Chapter 5: Time value of money

There are three basic patterns of cashflows:

1. Single amount
PV=FV/(1+r)n
FV=PV*(1+r)n
2. Annuity
 Ordinary Annuity (is an equal payment paid or received at the end of each period).

 Annuity due (is an equal payment paid or received at the beginning of each period).

 Perpetuity (An annuity with an infinite life).

3. Mixed stream

Problems:

Single Amount

1. The future value of $100 received today and deposited at 6 percent for four years is
A) $126.
B) $ 79.
C) $124.
D) $116.
Answer: A

2. The present value of $100 to be received 10 years from today, assuming an opportunity
cost of 9 percent, is

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 A) $236.
B) $699.
C) $ 42.
D) $ 75.
Answer: C

3. If you expect to retire in 30 years, are currently comfortable living on $50,000 per year
and expect inflation to average 3% over the next 30 years, what amount of annual
income will you need to live at the same comfort level in 30 years?
A) $121,363
B) $95,000
C) $20,599
D) $51,500
Answer: A

4. Calculate the future value of $4,600 received today if it is deposited at 9 percent for three
years.
Answer: FV = $4,600(1.09)3 = $5,957

5. Calculate the present value of $89,000 to be received in 15 years, assuming an

6. Aunt Tillie has deposited $33,000 today in an account which will earn 10 percent
annually. She plans to leave the funds in this account for seven years earning interest. If
the goal of this deposit is to cover a future obligation of $65,000, what recommendation
would you make to Aunt Tillie?
Answer: FV = 33,000(1.1)7 = $64,317
Aunt Tillie will only have $64,317 at the end of seven years under the stated arrangement. She
must find an account with a higher interest rate or deposit a larger sum today.

7. Dan and Jia are newlyweds and have just purchased a condominium for $70,000. Since
the condo is very small, they hope to move into a single-family house in 5 years. How
much will their condo worth in 5 years if inflation is expected to be 8 percent?
Answer: PV = $70,000, r = 8%, n = 5
FV = 70,000(1.08)5 = $102,830.

8. Congratulations! You have just won the lottery! However, the lottery bureau has just
informed you that you can take your winnings in one of two ways. Choice X pays
$1,000,000. Choice Y pays $1,750,000 at the end of five years from now. Using a
discount rate of 5 percent, based on present values, which would you choose? Using the
same discount rate of 5 percent, based on future values, which would you choose? What
do your results suggest as a general rule for approaching such problems? (Make your
choices based purely on the time value of money.)
Answer: The PV of X = $1,000,000; The PV of Y = $1,371,000; The FV of X = $1,276,000; The

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 FV of Y = $1,500,000. Based on both present values and future values, B is the better choice.
The student should recognize that finding present values and finding future values are simply
reverse processes of one another, and that choosing between two lump sums based on PV will
always give the same result as choosing between the same two lump sums based on FV.

Annuity

9. The present value of a $25,000 perpetuity at a 14 percent discount rate is

10. Bill plans to fund his individual retirement account (IRA) with the maximum contribution
of $2,000 at the end of each year for the next 20 years. If Bill can earn 12 percent on his
contributions, how much will he have at the end of the twentieth year?
A) $19,292
B) $14,938
C) $40,000
D) $144,104
Answer: D

11. A generous benefactor to the local ballet plans to make a one-time endowment which
would provide the ballet with $150,000 per year into perpetuity. The rate of interest is
expected to be 5 percent for all future time periods. How large must the endowment be?
A) $ 300,000
B) $3,000,000
C) $ 750,000
D) $1,428,571
Answer: B

12. Mary will receive $12,000 per year for the next 10 years as royalty for her work on a
finance book. What is the present value of her royalty income if the opportunity cost is 12
percent?
A) $120,000
B) $ 67,800
C) $ 38,640
D) None of the above.
Answer: B

13. James plans to fund his individual retirement account, beginning today, with 20 annual
deposits of $2,000, which he will continue for the next 20 years. If he can earn an annual
compound rate of 8 percent on his deposits, the amount in the account upon retirement
will be

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 A) $19,636.
B) $91,524.
C) $98,846.
D) $21,207.
Answer: C

14. Nico establishes a seven-year, 8 percent loan with a bank requiring annual end-of-year
payments of $960.43. Calculate the original principal amount.
Answer: PVA = (960.43/0.08)[1-1/(1.08)7] = $5,000

15. Jia has just won a $20 million lottery, which will pay her $1 million at the end of each
year for 20 years. An investor has offered her $10 million for this annuity. She estimates
that she can earn 10 percent interest, compounded annually, on any amounts she invests.
She asks your advice on whether to accept or reject the offer. What will you tell her?
(Ignore Taxes)
Answer: P = ($1,000,000/0.1) × [1-1/(1.1)20] = $8,514,000
$10,000,000 > $8,514,000 Accept the offer.

16. Mr. Knowitall has been awarded a bonus for his outstanding work. His employer offers
him a choice of a lump-sum of $5,000 today, or an annuity of $1,250 a year for the next
five years. Which option should Mr. Knowitall choose if his opportunity cost is 9
percent?
Answer: PVA = ($1,250/0.09) × [1-1/(1.09)5] = $4,862.50
Mr. Handyman should choose a lump-sum of $5,000 today.

17. In their meeting with their advisor, Mr. and Mrs. O'Rourke concluded that they would
need $40,000 per year during their retirement years in order to live comfortably. They
will retire 10 years from now and expect a 20-year retirement period. How much should
Mr. and Mrs. O'Rourke deposit now in a bank account paying 9 percent to reach financial
happiness during retirement?
Answer: The amount of money required at the beginning of the retirement period is:
n = 20, i = 9%
PVA = (CF/r) × [1-1/(1+r)n] = (40,000/.09) × [1-1/(1.09)20]= $365,160
n = 10, i = 9%
PV = 365,160(1.09)-10 = $154,097.52

Mixed Stream

18. $100 is received at the beginning of year 1, $200 is received at the beginning of year 2,
and $300 is received at the beginning of year 3. If these cash flows are deposited at 12
percent, their combined future value at the end of year 3 is
A) $1,536.
B) $ 672.
C) $ 727.
D) $1,245.

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 Answer: C

19. The present value of $1,000 received at the end of year 1, $1,200 received at the end of
year 2, and $1,300 received at the end of year 3, assuming an opportunity cost of 7
percent, is
A) $2,500.
B) $3,043
C) $6,516.
D) $2,856.
Answer: B

20. During her four years at college, Hayley received the following amounts of money at the
end of each year from her grandmother. She deposited her money in a saving account
paying 6 percent rate of interest. How much money will Hayley have on graduation day?

Answer:

21. You are considering the purchase of new equipment for your company and you have
narrowed down the possibilities to two models which perform equally well. However, the
method of paying for the two models is different. Model A requires $5,000 per year
payment for the next five years. Model B requires the following payment schedule.
Which model should you buy if your opportunity cost is 8 percent?

Answer: Model A: PV = (CF/i)x[1-1/(1+r)n]= (5,000/.08)x[1-1/(1.08)5] = $19,965

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 Buy Model A.

Loan Amortization

22. To expand its operation, International Tools Inc. has applied to the International Bank for
a 3-year, $3,500,000 loan. Prepare a loan amortization table assuming 10 percent rate of
interest.
Answer: PV= 3500000, I=10, N=3, FV=0, CPT PMT = $1,407,318.05

23. Ken borrows $15,000 from a bank at 10 percent annually compounded interest to be
repaid in six equal installments. Calculate the interest paid in the second year.
Answer: PPV= 15000, I=10, N=2, FV=0, CPT PMT = $3,444.32

The interest paid in the second year is $1,305.57.

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