5

TIME VALUE OF MONEY

Overview
A dollar in the hand today is worth more than a dollar to be received in the future because, if you had it
now, you could invest that dollar and earn interest. Of all the techniques used in finance, none is more
important than the concept of time value of money, also called discounted cash flow (DCF) analysis. It is
essential for financial managers to have a clear understanding of the time value of money and its impact
on stock prices.
Future value and present value techniques can be applied to a single cash flow (lump sum), ordinary
annuities, annuities due, and uneven cash flow streams. Future and present values can be calculated using
a regular calculator, a calculator with financial functions, or a computer spreadsheet program. The
principles of time value analysis have many applications, ranging from setting up schedules for paying off
loans to decisions about whether to acquire new equipment.

Outline
I. The time line is one of the most important tools in time value of money calculations.
A. Time lines help visualize what is happening in a particular problem.
1. Cash flows are placed directly below the tick marks, and interest rates are shown directly
above the time line; unknown cash flows are indicated by question marks.
2. To find the future value of $100 after 5 years at 5% interest, the following time line can
be set up as follows:
Time: 0 1 2 3 4 5
5%
| | | | | |
Cash flows: -100 FV5 = ?
B. Time lines are essential when you are first learning time value concepts, but even experts use
them to analyze complex finance problems.
1. Begin each problem by setting up a time line to show what’s happening, then determine
the equation(s) that must be solved to find the answer.
II. Finding the future value (FV), or compounding, is the process of going from today’s values
(or present values) to future amounts (or future values). The future value is calculated as:
FVN = PV(1 + I)N where PV = present value, or beginning amount; I = interest rate per
year; and N = number of periods involved in the analysis. This equation can be solved in
one of three ways: numerically, with a financial calculator, or with a computer spreadsheet

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Chapter 5

program. For calculations, assume the data that were presented in the time line above:
present value (PV) = $100, interest rate (I) = 5%, and number of years (N) = 5.
A. To solve numerically, use a regular calculator to find 1 + I = 1.05 raised to the fifth power,
(1.05)5, which equals 1.2763. Multiply this figure by PV = $100 to obtain the final answer of
FV5 = $127.63.
B. With a financial calculator, the future value can be found by using the time value of money
(TVM) input keys, where N = number of periods, I/YR = interest rate per period, PV =
present value, PMT = payment, and FV = future value. By entering N = 5, I/YR = 5, PV =
-100, and PMT = 0, and then pressing the FV key, the answer 127.63 is displayed.
1. Some financial calculators require that all cash flows be designated as either inflows or
outflows, thus an outflow must be entered as a negative number (for example, PV = -100
instead of PV = 100).
2. When PMT is zero, it doesn’t matter what sign you enter for PV as your calculator will
automatically assign the opposite sign to FV when it is calculated.
C. Spreadsheet programs are ideally suited for solving many financial problems, including time
value of money problems. With very little effort, the spreadsheet itself becomes a time line.
1. The format of Excel’s FV function is FV(rate,nper,pmt,[pv],[type]).
2. “Type” indicates whether cash flows occur at the beginning of the period or at the end of
the period.
a. Type is used only if PMT is a nonzero number.
b. Zero indicates that cash flows occur at the end, while 1 indicates that cash flows
occur at the beginning. If type is left blank, cash flows are assumed to occur at the
end.
D. A graph of the compounding process shows how any sum grows over time at various interest
rates. The greater the interest rate, the faster the growth rate.
1. Time value concepts can be applied to anything that grows—sales, population, earnings
per share, or your future salary.
III. Finding present values is called discounting, and it is simply the reverse of compounding.
A. The present value of a cash flow due N years in the future is the amount which, if it were on
hand today, would grow to equal the future amount. By solving for PV in the future value
equation, the present value, or discounting, equation can be developed and written as follows:
N
FV N  1 
PV =  FVN  
1  I 
N
(1 + I)
1. To solve for the present value of $127.63 discounted back 5 years at a 5% opportunity
cost rate, which is the rate of return that could be earned on an alternative investment of
similar risk, one can utilize any of the three solution methods:
a. Numerical solution: Divide $127.63 by 1.05 five times to get PV = $100.
b. Financial calculator solution: Enter N = 5, I/YR = 5, PMT = 0, and FV = 127.63, and
then press the PV key to get PV = -100.
c. With Excel, you can use the built-in spreadsheet PV function to solve for PV = 100.
The format for this function is PV(rate,nper,pmt,[fv],[type]).
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 TIME VALUE OF MONEY

B. A graph of the discounting process shows how the present value of any sum to be received in
the future diminishes as the years to receipt increases.
1. At relatively high interest rates, funds due in the future are worth very little today.
2. Even at a relatively low discount rate, the present value of a sum due in the very distant
future is quite small.
C. The fundamental goal of financial management is to maximize the firm’s value.
1. The value of a business (or any asset, including stocks and bonds) is the present value of
its expected future cash flows.
2. Present value lies at the heart of the valuation process.
IV. There are four variables used in the future value and present value equations: PV, FV, I,
and N. If three of the four variables are known, you can find the value of the fourth
variable. Note that the PMT variable in these two equations is zero.
A. If we are given PV, FV, and N, we can determine I by substituting the known values into
either the present value or future value equations, and then solving for I. Thus, if you can buy
a security at a price of $78.35 that will pay you $100 after 5 years, what is the interest rate
earned on the investment?
1. This is the numerical solution, and it requires a bit more algebra to solve for I.
$100 = $78.35(1  I) 5
1.2763  (1  I) 5
1.27631 / 5  (1  I)
1.05  1  I
I  5%
2. Financial calculator solution: Enter N = 5, PV = -78.35, PMT = 0, and FV = 100, then
press the I/YR key, and I/YR = 5 is displayed.
3. Computer spreadsheet program: Most spreadsheets have a built-in function to find the
interest rate.
a. The format for Excel’s function is RATE(nper,pmt,pv,[fv],[type],[guess]). In many
cases, you do not have to enter a guess for the interest rate.
B. Likewise, if we are given PV, FV, and I, we can determine N by substituting the known
values into either the present value or future value equations, and then solving for N. Thus, if
you can buy a security with a 5% interest rate at a price of $78.35 today, how long will it take
for your investment to return $100?
1. Numerical solution: We cannot use a simple formula—the situation is like that with
interest rates.
2. Financial calculator solution: Enter I/YR = 5, PV = -78.35, PMT = 0, and FV = 100, then
press the N key, and N = 5 is displayed.
3. Computer spreadsheet program: The format of Excel’s built-in function is
NPER(rate,pmt,pv,[fv],[type]).
V. An annuity is a series of equal payments made at fixed intervals for a specified number of
periods.
A. If the payments occur at the end of each period, as they typically do, the annuity is an
ordinary (or deferred) annuity.
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Chapter 5

B. If the payments occur at the beginning of each period, it is called an annuity due.
C. Annuities must have constant payments at fixed intervals for a fixed number of periods. If
these conditions don’t hold, then those cash flows don’t constitute an annuity.
VI. The future value of an annuity, FVAN, is the total amount one would have at the end of the
annuity period if each payment were invested at a given interest rate and held to the end of
the annuity period.
A. FVAN is the compound sum of an ordinary annuity of N years and PMT is the periodic
payment. The second line of the equation is a streamlined version of the first line.
N
FVA N = PMT  (1  I) N  t
t 1

 (1  I) N  1 
 PMT  
 I 
1. If PMT = 100, I = 0.05, and N = 3, we can solve for FVAN as follows:
 (1.05) 3  1 
FVA N = $100  
 0.05 
 0.1576 
 $100 
 0.05 
 $100(3.1525)  $315.25
B. With a financial calculator, the future value of an ordinary annuity can be found as follows:
Enter N = 3, I/YR = 5, PV = 0, and PMT = -100. Then press the FV key, and 315.25 is
displayed.
C. Most spreadsheets have a built-in function to find the future value of an annuity. The format
of Excel’s built-in function is FV(rate,nper,pmt,[pv],[type]).
1. The function allows you to specify the annuity “type,” that is, whether the annuity is an
ordinary annuity or an annuity due.
2. A zero indicates an ordinary annuity, while 1 indicates an annuity due. If type is left
blank, it is assumed that the annuity is an ordinary annuity.
VII. Each payment of an annuity due is compounded for one additional period, so the future
value of the entire annuity is equal to the future value of an ordinary annuity compounded
for one additional period.
A. Each payment of an annuity due occurs one period earlier than the payments of an ordinary
annuity, so the formula to calculate the future value of an annuity due is
FVAdue = FVAordinary(1 + I)
B. Most financial calculators have a switch, or key, marked “DUE” or “BEG” that permits you
to switch from end-of-period payments (an ordinary annuity) to beginning-of-period
payments (an annuity due).
1. Switch your calculator to “BEG” mode, and calculate the future value of an annuity due
as you would an ordinary annuity.
2. Do not forget to switch your calculator back to “END” mode when you are finished.

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 TIME VALUE OF MONEY

VIII. The present value of an annuity is the single (lump sum) payment today that would be
equivalent to the annuity payments received at fixed intervals over the annuity period.
A. It is the amount today that would permit withdrawals of an equal amount (PMT) at the end
(or beginning for an annuity due) of each period (must be same fixed interval) for N periods.
B. Defining PVAN as the present value of an ordinary annuity of N years and PMT as the
periodic payment, we can write
t
N
 1 
PVA N = PMT   
t 1  1  I 

 1 
1  (1  I) N 
 PMT  
 I 
 

1. If PMT = 100, I = 0.05, and N = 3, we can solve for PVAN as follows:

 1 
1  (1.05) 3 
PVA N = $100  
 0.05 
 
 0.1362 
 $100 
 0.05 
 $100(2.7232)  $272.32
C. Using a financial calculator, enter N = 3, I/YR = 5, PMT = -100, and FV = 0, and then press
the PV key, for an answer of $272.32.
D. Most spreadsheets have a built-in function to find the present value of an annuity. The format
of Excel’s built-in function is PV(rate,nper,pmt,[fv],[type]).
1. The function allows you to specify the annuity “type,” that is, whether the annuity is an
ordinary annuity or an annuity due. A zero indicates an ordinary annuity, while 1
indicates an annuity due. If you leave type blank, it is assumed that the annuity is an
ordinary annuity.
2. For an annuity due, each payment is discounted for one less period, so the present value
of the entire annuity is equal to the present value of an ordinary annuity multiplied by
(1 + I). Solving for PVAdue:
PVA due  PVA ordinary (1  I)
 $272.32(1.05)  $285.94
3. Using a financial calculator, switch to the “BEG” mode, and then enter N = 3, I/YR = 5,
PMT = -100, and FV = 0, and then press PV to get the answer, $285.94. Again, do not
forget to switch your calculator back to “END” mode when you are finished.
IX. We can find payments, periods, and interest rates for annuities. Here five variables come
into play: N, I, PMT, FV, and PV. If we know any four variables, we can find the value of
the fifth variable.

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Chapter 5

A. Suppose you need to accumulate $10,000 in 5 years and you can earn a return of 6% on the
savings, which are currently zero. What is the annual deposit that you need to make?
1. End Mode: N = 5, I/YR = 6, PV = 0, and FV = 10000. Solve for PMT = -$1,773.96.
2. Begin Mode: N = 5, I/YR = 6, PV = 0, and FV = 10000. Solve for PMT = -$1,673.55.
a. Because payments occur at the beginning of the period, the deposit is smaller than if
they were made at the end of the period. Payments received at the beginning earn
interest for one additional year.
3. The format of Excel’s built-in function is PMT(rate,nper,pv,[fv],[type]).
a. “Type” indicates whether the annuity is an ordinary annuity or an annuity due. A
zero indicates an ordinary annuity, while a 1 indicates an annuity due. If you leave
type blank, it is assumed that the annuity is an ordinary annuity.
B. Suppose you still need to accumulate $10,000 and you can earn a return of 6% on the savings,
which are currently zero. If you can only make deposits of $1,200, how long will it take you
to reach your $10,000 goal?
1. End Mode: I/YR = 6, PV = 0, PMT = -1200, and FV = 10000. Solve for N = 6.96.
2. Begin Mode: I/YR = 6, PV = 0, PMT = -1200, and FV = 10000. Solve for N = 6.63.
a. Because payments occur at the beginning of the period, it takes less time to reach
your goal than if payments were made at the end of the period. Payments received at
the beginning earn interest for one additional year.
3. The format of Excel’s built-in function is NPER(rate,pmt,pv,[fv],[type]).
a. “Type” indicates whether the annuity is an ordinary annuity or an annuity due. A
zero indicates an ordinary annuity, while a 1 indicates an annuity due. If you leave
type blank, it is assumed that the annuity is an ordinary annuity.
C. Suppose you still need to accumulate $10,000 in 5 years, you can save only $1,200 annually,
and your current savings are zero. What rate of return would enable you to achieve your
goal?
1. End Mode: N = 5, PV = 0, PMT = -1200, and FV = 10000. Solve for I/YR = 25.78%.
2. Begin Mode: N = 5, PV = 0, PMT = -1200, and FV = 10000. Solve for I/YR = 17.54%.
a. Because payments occur at the beginning of the period, it takes a lower rate of return
to reach your goal than if payments were made at the end of the period. Payments
received at the beginning earn interest for one additional year.
3. The format of Excel’s built-in function is RATE(nper,pmt,pv,[fv],[type],[guess]).
a. “Type” indicates whether the annuity is an ordinary annuity or an annuity due. A
zero indicates an ordinary annuity, while a 1 indicates an annuity due. If you leave
type blank, it is assumed that the annuity is an ordinary annuity.
X. An annuity that goes on indefinitely is called a perpetuity. The payments of a perpetuity
constitute an infinite series.
A. The present value of a perpetuity is:
Payment PMT
PV(Perpetuity) = 
Interest rate I

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 TIME VALUE OF MONEY

B. For example, if the interest rate were 12%, a perpetuity of $1,000 a year would have a present
value of $1,000/0.12 = $8,333.33.
XI. Many financial decisions require the analysis of uneven, or nonconstant, cash flows rather
than a stream of fixed payments. Dividends on common stocks typically increase over time,
and investments in capital equipment almost always generate uneven cash flows.
A. The present value of an uneven stream of income is the sum of the PVs of the individual cash
flow components. Similarly, the future value of an uneven stream of income is the sum of the
FVs of the individual cash flow components.
1. PMT (payment) is the term designated for equal cash flows coming at regular intervals,
while CF (cash flow) is the term designated for uneven cash flows.
2. With a financial calculator, enter each cash flow (beginning with the t = 0 cash flow) into
the cash flow register, CFj, enter the appropriate interest rate, and then press the NPV key
to obtain the PV of the cash flow stream.
3. Some calculators have a net future value (NFV) key that allows you to obtain the FV of
an uneven cash flow stream.
a. Even if your calculator doesn’t have the NFV feature, you can use the cash flow
stream’s net present value to find its net future value:
NFV = NPV(1 + I)N
4. Spreadsheets are especially useful for solving problems with uneven cash flows. Just as
with a financial calculator, you must enter the cash flows in the spreadsheet. To find the
PV of an uneven cash flow stream, you can use Excel’s NPV function.
B. If one knows the relevant cash flows, the effective interest rate can be calculated efficiently
with a financial calculator.
1. Enter each cash flow (beginning with the t = 0 cash flow) into the cash flow register, CFj,
and then press the IRR key to obtain the interest rate of an uneven cash flow stream.
2. Excel has an IRR function that can be used to obtain the interest rate of an uneven cash
flow stream.
XII. Semiannual, quarterly, and other compounding periods more frequent than an annual basis
are often used in financial transactions. Compounding on a nonannual basis requires an
adjustment to both the compounding and discounting procedures discussed previously.
A. Whenever payments occur more than once a year, you must make two conversions: (1)
convert the stated interest rate into a “periodic rate,” and (2) convert the number of years into
“number of periods.”
1. Periodic rate = Stated annual rate/Number of payments per year = I/M.
2. Number of periods = Number of years  Periods per year = N  M.
XIII. Different compounding periods are used for different types of investments. If we are to
compare investments or loans with different compounding periods properly, we need to put
them on a common basis.
A. The nominal rate is the rate that is quoted by borrowers and lenders. Nominal rates can only
be compared with one another if the instruments being compared use the same number of
compounding periods per year.

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Chapter 5

1. The nominal rate is never shown on a time line, or used as an input in a financial
calculator, unless compounding occurs only once a year. In general, nonannual
compounding can be handled one of two ways:
a. State everything on a periodic rather than on an annual basis. Thus, N = 6 periods
rather than N = 3 years and I = 3% instead of I = 6% with semiannual compounding.
b. Find the effective annual rate (EAR) with the equation below and then use the EAR
as the rate over the given number of years.
M
 I 
EAR = 1  NOM  1
 M 
B. The effective annual rate (EAR or EFF%) is the rate that would have produced the same
future value under annual compounding as would more frequent compounding at a given
nominal rate.
1. The effective annual percentage rate is given by the following formula:
M
 I 
Effective annual rate (EAR)  EFF% = 1  NOM  1
 M 
a. INOM is the nominal, or quoted, interest rate and M is the number of compounding
periods per year.
2. The format of Excel’s built-in function to calculate the effective annual rate is
EFFECT(nominal_rate,npery). Here, npery corresponds to the number of payments per
year.
3. The EAR is useful in comparing securities with different compounding periods.
4. If a loan or investment uses annual compounding, then the nominal annual rate is also its
effective annual rate.
a. However, if compounding occurs more than once a year, the EFF% is higher than
INOM.
C. The annual percentage rate (APR) is the periodic rate times the number of periods per year:
APR = IPER  M
XIV. Fractional time periods are used when payments occur within periods, instead of either at
the beginning or at the end of periods.
A. Solving these problems requires using the fraction of the time period for N, number of
periods, and then solving numerically, with a financial calculator, or with a computer
spreadsheet program. (Some older calculators will produce incorrect answers because of
their internal “solution” programs.)
XV. An important application of compound interest involves amortized loans, which are paid off
in equal installments over time.
A. With a financial calculator, enter N (number of years), I/YR (interest rate), PV (amount
borrowed), and FV = 0, and then press the PMT key to find the periodic payment.
B. Each payment consists partly of interest and partly of the repayment of principal. This
breakdown is often developed in a loan amortization schedule.

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 TIME VALUE OF MONEY

1. The interest component is largest in the first period, and it declines over the life of the
loan.
2. The repayment of principal is smallest in the first period, and it increases thereafter.
C. Financial calculators are programmed to calculate amortization tables.
D. Spreadsheets are ideal for developing amortization tables.
XVI. Web Appendix 5A discusses the formulas necessary for continuous compounding and
discounting.
A. The equation for continuous compounding is FVN = PV(eIN), where e is the approximate
value 2.7183.
B. The equation for continuous discounting is PV = FVN(e-IN).
XVII. Web Appendix 5B discusses growing annuities, which are defined as a series of payments
that are growing at a constant rate.
A. These types of problems can be solved two ways.
1. Use a financial calculator and calculate the real rate of return. The real rate of return is
the nominal rate adjusted for inflation. This adjusted number is then used for I/YR.
a. Real rate = [(1 + rNOM)/(1 + Inflation)] – 1.
2. Use a spreadsheet model similar to an amortization table. You can then use Excel’s goal
seek function to find the inflation-adjusted withdrawal that produces a zero balance at the
end of the growing annuity’s term.
3. If you need to solve for constant real income with end-of-year withdrawals, the initial
withdrawal amount needs to be multiplied by 1 + inflation. This calculated amount
would be the first withdrawal.
4. If you’re calculating the initial deposit to accumulate a future sum, you must first
calculate the purchasing power of the target sum as
Target
(1  Inflation) N
The purchasing power amount is entered as the FV, N = term, PV = 0, and I/YR = the
real rate, and then solve for PMT.

Self-Test
Definitional Questions
1. The beginning value of an account or investment in a project is known as its _________ value.
2. The difference between a savings account’s present value and its future value at the end of the period
is due to __________ earned during the period.
3. The process of finding present values is often referred to as _____________ and is the reverse of the
_____________ process.

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Chapter 5

4. A series of payments of a constant amount at fixed intervals for a specified number of periods is a(n)
_________. If the payments occur at the end of each period it is a(n) __________ annuity, while if
the payments occur at the beginning of each period it is an annuity _____.
5. The present value of an uneven stream of future payments is the _____ of the PVs of the individual
payments.
6. Since different types of investments use different compounding periods, it is important to distinguish
between the quoted, or _________, rate and the ___________ annual interest rate.
7. The time ______ is one of the most important tools in time value of money calculations; it helps
visualize what is happening in the situation at hand.
8. An annuity that goes on indefinitely is called a(n) ____________.
9. ___________ loans are those that are paid off in equal installments over time.
10. The breakdown of each loan payment as partly interest and partly principal is developed in a loan
______________ schedule.
11. The _____________ cost rate is the rate of return that could be earned on an alternative investment of
similar risk.
12. _____ is the term designated for equal cash flows coming at regular intervals, while ____ is the term
designated for uneven cash flows.
13. The ___________ annual rate is that rate that would have produced the same future value under
annual compounding as would more frequent compounding at a given nominal rate.
14. The ________ percentage rate is the periodic rate times the number of periods per year.
15. The value of a business (or any asset, including stocks and bonds) is the _________ value of its
expected future cash flows.
16. Whenever payments occur more than once a year, you must make two conversions: (1) convert the
stated interest rate into a(n) __________ rate, and (2) convert the number of years into number of
_________.
17. If a loan or investment uses ________ compounding, then its nominal rate is also its effective rate.
18. ____________ time periods are used when payments occur within periods, instead of either at the
beginning or at the end of periods.
19. A(n) _________ _________ is defined as a series of payments that increase at a constant rate.
20. The ______ rate of return is equal to the nominal rate adjusted for inflation.

Conceptual Questions
1. If a bank uses quarterly compounding for savings accounts, the nominal rate will be greater than the
effective annual rate (EAR).
a. True
b. False

2. If money has time value (that is, I > 0), the future value of some amount of money will always be
more than the amount invested. The present value of some amount to be received in the future is
always less than the amount to be received.

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 TIME VALUE OF MONEY

a. True
b. False

3. You have determined the profitability of a planned project by finding the present value of all the cash
flows from that project. Which of the following would cause the project to look less appealing, that is,
have a lower present value?
a. The discount rate decreases.
b. The cash flows are extended over a longer period of time.
c. The discount rate increases.
d. Statements b and c are correct.
e. Statements a and b are correct.

4. As the discount rate increases without limit, the present value of a future cash inflow
a. Gets larger without limit.
b. Stays unchanged.
c. Approaches zero.
d. Gets smaller without limit; that is, approaches minus infinity.
e. Goes to eIN.

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Chapter 5

5. Which of the following statements is correct?

a. Except in situations where compounding occurs annually, the periodic interest rate exceeds the
nominal interest rate.
b. The effective annual rate always exceeds the nominal rate, no matter how few or many
compounding periods occur each year.
c. If compounding occurs more frequently than once a year, and if payments are made at times other
than at the end of compounding periods, it is impossible to determine present or future values,
even with a financial calculator. The reason is that under these conditions, the basic assumptions
of discounted cash flow analysis are not met.
d. Assume that compounding occurs quarterly, that the nominal interest rate is 8%, and that you
need to find the present value of $1,000 due 6 months from today. You could get the correct
answer by discounting the $1,000 at 2% for 2 periods.
e. All of the above statements are false.

Problems
Note: In working these problems, you may get an answer that differs from ours by a few cents due to
rounding differences. This should not concern you; just pick the closest answer.

1. Assume that you purchase a 6-year, 8% savings certificate for $1,000. If interest is compounded
annually, what will be the value of the certificate when it matures?
a. $ 630.17
b. $1,469.33
c. $1,677.10
d. $1,586.87
e. $1,766.33

2. Assume that you purchase a 6-year, 8% savings certificate for $1,000. What is the difference
between the ending value of the savings certificate if it were compounded semiannually and if it were
compounded annually?
a. The semiannual is worth $14.16 more than the annual.
b. The semiannual is worth $14.16 less than the annual.
c. The semiannual is worth $21.54 more than the annual.
d. The semiannual is worth $21.54 less than the annual.
e. The semiannual is worth the same as the annual.

3. A friend promises to pay you $600 two years from now if you loan him $500 today. What annual
interest rate is your friend offering?
a. 7.5%
b. 8.5%
c. 9.5%
d. 10.5%
e. 11.5%

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 TIME VALUE OF MONEY

4. At an inflation rate of 9%, the purchasing power of $1 would be cut in half in just over 8 years (some
calculators round to 9 years). How long, to the nearest year, would it take for the purchasing power
of $1 to be cut in half if the inflation rate were only 4%?
a. 12 years
b. 15 years
c. 18 years
d. 20 years
e. 23 years

5. Jane Smith has $20,000 in a brokerage account, and she plans to contribute an additional $7,500 to
the account at the end of every year. The brokerage account has an expected annual return of 8%. If
Jane’s goal is to accumulate $375,000 in the account, how many years will it take for Jane to reach
her goal?
a. 5.20
b. 10.00
c. 12.50
d. 16.33
e. 18.40

6. You are offered an investment opportunity with the “guarantee” that your investment will double in 5
years. Assuming annual compounding, what annual rate of return would this investment provide?
a. 40.00%
b. 100.00%
c. 14.87%
d. 20.00%
e. 18.74%

7. You decide to begin saving towards the purchase of a new car in 5 years. If you put $1,000 at the end
of each of the next 5 years in a savings account paying 6% compounded annually, how much will you
accumulate after 5 years?
a. $6,691.13
b. $5,637.09
c. $1,338.23
d. $5,975.32
e. $5,731.94

8. Suppose you make 5 annual deposits of $1,000 in a savings account paying 6% compounded
annually. The deposits are made at the beginning of each year. What amount would be in your
account in Year 5?
a. $6,691.13
b. $5,637.09
c. $1,338.23
d. $5,975.32
e. $5,731.94

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Chapter 5

9. What would be the ending amount if you deposit $500 in an account at the end of each 6-month
period for 5 years and the account paid 6% compounded semiannually?
a. $6,691.13
b. $5,637.09
c. $1,338.23
d. $5,975.32
e. $5,731.94

10. Calculate the present value of $1,000 to be received at the end of 8 years. Assume an annual interest
rate of 7%.
a. $ 582.01
b. $1,718.19
c. $ 531.82
d. $5,971.30
e. $ 649.37

11. How much would you be willing to pay today for an investment that would return $800 each year at
the end of each of the next 6 years? Assume an annual interest rate of 5%.
a. $5,441.53
b. $4,800.00
c. $3,369.89
d. $4,060.55
e. $4,632.37

12. You have applied for a mortgage of $60,000 to finance the purchase of a new home. The bank will
require you to make annual payments of $7,047.55 at the end of each of the next 20 years. Determine
the interest rate in effect on this mortgage.
a. 8.0%
b. 9.8%
c. 10.0%
d. 10.5%
e. 11.2%

13. If you would like to accumulate $7,500 over the next 5 years, how much must you deposit each six
months, starting six months from now, given a 6% interest rate and semiannual compounding?
a. $1,330.47
b. $ 879.23
c. $ 654.23
d. $ 569.00
e. $ 732.67

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 TIME VALUE OF MONEY

14. A company is offering bonds that pay $100 per year indefinitely. If you require a 12% return on
these bonds—that is, the discount rate is 12%—what is the value of each bond?
a. $1,000.00
b. $ 962.00
c. $ 904.67
d. $ 866.67
e. $ 833.33

15. What is the present value (t = 0) of the following cash flows if the discount rate is 12%?
0 12%
1 2 3 4 5
| | | | | |
0 2,000 2,000 2,000 3,000 -4,000
a. $4,782.43
b. $4,440.51
c. $4,221.79
d. $4,041.23
e. $3,997.98

16. What is the effective annual rate (EAR) of 12% compounded monthly?
a. 12.00%
b. 12.55%
c. 12.68%
d. 12.75%
e. 13.00%

17. Martha Mills, manager of Plaza Gold Emporium, wants to sell on credit, giving customers 4 months
in which to pay. However, Martha will have to borrow from her bank to carry the accounts
receivable. The bank will charge a nominal 18%, but with monthly compounding. Martha wants to
quote a nominal rate to her customers (all of whom are expected to pay on time at the end of 4
months) that will exactly cover her financing costs. What nominal annual rate should she quote to her
credit customers?
a. 15.44%
b. 19.56%
c. 17.11%
d. 18.41%
e. 16.88%

18. How much principal will be repaid in the second year on a 20-year, $60,000 mortgage requiring
annual payments and a 10% annual interest rate?
a. $1,152.34
b. $1,725.70
c. $5,895.24
d. $7,047.58
e. $1,047.58

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Chapter 5

19. You have $1,000 invested in an account that pays 16% compounded annually. A commission agent
(called a “finder”) can locate for you an equally safe deposit that will pay 16%, compounded
quarterly, for 2 years. What is the maximum amount you should be willing to pay him now as a fee
for locating the new account?
a. $10.92
b. $13.78
c. $16.14
d. $16.78
e. $21.13

20. The present value (t = 0) of the following cash flow stream is $11,958.20 when discounted at 12%
annually. What is the value of the missing t = 2 cash flow?
0 12%
1 2 3 4
| | | | |
PV = 11,958.20 2,000 ? 4,000 4,000
a. $4,000.00
b. $4,500.00
c. $5,000.33
d. $5,500.50
e. $6,000.16

21. Today is your birthday, and you decide to start saving for your college education. You will begin
college on your 18th birthday and will need $4,000 per year at the end of each of the following 4
years. You will make a deposit 1 year from today in an account paying 12% annually and continue to
make an identical deposit each year up to and including the year you begin college. If a deposit
amount of $2,542.05 will allow you to reach your goal, what birthday are you celebrating today?
a. 13
b. 14
c. 15
d. 16
e. 17

22. Assume that your aunt sold her house on December 31 and that she took a mortgage in the amount of
$50,000 as part of the payment. The mortgage has a stated (or nominal) interest rate of 8%, but it calls
for payments every 6 months, beginning on June 30, and the mortgage is to be amortized over 20
years. Now, one year later, your aunt must file Schedule B of her tax return with the IRS informing
them of the interest that was included in the two payments made during the year. (This interest will
be income to your aunt and a deduction to the buyer of the house.) What is the total amount of
interest that was paid during the first year?
a. $1,978.95
b. $ 526.17
c. $3,978.95
d. $2,000.00
e. $ 750.02

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 TIME VALUE OF MONEY

23. Assume that you inherited some money. A friend of yours is working as an unpaid intern at a local
brokerage firm, and her boss is selling some securities that call for five payments, $75 at the end of
each of the next 4 years, plus a payment of $1,075 at the end of Year 5. Your friend says she can get
you some of these securities at a cost of $960 each. Your money is now invested in a bank that pays
an 8% nominal (quoted) interest rate, but with quarterly compounding. You regard the securities as
being just as safe, and as liquid, as your bank deposit, so your required effective annual rate of return
on the securities is the same as that on your bank deposit. You must calculate the value of the
securities to decide whether they are a good investment. What is their present value to you?
a. $ 957.75
b. $ 888.66
c. $ 923.44
d. $1,015.25
e. $ 970.51

24. Your company is planning to borrow $500,000 on a 5-year, 7%, annual payment, fully-amortized
term loan. What fraction of the payment made at the end of the second year will represent repayment
of principal?
a. 76.29%
b. 42.82%
c. 50.28%
d. 49.72%
e. 60.27%

25. Your firm can borrow from its bank for one month. The loan will have to be “rolled over” at the end
of the month, but you are sure the rollover will be allowed. The nominal interest rate is 14%, but
interest will have to be paid at the end of each month, so the bank interest rate is 14%, monthly
compounding. Alternatively, your firm can borrow from an insurance company at a nominal rate that
would involve quarterly compounding. What nominal rate with quarterly compounding would be
equivalent to the rate charged by the bank?
a. 12.44%
b. 14.16%
c. 14.93%
d. 13.12%
e. 14.55%

26. Assume that you have $15,000 in a bank account that pays 5% annual interest. You plan to go back to
school for a combination MBA/law degree 5 years from today. It will take you an additional 5 years
to complete your graduate studies. You figure you will need a fixed income of $25,000 in today’s
dollars; that is, you will need $25,000 of today’s dollars during your first year and each subsequent
year. (Thus, your real income will decline while you are in school.) You will withdraw funds for
your annual expenses at the beginning of each year. Inflation is expected to occur at the rate of 3%
per year. How much must you save during each of the next 5 years in order to achieve your goal?
The first increment of savings will be deposited one year from today.
a. $20,241.66
b. $19,224.55
c. $18,792.11
d. $19,559.42
e. $20,378.82

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Chapter 5

27. You plan to buy a new TV. The dealer offers to sell the set to you on credit. You will have 3 months
in which to pay, but the dealer says you will be charged a 15% interest rate; that is, the nominal rate is
15%, quarterly compounding. As an alternative to buying on credit, you can borrow the funds from
your bank, but the bank will make you pay interest each month. At what nominal bank interest rate
should you be indifferent between the two types of credit?
a. 13.7643%
b. 14.2107%
c. 14.8163%
d. 15.5397%
e. 15.3984%

28. Assume that your father is now 40 years old, that he plans to retire in 20 years, and that he expects to
live for 25 years after he retires, that is, until he is 85. He wants a fixed retirement income that has
the same purchasing power at the time he retires as $75,000 has today. (He realizes that the real value
of his retirement income will decline year-by-year after he retires.) His retirement income will begin
the day he retires, 20 years from today, and he will then receive 24 additional annual payments.
Inflation is expected to be 4% per year from today forward; he currently has $200,000 saved; and he
expects to earn a return on his savings of 7% per year, annual compounding. To the nearest dollar,
how much must he save during each of the next 20 years (with deposits being made at the end of each
year) to meet his retirement goal?
a. $31,105.90
b. $35,709.25
c. $54,332.88
d. $41,987.33
e. $62,191.25

29. A rookie quarterback is in the process of negotiating his first contract. The team’s general manager
has offered him three possible contracts. Each of the contracts lasts for four years. All of the money
is guaranteed and is paid at the end of each year. The payment terms of the contracts are listed below:
Year Contract 1 Contract 2 Contract 3
1 $1.5 million $1.0 million $3.5 million
2 1.5 million 1.5 million 0.5 million
3 1.5 million 2.0 million 0.5 million
4 1.5 million 2.5 million 0.5 million
The quarterback discounts all cash flows at 12%. Which of the three contracts offers the most value?
a. Contract 1; its present value is $4.56 million.
b. Contract 2; its present value is $5.10 million.
c. Contract 3; its present value is $4.20 million.
d. Either Contract 2 or Contract 3; each provides a present value of $5.10 million.
e. Either Contract 1 or Contract 2; each provides a present value of $5.10 million.

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 TIME VALUE OF MONEY

30. The Wade family is interested in buying a home. The family is applying for a $200,000 30-year
mortgage. Under the terms of the mortgage, they will receive $200,000 today to help purchase their
home. The loan will be fully amortized over the next 30 years. Current mortgage rates are 7.5%.
Interest is compounded monthly and all payments are due at the end of the month. What is the
monthly mortgage payment?
a. $ 989.66
b. $1,047.50
c. $1,111.25
d. $1,398.43
e. $1,563.97

31. Consider a $200,000 30-year mortgage with monthly payments. If the interest is 7.5% with monthly
compounding, what portion of the mortgage payments during the first year will go toward interest?
a. 89%
b. 100%
c. 75%
d. 65%
e. 95%

32. Consider a $200,000 30-year mortgage with monthly payments. If the interest is 7.5% with monthly
compounding, what will be the remaining balance on the mortgage after five years?
a. $ 73,141
b. $166,752
c. $189,235
d. $195,750
e. $190,433

33. Consider a $200,000 30-year mortgage with monthly payments. If the interest is 7.5% with monthly
compounding, how much could you borrow today if you were willing to have an $1,800 monthly
mortgage payment?
a. $225,557
b. $257,432
c. $210,333
d. $244,125
e. $253,456

34. Janet and Denise have both been given $15,000 by their grandparents today on their 21st birthdays.
They want to save for their future and have aspirations of one day being millionaires. Each woman
plans to make annual contributions on her birthday, beginning next year. Janet and Denise have each
opened investment accounts at the 1st National Bank and 2nd National Bank, respectively, and they
expect to earn nominal returns of 6% and 7%, respectively. Janet has already decided to deposit
$7,500 each year into her investment account, while Denise is unsure of the amount she will deposit
annually. How many years will it take Janet before she reaches her investment goal of $1 million?
a. 20.33
b. 25.50
c. 30.00
d. 32.45
e. 35.76

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Chapter 5

35. Refer to Problem 34. If Denise decides to make the same annual contributions as Janet, how much
sooner (in years) would she reach the investment goal?
a. 2.50
b. 3.18
c. 3.75
d. 4.00
e. 4.25

36. Refer to Problem 34. Suppose Denise was interested in reaching the investment goal at the same time
as Janet. What is the minimum monthly contribution she could make in order to reach $1 million at
the same time as Janet?
a. $5,683.44
b. $4,250.00
c. $6,195.76
d. $5,333.33
e. $4,888.97

37. John has just won the state lottery and has three award options from which to choose. He can elect to
receive a lump sum payment today of $46 million, 10 annual end-of-year payments of $7 million, or
30 annual end-of-year payments of $4 million. If he expects to earn a 7% annual return on his
investments, which option should he choose?
a. Lump sum
b. 10 payments
c. 30 payments
d. It doesn’t matter, the present value of each of the options is equal.

38. John has just won the state lottery and has three award options from which to choose. He can elect to
receive a lump sum payment today of $46 million, 10 annual end-of-year payments of $7 million, or
30 annual end-of-year payments of $4 million. If he expects to earn an 8% annual return on his
investments, which option should he choose?
a. Lump sum
b. 10 payments
c. 30 payments
d. It doesn’t matter, the present value of each of the options is equal.

39. John has just won the state lottery and has three award options from which to choose. He can elect to
receive a lump sum payment today of $46 million, 10 annual end-of-year payments of $7 million, or
30 annual end-of-year payments of $4 million. If he expects to earn a 9% annual return on his
investments, which option should he choose?
a. Lump sum
b. 10 payments
c. 30 payments
d. It doesn’t matter, the present value of each of the options is equal.

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 TIME VALUE OF MONEY

40. Henry has saved $5,000 and intends to use his savings as a down payment on a new car. After careful
examination of his income and expenses, Henry has concluded that the most he can afford to spend
every month on his car payment is $425. The car loan that Henry uses to buy the car will have an
APR of 10%. What is the price of the most expensive car that Henry can afford if he finances his
new car for 48 months?
a. $16,756.97
b. $17,500.00
c. $19,125.25
d. $21,756.97
e. $22,450.50

41. Henry has saved $5,000 and intends to use his savings as a down payment on a new car. After careful
examination of his income and expenses, Henry has concluded that the most he can afford to spend
every month on his car payment is $425. The car loan that Henry uses to buy the car will have an
APR of 10%. What is the price of the most expensive car that Henry can afford if he finances his
new car for 60 months?
a. $18,333.33
b. $20,002.78
c. $21,756.97
d. $23,750.00
e. $25,002.78

Answers
Definitional Questions
1. present 11. opportunity
2. interest 12. PMT; CF
3. discounting; compounding 13. effective
4. annuity; ordinary; due 14. annual
5. sum 15. present
6. nominal; effective 16. periodic; periods
7. line 17. annual
8. perpetuity 18. Fractional
9. Amortized 19. growing annuity
10. amortization 20. real

Conceptual Questions
1. b. The EAR is always greater than or equal to the nominal rate.

2. a. Both these statements are correct.

3. d. The slower the cash flows come in and the higher the interest rate, the smaller the present value.

4. c. As the discount rate increases, the present value of a future sum decreases and eventually
approaches zero.

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Chapter 5

5. d. Using a financial calculator, enter N = 2, I/YR = 2, PMT = 0, and FV = 1000 to find PV =

-961.1688.

Solutions
Problems
1. d. 0 8% 1 2 3 4 5 6
| | | | | | |
-1,000 FV6 = ?
With a financial calculator, input N = 6, I/YR = 8, PV = -1000, PMT = 0, and solve for FV =
$1,586.87.

2. a. 0 1 2 3 4 5 6 Years
0 4% 1 2 3 4 5 6 7 8 9 10 11 12 Periods
| | | | | | | | | | | | |
-1,000 FV12 = ?
Semiannual compounding: Input N = 12, I/YR = 4, PV = -1000, and PMT = 0, and then solve for
FV = $1,601.03.

Annual compounding: Input N = 6, I/YR = 8, PV = -1000, and PMT = 0, and then solve for FV =
$1,586.87.

The difference, $1,601.03 – $1,586.87 = $14.16.

3. c. 0 1 2
I=?
| | |
-500 600
With a financial calculator, input N = 2, PV = -500, PMT = 0, FV = 600, and solve for I/YR =
9.54% ≈ 9.5%.

4. c. 0 N=?
4%
| |
-1.00 0.50
With a financial calculator, input I/YR = 4, PV = -1.00, PMT = 0, and FV = 0.50. Solve for N =
17.67 ≈ 18 years.

5. e. Using your financial calculator, enter the following data: I/YR = 8; PV = -20000; PMT = -7500;
FV = 375000; N = ? Solve for N = 18.4. It will take 18.4 years for Jane to accumulate $375,000.

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 TIME VALUE OF MONEY

6. c. Assume any value for the present value and double it:
0 1 2 3 4 5
I=?
| | | | | |
-1 2
With a financial calculator, input N = 5, PV = -1, PMT = 0, FV = 2, and solve for I/YR = 14.87%.

7. b. 0 1 2 3 4 5
6%
| | | | | |
-1,000 -1,000 -1,000 -1,000 -1,000
FVA5 = ?
With a financial calculator, input N = 5, I/YR = 6, PV = 0, PMT = -1000, and solve for FV =
$5,637.09.

8. d. 0 1 2 3 4 5
6%
| | | | | |
-1,000 -1,000 -1,000 -1,000 -1,000 FVA5 = ?
With a financial calculator, switch to “BEG” mode, then input N = 5, I/YR = 6, PV = 0, PMT =
-1000, and solve for FV = $5,975.32. Be sure to switch back to “END” mode after working this
problem.

9. e. 0 1 2 3 4 5 Years
0 3% 1 2 3 4 5 6 7 8 9 10 Periods
| | | | | | | | | | |
-500 -500 -500 -500 -500 -500 -500 -500 -500 -500
FV10 = ?
With a financial calculator, input N = 10, I/YR = 3, PV = 0, PMT = -500, and solve for FV =
$5,731.94.

10. a. 0 7% 1 2 3 4 5 6 7 8
| | | | | | | | |
PV = ? 1,000
With a financial calculator, input N = 8, I/YR = 7, PMT = 0, FV = 1000, and solve for PV =
-$582.01.

11. d. 0 5% 1 2 3 4 5 6
| | | | | | |
PVA = ? 800 800 800 800 800 800
With a financial calculator, input N = 6, I/YR = 5, PMT = 800, FV = 0, and solve for PV =
-$4,060.55.

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Chapter 5

12. c. 0 1 2 3 20
I=?
| | | |  |
60,000 -7,047.55 -7,047.55 -7,047.55 -7,047.55
With a financial calculator, input N = 20, PV = 60000, PMT = -7047.55, FV = 0, and solve for
I/YR = 10.00%.

13. c. 0 1 2 3 4 5 Years
0 3% 1 2 3 4 5 6 7 8 9 10 Periods
| | | | | | | | | | |
-PMT -PMT -PMT -PMT -PMT -PMT -PMT -PMT -PMT -PMT
7,500
With a financial calculator, input N = 10, I/YR = 3, PV = 0, FV = 7500, and solve for PMT =
-$654.23.

14. e. PV = PMT/I = $100/0.12 = $833.33

15. b. With a financial calculator, using the cash flow register, CFj, input 0; 2000; 2000; 2000; 3000;
and -4000. Enter I/YR = 12 and solve for NPV = $4,440.51.

16. c. EAR = (1 + INOM/M)M – 1.0

= (1 + 0.12/12)12 – 1.0
= (1.01)12 – 1.0
= 1.1268 – 1.0
= 0.1268 = 12.68%

With a financial calculator, enter P/YR = 12 and NOM% = 12, and then solve for EFF% = 12.68%.
Don’t forget to return P/YR = 1 after solving this problem.

17. d. Here we want to have the same effective annual rate on the credit extended as on the bank loan that
will be used to finance the credit extension.

First, we must find the EAR = EFF% on the bank loan. With a financial calculator, enter P/YR = 12,
NOM% = 18, and press EFF% to get EAR = 19.56%.

Because 4 months of credit is being given there are 3 credit periods in a year, so enter P/YR = 3,
EFF% = EAR = 19.56, and press NOM% to find the nominal rate of 18.41%. Therefore, if Martha
charges an 18.41% nominal rate and gives credit for 4 months, she will cover the cost of her bank
loan.

Alternative solution: First, we need to find the effective annual rate charged by the bank:

EAR = (1 + INOM/M)M – 1
= (1 + 0.18/12)12 – 1
= (1.0150)12 – 1 = 19.56%

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 TIME VALUE OF MONEY

Now, we can find the nominal rate Martha must quote her customers so that her financing costs are
exactly covered:

19.56% = (1 + INOM/3)3 – 1
1.1956 = (1 + INOM/3)3
1.0614 = 1 + INOM/3
0.0614 = INOM/3
INOM = 18.41%

18. a. N = 20; I/YR = 10; PV = -60000; FV = 0; and solve for PMT = $7,047.58.

Repayment on Remaining
Year Payment Interest Principal Principal Balance
1 $7,047.58 $6,000.00 $1,047.58 $58,952.42
2 7,047.58 5,895.24 1,152.34 57,800.08

19. d. Currently:

Find the future value of your current account:

With a financial calculator, input N = 2, I/YR = 16, PV = -1000, PMT = 0, and solve for FV =
$1,345.60.

Find the future value of the new account:

With a financial calculator, input N = 8, I/YR = 4, PV = -1000, PMT = 0, and solve for FV =
$1,368.57.

Thus, the new account will be worth $1,368.57 – $1,345.60 = $22.97 more after 2 years.

Determine how much you’re willing to pay the agent today:

With a financial calculator, input N = 8, I/YR = 4, PMT = 0, FV = 22.97, and solve for PV = -$16.78.

Therefore, the most you should be willing to pay the agent for locating the new account is $16.78.

20. e. With a financial calculator, input cash flows into the cash flow register, using -11,958.20 as the cash
flow for time 0 (CF0), and using 0 as the value for the unknown cash flow, input I/YR = 12, and then
press the NPV key to solve for the present value of the unknown cash flow, $4,783.29. This value
should be compounded by (1.12)2, so that $4,783.29(1.2544) = $6,000.16.

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Chapter 5

21. b. First, how much must you accumulate on your 18th birthday?
? 18 19 20 21 22
12%
| | |  | | | | |
2,542.05 2,542.05 2,542.05 4,000 4,000 4,000 4,000
Today’s
Birthday 3,571.43
3,188.78
2,847.12
2,542.07
Total FV needed = $12,149.40
Using a financial calculator (with the calculator set for an ordinary annuity), enter N = 4, I/YR =
12, PMT = 4000, FV = 0, and solve for PV = -$12,149.40. This is the amount (or lump sum) that
must be present in your bank account on your 18th birthday in order for you to be able to
withdraw $4,000 at the end of each of the next 4 years.

Now, how many payments of $2,542.05 must you make to accumulate $12,149.40?

Using a financial calculator, enter I/YR = 12, PV = 0, PMT = -2542.05, FV = 12149.40, and
solve for N = 4. Therefore, if you make payments at 18, 17, 16, and 15, you are now 14.

22. c. This can be done with a calculator by specifying an interest rate of 4% per period for 40 periods.

N = 20  2 = 40
I = 8/2 = 4
PV = -50000
FV = 0

PMT = $2,526.17

Set up an amortization table:

Beginning Payment of Ending

Period Balance Payment Interest Principal Balance
1 $50,000.00 $2,526.17 $2,000.00 $526.17 $49,473.83
2 49,473.83 2,526.17 1,978.95
$3,978.95

You can really just work the problem with a financial calculator using the amortization function.
Find the interest in each 6-month period, sum them, and you have the answer. Even simpler, with
some calculators such as the HP-17BII, just input 2 for periods and press INT to get the interest
during the first year, $3,978.95.

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 TIME VALUE OF MONEY

23. e. 0 4 8 12 16 20
2%
| | | | | | | | | | | | | | | | | | | | |
PV = ? 0 0 0 75 0 0 0 75 0 0 0 75 0 0 0 75 0 0 0 1,075
Input the cash flows in the cash flow register, input I/YR = 2, and solve for NPV = $970.51.

24. a. Input N = 5, I/YR = 7, PV = -500000, and FV = 0 to solve for PMT = $121,945.35.

Beginning Payment of Ending

Year Balance Payment Interest Principal Balance
1 $500,000.00 $121,945.35 $35,000.00 $86,945.35 $413,054.65
2 413,054.65 121,945.35 28,913.83 93,031.52 320,023.13

The fraction that is principal is $93,031.52/$121,945.35 = 76.29%.

25. b. Start with a time line to picture the situation:

Bank: 14% nominal; EAR = 14.93%.

0 1 2 3 4 5 6 7 8 9 10 11 12
| | | | | | | | | | | | |

Insurance company: EAR = 14.93%; Nominal = 14.16%.

0 1 2 3 4
| | | | |

Here we must find the EAR on the bank loan and then find the nominal interest rate with
quarterly compounding for that EAR. The bank loan rate is a nominal 14% with monthly
compounding.

Using the interest conversion feature of the calculator, or the EAR formula, we must find the EAR on
the bank loan. Enter P/YR = 12 and NOM% = 14, and then press the EFF% key to find EAR bank
loan = 14.93%.

Now, we can find the nominal rate with quarterly compounding that also has an EAR of 14.93%.
Enter P/YR = 4 and EFF% = 14.93, and then press the NOM% key to get 14.16%. If the insurance
company quotes a nominal rate of 14.16%, with quarterly compounding, then the bank and insurance
company loans would be equivalent in the sense that they both have the same effective annual rate,
14.93%.

Alternative solution:

EAR = (1 + INOM/12)12 – 1
= (1 + 0.14/12)12 – 1
= 14.93%

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Chapter 5

14.93% = (1 + INOM/4)4 – 1
1.1493 = (1 + INOM/4)4
1.0354 = 1 + INOM/4
0.0354 = INOM/4
INOM = 14.16%

26. e. Inflation = 3%

0 1 2 3 4 5 6 7 8 9 10
5%
| | | | | | | | | | |
PV = 15,000 PMT PMT PMT PMT PMT
School Grad.
-28,982 -28,982 -28,982 -28,982 -28,982

Fixed income = $25,000(1.03)5 = $28,981.85.

1. Find the FV of $25,000 compounded for 5 years at 3%; that FV, $28,981.85, is the amount you
will need each year while you are in school. (Note: Your real income will decline.)

2. You must have enough in 5 years to make the $28,981.85 payments to yourself. These payments
will begin as soon as you start school, so we are dealing with a 5-year, 5% interest rate annuity
due. Set the calculator to “BEG” mode, because we are dealing with an annuity due, and then
enter N = 5, I/YR = 5, PMT = -28981.85, and FV = 0. Then press the PV key to find the PV,
$131,750.06. This is the amount you must have in your account 5 years from today. (Do not
forget to switch the calculator back to “END” mode after this step.)

3. You now have $15,000. It will grow at 5% to $19,144.22 after 5 years. Enter N = 5, I/YR = 5,
PV = -15000, and PMT = 0, to solve for FV = $19,144.22. You can subtract this amount to
determine the FV of the amount you must save: $131,750.06 – $19,144.22 = $112,605.84.

4. Therefore, you must accumulate an additional $112,605.84 by saving PMT per year for 5 years,
with the first PMT being deposited at the end of this year and earning a 5% interest rate. Now we
have an ordinary annuity, so be sure you returned your calculator to “END” mode. Enter N = 5,
I/YR = 5, PV = 0, FV = 112605.84, and then press PMT to find the required payments,
-$20,378.82.

27. c. Find the EAR on the TV dealer’s credit. Use the interest conversion feature of your calculator. First,
though, note that if you are charged a 15% nominal rate, you will have to pay interest of 15%/4 =
3.75% after 3 months. The dealer then has the use of the interest, so he can earn 3.75% on it for the
next three months, and so forth. Thus, we are dealing with quarterly compounding. The nominal rate
is 15%, quarterly compounding.

Enter NOM% = 15, P/YR = 4, and then press EFF% to get EAR = 15.8650%.

You should be indifferent between the dealer credit and the bank loan if the bank loan has an EAR of
15.8650%. The bank is using monthly compounding, or 12 periods per year. To find the nominal rate
at which you should be indifferent, enter P/YR = 12, EFF% = 15.8650, and then press NOM% to get
NOM% = 14.8163%.

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 TIME VALUE OF MONEY

Conclusion: A loan that has a 14.8163% nominal rate with monthly compounding is equivalent to a
15% nominal rate loan with quarterly compounding. Both have an EAR of 15.8650%.

Alternative Solution

EAR = (1 + INOM/4)4 – 1
= (1 + 0.15/4)4 – 1
= (1.0375)4 – 1
= 15.8650%

15.8650% = (1 + INOM/12)12 – 1
1.15865 = (1 + INOM/12)12
1.012347 = 1 + INOM/12
INOM = 14.8163%

28. a. Information given:

1. Will save for 20 years, then receive payments for 25 years.

2. Wants payments of $75,000 per year in today’s dollars for first payment only. Real income will
decline. Inflation will be 4%. Therefore, to find the inflated fixed payments, we have this time line:

0 5 10 15 20
| 4% | | | | |  |  |  |
75,000 FV = ?

Enter N = 20, I/YR = 4, PV = -75000, PMT = 0, and press FV to get FV = $164,334.24.

3. He now has $200,000 in an account that pays 7%, annual compounding. We need to find the
FV of $200,000 after 20 years. Enter N = 20, I/YR = 7, PV = -200000, PMT = 0, and press
FV to get FV = $773,936.89.

4. He wants to withdraw, or have payments of, $164,334.24 per year for 25 years, with the first
payment made at the beginning of the first retirement year. So, we have a 25-year annuity
due with PMT = $164,334.24, at an interest rate of 7%. (The interest rate is 7% annually, so
no adjustment is required.) Set the calculator to “BEG” mode, then enter N = 25, I/YR = 7,
PMT = -164334.24, FV = 0, and press PV to get PV = $2,049,138.53. This amount must be
on hand to make the 25 payments.

5. Since the original $200,000, which grows to $773,936.89, will be available, he must save
enough to accumulate $2,049,138.53  $773,936.89 = $1,275,201.64.

6. The $1,275,201.64 is the FV of a 20-year ordinary annuity. The payments will be deposited
in the bank and earn 7% interest. Therefore, set the calculator to “END” mode and enter N =
20, I/YR = 7, PV = 0, FV = 1275201.64, and press PMT to find PMT = $31,105.90.

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Chapter 5

29. b. Contract 1: Using your financial calculator, enter the following data: CF0 = 0; CF1-4 =
1500000; I/YR = 12; NPV = ? Solve for NPV = $4,556,024.02.

Contract 2: Using your financial calculator, enter the following data: CF0 = 0; CF1 =
1000000; CF2 = 1500000; CF3 = 2000000; CF4 = 2500000; I/YR = 12; NPV
= ? Solve for NPV = $5,101,003.65.

Contract 3: Using your financial calculator, enter the following data: CF0 = 0; CF1 =
3500000; CF2 = 500000; CF3 = 500000; CF4 = 500000; I/YR = 12; NPV = ?
Solve for NPV = $4,197,246.10.

Contract 2 gives the quarterback the highest present value; therefore, he should accept
Contract 2.

30. d. Using your financial calculator, input the following data: N = 30 × 12 = 360; I/YR = 7.5/12 =
0.6250; PV = -200000; FV = 0; PMT = ? Solve for PMT = $1,398.43.

31. a. Use your financial calculator to find the monthly mortgage payment: N = 30 × 12 = 360; I/YR =
7.5/12 = 0.6250; PV = -200000; FV = 0; and solve for PMT = $1,398.43.

Then, use the amortization feature of your calculator to find interest and principal repayments
during the year and the remaining mortgage balance as follows:

1 INPUT 12  AMORT
= $14,937.47 (Interest)
= $1,843.69 (Principal)
= $198,156.31 (Balance)

Total mortgage payments made during the first year equals 12  $1,398.43 = $16,781.16.

Portion of first year mortgage payments that go towards interest equals $14,937.47/$16,781.16 =
89.01  89%.

32. c. Use your financial calculator to find the monthly mortgage payment: N = 30  12 = 360; I/YR =
7.5/12 = 0.6250; PV = -200000; FV = 0; and solve for PMT = $1,398.43.

Then, use the amortization feature of your calculator to find the remaining balance after 5 years:

1 INPUT 60  AMORT
= $73,140.61 (Interest)
= $10,765.19 ( Principal)
= $189,234.81 (Balance)

33. b. Using your financial calculator, input the following data: N = 30  12 = 360; I/YR = 7.5/12 =
0.6250; PMT = -1800; FV = 0; PV = ? Solve for PV = $257,431.73 ≈ $257,432.

If you are willing to have a $1,800 monthly mortgage payment, you can borrow $257,432 today.

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 TIME VALUE OF MONEY

34. e. Using the information given in the problem, you can solve for the number of years required to reach
$1 million. I/YR = 6; PV = 15000; PMT = 7500; FV = -1000000; and then solve for N = 35.76.

Therefore, it will take Janet 35.76 years to reach her investment goal.

35. b. Again, you can solve for the number of years required to reach $1 million. I/YR = 7; PV = 15000;
PMT = 7500; FV = -1000000; and then solve for N = 32.58.

It will take Denise 32.58 years to reach her investment goal. The difference in time is 35.76 – 32.58 =
3.18 years.

36. a. Using the 35.76 year target, you can solve for the required payment. N = 35.76; I/YR = 7; PV =
15000; FV = -1000000; then solve for PMT = $5,683.44.

If Denise wishes to reach the investment goal at the same time as Janet, she can contribute as little as
$5,683.44 every year.

37. c. If John expects a 7% annual return on his investments:

1 payment 10 payments 30 payments

N = 10 N = 30
I/YR = 7 I/YR = 7
PMT = -7000000 PMT = -4000000
FV = 0 FV = 0

PV = 46,000,000 PV = 49,165,071 PV = 49,636,165

John should accept the 30-year payment option as it carries the highest present value ($49,636,165).

38. b. If John expects an 8% annual return on his investments:

1 payment 10 payments 30 payments

N = 10 N = 30
I/YR = 8 I/YR = 8
PMT = -7000000 PMT = -4000000
FV = 0 FV = 0

PV = 46,000,000 PV = 46,970,570 PV = 45,031,133

John should accept the 10-year payment option as it carries the highest present value ($46,970,570).

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Chapter 5

39. a. If John expects a 9% annual return on his investments:

1 payment 10 payments 30 payments

N = 10 N = 30
I/YR = 9 I/YR = 9
PMT = -7000000 PMT = -4000000
FV = 0 FV = 0

PV = 46,000,000 PV = 44,923,604 PV = 41,094,616

John should accept the lump-sum payment option as it carries the highest present value ($46,000,000).

40. d. Using the information given in the problem, you can solve for the maximum attainable car price.

Financed for 48 months

N = 48
I/YR = 0.8333 (10/12 = 0.8333)
PMT = -425
FV = 0

PV = $16,756.97

You must add the value of the down payment to the present value of the car payments. If financed for
48 months, Henry can afford a car valued up to $21,756.97 ($16,756.97 + $5,000).

41. e. Using the information given in the problem, you can solve for the maximum attainable car price.

Financed for 60 months

N = 60
I/YR = 0.8333
PMT = -425
FV = 0

PV = $20,002.78

If financing for 60 months, Henry can afford a car valued up to $25,002.78 ($20,002.78 + $5,000).

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