Chapter 02 - How to Calculate Present Values

CHAPTER 2
How to Calculate Present Values

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. a. False. The opportunity cost of capital varies with the risks associated with each individual
project or investment. The cost of borrowing is unrelated to these risks.

b. True. The opportunity cost of capital depends on the risks associated with each project and
its cash flows.

c. True. The opportunity cost of capital is dependent on the rates of returns shareholders can
earn on the own by investing in projects with similar risks

d. False. Bank accounts, within FDIC limits, are considered to be risk-free. Unless an investment
is also risk-free, its opportunity cost of capital must be adjusted upward to account for
the associated risks.
Est time: 01-05

2. a. In the first year, you will earn $1,000 × 0.04 = $40.00

b. In the second year, you will earn $1,040 × 0.04 = $41.60

c. By the end of the ninth year, you will accrue a principle of $1,040 × (1.049) = $1,423.31.
Therefore, in the Tenth year, you will earn $1,423.31 × 0.04 = $56.93
Est time: 01-05

3.

Est time: 01-05

4. The “Rule of 72” is a rule of thumb that says with discrete compounding the time it takes for an
investment to double in value is roughly 72/interest rate (in percent).
Therefore, without a calculator, the Rule of 72 estimate is:
Time to double = 72 / r
Time to double = 72 / 4
Time to double = 18 years, so less than 25 years.

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Chapter 02 - How to Calculate Present Values

If you did have a calculator handy, this estimate is verified as followed:

Ct = PV × (1 + r)t
t = ln2 / ln1.04
t = 17.67 years
Est time: 01-05

5. a. Using the inflation adjusted 1958 price of $1,060, the real return per annum is:

$450,300,000 = $1,060 × (1 + r)(2017-1958)

r = [$450,300,000/$1,060](1/59 ) – 1 = 0.2456 or 24.56% per annum

b. Using the inflation adjusted 1519 price of $575,000, the real return per annum is:

$450,300,000 = $575,000 × (1 + r)(2017-1519)

r = [$450,300,000/$575,000](1/498 ) – 1 = 0.0135 or 1.35% per annum

Est time: 01-05

6. Ct = PV × (1 + r)t
C8 = $100 × 1.158
C8 = $305.90
Est time: 01-05

7. a. Ct = PV × (1 + r)t
C10 = $100 × 1.0610
C10 = $179.08

b. Ct = PV × (1 + r)t
C20 = $100 × 1.0620
C20 = $320.71

c. Ct = PV × (1 + r)t
C10 = $100 × 1.0410
C10 = $148.02

d. Ct = PV × (1 + r)t
C20 = $100 × 1.0420
C20 = $219.11
Est time: 01-05

8. a. PV = Ct × DFt
DFt = $125 / $139
DFt = .8993

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Chapter 02 - How to Calculate Present Values

b. Ct = PV × (1 + r)t
$139 = $125 × (1+r)5
r = [$139/$125](1/5) – 1 = 0.0215 or 2.15%
Est time: 01-05

9. PV = Ct / (1 + r)t
PV = $374 / 1.099
PV = $172.20
Est time: 01-05

10. PV = C1 / (1 + r)1 + C2 / (1 + r)2 + C3 / (1 + r)3

PV = $432 / 1.15 + $137 / 1.152 + $797 / 1.153
PV = $1,003.28

NPV = PV – investment
NPV = $1,003.28 – 1,200
NPV = –$196.72
Est time: 01-05

11. The basic present value formula is: PV = C / (1 + r)t

a. PV = $100 / 1.0110
PV = $90.53

b. PV = $100 / 1.1310
PV = $29.46

c. PV = $100 / 1.2515
PV = $3.52

d. PV = C1 / (1 + r) + C2 / (1 + r)2 + C3 / (1 + r)3
PV = $100 / 1.12 + $100 / 1.122 + $100 / 1.123
PV = $89.29 + $79.72 + $71.18
PV = $240.18
Est time: 01-05

10 Ct
NPV= ∑
12. t=0 (1. 12)t
NPV = –$380,000 + $50,000 / 1.12 + $57,000 / 1.122 + $75,000 / 1.123 + $80,000 / 1.124 +
$85,000 / 1.125 + $92,000 / 1.126 + $92,000 / 1.127 + $80,000 / 1.128 + $68,000 / 1.129
+ $50,000 / 1.1210
NPV = $23,696.15
Est time: 01-05

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Chapter 02 - How to Calculate Present Values

13. a. NPV = – Investment + C × ((1 / r) – {1 / [r(1 + r)t]})

NPV = –$800,000 + $170,000 × ((1 / .14) – {1 / [.14(1.14)10]})
NPV = $86,739.66

b. After five years, the factory’s value will be the present value of the remaining cash flows:
PV = $170,000 × ((1 / .14) – {1 / [.14(1.14)(10 – 5)]})
PV = $583,623.76
Est time: 01-05

14. Use the formula: NPV = –C0 + C1 / (1 + r) + C2 / (1 + r)2

NPV5% = –$700,000 + $30,000 / 1.05 + $870,000 / 1.052

NPV5% = $117,687.07

NPV10% = –$700,000 + $30,000 / 1.10 + $870,000 / 1.102

NPV10% = $46,280.99

NPV15% = –$700,000 + $30,000 / 1.15 + $870,000 / 1.152

NPV15% = –$16,068.05

The figure below shows that the project has a zero NPV at about 13.65%.

NPV13.65% = –$700,000 + $30,000 / 1.1365 + $870,000 / 1.13652

NPV13.65% = –$36.83

Est time: 11-15

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Chapter 02 - How to Calculate Present Values

15. a. NPV = –Investment + PVAoperating cash flows – PVrefits + PVscrap value

NPV = –$8,000,000 + ($5,000,000 – 4,000,000) × ((1 / .08) – {1 / [.08(1.08)15]}) –
($2,000,000 / 1.085 + $2,000,000 / 1.0810) + $1,500,000 / 1.0815
NPV = –$8,000,000 + 8,559,479 – 2,287,553 + 472,863
NPV = –$1,255,212

b. The cost of borrowing does not affect the NPV because the opportunity cost of capital
depends on the use of the funds, not the source.
Est time: 06-10

16. NPV = C / r – investment

NPV = $138 / .09 − $1,548
NPV = −$14.67
Est time: 01-05

17. One way to approach this problem is to solve for the present value of:

(1) $100 per year for 10 years, and

(2) $100 per year in perpetuity, with the first cash flow at year 11.

If this is a fair deal, the present values must be equal, thus solve for the interest rate (r).

The present value of $100 per year for 10 years is:

PV = C × ((1 / r) – {1 / [r × (1 + r)t]})
PV = $100 × ((1 / r) – {1 / [r × (1 + r)10]})

The present value, as of year 0, of $100 per year forever, with the first payment in year 11, is:
PV = (C / r) / (1 + r)t
PV = ($100 / r) / (1 + r)10

Equating these two present values, we have:

$100 × ((1 / r) – {1 / [r × (1 + r)10]}) = ($100 / r) / (1 + r)10

Using trial and error or algebraic solution, r = 7.18%.

Est time: 06-10

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Chapter 02 - How to Calculate Present Values

18. a. PV = C / r
PV = $1 / .10
PV = $10

b. PV7 = (C8 / r)
PV0 approx = (C8 / r) / 2
PV0 approx = ($1 / .10) / 2
PV0 approx = $5

c. A perpetuity paying $1 starting now would be worth $10 (part a), whereas a perpetuity
starting in year 8 would be worth roughly $5 (part b). Thus, a payment of $1 for the next
seven years would also be worth approximately $5 (= $10 – 5).

d. PV = C / ( r − g)
PV = $10,000 / (.10 − .05)
PV = $200,000
Est time: 06-10

19. a. DF1 = 1 / (1 + r)
r = (1 – .905) / .905
r = .1050, or 10.50%

b. DF2 = 1 / (1 + r)2
DF2 = 1 / 1.1052
DF2 = .8190

c. PVAF2 = DF1 + DF2

PVAF2 = .905 + .819
PVAF2 = 1.7240

d. PVA = C  PVAF3
PVAF3 = $24.65 / $10
PVAF3 = 2.4650

e. PVAF3 = PVAF2 + DF3

DF3 = 2.465 – 1.7240
DF3 = .7410
Est time: 06-10

20. PV = Ct / (1 + r)t
PV = $20,000 / 1.105
PV = $12,418.43

C = PVA / ((1 / r) – {1 / [r(1 + r)t]})

C = $12,418.43 / ((1 / .10) – {1 / [.10 (1 + .10)5]})
C = $3,275.95
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

21. C = PVA / ((1 / r) – {1 / [r(1 + r)t]})

C = $20,000 / ((1 / .08) – {1 / [.08(1 + .08)12]})
C = $2,653.90
Est time: 01-05

22. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = ($9,420,713 / 19) × ((1 / .08) – {1 / [.08(1 + .08)19]})
PV = $4,761,724

b. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

$4,200,000 = ($9,420,713 / 19) × ((1 / r) – {1 / [r(1 + r)t]})

Using Excel or a financial calculator, we find that r = 9.81%.

Est time: 06-10

23. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $50,000 × ((1 / .055) – {1 / [.055(1 + .055)12]})
PV = $430,925.89

b. Since the payments now arrive six months earlier than previously:
PV = $430,925.89 × {1 + [(1 + .055).5 – 1]}
PV = $442,617.74
Est time: 06-10

24. Ct = PV × (1 + r)t
Ct = $1,000,000 × (1.035)3
Ct = $1,108,718

Annual retirement shortfall = 12 × (monthly aftertax pension + monthly aftertax Social Security –
monthly living expenses)
= 12 × ($7,500 + 1,500 – 15,000)
= –$72,000

The withdrawals are an annuity due, so:

PV = C × ((1 / r) – {1 / [r(1 + r)t]}) × (1 + r)
$1,108,718 = $72,000 × ((1 / .035) – {1 / [.035(1 + .035)t]}) × (1 + .035)
14.878127 = (1 / .035) – {1 / [.035(1 + .035)t]}

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Chapter 02 - How to Calculate Present Values

13.693302 = 1 / [.035(1 + .035)t]

.073028 / .035 = 1.035t
t = ln2.086514 / ln1.035
t = 21.38 years
Est time: 06-10

25. a. PV = C / r = $1 billion / .08

PV = $12.5 billion

b. PV = C / (r – g) = $1 billion / (.08 – .04)

PV = $25.0 billion

c. PV = C × ((1 / r) – {1 / [r (1 + r)t]}) = $1 billion × ((1 / .08) – {1 / [.08(1 + .08)20]})

PV = $9.818 billion

d. The continuously compounded equivalent to an annually compounded rate of 8% is

approximately 7.7%, which is computed as:
Ln(1.08) = .077, or 7.7%

PV = C × {(1 / r) – [1 / (r × ert)]} = $1 billion × {(1 / .077) – [1 / (.077 – e.077 × 20)]}

PV = $10.206 billion
This result is greater than the answer in Part (c) because the endowment is now earning
interest during the entire year.
Est time: 06-10

26. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $2.0 million × ((1 / .08) – {1 / [.08(1.08)20]})
PV = $19.64 million

b. If each cashflow arrives one year earlier, then you can simply compound the PV
calculated in part a by (1+r) $19.64 million × (1.08) = $21.21 million
Est time: 01-05

27. a. Start by calculating the present value of an annuity due assuming a price of $1:
PV = 0.25 + 0.25 × ((1 / .05) – {1 / [.05(1.05)3]})
PV = 0.93, therefore it is better to pay instantly at a lower cost of 0.90 [= 1 × 0.9]

b. Recalculate, except this time using an ordinary annuity:

PV = 0.25 × ((1 / .05) – {1 / [.05(1.05)4]})
PV = 0.89, therefore it is better to take the financing deal as it costs less than 0.90.
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

28. a. Using the annuity formula:

PV = $70,000 × ((1 / .08) – {1 / [.08(1 + .08)8]})
PV = $402,264.73

b. The amortization table follows:

Year Beg Bal. Payment Interest (8%) Loan Red. Ending Bal.
1 $ 402,265 $ (70,000) $ (32,181) $ (37,819) $ 364,446
2 364,446 (70,000) (29,156) (40,844) 323,602
3 323,602 (70,000) (25,888) (44,112) 279,490
4 279,490 (70,000) (22,359) (47,641) 231,849
5 231,849 (70,000) (18,548) (51,452) 180,397
6 180,397 (70,000) (14,432) (55,568) 124,829
7 124,829 (70,000) (9,986) (60,014) 64,815
8 64,815 (70,000) (5,185) (64,815) -
Est time: 06-10

29. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

C = PV / ((1 / r) – {1 / [r (1 + r)t]})
C = $200,000 / ((1 / .06) – {1 / [.06(1 + .06)20]})
C = $17,436.91

b.

Year Beg Bal. Payment Interest Loan Red.

1 $ 200,000.00 $ (17,436.91) $ (12,000.00) $ (5,436.91)
2 194,563.09 (17,436.91) (11,673.79) (5,763.13)
3 188,799.96 (17,436.91) (11,328.00) (6,108.91)
4 182,691.05 (17,436.91) (10,961.46) (6,475.45)
5 176,215.60 (17,436.91) (10,572.94) (6,863.98)
6 169,351.63 (17,436.91) (10,161.10) (7,275.81)
7 162,075.81 (17,436.91) (9,724.55) (7,712.36)
8 154,363.45 (17,436.91) (9,261.81) (8,175.10)
9 146,188.34 (17,436.91) (8,771.30) (8,665.61)
10 137,522.73 (17,436.91) (8,251.36) (9,185.55)
11 128,337.19 (17,436.91) (7,700.23) (9,736.68)
12 118,600.51 (17,436.91) (7,116.03) (10,320.88)
13 108,279.62 (17,436.91) (6,496.78) (10,940.13)
14 97,339.49 (17,436.91) (5,840.37) (11,596.54)
15 85,742.95 (17,436.91) (5,144.58) (12,292.33)
16 73,450.61 (17,436.91) (4,407.04) (13,029.87)
17 60,420.74 (17,436.91) (3,625.24) (13,811.67)
18 46,609.07 (17,436.91) (2,796.54) (14,640.37)

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Chapter 02 - How to Calculate Present Values

c. Interest percent of first payment = Interest1 / Payment

Interest percent of first payment = (.06 × $200,000) / $17,436.91
Interest percent of first payment = .6882, or 68.82%

Interest percent of last payment = Interest20 / Payment = $986.99 / $17,436.91

Interest percent of last payment = .0566, or 5.66%

Without creating an amortization schedule, the interest percent of the last payment
can be computed as:

Interest percent of last payment = 1 – {[Payment / (1 + r)] / Payment}

Interest percent of last payment = 1 – [($17,436.91 / 1.06) / $17,436.91]
Interest percent of last payment = .0566, or 5.66%

After 10 years, the balance is:

PV10 = C × ((1 + r) – {1 / [r × (1 + r)t]}) = $17,436.91 × {1.06 – [1 / (.06 × 1.0610)]}

PV10 = $128,337.19

Fraction of loan paid off = (Loan amount – PV10) / Loan amount

= ($200,000 – 128,337.19) / $200,000
Fraction of loan paid off = .3583, or 35.83%
Though 50% of time has passed, only 35.83% of the loan has been paid off; this is
because interest comprises a higher portion of the monthly payments at the
beginning of the loan (e.g., Interest percent of first payment > interest percent of
last payment).
Est time: 16-20

30. a. PV = Ct / (1 + r)t = $10,000 / 1.055

PV = $7,835.26

b. PV = C((1 / r) – {1 / [r(1 + r)t]}) = $12,000((1 / .08) – {1 / [.08(1.08)6]})

PV = $55,474.56

c. Ct = PV × (1 + r)t = ($60,476 − 55,474.56) × 1.086

Ct = $7,936.66
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

31.
Est time: 01-05

32. a. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

C = $2,000,000 / ((1 / .08) – {1 / [.08(1 + .08)15]})
C = $233,659.09

b. r = (1 + R) / (1 + h) – 1 = 1.08 / 1.04 – 1
r = .0385, or 3.85%

PV = C × ((1 / r) – {1 / [r(1 + r)t]})

C = $2,000,000 / ((1 / .0385) – {1 / [.0385(1 +.0385)15]})
C = $177,952.49

The retirement expenditure amount will increase by 4% annually.

Est time: 06-10

33. Calculate the present value of a growing annuity for option 1, then compare this amount with the
option to pay instantly $12,750:

PV = C × ([1 / (r – g)] – {(1 + g)t / [(r – g) × (1 + r)t]})

PV = $5,000 × ([1 / (.10 – .06)] – {(1 + .06)3 / [(.10 – .06) × (1 + .10)3]})
PV = $13,146.51

Since the $13,147 present value of the three year growing annual membership dues exceeds the
single $12,750 payment for three years, it is better to pay the lower upfront 3-year dues.
Est time: 06-10

34. a. PV = C0
PV = $100,000

b. PV = Ct / (1 + r)t = $180,000 / 1.125

PV = $102,136.83

c. PV = C / r = $11,400 / .12
PV = $95,000

d. PV = C × ((1 / r) – {1 / – [r(1 + r)t]}) = $19,000 × ((1 / .12) – {1 / – [.12(1.12)10]})

PV = $107,354.24

e. PV = C / (r – g) = $6,500 / (.12  .05)

PV = $92,857.14

Prize (d) is the most valuable because it has the highest present value.
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

35. a. PV = C / r
PV = $2,000,000 / .12
PV = $16,666,667

b. PV = C × ((1 / r) – {1 / [r(1 + r)t]})

PV = $2,000,000 × ((1 / .12) – {1 / [.12(1 + .12)20]})
PV = $14,938,887

c. PV = C / (r – g)
PV = $2,000,000 / (.12 – .03)
PV = $22,222,222

d. PV = C × ([1 / (r – g)] – {(1 + g)t / [(r – g) × (1 + r)t]})

PV = $2,000,000 × ([1 / (.12 – .03)] – {(1 + .03)20 / [(.12 – .03) × (1 + .12)20]})
PV = $18,061,473
Est time: 06-10

36. First, find the semiannual rate that is equivalent to the annual rate:
1 + r = (1 + rsemi )2
1.08 = (1 + rsemi)2
rsemi = 1.08.5 – 1
rsemi = .039230, or 3.9230%

PV = C 0 + C × ((1 / rsemi) – {1 / [rsemi × (1 + rsemi)t]})

PV = $100,000 + $100,000 × ((1 / .039230) – {1 / [.039230(1 + .039230)9]})
PV = $846,147.28
Est time: 06-10

37. a. Ct = PV × (1 + r)t
C1 = $1 × 1.121 = $1.1200
C5 = $1 × 1.125 = $1.7623
C10 = $1 × 1.1210 = $9.6463

b. Ct = PV × (1 + r / m)mt
C1 = $1 × [1 + (.117 / 2)2 × 1 = $1.1204
C5 = $1 × [1 + (.117 / 2)2 × 5 = $1.7657
C10 = $1 × [1 + (.117 / 2)2 × 20 = $9.7193

c. Ct = PV × emt
C1 = $1 × e(.115 × 1) = $1.1219
C5 = $1 × e(.115 × 5) = $1.7771
C10 = $1 × e(.115 × 20) = $9.9742

The preferred investment is (c) because it compounds interest faster and produces the highest
future value at any point in time.
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

38.
a. Ct = PV × (1 + r)t
Ct = $10,000,000 x (1.06)4
Ct = $12,624,770

b. Ct = PV × [1+ (r / m)mt
Ct = $10,000,000 × [1 + (.06 / 12)]12 × 4
Ct = $12,704,892

c. Ct = PV × ert
Ct = $10,000,000 × e.06 × 4
Ct = $12,712,492
Est time: 01-05

39. a. PVend of year = C / r

PVend of year = $100 / .07
PVend of year = $1,428.57

b. PVbeginning of year = (C / r) × (1 + r)
PVbeginning of year = ($100 / .07) × (1 + .07)
PVbeginning of year = $1,528.57

c. To find the present value with payments spread evenly over the year, use the
continuously compounded rate that equates to 7% compounded annually. This rate is
found using natural logarithms.

PVCC = C / rCC
PVCC = $100 / ln(1 + .07)
PVCC = $1,478.01

[Note: the continuously compounded rate is :Ln(1 + .07) = .0677, or 6.77%]

The sooner payments are received, the more valuable they are.
Est time: 06-10

40. Annual compounding:

Ct = PV × (1 + r)t
C20 = $100  1.1520
C20 = $1,636.65

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Chapter 02 - How to Calculate Present Values

Continuous compounding:

Ct = PV × ert
C20 = $100  e.15 × 20
C20 = $2,008.55

Est time: 01-05

41. a. FV = C × ert
FV = $1,000 × e.12 x 5
FV = $1,822.12

b. PV = C / ert
PV = $5,000,000 / e.12 × 8
PV = $1,914,464

c. PV = C (1 / r – 1 / rert)
PV = $2,000 (1 / .12 – 1 / .12e .12 x 15)
PV = $13,911.69
Est time: 01-05

42. Spreadsheet exercise, answers will vary

Est time: 11-15

43. a. PV = C / (r – g)
PV = $2,000,000 / [.10 – (–.04)]
PV = $14,285,714

b. PV20 = C21 / (r – g)
PV20 = {$2,000,000 × [1 + (–.04)]20} / [.10 – (–.04)]
PV20 = $6,314,320

PV cash flows 1-20 = PV – PV20 / (1 + r)20

PV cash flows 1-20 = $14,285,714 – ($6,314,320 / 1.1020)
PV cash flows 1-20 = $13,347,131
Est time: 06-10

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Chapter 02 - How to Calculate Present Values

44. a. Rule of 72 estimate:

Time to double = 72 / r
Time to double = 72 / 12
Time to double = 6 years

Exact time to double:

Ct = PV × (1 + r)t
t = ln2 / ln1.12
t = 6.12 years

b. With continuous compounding for interest rate r and time period t:

e rt = 2
rt = ln2

Solving for t when r is expressed as a decimal:

rt = .693
t = .693 / r
Est time: 06-10

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