Chapter 5

Time Value of Money

„ Instructor’s Resources
Chapter Overview
This chapter introduces a key—indeed, perhaps the most important—concept in finance: the time
value of money. The present and future value of a sum and an annuity are explained. Special
applications include intra-year compounding, mixed cash-flow streams, mixed cash flows with an
embedded annuity, perpetuities, loan amortization, and deposits necessary to accumulate a future
sum. The discussion employs numerous business and personal examples to stress all applications as
variations on the same theme—sums received at different points in time are worth different amounts
to the recipient, with differences traceable to when the sums are received and how frequently interest
is compounded. The chapter drives home the need to understand the time value of money to analyze
project profitability as a finance professional and achieve personal-finance goals as an individual.

„ Suggested Answer to Opener-in-Review

A lottery winner can choose between two options: (i) $480 million now or (ii) mixed stream of 30
payments, with an immediate payment of $11.42 million and 29 additional annual payments growing
at 5% per year. [So the second payment will be $11.42 million × (1.05), the third $11.42 million ×
(1.05)2, …, and the 30th $11.42 million × (1.05)29.] If the winner could earn 2% on cash invested
today, should she take the lump sum or mixed stream? What if the rate of return is 3%? What
general principle do those calculations illustrate?
The lottery winner should choose the payment option with the higher present value. With a 2%
discount rate, the present value of the mixed stream is $538.2 million—significantly higher than
immediate payment of $480 million—so the winner should opt for the mixed-stream payment.
$11.42(1.05) $11.42(1.05) $11.42(1.05)
𝑃𝑉 = $11.42 + + + ⋯.+ = $538.2
(1.02) (1.02)  (1.02)
But with a 3% discount rate, the present value of the mixed stream is only $459.1 million—less than
the immediate payment option of $480 million. Now, the lottery winner should take the lump sum.
$11.42(1.05) $11.42(1.05) $11.42(1.05)
𝑃𝑉 = $11.42 + + + ⋯ . + = $459.1
(1.03) (1.03) (1.03)
In general, other things equal, a rise in the interest rate reduces the present value of an annuity due.

„ Answers to Review Questions

5-1 Future value (FV) is the sum an amount today will grow to equal by a future date with compound
interest. Present value (PV ) is the dollar value today of an amount promised at a specific future date for
a given interest rate. Viewed another way, it is also the amount, if invested today at the given interest

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80 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

rate, would grow to equal the future amount. Financial managers prefer evaluating projects with present
value because decisions are typically made before a project starts (i.e., time period zero).

5-2 A single amount cash flow refers to a single payment or cash receipt, occurring at one point in
time. An annuity is an unbroken series of equal cash flows occurring over multiple periods. A
mixed stream is an unequal series of cash flows that take place over multiple periods.

5-3 Compounding occurs when interest earned in the initial period is added to the original
principal and that sum grows by the interest rate in the second period, and so on. With
compounding, interest is earned not only on original principal but also on interest earned.
Assuming interest compounds once per period, the equation showing how much a sum today
(present value, or PV) will grow to equal (FVn) if compounded over (n) periods at a given
interest rate per period (r) is:
FVn = PV × (1 + r)n
5-4 A fall in the interest rate reduces the future value of a deposit for a given holding period
because of the decline in the amount of interest on which additional interest is subsequently
paid (i.e., the deposit compounds at a lower rate). A rise in the holding period for a given
interest rate increases future value because interest is paid on interest over a longer period of
time (i.e., the deposit compounds longer).

5-5. Present value (PV) is the current dollar value of a future amount (FVn)—that is, the amount
today that would grow to equal the future amount if compounded at a given interest rate (r) for
a specific number of compounding periods (n). The equation showing the present value of a
future sum (FVn) is:
PV = FVn ÷ (1 + r)n
5-6. Increasing required rate of return (discount rate) reduces the present value of a sum promised
in the future. Mathematically, a higher interest rate (r) increases the denominator in the
present-value equation in question 5-5—which for a given number of periods (n) and future
value (FV) implies a smaller value. More intuitively, with a higher interest rate (compounding
periods and future value held constant), a smaller sum would grow to the same future value.

5-7 The same equation links present and future value for a given interest rate and compounding
period; the only difference is the given information. Consider, for example, the present-value
equation in question 5.5. Now, assume present value is given, and the goal is solving for
future value. All that is needed is to multiply both sides of the equation by (1 + r)n—which
yields the future-value equation in question 5-3.

5-8 The value at retirement of a sum invested today may be obtained with the future-value
equation for a simple sum, FVn = PV × (1 + r)n, assuming FVn is value at retirement, PV the
sum invested today, n the number of periods to retirement, and r the interest rate per period.
Numerical answers will vary because values are algorithmically generated in MyFinanceLab.

5-9 The amount needed for investment today to cover future college expenses may be obtained
with present-value equation for a simple sum. Assuming, for simplicity, expenses for all four
years must be paid at the beginning of the child’s freshmen year, PV = FVn ÷ (1 + r)n, FVn is
the amount needed n periods in the future, n the number of periods in the future, and r the
interest rate per period. Specific numerical answers will vary because values are
algorithmically generated in MyFinanceLab.

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 Chapter 5 Time Value of Money 81

5-10 Annuities offer equal per-period payments for a given number of periods. Ordinary annuities
make payments at the end of each period while payments for annuities due occur at the
beginning of the period. For the same interest rate and number of payments, annuities due are
more valuable—that is, have higher present values—because each payment of an annuity due
comes one period sooner than the equivalent payment on an ordinary annuity. For example,
the first payment of an annuity due is immediate, so the future value of that payment equals its
present value. In contrast, the first payment on an ordinary annuity takes place one period in
the future, so its present value equals CF1 ÷ (1 + r).

5-11 The most efficient ways to calculate the present value of an ordinary annuity are with an
algebraic equation, a financial calculator, or a spreadsheet program like Excel.

5-12 The future value (FV) of an ordinary annuity, where CF1 is the first payment made at end of
period 1, n the number of payments, and r the interest rate, is given by:

⎪ ⎢( ) ⎥⎦ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF1 × ⎨ ⎣ ⎬
⎪ r ⎪
⎩ ⎭
The future value of an annuity due, where CF0 is the first payment made immediately (period
0), n is number of payments, and r the interest rate, is given by:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF0 × ⎨ ⎣ ⎬ × (1+ r )
⎪ r ⎪
⎩ ⎭
Assuming the same cash flows (i.e., CF0 = CF1), interest rate and number of payments, the
only difference is that each payment on the annuity due arrives one period sooner than the
payment on an ordinary annuity. In other words, each annuity-due payment earns interest one
more period than payments on an ordinary annuity. Multiplying the first two terms in the
future-value equation for an ordinary annuity (which are identical in the annuity due and
ordinary annuity equations) by (1 + r) corrects for the additional year of compounding.

5-14 A perpetuity is an infinite-lived annuity; the present value of an ordinary annuity is given by:
⎛ CF ⎞ ⎡ 1 ⎤⎥
PV0 = ⎜ 1 ⎟ × ⎢1−
⎝ r ⎠ ⎢ (1+ r )n ⎥
⎣ ⎦
where CF1 is the first payment received at the end of the first period, n is the number of
periods, and r the interest rate per period. For a perpetuity, n is infinity, so raising (1 + 𝑟) to

the infinite power makes  equal to zero, and the formula for present value simplifies to:
()
𝐶𝐹 𝐶𝐹
𝑃𝑉 =   × [1 − 0] =  
𝑟 𝑟
If the number of payments (n) goes to infinity in the equations for the future value of ordinary
annuities and annuities due (meaning the instrument is a perpetuity rather than a regular
annuity), then (1 + 𝑟) approaches infinity and future value is infinity. Intuitively, future
value of a perpetuity is infinite because cash flows never end and never stop earning interest.
The present value of a perpetuity, in contrast, is finite because present value of cash flows far
into the future is effectively zero.

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82 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

5-15 The future value (at retirement) of equal annual IRA contributions at the end of every year can
be determined using the formula for the future value of an ordinary annuity:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF1 × ⎨ ⎣ ⎬
⎪ r ⎪
⎩ ⎭
where CF1 is the equal contribution made at the end of each year, r the interest rate, and n the
number of contributions until retirement. Specific numerical answers will vary because values
are algorithmically generated in MyFinanceLab.

5-16 Specific numerical answers will vary because values are algorithmically generated in
MyFinanceLab.

5-17 The future value (at retirement) of equal annual IRA contributions at the beginning of every
year can be determined using the formula for the future value of an annuity due:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF0 × ⎨ ⎣ ⎬ × (1+ r )
⎪ r ⎪
⎩ ⎭
where CF0 is the equal contribution made at the beginning of each year, r the interest rate, and
n the number of contributions until retirement. Specific numerical answers will vary because
values are algorithmically generated in MyFinanceLab.

5-18 The future value of a mixed stream of cash flows equals the sum of the future values of the
individual cash flows—that is, each cash flow should be treated like a single payment in the
“future value of a single payment” equation [FVn = PV × (1 + r)n] and individual future values
summed. Similarly, the present value of a mixed stream of cash flows equals the sum of the
present value of each individual cash flow—that is, cash flow should be treated like a single
payment in the “present value of a single payment equation” [PV = FVn ÷ (1 + r)n] and
individual present values summed.

5-19 Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
But the general approach is to calculate the future value of each individual contribution for n
periods until graduation at per period interest rate r and sum the individual future values.

5-20 For a given interest rate and holding period, as the number of compounding periods per year
rises, both (a) future value and (b) the effective annual rate of interest (EAR) increase. Future
value and EAR rise because more frequent compounding means more periods in which
interest can be earned on interest.

5-21 Continuous compounding means interest is compounded an infinite number of times per
year—that is, every nanosecond. Continuous compounding at a given rate of interest produces
the largest future value compared with any other compounding period.

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 Chapter 5 Time Value of Money 83

5-22 The nominal annual rate is the contractual annual rate of interest charged by the lender or
promised to the borrower, while the effective annual rate is the rate actually charged or paid
after accounting for the number of compounding periods per year. When interest is
compounded annually, the two rates are the same, but when compounding occurs more
frequently, the effective annual rate exceeds the nominal annual rate. “Truth in lending” laws
require disclosure of the annual percentage rate (APR) to consumers; this rate equals the rate
of interest charged on loans in each compounding period multiplied by the number of
compounding periods each year. The APY, or annual percentage yield, is the effective rate of
interest depository institutions pay on savings products after accounting for the number of
compounding periods per year; “truth-in-savings laws” mandate disclosure of APYs.

5-23 Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
But the general principle is, other things equal, the greater the compounding frequency, the
higher the future value of investment opportunities.

5-24 Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
But the general principle is, other things equal, the effective annual rate exceeds the nominal
interest rate when interest is compounded more than once per year.

5-25. Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
In general, the effective annual rate will range from the nominal interest rate when interest is
compounded annually to a maximum (relative to the nominal rate) when compounding is
continuous.

5-26 The equal annual end-of-year deposits (CF1) needed to accumulate a given amount over a
certain number of periods (n) for a specific rate of interest per period (r) can be determined
using the equation for the future value of an ordinary annuity:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF1 × ⎨ ⎣ ⎬
⎪ r ⎪
⎩ ⎭
Here, FVn, n, and r are given; the answer may be obtained by solving for CF1.

5-27 Amortizing a loan over equal annual payments involves finding the sequence of payments
with a present value at the loan interest rate equal to the initial principal borrowed. In other
words, start with the formula for the present value of an ordinary annuity:

⎛ CF ⎞ ⎡ 1 ⎤⎥
PV0 = ⎜ 1 ⎟ × ⎢1−
⎝ r ⎠ ⎢ (1+ r )n ⎥
⎣ ⎦
Insert loan amount for PV0, n for number of payments, r for interest rate r; and solve for CF1.

5-28 If the present value, future value, and interest rate are given, and the goal is finding the
number of periods needed for a sum today to grow to the future sum, then insert given
information in the equation for future value of simple sum [FVn = PV × (1 + r)n] and solve for
n:
 
(i)    = (1 + r)n (iii) 𝑙𝑜𝑔    = 𝑛 × 𝑙𝑜𝑔(1 + 𝑟)
 

  
(ii) 𝑙𝑜𝑔   = 𝑙𝑜𝑔[(1 + 𝑟) ] (iv) 𝑛 = 
 ()

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84 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

The same approach will yield the number of periods it will take an ordinary annuity to grow to
a specific future value; the algebra is just a bit more complicated:

𝐹𝑉 × 𝑟
𝑙𝑜𝑔   + 1
𝐶𝐹
𝑛=
𝑙𝑜𝑔(1 + 𝑟)
An alternative approach is to use trial and error, plugging in various values for the number of
periods in a calculator or spreadsheet program (like Excel) with the given present value (or
cash flows), future value, and interest rate until an approximate value of n is obtained.

5-29 Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
The general approach is to treat the car payment as an annuity due (because such payments are
made at the beginning of the period), and use the present-value formula. That is, plug in given
values for present value (car price), interest rate, and number of periods; then solve for the
cash flow (CF0).

5-30 Numerical answers will vary because values are algorithmically generated in MyFinanceLab.
The approach is to treat retirement age as n months from now in the formula for future-value
of an ordinary annuity. That is, plug in given values for future value of the ordinary annuity
(FVn), monthly contribution (CF1), interest rate (r), and solve for number of months.

„ Suggested Answer to Focus on Practice Box:

“New Century Brings Trouble for Subprime Mortgages”
As a reaction to problems in the subprime area, lenders tightened lending standards. What effect do
you think this change had on the housing market?

When mortgage lenders tightened underwriting standards, fewer people qualified for home loans,
and demand for homes declined. This decline contributed the unprecedented nationwide slide in
home prices which did not bottom out until early 2012.

„ Suggested Answer to Focus on Ethics Box:

“Was the Deal for Manhattan a Swindle?
How much responsibility do lenders have to educate borrowers? The federal government requires
disclosure statements with standardized examples illustrating the time value of money; does this
change your answer?

This question is an excellent springboard to class discussion because there is no “correct” answer.
Conservative-leaning students may argue the borrower has a responsibility to educate herself—that
is, “let the buyer beware.” Progressive-leaning students might counter that poorer borrowers lack the
numeracy to offer informed consent to complex loan contracts. Irrespective of politics, recent
experience and research suggests two factors to keep in mind when thinking about lender
responsibility. First, failure to educate borrowers could come back to haunt lenders through bad
publicity and the resulting loss of customers. Second, many patrons of payday lenders understand the
high cost of their loans yet remain satisfied customers. A recent Freakonomics podcast summarizing
research on payday loans, along with interviews with payday-loan customers, may be accessed here:
http://freakonomics.com/podcast/payday-loans/.

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 Chapter 5 Time Value of Money 85

„ Answers to Warm-Up Exercises

E5-1 Future value of a lump-sum investment (LG 2)
Answer: FV = $2,500 × (1 + 0.007) = $2,517.50, or in Excel, write the bracketed formula
[=fv(0.007,1,0,-2500,0)] in a cell to obtain $2,517.50] in a cell.

E5-2 Finding future value (LG 2 and LG 5)

Answer: Because interest is compounded monthly, the number of periods is 4 (years) × 12
(months) = 48 and the monthly interest rate is 1/12th of the annual rate = 0.00166667:
FV48 = PV × (1 + r)48 where r is the monthly interest rate
FV48 = ($1,260 + $975) × (1 + 0.00166667)48 = ($2,235) × 1.083215 = $2,420.99
Or in Excel insert the bracketed formula [= fv(0.02/12,48,0,-2235,0)] in a cell.

E5-3 Comparing a lump sum with an annuity (LG 3)

Answer: Note the 25-year payout option is an ordinary annuity. So the answer turns on whether
the present value of an ordinary annuity offering $100,000 annual cash flows for 25 years
(given a 5% interest rate) is greater or less than the sum available immediately ($2.5
million). Recall, the formula for the present value of an ordinary annuity is:

⎛ CF ⎞ ⎡ 1 ⎤⎥ = $, × 1 − 
= $1,409,394.06
PV0 = ⎜ 1 ⎟ × ⎢1− (.)
⎝ r ⎠ ⎢ (1+ r ) ⎥
n .
⎣ ⎦
This problem can also be solved with a financial calculator or spreadsheet program like
Excel. In Excel, the command for the present value of an ordinary is:
=PV(interest rate, periods, -[cash flow], 0 if ordinary annuity [1 if annuity due])
=PV(0.05,25,−100000,0) = $1,409,394.06.
Gabrielle should take the 25-year payout because the present value ($1.41 million)
exceeds the lump-sum payment of $1.3 million.

E5-4 Comparing the present value of two alternatives (LG 4)

Answer: You have the option of investing a sum today in software that offers the company a
mixed stream of savings over the next five years. This option will be profitable if the
present value of the savings (marginal benefit of the investment) exceeds the current cost
(marginal cost). To find the marginal benefit, the present value of expected savings over
the 5-year life of the software must be calculated. Present value (PV) = FVn ÷ (1 + r)n,
where FVn is the cost savings in year n, n is the number of years in the future, and r the
interest rate per period (9%).
Year Savings Estimate Discount Factor (1+r)n Present Value of Savings
1 $35,000 (1.09)1 $32,110
2 50,000 (1.09)2 42,084
3 45,000 (1.09)3 34,748
4 25,000 (1.09)4 17,711
5 15,000 (1.09)5 9,749
$136,402

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86 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Because the $136,402 present value of the savings (marginal benefit) exceeds the
$130,000 cost of the software (marginal cost), the firm should invest in the new
software.

E5-5 Compounding more frequently than annually (LG 5)

Answer: The future value of $12,000 invested for one year in Partners’ Savings Bank at 3%,
compounded semi-annually (where m is compounding periods per year, and n is years, so
r/m is the interest rate per compounding period, and m × r is the number of total
compounding periods) is:
 ×
FV = PV × 1 +  = $12,000 × (1 + 3/2)2 = $12,000 + $1.030225 = $12,362.70


In Excel, the bracketed command [=FV(0.015,2,0,-12000,0)] will yield the answer.

FV of $12,000 invested one year in Selwyn’s Bank at 2.75%, compounded continuously,
is:
FV = PV × 𝑒  ×  , where the value of e is approximately 2.7183
FV = $12,000 × 𝑒 . × = $12,000 × 2.71860.0275 = $12,000 × 1.027882 =
$12,334.58
In Excel, the command for continuous compounding is the exp() function; the bracketed
formula [=$12,000*exp(0.0275) = $12,334.58] in a cell will yield the correct answer.
Joseph should choose Partners’ Savings Bank because the 3% rate with semiannual
compounding will earn him $28.12 more over the course of a year.

E5-6 Determining deposits needed to accumulate a future sum (LG 6)

Answer: Jack and Jill want to make equal, end-of-year contributions for 18 years to accumulate
$150,000 for their child’s college education. Equal, end-of-year contributions means
ordinary annuity. Specifically, plug future value ($150,000), interest rate (6%), and
period (years = 18) into the formula for the FV of an ordinary annuity and solve for CF1:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF1 × ⎨ ⎣ ⎬
⎪ r ⎪
⎩ ⎭
18
$150,000 = CF1 × [(1.06) – 1]/0.06 → CF1 = $4,853.48
This problem can also be solved with a financial calculator or spreadsheet program like
Excel. In Excel, annual contributions may be found using the PMT command.
Specifically,
= PMT(rate,nper,pv,fv,type) = PMT(0.06,18,0, −150000,0) = $4,853.48
Jack and Jill should put aside $4,853.48 each year.

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 Chaapter 5 Time V
Value of Money 87

„ Solutions to
o Problem
ms
P5-1
1 Using a tiime line (LG 1; Basic)
a, b, and c

d. Finanncial managerrs rely more on

o present valuue than futuree value becauuse their decissions
are ty
ypically made before a projject starts (i.ee., at time zeroo).

P5-2
2 Future va
alue calculatio
on (LG 2; Ba
asic)
To find fu
uture value in
n each case, pllug $1 for PV
V as well as thhe given interest rates (r) aand
compound ( into FVn = PV × (1 + rr)n.
ding periods (n)
Case
A: FV2 = $1 × (1 + 0.12)2 = $1..2544 or in Exxcel: =fv(0.122,2,0,-1,0) = $1.2544
B: FV3 = $1 × (1 + 0.06)3 = $1..1910 or in Exxcel: =fv(0.066,3,0,-1,0) = $1.1910
C: FV2 = $1 × (1 + 0.09)2 = $1..1881 or in Exxcel: =fv(0.099,2,0,-1,0) = $1.1881
D: FV4 = $1 × (1 + 0.03)4 = $1..1255 or in Exxcel: =fv(0.033,4,0,-1,0) = $1.1255

P5-3 Future va
alue (LG 1; Basic)
B
With commpound interest: FVn = PV × (1 + r)n = $$100 × (1 + 00.05)10 =$1622.89, or in Exxcel
the brackeeted formula [=fv(0.05,10,,0,-100,0) = $$162.89]. Witth simple inteerest, 5% wouuld be
earned on
n the original principal
p each
h year; no intterest would bbe earned on pprior interest
earned. So $5 × 10 yearss) = $150.
o, FV (simplee) = $100 + ($

P5-4 Future va
alues (LG 2; Intermediate
I e)
Case
A: FV20 = $200 × (1 + 0.05)20 = $5
530.66; in Exxcel: =fv(0.055,20,0,-200,0)) = $530.66
B: FV7 = $4,500 × (11 + 0.08)7 = $7,712.21;
$ in Excel: =fv(00.08,7,0,-45000,0) = $7,712.21
10
C: FV10 = $10,000 × (1
( + 0.09) = $23,673.64;; in Excel: =fv fv(0.09,10,0,-10000,0) = $223,673.64
( + 0.10)12 = $78,460.71 ; in Excel: =ffv(0.10,12,0,--25000,0) = $78,460.71
D: FV12 = $25,000 × (1
( + 0.11)5 = $62,347.15. In Excel: =fvv(0.11,5,0,-377000,0) = $622,347.15
E: FV5 = $37,000 × (1
( + 0.12)9 = $110,923.155. In Excel: =ffv(0.12,9,0,-440000,0) = $1110,923.15
F: FV9 = $40,000 × (1

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88 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P5-5 Personal finance problem: Compounding (LG 2; Intermediate)

a. (1) FV3 = $1,500 × (1 + 0.03)3 = $1,837.56. In Excel: =fv(0.03,3,0,-1500,0) = $1,837.56
(2) FV6 = $1,500 × (1 + 0.03)6 = $2,251.10. In Excel: =fv(0.03,6,0,-1500,0) = $2,251.10
(3) FV6 = $1,500 × (1 + 0.03)9 = $2,757.69. In Excel: =fv(0.03,9,0,-1500,0) = $2,757.69
b. (1) Interest earned, years 1 through 3 = FV3 − PV0 = $1,837.56 − $1,500 = $337.56

(2) Interest earned, years 4 through 6 = FV6 – FV3= $2,251.10 − $1,837.56 = $413.53

(3) Interest earned, years 7 through 9 = FV9 –FV6 = $2,757.69 − $2,251.10 = $506.59

c. The amount of interest earned in the second three-year period ($413.53) exceeds the
amount earned in the first ($337.56), and interest earned in the third three-year period
($506.59) exceeds interest earned in the second. Interest earned in each subsequent
three-year period rises because of compounding. That is, in each three-year period,
interest is earned on prior interest paid, and the greater the interest earned in prior
periods, the greater the impact of compounding.

P5-6 Personal finance: Time value (LG 2; Challenge)

a. To find car price in five years with 2% inflation, use future-value equation with PV =
$14,000, r = 2% and solve for FV5 [$14,000 × (1 + 0.02)5 = $15,457.13]. To find price
with 4% inflation, change r to 4% and re-solve [$14,000 × (1 + 0.04)5 = $17,033.14].
b. The car will cost $1,576.01 more with a 4% inflation rate than an inflation rate of 2% –
an increase of 10.2% ($1,576 ÷ $15,457).
c. Again, use the future-value equation for both steps. Specifically, for the first two years:
FV2 = $14,000 × (1 + 0.02)2 = $14,565.60
Now, use FV2 as present value: FV5 = $14,565.60 × (1 + 0.04)3 = $16,384.32

P5-7 Personal finance: Time value (LG 2; Challenge)

To find the future value of $10,000 today, invested at 9% annual interest for 40 years:
FV40 = $10,000 × (1 + 0.09)40 = $314,094.20 or =fv(0.09,40,0,-10000,0) = $314,094.20
With 10 fewer years to compound:
FV30 = $10,000 × (1 + 0.09)30 = $132,676.78 or =fv(0.09,30,0,-10000,0) = $132,676.78
Investing now rather than waiting 10 years will yield $181,417 more ($314,094 − $132,677).
The difference is the magic of compounding (i.e., earning interest on interest).

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 Chapter 5 Time Value of Money 89

P5-8 Personal finance: Time value (LG 2; Challenge)

The problem asks students to use a financial calculator or Excel spreadsheet to obtain
approximations. Exact answers are offered below. Using the future-value framework (5
years, $15,000 = FV5), solve for r with the various starting present values.
a. FVn = PV × (1 + r)n

(i) $15,000 = $10,200 × (1 + r)5 (iii) $1.4706 − 1 = r
(ii) 1.4706 = (1 + r)5 (iv) r = 8.02%
b. FVn = PV × (1 + r)n

(i) $15,000 = $8,150 × (1 + r)5 (iii) √1.8405 − 1 = r
(ii) 1.8405 = (1 + r)5 (iv) r = 12.98%
c. FVn = PV × (1 + r)n

(i) $15,000 = $7,150 × (1 + r)5 (iii) √1.5797 − 1 = r
(ii) 2.0979 = (1 + r)5 (iv) r = 15.97%

P5-9 Personal finance: Single-payment loan repayment (LG 2; Intermediate)

To find the amount that must be repaid, use the future-value framework with $200 as the
present value, 8.5% the interest rate, and various values for n.
a. In one year: FVn = PV × (1 + r)n = $200× (1 + 0.085) = $217.00
b. In four years: FVn = PV × (1 + r)n = $200× (1 + 0.085)4 = $277.17
c. In eight years: FVn = PV × (1 + r)n = $200× (1 + 0.085)8 = $384.12

P5-10 Present value calculation (LG 2; Basic)

In all cases, solve for present value using the present-value equation: PV = FVn ÷ (1 + r)n
Case
A PV = $1 ÷ (1 + 0.02)4= $0.9238 or in Excel: =pv(0.02,4,0,-1,0) = $0.9238
B PV = $1 ÷ (1 + 0.10)2 = $0.8264 or in Excel: =pv(0.10,2,0,-1,0) = $0.8264
C PV = $1 ÷ (1 + 0.05)3 = $0.8638 or in Excel: =pv(0.05,3,0,-1,0) = $0.8638
D PV = $1 ÷ (1 + 0.13)2 = $0.7831 or in Excel: =pv(0.13,2,0,-1,0) = $0.7831

P5-11 Present values (LG 2; Basic)

Case
A: PV = $7,000 ÷ (1 + 0.12)4 = $4,448.63; in Excel: =pv(0.12,4,0,-7000,0) = $4,448.63
B: PV = $28,000 ÷ (1 + 0.08)20 = $6,007.35; in Excel: =pv(0.08,20,0,-28000,0) = $6,007.35
C: PV = $10,000 ÷ (1 + 0.14)12 = $2,075.59; in Excel: =pv(0.14,12,0,-10000,0) = $2,075.59
D: PV = $150,000 ÷ (1 + 0.11)6 = $80,196.13; in Excel: =pv(0.11,6,0,-150000,0) = $80,196.13
E PV = $45,000 ÷ (1 + 0.20)8 = $10,465.56; in Excel: =pv(0.20,8,0,-45000,0) = $10,465.56

P5-12 Present value concept (LG 2; Intermediate)

a. PV = FVn ÷ (1 + r)n = $6,000 ÷ (1 + 0.12)6 = $3,039.79
b. PV = FVn ÷ (1 + r)n = $6,000 ÷ (1 + 0.12)6 = $3,039.79
c. PV = FVn ÷ (1 + r)n = $6,000 ÷ (1 + 0.12)6 = $3,039.79
d. The same question is asked in three different ways, so the answer is the same each time.

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90 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

P5-13 Personal finance: Time Value (LG 2; Basic)

a. PV = FVn ÷ (1 + r)n = $500 ÷ (1 + 0.07)3 = $408.15
b. Jim should pay no more than $408.15 for $500 in three years if his discount rate is 7%.
c. If Jim pays less than $408.15, his rate of return will exceed 7%.

P5-14 Time value: Present value of a lump sum (LG 2; Intermediate)

The state will sell bonds at a price equal to present value of cash flows. The bond can be
converted to $100 in 6 years, and comparable bonds offer 3% compounded annually. So:
PV = FVn ÷ (1 + r)n = $100 ÷ (1 + 0.03)6 = $83.75; in Excel: =pv(0.03,6,0,-100,0)

P5-15 Personal finance: Time value and discount rates LG 2; Intermediate

a. (1) PV = FVn ÷ (1 + r)n = $1,000,000 ÷ (1 + 0.06)10 = $558,394.78
(2) PV = $1,000,000 ÷ (1 + 0.09)10 = $422,410.81
(3) PV = $1,000,000 ÷ (1 + 0.12)10 = $321,973.24
b. (1) PV = FVn ÷ (1 + r)n = $1,000,000 ÷ (1 + 0.06)15 = $417,265.06
(2) PV = $1,000,000 ÷ (1 + 0.09)15 = $274,538.04
(3) PV = $1,000,000 ÷ (1 + 0.12)15 = $182,696.26
c. As the discount rate increases, present value decreases because of the higher opportunity
cost associated with the higher rate. Moreover, the longer the time until the lottery
payment is collected, the lower the present value because of the longer opportunity for
compounding. More generally, the larger the discount rate and number of periods until
the money is received, the lower the present value of a future payment.

P5-16 Personal finance: Time value comparisons of single amounts (LG 2; Intermediate)
a. (A) PV = FVn ÷ (1 + r)n = $28,500 ÷ (1 + 0.09)3 = $22,007.22
(B) PV = $54,000 ÷ (1 + 0.09)9 = $24,863.10
(C) PV = $160,000 ÷ (1 + 0.09)20 = $28,548.94
b. The benchmark for an acceptable alternative is $23,000, what you would have to pay
today to undertake it. Alternatives (B) and (C) have present values exceeding $23,000
(i.e., marginal benefits exceeding marginal cost) and should, therefore, be undertaken.
c. Although alternatives (B) and (C) are both attractive, (C) is the most attractive if only
one can be chosen because it has the highest present value. Put another way, for the
same marginal cost, alternative (C) offers the greater marginal benefit.

P5-17 Personal finance: Cash flow investment decision (LG 2; Intermediate)

The general approach is to determine the present value of each investment and then compare
that present value to the purchase price. All investments with present values exceeding price
should be purchased. As always, the formula for present value is PV = FVn ÷ (1 + r)n.
(A) PV = $28,500 ÷ (1 + 0.09)3 = $18,627.64. Price = $18,000. Decision: Purchase
(B) PV = $600 ÷ (1 + 0.09)20 = $445.93. Price = $600. Decision: Do not purchase
3
(C) PV = $3,500 ÷ (1 + 0.09) = $3,855.43. Price = $3,500. Decision: Purchase
(D) PV = $1,000 ÷ (1 + 0.09)40 = $331.42. Price $1,000. Decision: Do not purchase

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 Chapter 5 Time Value of Money 91

If limited to one investment, Tom should purchase option A because marginal benefits
exceed price by $627.644 while marginal benefits for option B exceed price by $355.43.

P5-18 Calculating deposit needed (LG 2; Challenge)

Step 1: Determine future value of initial deposit at the end of the 7 years.
FVn = PV × (1 + r)n = $10,000 × (1 + 0.05)7 = $14,071
Step 2: Determine future value of second deposit
$20,000 − $14,071 = $5,929
Step 3: Calculate the present value of second deposit at the end of year 3 (i.e., actual amount
deposited at that time):
PV = $5,929 ÷ (1 + 0.05)4 = $4,877.80
It might help to see the underlying algebra for this solution. The two payments have
a future value of $20,000. The first earns 5% interest for 7 years, and the second
earns 5% for 4 years. To solve for the missing payment:
$20,000 = $10,000 × (1.05) + $𝑋 × (1.05)
$20,000 = $14,071 + $𝑋 × (1.05)
$5,929 ÷ (1.05) = 𝑋
In the last equation, $5,929 is future value of the missing payment, and X is the
present value of the missing payment.

P5-19 Future value of an annuity (LG 3; Intermediate)

a. The future value of an ordinary annuity is given by:

⎪ ⎢( ) ⎦⎥ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF1 × ⎨ ⎣ ⎬
⎪ r ⎪
⎩ ⎭
where CF1 is the equal end-of-period payments, r the interest rate, and n the number of
periods.
Case
A FV10 = $2,500 × {[(1 + 0.08)10 − 1] ÷ 0.08}= $36,216.41
B FV6 = $500 × {[(1 + 0.12)6 − 1] ÷ 0.12}= $4,057.59
C FV5 = $30,000 × {[(1 + 0.20)5 − 1] ÷ 0.20}= $223,248.00
D FV8 = $11,500 × {[(1 + 0.09)8 − 1] ÷ 0.09}= $126,827.45
E FV30 = $6,000 × {[(1 + 0.14)30 − 1] ÷ 0.14}= $2,140,721.08
Future value of an ordinary annuity may also be found with a financial calculator or
spreadsheet program like Excel. In Excel, command format is FV(r, n, -CF1,0,0)
where the final “0” inside the parentheses indicates ordinary annuity (1 = annuity
due). For case A above, the specific Excel entry is: =FV(0.08,10,-2500,0,0)
The future value of an annuity due is given by:

⎪ ⎢( ) ⎥⎦ ⎪
⎧ ⎡ 1+ r n − 1⎤ ⎫
FVn = CF0 × ⎨ ⎣ ⎬ × (1+ r )
⎪ r ⎪
⎩ ⎭

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92 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

where CF0 is the equal beginning-of-period payments, r the interest rate, and n the
number of periods.
Case
A FV10 = $2,500 × {[(1 + 0.08)10 − 1] ÷ 0.08}× (1 + 0.08) = $39,113.72
B FV6 = $500 × {[(1 + 0.12)6 − 1] ÷ 0.12}= $4,544.51
C FV5 = $30,000 × {[(1 + 0.20)5 − 1] ÷ 0.20}= $267,897.60
D FV8 = $11,500 × {[(1 + 0.09)8 − 1] ÷ 0.09}= $138,241.92
E FV30 = $6,000 × {[(1 + 0.14)30 − 1] ÷ 0.14}= $2,440,422.03
Again, future value of an annuity due may be found with a financial calculator or
spreadsheet program like Excel. In Excel, command format is FV(r, n, -CF1,0,1) where
the final “1” inside the parentheses indicates annuity due. For case A above, the
following would be entered in a cell: =FV(0.08,10,-2500,0,1)
b. The annuity due has a greater future value in each case. By making deposits at the
beginning rather than the end of the year, each cash flow enjoys one additional year of
compounding.

P5-20 Present value of an annuity (LG 3; Intermediate)

a. Using the formula for present value of an ordinary annuity:

⎛ CF ⎞ ⎡ 1 ⎤⎥
PV0 = ⎜ 1 ⎟ × ⎢1−
⎝ r ⎠ ⎢ (1+ r ) n ⎥
⎣ ⎦
where CF1 is the equal end-of-period payments, n the number of periods, and r the
interest rate per period.
Case
A PV3 = ($12,000 ÷ 0.07) × [1 − (1 + 0.07)-3] = $31,491.79
B PV15 = ($55,000 ÷ 0.12) × {1 − (1 + 0.12)-15] = $374,597.55
C PV9 = ($700 ÷ 0.20) × [1 − (1 + 0.20)-9] = $2,821.68
D PV7 = ($140,000 ÷ 0.05) × [1 − (1 + 0.05)-7]= $810,092.28
E PV5 = ($22,500 ÷ 0.10) × [1 − (1 + 0.10)-5] = $85,292.70
Present value of an ordinary annuity may also be in Excel using the bracketed formula
[=PV(r, n, -CF1,0,0)], where the final “0” inside the parentheses denotes ordinary
annuity (1 = annuity due). For case A above, the specific cell for the present value of the
ordinary annuity is: =PV(0.07, 3, -12000,0,0)
The present value of an annuity due is given by:

⎛ CF ⎞ ⎡ 1 ⎤⎥
PV0 = ⎜ 0 ⎟ × ⎢1− × (1+ r )
⎝ r ⎠ ⎢ (1+ r )n ⎥
⎣ ⎦
where CF0 is the equal beginning-of-period payments, r the interest rate, and n the
number of periods.

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 Chapter 5 Time Value of Money 93

Case
A PV3 = ($12,000 ÷ 0.07) × [1 − (1 + 0.07)-3] × (1 + 0.07) = $33,696.22
B PV15 = ($55,000 ÷ 0.12) × {1 − (1 + 0.12)-15] × (1 + 0.12) = $419,549.25
C PV9 = ($700 ÷ 0.20) × [1 − (1 + 0.20)-9] × (1 + 0.20) = $3,386.01
D PV7 = ($140,000 ÷ 0.05) × [1 − (1 + 0.05)-7] × (1 + 0.05) = $850,596.89
E PV5 = ($22,500 ÷ 0.10) × [1 − (1 + 0.10)-5] × (1 + 0.10) = $93,821.97
Present value of an annuity due may be in Excel with the bracketed formula
[=PV(r, n, -CF0,0,1)], where the final “1” inside the parentheses denotes annuity due.
For case A above, the specific cell entry to obtain PV is: =PV(0.07, 3, -12000,0,1)
b. The annuity due has the greater present value in each case. By making deposits at the
beginning rather than the end of the year, each cash flow is discounted one less year.

P5-21 Personal finance: Time value—annuities (LG 3; Challenge)

a. The future value of the ordinary annuity is $32,951.99 when the interest rate is 6% and
$39,843.56 when the interest rate is 10%. The future value of the annuity due is
$32,134.78 when the interest rate is 6% and $40,321.68 when the interest rate is 10%.
b. When the interest rate is 6%, the ordinary annuity has a higher future value, but when
the interest rate is 10%, the annuity due has the higher future value.
c. The present value of the ordinary annuity is $18,400.22 when the interest rate is 6% and
$15,361.42 when the interest rate is 10%. The present value of the annuity due is
$17,943.89 when the interest rate is 6% and $15,545.75 when the interest rate is 10%.
d. At 6% the ordinary annuity has a higher present value, but at 10% the annuity due has
the higher present value.
e. Ignoring the time value of money, the ordinary annuity pays out more cash ($25,000 vs.
$23,000 for the annuity due), but Marian receives the cash at the end of the year. When
interest rates are low, the penalty for waiting longer is not very high, so the ordinary
annuity is more desirable. As interest rates rise, however, collecting cash faster becomes
more important until at some point the annuity due becomes more valuable. Even though
it offers less total cash, it pays that cash faster.

P5-22 Personal finance: Retirement planning (LG 3; Challenge)

a. The correct framework is the future value of an ordinary annuity. Specifically, FV with
end-of-year $2,000 contributions, an interest rate of 10% and 40 years to retirement, is
$885,185.11.
b. If contributions begin 10 years later (i.e., are made for thirty years), but all other
information remains the same, future value falls to $328,988.05.
c. The opportunity cost of delaying deposits for 10 years is the difference in future values
in parts (a) and (b), or $556,197. This large difference is traceable to two factors: (i) 10
years of lost deposits and (ii) 10 years of lost compound interest.
d. The correct framework is the future value of an annuity due. Specifically, future value of
an annuity due—given annual end-of-year contributions of $2,000, an interest rate of
10% and 40 years to retirement, is $973,703.62. If contributions begin 10 years later
(i.e., are made for 30 years), but all other information remains the same, future value
falls to $361,886.85. The opportunity cost of delaying deposits for 10 years is the
difference in future values, $611,816.77.

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P5-23 Personal finance: Value of a retirement annuity (LG 3; Intermediate)

The correct framework is present value of an ordinary annuity, with $12,000 payments for
25 years and an interest rate of 9%. This PV ($117,870.96) is the maximum you should pay
for the annuity.

P5-24 Personal finance: Funding your retirement (LG 2, 3; Challenge)

a. At age 65, Emily will be one year away from making the first of 25, $50,000 annual
withdrawals (i.e., she will take out $50,000 each birthday from age 66 to age 90).
Imagine today is Emily’s 65th birthday, and she expects the 25-year annuity to begin in
one year. The present value of that ordinary annuity (on Emily’s 65th birthday) is
$421,087.23. This value can be obtained using Equation 5.4 in the text where CF1 =
$50,000, n = 25, and r = 11%, or with the PV function in Excel with the syntax
PV(0.11,25,-50000,0,0). Now, to find out how much Emily should invest now at an
interest rate of 11%, so she will have $421,087.23 in 20 years, plug FV20 = $421,087.23,
r = 11%, and n = 20 into Equation 5.2 in the text (i.e. PV = $421,087.23 ÷ (1.11)20) or
use the PV function in Excel with the syntax PV(0.11,20,0,421087.32,0). Emily must
invest $52,229.09 to accumulate the funds necessary to pay the $50,000 annuity.
b. The approach is the same as in part (a) except the present value of the 25-year, $50,000
annuity on Emily’s 65th birthday is calculated with a discount rate of 8% rather than
11%. Now, present value is $533,738.81—a much larger than in part (a) because Emily
will need more money at age 65 if the rate of return after retirement is lower. To
accumulate this higher sum over the next 20 years given a discount rate of 11%, Emily
must invest $66,201.71 today [PV = $533,738.81 ÷ (1.11)20]—nearly $14,000 more
today than if she earned 11% to age 90.
c. In part (b) Emily needs to invest $66,201.71 today to reach her retirement-income goals.
If she deposits $75,000 instead, the difference ($8,798.29) will compound at 11% for 20
years then at 8% for 25 more years. Over the first 20 years, the $8,798.42 will reach a
value of $70,934.56 [FV20 = $8,798.29 × (1.11)20]. Over the next 25 years, $70,934.56
will earn 8% to reach a value of $485,793.57 [FV20 = $70,934.56 × (1.08)25].
Correct answers may be obtained another way. Consider part (b). Suppose Emily
deposits $75,000 today at 11% to reach a value of $604,673.36 in 20 years [FV =
$75,000 × (1.11)20]. Now, at age 65 she must purchase an ordinary annuity paying
$50,000 per year for 25 years given an interest rate of 8%. At that point, the price of the
annuity (which equals the present value) will equal $533,781.81. After purchasing the
annuity, Emily will have $70,934.55 remaining ($604,673.36 − $533,781.81). Now, she
can invest this remainder at 8% for 25 years to reach a final value at age 90 of
$485,793.51.

P5-25 Personal finance: Value of an annuity vs. a single amount (LG 2 and LG 3;
Intermediate)
a. n = 25, r = 5%, PMT = $40,000; solve for PV = $563,757.78. Take the annuity because
its present value exceeds the lump sum by $63,757.58.
b. n = 25, r = 7%, PMT = $40,000; solve for PV = $466,143.33. Take the lump sum
because it exceeds the present value of the annuity by $33,856.67.

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 Chapter 5 Time Value of Money 95

c. View this problem as a $500,000 investment offering a 25-year annuity of $40,000, and
determine the discount rate necessary to make the present value of the annuity equal
$500,000. The discount rate equating the two sums is 6.24%. This may be obtained by
solving for r, given n = 25, PV = $500,000, PMT = $40,000. In Excel, use RATE
function with the bracketed syntax [=rate(periods, -(annuity),present value,0,0)].
Specifically, [= rate (25,-40000,500000,0,0)].

P5-26 Perpetuities (LG 3; Basic)

Case Equation Present Value
A $20,000 ÷ 0.08 $250,000
B $100,000 ÷ 0.10 $1,00,000
C $3,000 ÷ 0.06 $50,000
D $60,000 ÷ 0.05 $1,200,000

P5-27 Perpetuities (LG 3; Intermediate)

a. The present value of the perpetuity is $100 ÷ 0.07 = $1,428.57. To see this is the correct answer,
suppose you invested $1,428.57 invested in an account right now paying 7% interest. If you
withdrew the interest each year, you would have $1,428.57 × 7% = $100.
b. This problem is identical to part (a) except here you also get $100 immediately. If the stream in
part (a) is worth $1,428.57, then the part (b) stream is worth $100 more or $1,528.57.
c. This situation is the same as part (a) except here you must wait 2 additional years before the $100
payments begin. The perpetuity in part (a) is worth $1,428.57; to obtain the present value of this
amount in two years, then simply discount this amount by 2 years. PV = $1,428.57 ÷ (1.07)2 =
$1,247.77. Again it is easy to verify this answer is correct. Suppose you have $1,247.77 in an
account right now paying 7%. If that grows at 7% for two years, then by January 1, 2021 you
have FV = $1,247.77 × 1.072 = $1,428.57.

P5-28 Perpetuities (LG 3; Intermediate)

a. Present value is $75 ÷ 1.10 = $68.18.
b. In 100 years, the payment will be $75 × 1.0499 = $3,642.18. The present value of this payment
will be $3,642.18 ÷ 1.10100 = $0.26.
c. Using Equation 5.8 in the text, the present value of a perpetuity initially paying $75 but growing
by 4% per year thereafter, and a discount rate of 10% is PV = $75 ÷ (0.10 − 0.04) = $1,250.
d. Payments further in the future have a lower present value, with present value going to zero as the
number of periods goes to infinity. Because the present value of payments after a point way into
the future is zero, the sum of the present values of all future payments is finite.

P5-29 Personal finance: Creating an Endowment (LG 4; Intermediate)

a. Cost next year = $600 × (1.02) = $612.
b. The present value of an annuity paying $612 initially but growing at 2% per year with a
discount rate of 6% is $612 ÷ (0.06 − 0.02) = $15,300.
c. The present value of an annuity paying $612 initially but growing at 2% per year with a
discount rate of 9% is $612 ÷ (0.09 − 0.02) = $8,742.86.

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P5-30 Value of a mixed stream (LG 4; Challenge)

a.
Stream Year Compounding Years Cash flow Interest Rate Future Value
1 2 $ 900 12% $ 1,128.96
A 2 1 1,000 12% 1,120.00
3 0 1,200 12% 1,200.00
Sum = $ 3,448.96
Stream Year Compounding Years Cash flow Interest Rate Future Value
1 4 $30,000 12% $ 47,205.58
2 3 25,000 12% 35,123.20
B 3 2 20,000 12% 25,088.00
4 1 10,000 12% 11,200.00
5 0 5,000 12% 5,000.00
Sum = $123,616.78
Stream Year Compounding Years Cash flow Interest Rate Future Value
1 3 $ 1,200 12% $1,685.91
C 2 2 1,200 12% 1,505.28
3 1 1,000 12% 1,120.00
4 0 1,900 12% 1,900.00
Sum = $ 6,211.19
b. If payments are made at the beginning of each period, the present value of each end-of-
period cash flow should be multiplied by (1 + r) to obtain present values for beginning-of-
period cash flows. So, A: $3,448.96 (1 + 0.12) = $3,862.84, B: $123,616.78 (1 + 0.12) =
$138,450.79, and C: $6,211.19 (1 + 0.12) = $6,956.53.

P5-31 Value of a single amount versus mixed stream (LG 4; Challenge)

If Gina takes $24,000 and leaves it in account earning 7% for five years, she will have
$33,661.24 (PV = $24,000, n = 5, and r = 0.07) for her home. The future value of the mixed
stream is:
Time Compounding Years Cash Flow
Interest Rate Future Value
0 5 $ 2,000 7% $ 2,805.10
1 4 $ 4,000 7% $ 5,243.18
2 3 $ 6,000 7% $ 7,350.26
3 2 $ 8,000 7% $ 9,159.20
4 1 $10,000 7% $10,700.00
Total = $35,257.75
Gina should take the mixed-stream the stream of payments because its future value will be
$1,596.51 than the lump-sum payment.

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P5-32 Value of mixed streams (LG 4; Basic)

Project A: Interpret the negative cash flow as a payment made rather than one received;
discount it as you would a positive value. Cash flows are received/paid at year
end, so the $2,000 payment made should be discounted back one period, the
$3,000 payment made discounted back two periods, and so on. Given cash flows
of CF1 = −$2,000, CF2 = $3,000, CF3 = $4,000, CF4 = $6,000, CF5 = $8,000 and
an interest rate (r) of 12%, present value = $11,805.51.
Project B: Given end-of-year cash flows of CF1 = $10,000, CF2 = $5,000, F2 = 4, CF3 =
$7,000 and an interest rate of 12%, present value = $26,034.58.
Project C: Treat this mixed stream as two ordinary annuities—the first paying $10,000 for 5
years with an interest rate of 12% and present value of $36,047.76 and the second
paying $8,000 for 5 years with an interest rate of 12%, and present value of
$28,838.21. The second annuity does not begin until the end of year six, so
$28,838.21 is present value in six years. To obtain the total present value of the
mixed stream, $28,838.21 must first be discounted to current dollars before
adding the present value of the first annuity. Discounting the second annuity s
yields $16,363.57. So, present value of the two annuities together –the present
value of the 10-year mixed stream—is $52,411.34.

P5-33 Present value: Mixed streams (LG 4; Intermediate)

a. The present value of stream A with cash flows of CF0 = −$50,000 (i.e., a $50,000
payment is made immediately), CF1 = $40,000 (i.e., a $40,000 payment is received at the
end of year one), CF2 = $30,000, CF3 = $20,000, CF4 = $10,000 and an interest rate of
5% = $40,809.90. The present value of stream B with cash flows of CF0 = $10,000 (i.e.,
a $10,000 payment is received immediately), CF1 = $20,000, CF2 = $30,000, CF3 =
$40,000, CF4 = −$50,000 (i.e., a $50,000 payment is made at the end of year 4) and an
interest rate of 5% = $49,676.88.
b. Both streams pay $50,000, but stream A has a large negative cash outflow right away
whereas stream B’s large negative cash outflow occurs 4 years later. Because money
today is more valuable than money in the future, the cash-flow stream that delays the
large outflow (i.e., stream B) will generally be more valuable. The two streams will have
the same present value if the discount rate is 0%, which means money today and money
tomorrow have the same value. With a 0% discount rate, it does not matter when the
$50,000 outflow occurs.

P5-34 Value of a mixed stream (LG 1 and LG 4; Intermediate)

a.

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98 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

b.
Year Cash Flow Interest Rate Present Value
1 $30,000 12% $ 26,785.71
2 $25,000 12% $ 19,929.85
3 $15,000 12% $ 10,676.70
4 $15,000 12% $ 9,532.77
5 $15,000 12% $ 8,511.40
6 $15,000 12% $ 7,599.47
7 $15,000 12% $ 6,785.24
8 $15,000 12% $ 6,058.25
9 $15,000 12% $ 5,409.15
10 $10,000 12% $ 3,219.73
Total = $ 104,508.28
c. Harte should still accept the offer of a 10-year mixed stream because its present value of
that mixed stream exceeds the $100,000 immediate payment.

P5-35 Value of a mixed stream (LG 1 and LG 4; Intermediate)

a.
Year
0 1 2 3 4 5 6

-$10 million $4 million $4 million $4 million $4 million $4 million -$22 million

b. Total undiscounted cash flow is −$10 million. At first glance, this project seems
unattractive, but the large cash outflow of $22 million comes six years in the future, and
a high discount rate could make its present value relatively low. In other words, total
present value for the project might be positive if the cost of capital is sufficiently.
c. Project present value with a 5% discount rate is −$9.10 million, which means the project
is unattractive. At 10%, PV is −$7.26, still unattractive but not as much so as at the
lower rate. This suggests PV could become positive at a sufficiently high discount rate.
Note to Instructors: The text contains a typo; year 1 outflow was to be $1 million. With
this lower outflow, present value is −$98,832.04 at a 5% discount rate and
$1,744,720.62 at 10%. These numbers illustrate the key idea: future outflows have small
present values if payment is sufficiently distant or the discount rate sufficiently high.

P5-36 Relationship between future value and present value-mixed stream

(LG 4; Intermediate)
a. The present value of end-of-year cash flows CF1 = $800, CF2 = $900, CF3 = $1,000, CF4
= $1,500, CF5 = $2,000 with a 5% discount rate of 5% is $5,243.17.
b. FV = $5,243.17 × (1 + 0.05)5 = $6,691.76.
c. Future value is $6,691.77, apart for rounding error the same as in part (b). The point here
is the three ways of obtaining equivalent value: (i) taking the mixed stream as received,
(ii) taking $5,243.17 today, or (iii) taking $6,691.76 in 5 years.
d. The appropriate price for the mixed stream is its present value ($5,243.17).

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 Chapter 5 Time Value of Money 99

P5-37 Relationship between future value and present value (LG 4; Intermediate)
Step 1: Calculate present value of known cash flows:
Year CFt PV @ 4%
1 $10,000 $9,615.38
2 $5,000 $4,622.78
3 ?
4 $20,000 $17,096.08
5 $3,000 $ 2,465.78
Total = $33,800.02
Step 2: Subtract present values for years 1, 2, 4, and 5 from present value of entire stream:
$32,911.03 − $33,800.02 = −$888.99.
Step 3: Calculate value in 3 years of Step 2 value today: The future value of −$888.99,
compounding for 3 years at 4% is −$999.99

P5-38 Changing compounding frequency (LG 5; Intermediate)

Future value with different compounding frequencies:
(1) Annual Semiannual
n = 5, r = 12%, PV = $5,000 n = 5 × 2 = 10, r = 12% ÷ 2 = 6%, PV = $5,000
Solve for FV = $8,811.71 Solve for FV = $8,954.24
Quarterly
n = 5 × 4 = 20 periods, r = 12% ÷ 4 = 3%, PV = $5,000. Solve for FV = $9,030.56
(2) Annual Semiannual
n = 6, r = 16%, PV = $5,000 n = 6 × 2 = 12, r = 16% ÷ 2 = 8%, PV = $5,000
Solve for FV = $12,181.98 Solve for FV = $12,590.85
Quarterly
n = 6 × 4 = 24 periods, r = 16% ÷ 4 = 4%, PV = $5,000. Solve for FV = $12,816.52
(3) Annual Semiannual
n = 10, r = 20%, PV = $5,000 n = 10 × 2 = 20, r = 20% ÷ 2 = 10%, PV =
$5,000
Solve for FV = $30,958.68 Solve for FV = $33,637.50
Quarterly
n = 10 × 4 = 40 periods, r = 20% ÷ 4 = 5%, PV = $5,000. Solve for FV = $35,199.94
Effective interest rate: reff = (1 + r/m)m – 1
(1) Annual Semiannual Quarterly
reff = (1 + 0.12/1)1 – 1 reff = (1 + 12/2)2 – 1 reff = (1 + 12/4)4 – 1
reff = (1.12)1 – 1 reff = (1.06)2 – 1 reff = (1.03)4 – 1
reff = (1.12) – 1 reff = (1.124) – 1 reff = (1.126) – 1
reff = 0.12 = 12% reff = 0.124 = 12.4% reff = 0.126 = 12.6%

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100 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

(2) Annual Semiannual Quarterly

reff = (1 + 0.16/1)1 – 1 reff = (1 + 0.16/2)2 – 1 reff = (1 + 0.16/4)4 – 1
reff = (1.16)1 – 1 reff = (1.08)2 – 1 reff = (1.04)4 − 1
reff = (1.16) – 1 reff = (1.166) – 1 reff = (1.170) − 1
reff = 0.16 = 16% reff = 0.166 = 16.6% reff = 0.170 = 17%
(3) Annual Semiannual Quarterly
reff = (1 + 0.20/1)1 – 1 reff = (1 + 0.20/2)2 – 1 reff = (1 + 0.20/4)4 – 1
reff = (1.20)1 – 1 reff = (1.10)2 – 1 reff = (1.05)4 – 1
reff = (1.20) – 1 reff = (1.210) – 1 reff = (1.216) – 1
reff = 0.20 = 20% reff = 0.210 = 21% reff = 0.216 = 21.6%

P5-39 Compounding frequency, time value, and effective annual rates

(LG 5; Intermediate)
a. Different compounding frequencies:
A: n = 10, r = 3%, PV = $2,500 B: n = 18, r = 2%, PV = $50,000
Solve for FV5 = $3,359.79 Solve for FV3 = $71,412.31
C: n = 10, r = 5%, PV = $1,000 D: n = 24, r = 4%, PV = $20,000
Solve for FV10 = $1,628.89 Solve for FV6 = $51,226.08
b. Effective interest rate: reff = (1 + r%/m)m – 1
A: reff = (1 + 0.06/2)2 − 1 B: reff = (1 + 0.12/6)6 − 1
reff = (1 + 0.03)2 − 1 reff = (1 + 0.02)6 − 1
reff = (1.061) − 1 = 0.061 = 06.1% reff = (1.126) − 1 = 0.126 = 12.6%
C: reff = (1 + 0.05/1)1 − 1 D: reff = (1 + 0.16/4)4 – 1
reff = (1 + 0.05)1 − 1 reff = (1 + 0.04)4 − 1
reff = (1.05) − 1 = reff = 0.05 = 5% reff = (1.170) − 1 = reff = 0.17 = 17%
c. Effective interest rates rise relative to stated rates as compounding frequency rises.

P5-40 Continuous compounding (LG 5; Intermediate)

FVcont. = PV × er × n (where e = 2.718282, r = annual interest rate, and n = number of years)
A: FVcont. = $1,000 × e0.18 = $1,197.22 C: FVcont. = $4,000 × e0.56 = $7,002.69
B: FVcont. = $ 600 × e1 = $1,630.97 D: FVcont. = $2,500 × e0.48 = $4,040.19
The Excel command [in brackets] is [=PV*exp(r*n)].

P5-41 Personal finance: Compounding frequency and time value (LG 5; Challenge)
a. (1) Annually: n = 10; r = 8%, PV = $2,000. FV = $4,317.85.
(2) Semiannually: n = 20, r = 4%, PV = $2,000. FV $4,382.25.
(2) Daily: n = 3650; r = 8% ÷ 365 = 0.022, PV = $2,000. FV = $4,450.69
(4) Continuously: FV10 = $2,000 × (e0.8). FV = $4,451.08
b. (1) reff = (1 + 0.08/1)1 − 1 (2) reff = (1 + 0.08/2)2 − 1
reff = (1 + 0.08)1 − 1 reff = (1 + 0.08)2 − 1
reff = (1.08) – 1= 0.08 = 8% reff = (1.0816) − 1 =0.0816 = 8.16%

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 Chapter 5 Time Value of Money 101

(3) reff = (1 + 0.08/365)365 − 1 (4) reff = 𝑒  − 1

reff = (1 + 0.00022)365 − 1 reff = e0.08− 1
reff = (1.0833) – 1 = 0.0833 = 8.33% reff = 1.0833 − 1 = 0.0833 = 8.33%
c. Continuous compounding yields $133.23 more than annual compounding over 10 years.
d. The more frequent the compounding, the larger the future value. Part (a) demonstrates
this idea with larger future values as compounding increases from annual to continuous.
Because future value is larger for a given amount invested, effective return also rises
with compounding frequency. Part (b) demonstrates this idea with the effective rate
rising from 8% to 8.33% when compounding changed from annual to continuous.

P5-42 Personal finance: Annuities and compounding (LG 3 and LG 5; Intermediate)

a. For the ordinary annuity with annual compounding: n = 10, r = 8%, PMT = $300, and
solve for FV = $4,345.97. For the ordinary annuity with semiannual compounding: n =
10 × 2 = 20; r = 8 ÷ 2 = 4%, PMT = $150, and solve for FV = $4,466.71. For the
ordinary annuity with, quarterly compounding: n = 10 × 4 = 40; r = 8 ÷ 4 = 2%; PMT =
$75, and solve for FV = $4,530.15.
b. The sooner a deposit is made, the sooner the funds can earn interest. Thus, the sooner the
deposit and more frequent the compounding, the larger the future sum.

P5-43 Deposits to accumulate growing future sum (LG 6; Basic)

Using the framework for future value of an annuity:
Case Terms Given Information Payment
A 12%, 3 years n = 3, r = 12, FV = $5,000 $1,481.74
B 7%, 20 years n = 20, r = 7%, FV = 100,000 $2,439.29
C 10%, 8 years n = 8, r = 10%, FV = $30,000 $2,623.32
D 8%, 12 years n = 12, r = 8%, FV = $15,000 $ 790.43

P5-44 Personal finance: Creating a retirement fund (LG 6; Intermediate)

a. Given n = 42, r = 8%, and FV = $220,000, solve for PMT = $723.10.
b. Given n = 42, r = 8%, and PMT = $600, solve for FV = $182,546.11.

P5-45 Personal finance: Accumulating a growing future sum (LG 6: Intermediate)

Step 1: Determining cost of home in 20 years: Given n = 20, r = 6%, and PV = $185,000,
solve for FV20 = $593,320.06.
Step 2: Determining how much to save annually to afford home: Given n = 20, r = 10%, and
FV = $593,320.06, solve for PMT = $10,359.15.

P5-46 Personal finance: Inflation, time value, and annual deposits (LG 2, LG 3, and LG 6;
Challenge)
a. n = 25, r = 5%, PV = $200,000. Solve for FV25 = $677,270.99.
b. n = 25, r = 9%, FV25 = $677,270.99. Solve for PMT = $7,996.03.

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102 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

c. Because each of John’s deposits will earn interest an additional year’s worth of interest,
he can deposit a smaller sum each year and still hit his target of $677,270.99 in 25 years.
To determine how much smaller, let n = 25, r = 9%, and FV25 = $677,270.99, and solve
for the annuity due PMT (= $7,335.81).

P5-47 Loan payment (LG 6; Basic)

A: Given n = 3, r = 8%, and PV = $12,000, solve for PMT = $4,656.40.
B: Given n = 10, r = 12%, and PV = $60,000, solve for PMT = $10,619.05.
C: Given n = 30, r = 10%, and PV = $75,000, solve for PMT = $7,955.94.
D: Given n = 5, r = 15%, PV = $4,000, solve for PMT = $1,193.26.

P5-48 Personal finance: Loan-amortization schedule (LG 6; Intermediate)

a. Treat the problem like an ordinary annuity with n= 3, r = 4%, PV = $45,000, and solve
for PMT. Loan payment is $16,215.68.
b.
End of Loan Beginning-of- Payments
Year Payment Year Principal Interest Principal
1 $16,215.68 $45,000.00 $1,800.00 $14,415.68
2 16,215.68 30,584.32 1,223.37 14,992.31
3 16,215.68 15,592.00 623.68 15,592.00
Total = $45,000.00
c. The interest portion falls each period because some principal is being repaid (so the
same interest rate is applied to smaller principal).

P5-49 Loan-interest deductions (LG 6; Challenge)

a. Use the ordinary annuity framework with n = 3, r = 13%, PV (loan amount) = $10,000,
and solve for PMT. Annual end-of-year loan payments = $4,235.22.
b. and c.
End of Loan Beginning-of- Payments
Year Payment Year Principal Interest Principal
1 $4,235.22 $10,000.00 $1,300.00 $2,935.22
2 4,235.22 $7,064.78 918.42 3,316.80
3 4,235.22 $3,747.98 487.24 3,747.98
Totals = $2,705.66 $10,000.00

P5-50 Personal finance: Monthly loan payments (LG 6; Challenge)

a. Use the ordinary annuity framework with n = 12 × 3 = 36, r = 6% ÷ 12 = 0.005,
PV (loan amount) = $25,000, and solve for PMT. End-of-month payments = $760.55.
b. Use the ordinary annuity framework with n = 36, r = 4% ÷ 12 = 0.003333,
PV (loan amount) = $25,000, and solve for PMT. End-of-month payments = $738.10.

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 Chapter 5 Time Value of Money 103

P5-51 Growth rates (LG 6; Basic)

To find average annual growth rate, use the future-value framework and solve for the interest rate that
makes stock price grow from the purchase to the sales price over the holding period. Specifically:
Amazon: (754/134)1/7 – 1 = 28.0% Chipotle: (301/88)1/3 – 1 = 50.7% Netflix: (110/8)1/6 – 1 = 54.8%

P5-52 Personal finance: Rate of return (LG 6, Intermediate)

a. Use the future-value framework, and solve for the interest rate (r) that makes the
investment grow from initial to final value over the holding period, where n = 3, PV =
$1,500, FV = $2,000. Average annual growth rate (r) = 10.06%. In Excel, the answer
may be obtained with the RATE function, but PV must be entered as a negative number.
b. Mr. Singh should make the investment that returns $2,000 because it offers a higher
return for the same amount of risk.

P5-53 Personal finance: Rate of return and investment choice (LG 6; Intermediate)
a.
Purchase Future Average Annual
Investment Price Cash Inflow Years Rate of Return
A $ 5,000 $ 8,400 6 9.03%
B $ 5,000 $ 15,900 15 8.02%
C $ 5,000 $ 7,600 4 11.04%
D $ 5,000 $ 13,000 10 10.03%
In Excel, use RATE function, but PV must be entered as a negative number.
b. Investment C provides the highest return of the four alternatives. Assuming all
investments have equal risk, Clare should choose C.

P5-54 Rate of return-annuity (LG 6; Basic)

Use the framework for an ordinary annuity with n = 10, PMT = $2,000, PV = $10,606, and
solve for r. The rate of return = 13.58%. Note: In Excel, the answer may be obtained with
the RATE function, but PV must be entered as a negative number.

P5-55 Personal finance: Choosing the best annuity (LG 6; Intermediate)

Note: In Excel, use RATE function, but PV must be entered as a negative number.
a. Annuity A Annuity B
n = 20, PV = $30,000, PMT = $3,100 n = 10, PV = $25,000, PMT = $3,900
Solve for r = 8.19% Solve for r = 9.03%
Annuity C Annuity D
n = 15, PV = $40,000, PMT = $4,200 n = 12, PV = $35,000, PMT 4,000
Solve for r = 6.30% Solve for r = 5.23%
b. Annuity B offers the highest return at 9.03%. Because Raina considers all four annuities
equally risky and is indifferent about their differing lives, she should choose Annuity B.

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P5-56 Personal finance: Interest rate for an annuity (LG 6; Challenge)

Note: In Excel, use RATE function, but PV must be entered as a negative number.
a. Defendant’s interest rate assumption: n = 25, PV = $2,000,000, and PMT = $156,000.
Solve for r = 5.97% (or 6% when rounded to the nearest whole percent).
b. Anna’s interest rate assumption: n = 25, PV = $2,000,000, and PMT = $255,000.
Solve for r = 12.0%.
c. n = 25, r = 9%, PV = $2,000,000. Solve for PMT = $203,612.50.

P5-57 Personal finance: Loan rates of interest (LG 6; Intermediate)

Note: In Excel, use RATE function, but PV must be entered as a negative number.
a. Loan A: n = 5, PV = $5,000, PMT = $1,352.81. Solve for r = 11.0%
Loan B: n = 4, PV = $5,000 PMT = $1,543.21. Solve for r = 9.0%
Loan C: n = 3, PV = $5,000, PMT = $2,010.45. Solve for r = 10.0%
b. Mr. Fleming should choose Loan B, which has the lowest interest rate.

P5-58 Number of years to equal future amount (LG 6; Intermediate)

Note: In Excel, use NPER function, but PV must be entered as a negative number.
A Given r = 7%, PV = $300, and FV = $1,000, solve for n = 17.79 years.
B: Given r = 5%, PV = $12,000, FV = $15,000, solve for n = 4.57 years.
C: Given r = 10%, PV = $9,000, and FV = $20,000, solve for n = 8.38 years.
D: Given r = 9%, PV = $100, and FV = $500, solve for n = 18.68 years.
E: Given r = 15%, PV = $7,500, and FV = $30,000, solve for n = 9.92 years.

P5-59 Personal finance: Time to accumulate a given sum (LG 6; Intermediate)

Note: In Excel, use NPER function, but PV must be entered as a negative number.
a. r = 10%, PV = −$10,000, FV = $20,000. Solve for n = 7.27 years.
b. r = 7%, PV = −$10,000, FV = $20,000. Solve for n = 10.24 years.
c. r = 12%, PV = −$10,000, FV = $20,000. Solve for n = 6.12 years.
d. The higher the rate of interest, the less time is required to accumulate a given future sum.

P5-60 Number of years to provide a given return (LG 6; Intermediate)

Note: In Excel, use the NPER function, but PV must be entered as a negative number.
A: Given r = 11%, PV = $1,000, and PMT = $250, solve for n = 5.56 years.
B: Given r = 15%, PV = $150,000, and PMT = $30,000, solve for n = 9.92 years.
C: Given r = 10%, PV = $80,000, and PMT = $10,000, solve for n = 16.89 years.
D: Given r = 9%, PV = $600, and PMT = 275, solve for n = 2.54 years
E: Given r = 6%, PV = $17,000, and PMT = $3,500, solve for n = 5.91 years.

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 Chapter 5 Time Value of Money 105

P5-61 Personal finance: Time to repay installment loan LG 6; Intermediate

Note: In Excel, use the NPER function, but PV must be entered as a negative number.
a. r = 12%, PV = $14,000, PMT = $2,450. Solve for n = 10.21 years.
b. r = 9%, PV = $14,000, PMT = $2,450. Solve for n = 8.38 years.
c. r = 15%, PV = $14,000, PMT = $2,450. Solve for n = 13.92 years.
d. The higher the interest rate, the longer it will take Mia to repay the loan.

P5-62 Ethics problem (LG 6; Intermediate)

To find average annual return, use the future-value equation – plugging in purchase price
($545,000) for PV, sales price ($1,500,000) for FV17, and 17 for the number of periods (n):

(i) FVn = PV × (1 + r)n (iv) √2.7523 – 1 = r
(ii) $1,500,000 = $545,000 × (1 + r)17 (v) r = 6.14%
(iii) 2.7523 = (1 + r)17
As to Samantha “swindling” Michael by selling the house 17 years later for nearly three
times the price she paid him for it, if stocks offer a risk-adjusted return comparable to the
return on home ownership in San Francisco, then Samantha’s return on home-ownership
does not appear excessive. At a broader level, at the time Samantha purchased the home,
neither she nor Michael knew with certainty what the market for San Francisco real estate
would look like decades later. If both parties were reasonable informed about housing-
market fundamentals (i.e., what could have been known and reasonable predictions about
future prices based on that knowledge) and neither had undue power in the real-estate
market, then many economists would argue whatever price they agreed upon was fair.

„ Case: “Finding Jill Moran’s Retirement Annuity”

Case studies are available on www.pearson.com/mylab/finance.
Chapter 5’s case challenges the student to apply present and future value techniques to a real-world
situation. The first step is determining the total amount Sunrise Industries needs to accumulate until Ms.
Moran retires, remembering to take into account interest that will be earned during the 20-year payout
period. Then, needed annual deposits can be determined.
a.

b. Total amount needed at the end of year 12 is the present value of future annuity payments to Ms.
Moran. Those payments ($42,000) will be made at year end (ordinary annuity) for 20 years, and
the interest rate is 12%. The future value of this ordinary annuity is $313,716.63.
c. End-of-year deposits necessary over 12 years to fund Mr. Moran’s annuity may be found with
the formula for future value of an ordinary annuity, given a future value of $313,716.63 and an
interest rate of 9%. Necessary deposits = $15,576.24—that is, Sunrise must deposit $15,576.24
at year end for the next 12 years to accumulate the funds needed to pay $42,000 for 20 years.

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106 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

d. If the interest rate rises to 10%, needed deposits fall to $14,670.43—Sunrise must deposit
$14,670.43 at the end of years 1–12 to provide Ms. Moran a $42,000 in years 13 to 32.
e. Step one is determining the present value of the $42,000 perpetuity to Ms. Moran; the present
value of this perpetuity equals annual cash flows ($42,000) divided by the interest rate (12%) or
$350,000. Annual deposits needed to fund this perpetuity may be found using the formula for
future value of an ordinary annuity—given a future value of $350,000 and an interest rate of 9%.
Necessary deposits equal $17,377.73—that is, Sunrise must deposit $17,377.73 at year end for
the next 12 years to accumulate the funds needed to pay $42,000 annuity in perpetuity.

„ Spreadsheet Exercise
Answers to Chapter 5’s Uma Corporation spreadsheet problem are available on
www.pearson.com/mylab/finance.

„ Group Exercise
Group exercises are available on www.pearson.com/mylab/finance.
This chapter’s exercises provide each group with opportunities to use time value of money
techniques on their fictitious firm. In part (a), students analyze options for leasing a new copy
machine to replace the current unreliable one. In part (b), students analyze options for buying a
replacement copier outright. Students are asked to furnish a discount rate; instructors should discuss
various market rates as candidates. [A good source for interest-rate data is the Federal Reserve
Economic Data (FRED), the data website of the Federal Reserve Bank of St. Louis
(https://fred.stlouisfed.org/).] In part (c), students are asked to create an amortization schedule for a
loan to upgrade the firm’s computer systems. Finally, in part (d), students are asked to compute the
present value of a four-year stream of settlement payments, given a 6% discount rate.

„ Integrative Case 2: Track Software, Inc.

Integrative Case 2, Track Software, Inc., places the student in the role of financial manager to introduce
basic concepts like setting financial goals, measuring firm performance, and analyzing firm
condition. This seven-year-old company has cash-flow problems, so the student must prepare/analyze
the statement of cash flows. Interest expense is increasing, and the firm’s financing strategy should be
evaluated in view of current yields on loans of different maturities. Ratio analysis of Track’s
financial statements provides additional insight into firm condition. The student must then confront a
cost/benefit tradeoff: Is the additional expense of a new software developer (which depresses short-term
profitability) a good long-term investment? Wrestling with such decisions highlight the importance of
financial decisions to day-to-day firm operations and long-term profitability.

a. 1. Stanley has focused on maximizing profit, as suggested by the rise in net profits from 2013
to 2019. His concern about adding a software designer, which would depress near-term
earnings, also underscores his focus on profits. Stanley should maximize wealth, a goal
which considers risk and cash flows over time. Profit maximization does not integrate these
variables (cash flow, timing, risk) into decision-making.
2. An agency problem exists when managers place personal goals ahead of corporate goals.
Stanley owns 40% of outstanding equity, so agency problems are not a major concern.

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 Chapter 5 Time Value of Money 107

b. Earnings per share (EPS) calculation:

Year Net Profits After Taxes EPS (NPAT ÷ 50,000 shares)
2013 ($50,000) $ 0
2014 (20,000) 0
2015 15,000 0.30
2016 35,000 0.70
2017 40,000 0.80
2018 43,000 0.86
2019 48,000 0.96

EPS has increased steadily, suggesting Stanley has been focused on profit maximization.

c. Operating and Free Cash Flows

OCF = EBIT × (1 − T) + depreciation = $89 × (1 − 0.2) + 11 = $82.2
FCF = OCF − net fixed asset investment* − net current asset investment**
= $82.2 − 15 − 47 = $20.2
* NFAI = ∆ net fixed assets + depreciation = ($132 – 128) + 11 = $15.
** NCAI = ∆ current assets − ∆ accounts payable − ∆ accruals) = ($421 − 362) − (136 − 126) − (27 − 25) = 47.

Track Software is generating good cash flow from operating activities. OCF is sufficient to
provide needed cash for investment in fixed assets and net working capital, with $20,200 left
over for investors (creditors and equity holders).
d. Ratio Analysis -Track Software, Inc
Actual Industry Avg. TS: Time Series
Ratio 2018 2019 2019 CS: Cross Section
Net working capital $21,000 $58,000 $96,000 TS: Improving
CS: Poor
Current ratio 1.06 1.16 1.82 TS: Improving
CS: Poor
Quick ratio 0.63 0.63 1.10 TS: Stable
CS: Poor
Inventory turnover 10.40 5.39 12.45 TS: Deteriorating
CS: Poor
Avg. collection period 29.6 35.8 20.2 TS: Deteriorating
(days) CS: Poor
Total asset turnover 2.66 2.80 3.92 TS: Improving
CS: Poor
Actual Industry Avg. TS: Time Series

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108 Zutter/Smart • Principles of Managerial Finance, Fifteenth Edition

Ratio 2018 2019 2019 CS: Cross Section

Debt ratio 0.78 0.73 0.55 TS: Decreasing
CS: Poor
Times interest earned 3.0 3.1 5.6 TS: Stable
CS: Poor
Gross profit margin 32.1% 33.5% 42.3% TS: Improving
CS: Fair
Operating profit margin 5.5% 5.7% 12.4% TS: Improving
CS: Poor
Net profit margin 3.0% 3.1% 4.0% TS: Stable
CS: Fair
Return on assets 8.0% 8.7% 15.6% TS: Improving
(ROA) CS: Poor
Return on equity 36.4% 31.6% 34.7% TS: Deteriorating
(ROE) CS: Fair

Ratio analysis of Track Software:

1. Liquidity: Track’s liquidity (based on its current ratio, net working capital, and quick ratio)
has been stable or improved slightly but remains well below peer (industry average).
2. Activity: Inventory turnover has deteriorated considerably and is now much worse than
peer. Average collection period has also deteriorated and is now substantially worse than
peer. Total asset turnover improved slightly but remains well below the industry norm.
3. Debt: Track’s debt ratio improved slightly from 2018 but remains higher than the industry
average. The times interest earned ratio is stable and, though it suggests a reasonable
cushion for the firm, is still below the industry average.
4. Profitability: Track’s gross, operating, and net profit margins improved slightly in 2019
but remain low by industry standards. ROA ticked up but is still only half the industry
average. ROE dipped below the industry average.
Track Software, while showing improvement in most liquidity, debt, and profitability
ratios, still compares unfavorably with its peers. The firm should also take steps to
improve activity ratios, particularly inventory turnover and accounts-receivable collection.

5. Stanley should find the cash to hire the software developer. Adding a new product would
increase sales and lead to greater earnings for Track Software over the long term.

e. Stanley should seek to maximize the value of Track Software, not earnings in any one period.
Accordingly, he should focus less on the initial negative impact of hiring the software developer
and more on the potential for a significant long-term rise in sales/earnings.

f. The investor should view a $5,000 annual payment as a perpetuity, with a present value equal to
expected cash flows ($5,000) divided by required rate of return (10%), or $50,000.

g. You should view the $20,200 annual free cash flow as a perpetuity with a present value equal to
expected cash flows ($20,200) divided by required rate of return (10%) or $202,000.

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