Answers to Chapter 2 Questions 1.

Time value of money specifically assumes that any interest or other return earned on an investment is reinvested and interest is, in turn, earned on the earlier interest payments. That is, interest is compounded. This is in contrast to the earning of simple interest which is a 12-month (nominal or stated) interest rate. Simple interest on an investment assumes you do not reinvest the annual interest earned. 2. a. b. c. d. e. PV = \$5,000 (PVIF 6%/1, 5(1)) = \$5,000 (0.747258) = \$3,736.29 PV = \$5,000 (PVIF 8%/1, 5(1)) = \$5,000 (0.680583) = \$3,402.92 PV = \$5,000 (PVIF 10%/1, 5(1)) = \$5,000 (0.620921) = \$3,104.61 PV = \$5,000 (PVIF 10%/2, 5(2)) = \$5,000 (0.613913) = \$3,069.57 PV = \$5,000 (PVIF 10%/4, 5(4)) = \$5,000 (0.610271) = \$3,051.35

From these answers we see that the present values of a security investment decrease as interest rates increase. As rates rose from 6 percent to 8 percent, the (present) value of the security investment fell \$333.37 (from \$3,736.29 to \$3,402.92). As interest rates rose from 8 percent to 10 percent, the value of the investment fell \$298.31 (from \$3,402.92 to \$3,104.61). This is because as interest rates increase, fewer funds need to be invested at the beginning of an investment horizon to receive a stated amount at the end of the investment horizon. Also as interest rates increase, the present values of the investment decrease at a decreasing rate. The fall in present value is greater when interest rates rise from 6 percent to 8 percent compared to when they rise from 8 percent to 10 percent. The inverse relationship between interest rates and the present value of security investments is neither linear nor proportional. From the above answers, we also see that the greater the number of compounding periods per year, the smaller the present value of a future amount. This is because, the greater the number of compounding periods the more frequently interest is paid and thus, a greater amount of interest that is paid. Thus, to get to a stated amount at the end of an investment horizon, the greater the amount that will come from interest and the less the amount the investor must pay up front. 3. a. FV = \$5,000 (FVIF 6%/1, 5(1)) = \$5,000 (1.338226) = \$6,691.13 b. FV = \$5,000 (FVIF 8%/1, 5(1)) = \$5,000 (1.469328) = \$7,346.64 c. FV = \$5,000 (FVIF 10%/1, 5(1)) = \$5,000 (1.610510) = \$8,052.55 d. FV = \$5,000 (FVIF 10%/2, 5(2)) = \$5,000 (1.628895) = \$8,144.47 e. FV = \$5,000 (FVIF 10%/4, 5(4)) = \$5,000 (1.638616) = \$8,193.08

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63 FV = \$201.15 7 .198.000 (17.934.51 (from \$6.346.0415186) = \$36.451(PVIF 4%/1.796 (5.46 b.51 PV = \$550.219.000(FVIFA 6%/1. the greater the future value of a future amount. 21(1)) = \$183.212364)(1 + . PV = \$5.000(FVIFA 6%/4.310 (1.052.000 (23.0104826) = \$5. FV = \$2.325. FV = \$5. 8(1)) = \$51.130.164 (0.212364) = \$21.65 FV = \$251.79031453) = \$12. a greater amount of interest that is paid.61 6.06) = \$5. FV = \$5. the greater the number of compounding periods the more frequently interest is paid and thus. the value of the investment rose \$705.000 (4.168639) = \$85. FV = \$5.250(FVIF 18%/1.123667)(1..211. 5(1))(1 + .729.40388323) = \$20. PV = \$5.061. 5(4))(1 + .55).015) = \$87.168639)(1. we also see that the greater the number of compounding periods per year.788.637092) = \$28. PV = \$15. the (future) value of the security investment rose \$655. PV = \$5.From these answers we see that the future values of a security investment increase as interest rates increase.84 8.68947896) = \$15. From the above answers.000(PVIFA 6%/1.355 (5.842.50 7.346.000 (5. 5(4)) = \$5.585.06) = \$29.05 FV = \$76.000(PVIFA 6%/4.451 (0. EXCEL Problem: FV = \$179.03383372) = \$925.91 (from \$7.767.53 d.817.11 FV = \$183.25 FV = \$9. 5(1)) = \$5.250 (1.073(PVIF 22%/1. 6(1)) = \$15. 15(1)) = \$76.47356576) = \$417.01 PV = \$886.352.06/4) = \$5.000(PVIFA 6%/1.84 5 a.59 d.000 (23. 25(1)) = \$550.64 to \$8. a. The inverse relationship between interest rates and the present value of security investments is neither linear nor proportional. This is because as interest rates increase.618.185. This is because. 4(1)) = \$2.557(PVIF 12%/1.34 c.015) = \$117.355(FVIF 12%/1.362.000 (5.06) = \$22.000(FVIFA 6%/4.123667) = \$115. 5(4)) = \$5.). The greater the amount of interest paid and the greater the future value of a present amount. FV = \$5. 16(1)) = \$886. The rise in present value is greater when interest rates rise from 8 percent to 10 percent compared to when they rise from 6 percent to 8 percent.843.000(FVIFA 6%/1. the future values of the investment increase at an increasing rate. As rates rose from 6 percent to 8 percent.19 c. 5(1)) = \$5.15 PV = \$51.557 (0. 5(1))(1 + .073 (0.000 (17. 4.691. 9(1)) = \$9. Also as interest rates increase.637092)(1 + . PV = \$5.82 b.000(PVIFA 6%/4.06) = \$5.310(FVIF 6%/1.164(PVIF 20%/1.13 to \$7.000 (4.823.01 FV = \$313.06/4) = \$5. 5(4))(1 + . As interest rates rose from 8 percent to 10 percent. a stated amount of funds invested at the beginning of an investment horizon accumulates to a larger amount at the end of the investment horizon.796(FVIF 8%/1.9387778) = \$4.876.

325.04/1) = \$314.13/1) = \$4. 5(1))(1 + .332(FVIFA 1%/1.83 FV = \$74.322. 7(1))(1 + .998.37 PV = \$39.78 PV = \$20.27 FV = \$74.484(FVIFA 10%/1.51 PV = \$7.98 12.821. 4(1)) = \$148.38 PV = \$31.683.006. EXCEL Problem: FV = \$155.167. PV = \$678.278.10/1) = \$500.54(FVIFA 31%/1.011.74 PV = \$49.28 FV = \$163.330.193. 12(2)) = \$45.583.863.94 PV = \$69.696.161.688.93 PV = \$678.49 PV = \$69. 7(1)) = \$2. FV = \$950(FVIFA 11%/2.35 FV = \$182.555(FVIFA 8%/1. 13(1)) = \$35.555(FVIFA 8%/1.968.844.282.09(FVIFA 13%/1. FV = \$123(FVIFA 13%/1. EXCEL Problem: PV = \$55.10 8 . 8(1))(1 + .205.012.13/1) = \$3.79 14.879.93(FVIFA 4%/1.12 FV = \$123(FVIFA 13%/1. 13(1))(1 + . 13(1))(1 + .50 FV = \$167.449.968.712.08/1) = \$52.26(FVIFA 6%/1.946.54(FVIFA 31%/1. 23(1))(1 + .55 PV = \$20.712.654.54 13.388.711.322. EXCEL Problem: PV = \$55.15 PV = \$31.519. 23(1)) = \$301. 8(1)) = \$48.84 FV = \$4.54 PV = \$49. 4(1))(1 + .732.332(FVIFA 1%/1.31/1) = \$194.09(FVIFA 13%/1.40 FV = \$167.560.9. 13(1)) = \$3.934.79 PV = \$7. 9(1))(1 + .57 FV = \$4. 9(1)) = \$1. 5(1)) = \$454.08 10.04 FV = \$204.06/1) = \$39.240.95 11.01/1) = \$1.567.26(FVIFA 6%/1.484(FVIFA 10%/1.93(FVIFA 4%/1.94 PV = \$39.

Accordingly. the Federal Reserve increases the supply of funds available in the financial markets. and increasing the equilibrium quantity of funds traded. and the equilibrium interest rate falls. Foreign Economic Conditions. when financial market participants have near-term spending needs. The financial market. at every interest rate the supply of loanable funds increases. As competitive forces adjust. and an increase in the equilibrium quantity of funds traded. while the equilibrium quantity of funds traded decreases. and a decrease in the equilibrium quantity of funds traded. The shift in the supply curve creates a disequilibrium in this financial market that. Monetary Expansion. When financial market participants have few near-term spending needs. 11 . while the equilibrium quantity of funds traded increases. the Federal Reserve decreases the supply of funds available in the financial markets. At every interest rate the supply of loanable funds increases. Conversely. it becomes more attractive to supplier of funds. or the supply curve shifts up and to the left. the supply curve shifts down and to the right. Finally. The inflow of foreign funds to U. the growth in the money supply. The shift in the supply curve creates a disequilibrium in this financial market.Risk. the decrease in the supply of funds due to an increase in the financial security=s risk results in an increase in the equilibrium interest rate. when monetary policy objectives are to contract economic growth. and the equilibrium quantity of funds traded increases. the flow of funds to that country increases. the increase in the supply of funds due to a decrease in the risk of the financial security results in a decrease in the equilibrium interest rate. Future Spending Needs. when corrected results in an increase in the equilibrium interest rate. At every interest rate the supply of loanable funds decreases. Conversely.S. or the supply curve shifts up and to the left. and the equilibrium interest rate rises. Accordingly. holding all other factors constant. the supply curve shifts up and to the left. One method used by the Federal Reserve to implement monetary policy is to alter the availability of credit and thus. Conversely. At every interest rate the supply of loanable funds increases. the absolute dollar value of funds available to invest increases. as economic conditions improve in a country relative to other countries. at every interest rate the supply of loanable funds decreases. it becomes less attractive to supplier of funds. As competitive forces adjust. At every interest rate the supply of loanable funds decreases. or the supply curve shifts down and to the right. and holding all other factors constant. As the risk of a financial security decreases. financial markets increases the supply of loanable funds at every interest rate and the supply curve shifts down and to the right. and holding all other factors constant. and a decrease in the equilibrium quantity of funds traded. When monetary policy objectives are to enhance growth in the economy. reacts to this increased supply of funds by decreasing the equilibrium interest rate. the equilibrium interest rate falls. the absolute dollar value of funds available to invest decreases. as the risk of a financial security increases. or the supply curve shifts down and to the right. Accordingly. The shift in the supply curve creates a disequilibrium in this financial market.