Chapter 5

The Time Value of Money

CHAPTER 5
THE TIME VALUE OF MONEY
ANSWERS TO QUESTIONS:
1. The investment paying five percent compound interest is more attractive because you will
receive interest not only on the principal amount each year, but interest will be earned on the
previous year's interest as well.

2. The future value interest factor for 10 percent and two years is 1.210, whereas the present
value interest factor for 10 percent and two years is 0.826.

3. As the interest rate increases, any annuity amount is being discounted by a higher value,
thereby reducing the present value of the annuity. This can be seen in Table IV by looking
across any row of successively higher interest rates. In contrast, the future value of an annuity
increases as the interest (compounding) rate increases. (See Table III.)

4. Daily compounding is preferred because you will earn interest on the interest earned in the
account each day. Table 5-6 illustrates this.

5. Annuity due computations are common for lease contracts and insurance policies, where
payments are generally made at the beginning of each period.

6. As can be seen in Table 5-7, the more frequent the compounding period, the lower the
present values.

7. a. A marketing manager might use present value concepts to evaluate the success of an
advertising or other promotional campaign, the benefits of which are likely to extend beyond
one year in time. Also, a firm selling capital goods must be familiar with the type of present
value economic analysis that customers will use to evaluate purchases.

b. A personnel manager may need to use present value concepts to evaluate alternative
insurance and pension plans.

8. The Rule of 72 can be used to determine the approximate number of years it takes for an
amount of money to double, given an interest rate. It also can be used to determine the
effective interest rate required for a sum of money to double, given a number of years. To
solve for the number of years, the number "72" is divided by the interest rate (in percent). To
solve for the percentage interest rate, the number "72" is divided by the number of years.

9. Present value and future value concepts are closely related. For example, PVIF factors are
simply the reciprocal of FVIF factors and vice versa. Any problem which can be solved using
PVIF factors can also be solved using FVIF factors.

10. An ordinary annuity involves a series of equal, end-of-period payments or receipts. The

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interest payments on most bonds are ordinary annuities. An annuity due involves a series of
equal, beginning-of-period payments or receipts, such as in a lease or some insurance policies.

11. As the required rate of return increases, (a) the present value of an annuity decreases and
(b) the future value of an annuity increases.

12. The sinking fund problem tries to find the annuity amount that must be invested each year
to produce a future value. If the desired future value is known, it is divided by the FVIFA for
the given interest rate and number of years to determine the sinking fund amount.

13. In order to set up a loan amortization schedule, the annual loan payment must first be
computed using the appropriate PVIFA from Table IV. The interest portion of each period's
payment is equal to the periodic interest rate times the balance outstanding at the beginning of
each period. The interest is subtracted from the payment to determine the principal portion of
the payment. Finally, the principal for the period is subtracted from the beginning of period
principal balance to get the new beginning of period balance for the next period.

14. The insurance company is willing to take on the known loss because the settlement of
claims of this magnitude often takes five or more years. With the high interest rates prevailing
at the time of the disaster, the insurers felt they could earn enough on the new premiums to
more than cover their final liability.

15. This means that the basis for interest rate compounding is continuous. However, interest is
only credited to your account at the end of each quarter. Thus, in order to earn the effective
compounded rate you need to withdraw funds only on the quarterly payment dates.

16. The dividend payments on many preferred stocks are perpetuities. These preferred stocks
have no scheduled maturity date and they pay the same dividend each period. A perpetuity is
an annuity with no ending date.

17. The present value of an uneven cash flow stream is found by summing the present values
of the individual cash flows.

18. This statement is not correct. The powerful microcomputer can be used efficiently to help
solve complex problems. The hand calculator, on the other hand, is better suited to solving
relatively simple problems because the solution routines are programmed into the calculator
and there is a lower start-up cost associated with working the problem on the calculator.

19. The net present value of an investment represents the contribution of that investment to the
value of the firm and, accordingly, to the wealth of shareholders. The net present value is a
decision criterion that assists managers in achieving the objective of shareholder wealth
maximization.

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SOLUTIONS TO PROBLEMS:

1. a. FV3 = $1,000(FVIF.06,3) = $1,000(1.191) = $1,191

b. FV5 = $1,000(FVIF.06,5) = $1,000(1.338) = $1,338

c. FV10 = $1,000(FVIF.06,10) = $1,000(1.791) = $1,791

2. a. Present value of $5,000 today = $5,000

b. Present value of $15,000 received in 5 years at 9%:

PV0 = $15,000(PVIF.09,5) = $15,000 (0.650) = $9,750 (tables)

$9749 (calculator)

c. Present value of a 15 year, $1,000 annuity at 9%:

PVAN0 = $1,000 (PVIFA.09,15) = $1,000(8.061) = $8,061

Therefore, you prefer $15,000 in five years because it has the highest present value.

3. FVAND8 = $20,000(FVIFA.09,8)(1 + 0.09) = $20,000(11.028)(1.09)

= $240,410.40 ($240,420.73 with a calculator)

4. Alternative a:
PVAND0 = $1,200(PVIFA.08,12)(1 + 0.08) = $1,200(7.536)(1.08)

= $9,766.66 (tables); $9,766.76 (calculator)

Alternative b:

Present value cost equals $10,000 (given). Therefore, choose Alternative (a) because it

has a lower present value cost.

5. a. PV0 = $50,000 /[1 + (0.06/2)]2x5 = $37,204.70 (calculator)

b. PV0 = $50,000 /[1 + (0.06/4)]4x5 = $37,123.52 (calculator)

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6. $1,000 = $333.33(FVIFi,9)

FVIFi,9 = 3.000

i  13% from Table I. (12.98% by calculator)

7. a. PV0 = $800(PVIF.04,8) = $800 (0.731) = $584.80 (tables)

$584.55 (calculator)
b. PV0 = $800(0.540) = $432

c. PV = $800(PVIF.05,32) = $167.89 (by calculator)

d. PV = $800(1.000) = $800

8. PVAN0 = $60,000 - $10,000 = $50,000

$50,000 = PMT(PVIFA.10,25) = PMT(9.077)

PMT = $5,508.43 (tables)

$5,508.40 (calculator)

Interest (first year) = .10($50,000) = $5,000

Principal reduction = $5,508.43 - $5,000 = $508.43

9. $200,000 = $41,067(PVIFAi,20)

PVIFAi,20 = 4.870; From Table IV, i = 20%

10. $600,000 = PMT(FVIFA.09,25) = PMT(84.701)

PMT = $7,083.74 (tables); $7,083.75 (calculator)

11. a. PV0 = $70(PVIFA.05,25) + $1000(PVIF.05,25) = $70(14.094) + $1000(0.295) =

$1,281.58 (tables); $1,281.88 (calculator)

b. PV0 = $70(11.654) + 1000(0.184) = $1,000 ($999.78 using tables;

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difference from $1,000 due to rounding)

c. PV0 = $70(7.843) + $1000(0.059) = $608.01 (tables)

$607.84 (calculator)
12. ieff = [ 1 + (inom/m)]m - 1 = [ 1 + (.08/4)]4 -1 = 0.0824 or 8.24%

13. NPV1 = -$10,000 + $5,000(0.909) + $6,000(0.826) + $7,000(0.751) + $8,000(0.683) =

$10,222
NPV2 = -$10,000 + $8,000(0.909) + $7,000(0.826) + $6,000(0.751) + $5,000(0.683) =

$10,975 This is the preferred alternative.

14. PVAN0 = $80,000 = PMT(PVIFA.10,10) = PMT(6.145)

PMT = $13,018.71 (Calculator solution = $13,019.63)

15. PVAN0 = $30,000 - $5,000(down) - $750 (loan origination fee)

= $24,250

Origination fee = 0.03 x $25,000 = $750

$24,250 = $3,188(PVIFAi,15)

PVIFAi,15 = 7.607

Therefore, i  10% from Table IV and calculator

16. a. PV0 = $6,000(PVIFA.12,5) + $4,000(PVIFA.12,5)(PVIF.12,5)

= $6,000(3.605) + $4,000(3.605)(0.567) = $29,806 (tables)

$29,810 (calculator)
(Note: $4,000(PVIFA.12,5) gives the present value of that annuity at the end of

five years. Hence, it must be discounted back to time 0 at

a 12% rate.)

b. Both terms in the Part (a) solution need to be multiplied by (1 + 0.12). Hence, the annuity

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due solution to this problem is equal to $29,806 (1.12)

= $33,383 (tables); $33,387 (calculator)

17. $919 = $87.5(1 - 0.28)(PVIFAi,20) + [$919 + ($1000 - $919)

x (1 - 0.28)](PVIF i,20)

$919 = $63(PVIFAi,20) + $977.32(PVIFi,20)

Try i = 7%

$919 = $63(10.594) + $977.32(0.258) = $919.57

Therefore, i = 7%. (7.01% by calculator)

18. FV25 = $1000(FVIF.05,25) = $1000(3.386) = $3,386

19. PVAN0 = $6,000(PVIFA.08,15) = $6,000(8.559) = $51,354(tables)

$51,357(calculator)

Because the lifetime annuity has a higher expected present value

than the $50,000 lump sum payment, she should take the annuity.

20. FVAN10 = $10,000,000 = PMT(FVIFA.08,10) = PMT(14.487)

PMT = $690,274 (tables); $690,295 (calculator)

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21. $30,000 = PMT(PVIFA.11,3) = PMT(2.444)

PMT = $12,275 (tables); $12,276 (calculator)

End of Year PMT(Payment) Interest Principal Balance Remaining

0 - - - $30,000

1 $12,275 $3,300 $8,975 21,025

2 12,275 2,313 9,962 11,063

3 12,275 1,217 11,058 5*

* difference from zero due to rounding in tables

22. a. PV0 = $6,000(PVIFA.12,5) + $3,000(PVIFA.12,5)(PVIF.12,5)

+ $2,000(PVIFA .12,10)(PVIF.12,10)

PV0 = $6,000(3.605) + $3,000(3.605)(0.567) + $2,000(5.650)(0.322)

PV0 = $31,401

b. PV of beginning of year receipts = $31,401(1.12) = $35,169

23. PVAND30 = $250,000(PVIFA.10,5)(1 + .10)

= $250,000(3.791)(1.1)

= $1,042,525
FVAN30 = $1,042,525 = PMT(FVIFA.10,30) = PMT(164.494)

PMT = $6,338 (tables); $6,337 (calculator)

24. FVAN25 = $4,500(FVIFA.10,25) = $4,500(98.347)

FVAN25 = $442,561.50 (amount in account at the end of 25 years)

PVAN0 = $442,561.50 = PMT(PVIFA.10,20) = PMT(8.514)

PMT = $51,980.44 (Calculator solution = $51,983)

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25. FVAN4 = $10,000(FVIFA.12,4) = $10,000(4.779) = $47,790 (balance in the

account at the end of four years)

FV6 = $47,790(FVIF.12,6) = $47,790(1.974) = $94,337 (balance in the account at the end

of ten years) (tables); $94,335 (calculator)

26. a. FVn = PV0 [ 1 + (inom /m)]mn

FV3 = $10,000 [ 1 + (0.08/2)] 6 = $12,653.19

b. FV3 = $10,000 [ 1 + (0.08/4)] 12 = $12,682.42

c. FV3 = $10,000 [ 1 + (0.08/12)] 36 = $12,702.37 (by calculator)

27. NPV = $40,000(PVIFA.20,5)(PVIF.20,3) - $100,000

NPV = $40,000(2.991)(0.579) - $100,000

NPV = $-30,728 (tables) (The project should not be undertaken.)

$-30,773(calculator)

28. $100,000 = $60,000(PVIFi,1) + $79,350(PVIFi,2)

Try i = 24%

$100,000  $60,000(0.806) + $79,350(0.650)

$100,000  $99,937.5, hence i  24%

29. PV0 = $20,000(PVIF.15,1) + $30,000(PVIF.15,2)

+ $15,000(PVIF .15,3)

PV0 = $20,000(0.870) + $30,000(0.756) + $15,000(0.658)

PV0 = $49,950

$49,950 = PMT(PVIFA.15,3) = PMT(2.283)

PMT = $21,879 (tables); $21,872 (calculator)

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30. Amount needed by 18th birthday:

PV0 = $18,000(PVIF.10,0) + $19,000(PVIF.10,1)

+ $20,000(PVIF.10,2) + $21,000(PVIF.10,3)

= $18,000(1.0) + $19,000(0.909) + $20,000(0.826)

+ $21,000(0.751)

= $67,562
FV8 (at age 18) = PMT(FVIFA.10,8)

$67,562 = PMT(11.436)

PMT = $5,907.83 (tables) amount to be deposited in account on 11th through

18th birthdays; $5,909.40 (calculator)

31. FVANn = PMT(FVIFAi,n); n = 5 years x 4 quarters/year = 20 periods

i = 0.20/4 = 0.05 per period

FVAN20 = $10,000 = PMT(FVIFA.05,20)

$10,000 = PMT(33.066)

PMT = $302.43 (amount to be deposited each quarter)

32. Amount needed in account after final deposit on your 60th birthday:
PV0 = $120,000(PVIFA.12,15) + $250,000(PVIF.12,15)

PV0 = $120,000(6.811) + $250,000(0.183)

PV0 = $863,070

$863,070 = PMT(FVIFA.12,30) = PMT(241.333)

PMT = $3,576

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33. Present value of payments to first child for college:

$10,000 (PVIF.13,10) = $10,000 (0.295) = $2,950

$11,000(0.261) = $2,871

$12,000(0.231) = $2,772

$13,000(0.204) = $2,652

Total $11,245

Present value of payments to second child for college:

$15,000(PVIF.13,15) = $15,000(0.160) = $2,400

$16,000(0.141) = $2,256

$17,000(0.125) = $2,125

$18,000(0.111) = $1,998

Total $8,779

Present value of retirement annuity:

PV0 = $50,000(PVIFA.13,20)(PVIF.13,30)

PV0 = $50,000(7.025)(0.026) = $9,133

Present value of funds needed = $11,245 + $8,779 + $9,133

= $29,157

Payment needed for 30 years:

$29,157 = PMT(PVIFA.13,30) = PMT(7.496)

PMT = $3,890 (tables); $3,869 (calculator)

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34. a. PVAND0 = $100,000(PVIFA.10,20)(1 + .10)

$100,000(8.514)(1 + .10) = $936,540 needed

at age 60

PV (at age 45) = $936,540 (PVIF.10,15)

= $936,540(0.239) = $223,833 (tables);

$224,189 (calculator)

b. PV (at age 30) = $223,833(PVIF .12,15)

= $223,833(0.183) = $40,961

With $10,000 available, you must save an annuity amount at the end of each of the next 15

years that has a present value equal to $30,961, or:

$30,961 = PMT (PVIFA.12,15) = PMT (6.811)

PMT = $4,546 (tables); $4,545 (calculator)

35. PVAN0 = PMT(PVIFA0.10,t)

$400,000 = $40,000(PVIFA0.10,t)

PVIFA0.10,t = 10

Therefore, at 10% per year his $400,000 savings will last forever, i. e., $400,000 x

0.10 = $40,000

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36. FV7/1/2024 = $2,000 (FVIF0.07,10) + $1,000 (FVIFA0.07,6) x

(FVIF0.07,4) - $3,000 (FVIF0.07,2)

= $2,000 (1.967) + $1,000 (7.153)(1.311)

- $3,000 (1.145)

= $9,877 (tables); $9,880 (calculator)

37. 10% pretax x (1 - T) = 7% after tax

PVo = $15,000 (PVIF0.07,3) + $16,000 (PVIF0.07,4)

+ $17,000 (PVIF0.07,5) + $18,000 (PVIF0.07,6)

+ $25,000 (PVIF0.07,7)

= $15,000 (0.816) + $16,000 (0.763) + $17,000 (0.713)

+ $18,000 (0.666) + $25,000 (0.623)

= $64,132

Amount needed = $64,132 - $8,000 = $56,132

PVAN0 = PMT (PVIFA0.07,6)

$56,132 = PMT(4.766)

PMT = $11,778

38. 10% pretax x (1 - T) = 7% after tax

PV0 = $25,000 (PVIFA0.07,4) (PVIF0.07,9)

+ $55,000 (PVIF0.07,14)

= $25,000 (3.387) (0.544) + $55,000 (0.388)

= $67,403

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Amount needed = $67,403 - $10,000 - $25,000 (PVIF 0.07,9)

= $43,803
PVAN = PMT (PVIFA0.07,10)

$43,803 = PMT (7.024)

PMT = $6,236 (tables); $6,235 (calculator)

39. Amount needed by 60th birthday = $100,000(PVIFA.07,20)(1+0.07)

= $1,133,560

Future value of $35,000 at the end of year 10:

= $35,000(FVIF.05,10) = $57,011

Future value of $57,011 at the end of year 30:

= $57,011(FVIF.07,20) = $220,615

Future value of $5,000 annuity at the end of year 10:

= $5,000(FVIFA.05,10) = $62,889

Future value of $62,889 at the end of year 30:

= $62,889(FVIF.07,20) = $243,361

Net amount needed on 60th birthday:

= $1,133,560 - $220,615 - $243,361 = $669,584

Payment needed years 11-20:

= $669,584 = PMT(FVIFA.07,20)

PMT = $16,333

40. FV = $200,000 = $10,000(FVIF.07,5)(FVIF.09,5)

+ PMT(FVIFA.07,5)(FVIF.09,5) + PMT(FVIFA.09,5)

$200,000 = $10,000(1.403)(1.539) + PMT(5.751)(1.539)

+ PMT(5.985)

PMT = $12,025

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41. $1,000,000 = PMT (PVIFA0.1125, 5)

PMT = $272,274 (by calculator)

End of Year Payment Interest Principal Balance Remaining

0 -- -- -- $1,000,000

1 $272,274 $112,500 $159,774 840,226

2 272,274 94,525 177,749 662,477

3 272,274 74,529 197,745 464,732

4 272,274 52,282 219,992 244,740

5 272,274 27533 244,741 -1*

*Differs from $0 due to rounding.

42. Amount needed at 60th birthday = $500,000(PVIF0.07, 20)

+ $150,000(PVIFA0.07, 10)(PVIF0.07,10) + $100,000(PVIFA0.07, 10)

= $1,366,628

$1,366,628 = PMT[(FVIFA.06, 20)(FVIF.07, 10) + FVIFA.07, 10)]

PMT = $15,859 (tables); $15,864 (calculator)

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43. Amount needed by year 35 = $200,000 (PVIFA.08,25) = $2,134,955

Value of $5,000 annuity at year 35 = $5,000(FVIFA.12,15)(FVIF.12, 20)

= $1,798,049

Future Value of amount needed from 20 year annuity payments:

$2,134,955 - $1,798,049 = $336,905

$336,905 = PMT (FVIFA.12, 20)

PMT = $4,676 (calculator accuracy)

44. FVAND30 = $5,000 (FVIFA0.10,30)(1.10)

= $5,000 (164.494)(1.10)

= $904,717
PVAN0 = PMT (PVIFA0.12,20)(1.12)

$904,717 = PMT (7.469)(1.12)

PMT = $108,151

45. i12 = (1 + 0.12)1/12 -1 = 0.009489 or 0.949%

46. No recommended solution

Integrative Case Problem:

1. At age 65: n = 35; i = 0.03; PV0 = $60,000

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FV35 = $60,000 (FVIF.03, 35) = $168,831.75

2. At age 65: n = 15; PMT = $168,831.75 (annuity due); FV 15 = $1,000,000

a. i = 0.11

PV0 = $168,831.75 [PVIFA.11, 15 (1 + 0.11)] + $1,000,000 (PVIF .11, 15)

= $1,556,596.62

b. i = 0.06

PV0 = $168,831.75 [PVIFA.06, 15 (1 + 0.06)] + $1,000,000 (PVIF .06, 15)

= $2,155,385.21

c. i = 0.085

PV0 = $168,831.75 [PVIFA.085, 15 (1 + 0.085)] + $1,000,000 (PVIF .085, 15)

= $1,815,330.28

3. i = 0.11; FV needed = $1,556,596.62

a. At age 30: n = 35

$1,556,596.62 = PMT(FVIFA.11,35)

PMT = $4,556.92

b. At age 40: n = 25

$1,556,596.62 = PMT(FVIFA.11,25)

PMT = $13,605.03

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c. At age 50: n = 15

$1,556,596.62 = PMT(FVIFA.11,15)

PMT = $45,242.85

4. i = 0.06; FV needed = $2,155,385.21

a. At age 30: n = 35

$2,155,385.21 = PMT(FVIFA.06, 35)

PMT = $19,342.12

b. At age 40: n = 25

$2,155,385.21 = PMT(FVIFA.06, 25)

PMT = $39,285.60

c. At age 50: n = 15

$2,155,385.21 = PMT(FVIFA.06, 15)

PMT = $92,601.31

5. i = 0.085; FV needed = $1,815,330.28

a. At age 30: n = 35

$1,815,330.28 = PMT(FVIFA0.085, 35)

PMT = $9,420.42

b. At age 40: n = 25

$1,815,330.28 = PMT(FVIFA.085, 25)

PMT = $23,075.90

c. At age 50: n = 15

$1,815,330.28 = PMT(FVIFA.085, 15)

PMT = $64,299.84

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6. The earlier one begins investing, the lower the annual payments required. Also, the greater

the returns earned on investments, the lower the annual payments required.

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