Chapter 5 Selected Solutions; 5-4, 5-8, 5-12, 5-17, 5-25

4. Plan: Determine the EAR for each investment option.

Execute: For $1 invested in an account with 10% APR with monthly compounding you will have

So the EAR is 10.471%.

APR with annual compounding you will have
For $1 invested in an account with 10%

So the EAR is 10%.

For $1 invested in an account with 9% APR with daily compounding you will have

So the EAR is 9.416%.

Evaluate: One dollar invested at 10% APR compounded monthly will grow to $1.10471 in one
year. This is greater than the values for the other two investments and is, therefore, superior.

8. Plan: You need to convert the APR to something to be used in your formulas, and to an effective
annual rate (EAR). Remember, you need the discount rate to match the time between cash flows
when using the annuity formulas.

Execute:

(a) Since the payments will be monthly, you need to convert the APR to an effective monthly
rate. So, using Equation 5.2, we get 6% per year compounded monthly divided by 12
months per year = 0.5% per month (this is an effective monthly rate).

(b) To get the EAR, we can use Equation 5.2 followed by Equation 5.1:
Equation 5.2: 6%/12 = 0.5% per month effective
Equation 5.1: (1.005)12 = 1+EAR = 1.06167781, so EAR = 6.167781%.
Alternatively, you could have used Equation 5.3, which combines Equations 5.1 and 5.2:
(1+.06/12)12 = 1+ EAR = 1.06167781, so EAR = 6.167781%.

Evaluate: A car loan rate of 6% APR with monthly compounding costs you more than 6% per
year. It is equivalent to 0.5% per month, or 6.167781% per year (EAR).
12. Plan: Draw a timeline for the cash flows. Given that $8000 is the present value of an annuity of
payments, determine the amount of the payments.

Execute:

0 1 2 3 4 60

-8000 C C C C C

A 5.99% APR monthly implies a discount rate of

or 0.499167%.

Using the formula for computing a loan payment,

N I/Y PV PMT FV Excel Formula

8,000.0
Given: 60 0.499% 0 0
Solve for
PMT: (154.63) =PMT(0.00499166666666667,60,8000,0)

Evaluate: Your monthly payment for the motorcycle loan is $154.63.

17. Plan: Draw a timeline and compute the sums that are indicated.

Execute:
a. Timeline:
0 1 2 3 60

50,000 –C –C –C –C

First, solve for the monthly mortgage payment at 6% APR. The 6% APR implies a monthly
rate of .

N I/Y PV PMT FV Excel Formula

Given: 60 0.500% 50,000.00 0
Solve for PMT: (966.64) = PMT(0.005,60,50000,0)

Each monthly payment is $966.64. After one month, the balance (principal) of the loan will
be the PV of the 59 remaining payments.

N I/Y PV PMT FV Excel Formula

Given: 59 0.500% 966.64 0
Solve for PV: (49,283.36) =PV(0.005,59,966.64,0)

Thus, $50,000 - 49,283.36 = $716.64 is amount of the payment that went to paying the
principal, while $966.64 - 716.64 = $250 was interest.
For the second month, solve for the value of the remaining 58 payments:
 N I/Y PV PMT FV Excel Formula
966.6
Given: 58 0.500% 4 0
Solve for PV: (48,563.13) =PV(0.005,58,966.64,0)

Thus, $49,283.36 - 48,563.14 = $720.22 is amount of the payment that went to paying the
principal, while $966.64 – 720.22 = $246.42 was interest.
For the first year, solve for the value of the remaining 48 payments:

Thus, $50,000 - 41,159.84 = $8840.16 is amount of the payment that went to paying the
principal, while ($966.64  12) - 8840.416 = $2759.52 was interest.
b. At the end of year 3, there are 24 payments remaining. The balance of the loan is

At the end of year 4, there are only 12 payments remaining. The balance of the loan at the end
of the 4th year is

N I/Y PV PMT FV Excel Formula

Given: 12 0.500% 966.64 0
Solve for PV: (11,231.32) =PV(0.005,12,966.64,0)

Thus, $21,810.17 - 11,231.33 = $10,578.84 is amount of the payment that went to paying the
principal, while ($966.64  12) - 10,578.84 = $1020.84 was interest.

Evaluate: A financial analyst can determine the amount of any loan payment. The financial
analyst can also determine the outstanding amount on the loan at any time over its life.
25. Plan: Determine the principal outstanding on the old mortgage after calculating the effective
monthly rate applicable to it. Then, calculate the new payments for the new mortgage after
determining its relevant effective monthly interest rate. Then proceed to answer the parts.

a. First we calculate the outstanding balance of the mortgage. There are 25 × 12 = 300 months
remaining on the loan, so the timeline is
Timeline #1:
0 1 2 300

1,402 1,402 1,402

To determine the outstanding balance, we discount at the original rate after converting it to an
effective monthly interest rate. The 9% APR with semi-annual compounding implies an
effective semi-annual rate of 9% ÷ 2 = 4.5%. Converting the effective semi-annual rate to an
effective monthly rate, we get
(1 + 0.045)1/6  1 = 0.73631230%

Next, we calculate the loan payment on the new mortgage.

Timeline #2:
0 1 2 360

169,328.30 –C –C –C

The effective monthly discount rate on the new loan is the new loan rate:

Using the formula for the loan payment:

b.

c.
(you can use trial and error or the annuity calculator to solve for N).

d.
(Note: results may differ slightly due to rounding.)

Evaluate: Any way you look at it, this seems like a good plan. You either get to make smaller
payments or to keep some cash up front. Plus, you can live in Florida and avoid the Winnipeg
winters.