TIME VALUE OF MONEY

TUTORIAL QUESTION AND

SOLUTION
Question 1 Find the following present and future values:
a. An initial 500 compounded for 1 year at 6 percent.
b. An initial 500 compounded for 2 years at 6 percent.
c. The present value of 500 due in 1 year at a discount rate of 6 percent.
d. The present value of 500 due in 2 years at a discount rate of 6 percent.
SOLUTI ON
a. Given,
Present value (PV) = . 500
Interest rate (i) = 6%





FVn = PV(1 + i)
n
FV1 = PV (1 + i)
1
= 500 (1 + 0.06)
1
= . 530
b. Present value (PV) = . 500
Interest rate (i) = 6%



FVn = PV(1 + i)
n
FV2 = PV (1 + i)
2
= . 500 (1 + 0.06)
2
= . 561.80
c. Answer:
= . 471.70
d. Future value (FV) = . 500
Interest rate (i) = 6%
No. of periods (n) = 2
Present value (PV) = ?




PV =
FVn
(1 + i)
n
=
FV2
(1 + i)
2

= 445




Present and future
values
- 500
0
FV = ?
1 6%
- 500
0
FV = ?
2 6% 1
PV = ?
0
FV = 500
2 6% 1

Question 2 Suppose John deposits 10,000 in a bank account that pays 10 percent interest annually.
How much money will be in his account after 5 years?

SOLUTI ON
Here, Present value (P) = 10,000,
Interest rate (k) = 10%
Number of years (n) = 5 years,
Future value (FV5) = ?




We have,
FV5 = PV (1 + k)
n
= 10,000 (1.10)
5

= 10,000 1.6105
= 16,105.10
John will have 16,105.10 at the end of year 5 in his account.

Question 3 What is the present value of a security that promises to pay you 5,000 in 20 years?
Assume that you can earn 7 percent if you were to invest in other securities of equal risk?
SOLUTI ON
Here, Future value (FV) = 5,000
Number of years (n) = 20 years
Interest rate (k) = 7%
Present value (PV) = ?




We have,
PV =
FV20
(1 + k)
n
= 5000/ (1.07)
20

=5000/3.8697 = 1,292.09

Question 4 If you deposit money today into an account that pays 6.5 percent interest, how long will it
take for you to double your money?
SOLUTI ON
Here, Interest rate (i) = 6.5%
Number of period (n) = ?
Present value (PV) = 1000 (assume)
Future value (FV) = 2000




We have,
Present value (PV) =
FV
(1 + i)n

or, 1000 = 2000 / (1+0.065)
n

Future value
Present value
Time for a lump
sum to double
0 1 2 3
20
5,000 PV = ?
7%
0 1 2 3
5
FV = ?
10,000
10%
0 1 2 3
n = ?
FV = 2,000 PV = 1000
6.5%

or, (1 + 0.065)
n
= 2000/1000
or, (1.065)
n
= 2 .... (i)
Trying at n = 11
We get,
If n = 11, the left hand side in above equation (i) is approximately equal to 2. Hence
the required no. of years to double the sum of money is 11 years.

Question 5 Your broker offers to sell a note for 13250 that will pay 2345.05 per year for 10 years. If
you buy the note, what rate of interest will you be earning? Calculate to the closest
percentage.
SOLUTI ON
Here,
Present value of annuity (PVA) = . 13,250
Periodic equal payment (PMT) = . 2345.05
No. of periods (n) = 10 years
Interest rate (i) = ?
Time Line




We have,
PVA = PMT PVIFA i n yrs.
or, . 13,250 = . 2345.05 PVIFAi% 10 yrs
or, PVIFAi%, 10 yrs = 5.6502
From the PVIFA table, the value of 5.6502 in 10 years lies at 12%.
The required interest rate is 12%.

Question 6 Your parents are planning to retire in 18 years. They currently have 250,000, and they
would like to have 1,000,000 when they retire. What annual rate of interest would they
have to earn on their 250,000 in order to reach their goal, assuming they save no more
money?
SOLUTI ON
Here, Future value (FV) = 1,000,000
Present value (PV) = 250,000
Time period (n) = 18 years
Interest rate (i) = ?




We have,
FV = PV (1 + i)
n
or, 1,000,000 = 250,000 (1 + i)
18
or, (1 + i)
18
= 1,000,000/ 250,000
or, (1 + i)
18
= 4
or, 1 + i = (4)
1/18

or, i = 1.08 - 1 = 0.08 or 8%
The required rate of interest to reach the goal is 8%.
Effective rate of
interest
0 1 2 3
18
1,000,000
250,000
i = ?
Effective rate of
interest
PVA =
13250
0 10 1 2 3 4 5 6 7 8 9
2345.05 2345.05 2345.05 2345.05 2345.05 2345.05 2345.05 2345.05 2345.05 2345.05


Question 7 What is the future value of a 5-year ordinary annuity that promises to pay you 300 each
year? The rate of interest is 7 percent.
SOLUTI ON
Here, Future value of annuity (FVA) = ?
Payment (PMT) = 300
Number of period (n) = 5 years
Interest rate (i) = 7%




We have,
FVA = PMT

(1 + i)
n
- 1
i

= 300

(1 + 0.07)
5
- 1
0.07

= 300 5.7507 = 1,725.21

Question 8 What is the future value of a 5-year annuity due that promises to pay out 300 each year?
Assume that all payments are reinvested at 7% a year, until year 5.

SOLUTI ON
Here, Future value of annuity due (FVAdue) = ?
Payment (PMT) = 300
Number of period (n) = 5 years
Interest rate (i) = 7%




We have,
FVAdue = PMT

(1 + i)
n
- 1
i
(1 + i)
= 300

(1 + 0.07)
5
- 1
0.07
(1 + 0.07)
= 300 5.7507 1.07 = 1,845.97
Question 9 A company invests 4 million to clear a tract of land and to set out some young pine
trees. The trees will mature in 10 years, at which time the company plans to sell the forest
at an expected price of 8 million. What is company's expected rate of return?


SOLUTI ON
Here, Future value (FV) = 8,000,000
Present value (PV) = 4,000,000
Time period (n) = 10 years
Expected rate of return (i) = ?
First set up time line as follows:
Future value of an
annuity
Future value of an
annuity due
Expected rate of
return
0 1 2 3
5
300
FVA = ?
7%
300 300 300
0 1 2 3
5
FVA (due) = ? 300
7%
300 300 300





We have,
FV = PV (1 + i)
n

or, 8,000,000 = 4,000,000 (1 + i)
10

or, (1 + i)
10
=8,000,000/ 4,000,000
or, (1 + i)
10
= 2
or, 1 + i = (2)
1/10
i = 1.0718 - 1
= 0.0718 or 7.18%
Question 10 Rachel wants a refrigerator that costs 12000. She has arranged to borrow the total
purchase price of refrigerator from a finance company at a simple interest rate equal to 12
percent. The loan requires quarterly payments for a period of three years. If the first
payment is due three months after purchasing the refrigerator, what will be the amount
of her quarterly payments on the loan?
SOLUTI ON
Given,
Present value of an annuity (PVA) = . 12,000
Simple interest rate per annum (i) = 12%
Loan requires quarterly payment i.e. m = 4
Number of years (n) = 3 year
Periodic equal payment (PMT) = ?
Time line:



We have,
PVA = PMT

1 -
1
(1 + i/m)
n m
i
m

or, 12,000 = PMT

1 -
1
(1 + 0.12/4)
3 4
0.12
4

or, 12,000 = PMT 9.9540
PMT = 12,000/ 9.9540
= 1,205.55

Question 11 You need to accumulate 10,000. To do so, you plan to make deposits of 1,250 per year,
with the first payment being made a year from today, in a bank account which pays 12
percent annual interest compounded annually. Your last deposit will be less than 1,250
if less is needed to round out to 10,000. How many years will it take you to reach your
10,000 goal, and how large will the last deposit be?
SOLUTI ON
Here,
Annual payment (PMT) = 1,250
Future value of annuity (FVAn) = 10,000
Reaching a financial
goal
0 1 2 3
10
8 million 4 million
i = ?
Solving for payment
-12000
0
12%
12 1 2 3 4
PMT PMT PMT PMT PMT

Interest rate (i) = 12%
Time to maturity (n) = ?
Last deposit = ?
First, we determine the number of periods of the financial goal. This is calculated using
future value of annuity formula as follows:
We have,
FVAn = PMT FVIFAi, n
10,000 = 1,250 PViFA12, n
FVIFA12, n =
10000
1250
= 8
Looking FVIFA table the value 8 at 12 percent interest rate lies approximately in 6 years.
Therefore the number of years to reach the financial goal is 6 years. Now we calculate the
future value of 1,250 for 5 years at 12%, it is 7,941.06
FV = 1,250 FVIFA12, 5 = 1,250 6.3528 = 7,941
Compounding this value after 6 years and before the last payment is made, it is 7,941
(1.12) = 8,893.92. Thus, we will have to make a payment of 10,000 - 8,893.92 =
1,106.08 at year 6, therefore it will take 6 years, and 1,106.08 must be paid in the last
installment.

Question 12 Your Company is planning to borrow 1,000,000 on a 5-year, 15 percent, annual
payments, fully amortized term loan. What fraction of the payment made at the end of
the second year will represent repayment of principal?
SOLUTI ON
Here, Loan amount (PVA) = 1,000,000
Number of years (n) = 5 years
Interest rate (i) = 15%
First we determine the annual installment or payment (PMT)
We have,
PMT =
PVA
PVIFAi n
= 1,000,000/PVIFA15,5 =1,000,000/ 3.3522 = 293,311.55
Preparation of Amortization Schedule,
Amortization schedule
Year Payments Interest Payment of Principal Ending Balance
1
2
298,311.5566
298,311.5566
150,000
127,753.2665
148,311.5566
170,558.2901
851,688.4434
681,130.1533
% principal in 2
nd
year =
Principal payment in 2
nd
year
Payments
= 57.17%
That is 57.17% of the payment in second year represents the principal.

Question 13 You are branch manager of town centre Natwest Bank, Manchester. A borrower
approaches you for a term loan of 500,000. You agreed to give loan to be fully
amortized in a period of 5 year at 10 percent, annual payment. What will be the size of
each installment? What fraction of the payment made at the end of second year represents
repayment of interest?
SOLUTI ON
Here, Loan amount (PVA) = 500,000
Number of years (n) = 5 years
Interest rate (i) = 10%
First we determine the annual installment or payment (PMT)
We have,
Loan amortization
0 1 2 3
n =?
Last deposit = ?
FVA = 10,000
12%
1,250 1,250 1,250
Loan amortization


PMT =
PVA
PVIFAi n
= 500,000/ PVIFA10,5 = 500,000/3.7908
= 131898.28

Preparation of Amortization Schedule,
Amortization schedule
Year
Beginning
balance
PMT Interest
Repayment of
principal
Ending
balance
1
2
500,000
418,101.72
131,898.28
131,898.28
50,000
41,810.17
81898.28
90,088.11
418,101.72
328,013.61
% interest in 2
nd
year =
Interest payment in 2
nd
year
Payments
= 31.7%
That is 31.7% of the payment in second year represents the interest.

Question 14 a. It is now January 1, 2007. You plan to make 5 deposits of 100 each, on every 6
months, with the first payment being made today. If the bank pays a nominal
interest rate of 12 percent, but uses semiannual compounding, how much will be
in your account after 10 years?
b. Ten years from today you must make a payment of 1,432.02. To prepare for this
payment, you will make 5 equal deposits, beginning today and for the next 4
quarters, in a bank that pays a nominal interest rate of 12 percent, quarterly
compounding. How large must each of the 5 payments be?
SOLUTI ON
a. Here, Number of deposits (n) = 5 deposits;
Semiannual (every 6 months), payment = 100;
Nominal interest rate (i) = 12%,
Present value of annuity (PVA) = ?





We have,
FVA = PMT

(1 + i)
n
- 1
i
(1 + i) = 100

(1 + 0.06)
5
- 1
0.06
(1 + 0.06)
= 100 5.6371 1.06 = 597.5326
Now remaining period is 15 periods (20 periods - 5 periods), so we calculate the
future value of this 597.5326 for remaining periods.
We have,
FV = PV (1 + i)
n
= 597.5326 (1 + 0.06)
15
= 1,432.02
b. Here,
Future value at the end of 10 years = 1,432.02;
n = 35 periods because quarterly compounding (in 10 years there are 40 quarters);
Quarterly interest rate = 3%,
PMT = ?, PV = ?




We have,
Non annual
compounding
0 1 10
FV = ?
6%
100 100 100
2
100 100
0

10
FV = 1,432.02
3%
PMT = ? PMT = ? PMT = ?
1
PMT = ? PMT = ?

PV =
FV
(1 + i)
n
= 1,432.02/(1+0.03)
35
= 508.91
Now we calculate the payment (PMP)
Here, n = 5 periods, i = 3%, PV = ?; FV = 508.91, FVA = 508.91
PMT = ?
We have,
FVA = PMT

(1 + i)
n
- 1
i
(1 + i)
or, 508.91 = PMT

(1 + 0.03)
5
- 1
0.03
(1 + 0.03)
or, 508.91 = PMT 5.3091 1.03
PMT = 508.91/ 5.4684 = 93.06

Question 15 The prize in last week's Lottery was estimated to be worth 35 million. If you were lucky
enough to win, then it will pay you 1.75 million per year over the next 20 years. Assume
that the first installment is received immediately.
a. If interest rates are 8 percent, what is the present value of the prize?
b. If interest rates are 8 percent, what is the future value after 20 years?
c. How would your answers change if the payments were received at the end of each
year?
SOLUTI ON
Here, Payment (MPT) = 1.75 million
Number of periods (n) = 20 years,
a. Present value of annuity (PVA) = ? interest rate (i) = 8%
PVA = PMT

1 -
1
(1 + i)
n
i
(1 + i) = 1.75

1 -
1
(1 + 0.08)
20
0.08
(1 + 0.08)
= 1.75 9.8181 1.08
= 18.56 million
b. Future value of annuity (FVA) = ?, Interest rate (i) = 8%
FVA = PMT

(1 + i)
n
- 1
i
(1 + i)
= 1.75

(1 + 0.08)
20
- 1
0.08
(1 + 0.08)
= 1.75 45.7620 1.08
= 86.49 million
c. PVA and FVA assuming payments received at the end of year.
Present value of annuity (PVA) = ?, Interest rate (i) = 8%
We have,
PVA = PMT

1 -
1
(1 + i)
n
i

= 1.75

1 -
1
(1 + 0.08)
20
0.08

= 1.75 9.8181
= 17.18 million
Future value of annuity (FV) = ?, Interest rate (i) 8%
Value of an annuity

FVA = PMT

(1 + i)
n
- 1
i
= 1.75

(1 + 0.08)
20
- 1
0.08

= 1.75 45.7620
= 80.08 million





Question 16 Ashley has 42,180.53 in brokerage account, and plans to contribute an additional 5,000
every year at an annual interest rate of 12 percent. If Ashley has to accumulate 250,000,
how many years will it take for him to reach his goal?
SOLUTI ON
Here, Present value (PV) = 42,180.53
Payment (PMT) = 5,000
Annual return (i) = 12%
Future value (FV) = 250,000
Number of years to reach goal (n) = ?





We have,
42,180.53 (1 + 0.12)
n
+ 5,000

(1 + 0.12)
n
- 1
0.12
= 250,000
or, 5,061.66 (1.12)
n
+ 5,000 (1.12)
n
- 5,000 = 30,000
or, 10,061.66 (1.12)
n
= 35,000
or, (1.12)
n
= 35,000/ 10,061.66
or, (1.12)
n
= 3.4786 ... (i)
In above eq
n
. (i) if we go for trying several values of 'n', the left hand side is exactly
equal to right hand side at n = 11.
The required no. of years to reach the goal is 11 years.

Question 17 Your client is 40 years old and wants to begin saving for retirement. You advise the client
to put 5,000 a year into the stock market. You estimate that the market's return will be,
on average, 12 percent a year. Assume the investment will be made at the end of the year.
a. If the client follows your advice, how much money will she have by age 65?
b. How much will she have by age 70?
SOLUTI ON
Here, Your client is 40 years old, Payment (PMT) = 5,000, Interest rate (i) = 12%
Investment will be made at the end of the year
a. Future value of annuity (FVA) at the age of 65?
Number of periods (n) = 65 - 40 = 25 years
FVA = PMT

(1 + i)
n
- 1
i
= 5,000

(1 + 0.12)
25
- 1
0.12

= 5,000 133.3338 = 666,669
b. Future value of annuity (FVA) at the age of 70?
Number of periods (n) = 70 - 40 = 30 years
FVA = PMT

(1 + i)
n
- 1
i
= , 5,000

(1 + 0.12)
25
- 1
0.12

Future value of an
annuity
Solving for time
0 1 2 3
n
2,50,000 42,180.53
12%
5000 5000 5000

= 5,000 241.3327
= 1,206,66

Question 18 Jason has inherited 25,000 and wishes to purchase an annuity that will provide him with
a steady income over the next 12 years. He has heard that the local savings and loan
association is currently paying 6 percent compound interest on an annual basis. If he were
to deposit his funds, what year-end equal pound amount (to the nearest pound) would he
be able to withdraw annually such that he would have a zero balance after his last
withdrawal 12 years from now?
SOLUTI ON
Here,
Present value of annuity (PVA) = 25,000
Number of years (n) = 12 years
Interest rate (i) = 6%
Equal annual withdraw (PMT) = ?
PVA = PMT

1 -
1
(1 + i)
n
i

or, 25,000 = PMT

1 -
1
(1 + 0.06)
12
0.06

or, 25,000 = PMT 8.3838
PMT = 2,981.9414

Question 19 You need to have 50,000 at the end of 10 years. To accumulate this sum, you have
decided to save a certain amount at the end of each of the next 10 years and deposit it in
the bank. The bank pays 8 percent interest compounded annually for long term deposits.
How much will you have to save each year (to the nearest Pound)?
SOLUTI ON
FVA = PMT

(1 + i)
n
- 1
i

or, 50,000 = PMT

(1 + 0.08)
10
- 1
0.08

or, 50,000 = PTM 14.4866
PMT = 50,000/14.4866
= 3,451.46

Question 20 Louise wishes to borrow 10,000 for three years. A group of individuals agrees to lend
her this amount if she contracts to pay them 16,000 at the end of the three years. What is
the implicit compound annual interest rate you receive (to the nearest whole percent)?
SOLUTI ON
Here, Present value (PV) = 10,000
Number of year (n) = 3 years
Future value (FV) = 16,000
End payment, interest rate (i) = ?
We have,
FV = PV (1 + i)
n

or, 16,000 = 10,000 (1 + i)
3
or, 1.6 = (1 + i)
3
Solving for payment
Annual interest rate
Solving for payment


or, (1.6)
1/3
- 1 = 1
or, i = 0.1695 or 16.95%




Question 21 Calculate the present value of the following cash flow stream. Assume that the stated rate
of interest is 14 percent per annum discounted semiannually.


SOLUTI ON
If stated annual rate is 14 percent, discounted semiannually, first we calculate the effective
annual rate as follows:
Effective interest rate (EAR) = (1 + 0.14/2)
2
- 1 = 14.49%
Now present value of given cash flow stream discounted at 14.49 percent effective annual
rate is calculated as follows:
Year Cash flow 14.49% PVIF PV
0
1
2
3
1,000
1,600
1,500
850
1.0000
0.8734
0.7629
0.6663
1,000.00
1,397.44
1,144.35
566.36
Total present value 4,108.15

Question 22 National Lottery has offered you the choice of the following alternative payments.
Alternative 1: 10,000 one year from now
Alternative 2: 20,000 five years from now.
a. Which should you choose if the discount rate is 0 percent? 20 percent?
b. What rate makes the options equally attractive?

SOLUTI ON
a. Calculation of present value if discount rate is 0 percent
Alternative 1:
PV =
FV
(1+i)
n
=
10000
(1+0)
1
= 10,000
Alternative 2:
PV =
FV
(1+i)
n
=
20000
(1+0)
5
= 20,000
If discount rate is 0 percent, Alternative 2 is preferable because of higher present
value.
Calculation of present value if discount rate is 20 percent
Alternative 1:
PV =
FV
(1+i)
n
=
10000
(1+0.20)
1
= 8,333.33
Alternative 2:
PV =
FV
(1+i)
n
=
20000
(1+0.20)
5
= 8,037.55
If discount rate is 20 percent, Alternative 1 is preferable because of higher present
value.
Uneven cash flow
stream

1000
2
3
1600
End of year
Cash flow
1
1500 850
0
Uneven cash flow
stream

b. Calculation of rate of interest (i) at which both the options are equally likely
PV of Alternative 1 = PV of Alternative 2

10000
(1+i)
1
=
20000
(1+i)
5

(1+i)
4
= 2
i = (2)
1/4
1 = 0.1892 or 18.92%
That is, if the discount rate is 18.92 percent both the alternative would produce equal
present value so that both are equally likely.