percent ÷ number of half-years in a year
= 8.60 percent ÷ 2
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Solutions to lecture problems – time value of money, part 3
= 4.30 percent = .0430

PV = C10 / (1+r)10
= 10,000 / (1.0430)10 = 6,563.82

Mode is not relevant, since PMT = 0

Enter 10 4.30 0 10,000
N I% PV PMT FV
Solve for -6,563.82

The investment is worth $6,563.82

=============================

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