SELF-TEST QUESTIONS

Definitional

1. The beginning value of an account or investment in a project is known as its _________

_______.

2. Using a savings account as an example, the difference between the account's present
value and its future value at the end of the period is due to __________ earned during the
period.

3. The equation FVn = PV(1 + i)n determines the future value of a sum at the end of n
periods. The factor (1 + i)n is known as the ________ _______ __________ ________.

4. The process of finding present values is often referred to as _____________ and is the
reverse of the _____________ process.

5. The PVIFi,n for a 5-year, 5 percent investment is 0.7835. This value is the ____________
of the FVIFi,n for 5 years at 5 percent.

6. For a given number of time periods, the PVIFi,n will decline as the __________ ______
increases.

7. A series of payments of a constant amount 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
_____.

8. The present value of an uneven stream of future payments is the _____ of the PVs of the
individual payments.

9. Since different types of investments use different compounding periods, it is important to

distinguish between the quoted, or _________, rate and the ___________ annual interest
rate.

10. When compounding occurs more than once a year, divide the _________ ______ by the
number of times compounding occurs and multiply the years by the number of
_____________ _________ per year.

11. ______ _______ are used to help visualize what is happening in time value of money
problems.

12. An annuity that goes on indefinitely is called a(n) ____________.

13. ___________ loans are those which are paid off in equal installments over time.
14. The breakdown of each payment as partly interest and partly principal is developed in
a(n) ______ ______________ __________.

Conceptual

15. 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

16. 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.

a. True b. False

17. 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 both correct.
e. Statements a and b are both correct.

18. 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.

19. Which of the following statements is most correct?

a. For all positive values of i and n, FVIFi,n  1.0 and PVIFAi,n  n.

b. You may use the annuity formula to find the present value of an uneven series of
payments.
c. If a bank uses quarterly compounding for savings accounts, the nominal rate will be
greater than the effective annual rate.
d. The present value of a future sum decreases as either the nominal interest rate or the
number of discounting periods per year increases.
e. All of the above statements are false.

20. Which of the following statements is most 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 percent,
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 percent for 2 periods.
e. Statements a, b, c, and d are all false.

SELF-TEST PROBLEMS

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

1. Assume that you purchase a 6-year, 8 percent 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. $1,586.90 e. $1,766.33

2. A savings certificate similar to the one in the previous problem is available with the
exception that interest is compounded semiannually. What is the difference between the
ending value of the savings certificate compounded semiannually and the one
compounded annually?

a. The semiannual is worth $14.10 more than the annual.

b. The semiannual is worth $14.10 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%

4. At an inflation rate of 9 percent, 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
percent?

a. 12 years b. 15 years c. 18 years d. 20 years e. 23 years

 5. 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%

6. You decide to begin saving toward the purchase of a new car in five years. If you put
$1,000 at the end of each of the next 5 years in a savings account paying 6 percent
compounded annually, how much will you accumulate after 5 years?

a. $6,691.13 b. $5,637.10 c. $1,338.23 d. $5,975.33 e. $5,732.00

7. Refer to Self-Test Problem 6. What would be the ending amount if the payments were
made at the beginning of each year?

a. $6,691.13 b. $5,637.10 c. 1,338.23 d. $5,975.33 e. $5,732.00

8. Refer to Self-Test Problem 6. What would be the ending amount if $500 payments were
made at the end of each 6-month period for 5 years and the account paid 6 percent
compounded semiannually?

a. $6,691.13 b. $5,637.10 c. $1,338.23 d. $5,975.33 e. $5,732.00

9. Calculate the present value of $1,000 to be received at the end of 8 years. Assume an
interest rate of 7 percent.

a. $582.00 b. $1,718.19 c. $531.82 d. $5,971.30 e. $649.37

10. 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 a discount rate of 5 percent.

a. $5,441.53 b. $4,800.00 c. $3,369.89 d. $4,060.56 e. $4,632.37

11. 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. 5.1% e. 11.2%

12. 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 percent interest rate and
semiannual compounding?

a. $1,330.47 b. $879.23 c. $654.22 d. $569.00 e. $732.67

13. A company is offering bonds which pay $100 per year indefinitely. If you require a 12
percent return on these bonds (that is, the discount rate is 12 percent) what is the value
of each bond?

a. $1,000.00 b. $962.00 c. $904.67 d. $866.67 e. $833.33

14. What is the present value (t = 0) of the following cash flows if the discount rate is 12
percent?

0 12%
1 2 3 4 5

| | | | | |
0 2,000 2,000 2,000 3,000 -4,000

a. $4,782.43 b. $4,440.50 c. $4,221.79 d. $4,041.23 e. $3,997.98

15. What is the effective annual percentage rate (EAR) of 12 percent compounded monthly?

a. 12.00% b. 12.55% c. 12.68% d. 12.75% e. 13.00%

16. 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 payable. The bank will charge a nominal 18 percent, 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) which will exactly cover her
financing costs. What nominal annual rate should she quote to her credit customers?
(Note: Interest factor tables cannot be used to solve this problem.)

a. 15.44% b. 19.56% c. 17.11% d. 18.41% e. 16.88%

17. Self-Test Problem 11 refers to a 20-year mortgage of $60,000. This is an amortized loan.
How much principal will be repaid in the second year?

a. $1,152.30 b. $1,725.70 c. $5,895.25 d. $7,047.55 e. $1,047.55

18. You have $1,000 invested in an account which pays 16 percent compounded annually. A
commission agent (called a “finder”) can locate for you an equally safe deposit which
will pay 16 percent, 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. $16.81 e. $21.13

19. The present value (t = 0) of the following cash flow stream is $11,958.20 when
discounted at 12 percent annually. What is the value of the missing t = 2 cash flow?

0 1 2 3 4
12%
| | | | |
PV = 11,958.20 2,000 ? 4,000 4,000

a. $4,000.00 b. $4,500.00 c. $5,000.00 d. $5,500.00 e. $6,000.00

20. 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 percent 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

21. 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 percent, 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

22. 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 which 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 percent 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

23. Your company is planning to borrow $500,000 on a 5-year, 7 percent, 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%

24. 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 percent, but interest will have to be paid at the end of each month, so
the bank interest rate is 14 percent, monthly compounding. Alternatively, your firm can
borrow from an insurance company at a nominal rate which would involve quarterly
compounding. What nominal quarterly rate would be equivalent to the rate charged by
the bank? (Note: Interest factor tables cannot be used to solve this problem.)

a. 12.44% b. 14.16% c. 13.55% d. 13.12% e. 12.88%

25. Assume that you have $15,000 in a bank account that pays 5 percent 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 percent 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 d. $19,559.42
b. $19,224.55 e. $20,378.82
c. $18,792.11

26. You plan to buy a new HDTV. 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 percent
interest rate; that is, the nominal rate is 15 percent, 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%

27. 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 get 24 additional annual payments. Inflation is expected to be 4
percent per year from today forward; he currently has $200,000 saved up; and he expects
to earn a return on his savings of 7 percent 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 d. $41,987.33
b. $35,709.25 e. $62,191.25
c. $54,332.88