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Chapter 5: Time Value of Money

Multiple Choice Questions


1. What is the total amount accumulated after three years if someone invests $1,000 today with a
simple annual interest rate of 5 percent? With a compound annual interest rate of 5 percent?
A. $1,150, $1,103
B. $1,110, $1,158
C. $1,150, $1,158
D. $1,110, $1,103
Level of difficulty: Easy
Solution: C.
Simple interest rate: $1,000 + ($1,000)(5%)(3) = $1,150
Compound interest rate: $1,000(1.05)3 = $1,158

2. Which of the following has the largest future value if $1,000 is invested today?
A. Five years with a simple annual interest rate of 10 percent
B. 10 years with a simple annual interest rate of 8 percent
C. Eight years with a compound annual interest rate of 8 percent
D. Eight years with a compound annual interest rate of 7 percent
Level of difficulty: Easy
Solution: C.
A) $1,000 + ($1,000)(10%)(5) = $1,500
B) $1,000 + ($1,000)(8%)(10) = $1,800
C) $1,000(1.08)8 = $1,851
D) $1,000(1.07)8 = $1,718
Therefore, C is the largest.

Interest rates in the following questions are compound rates unless otherwise stated

3. Suppose an investor wants to have $10 million to retire 45 years from now. How much would
she have to invest today with an annual rate of return equal to 15 percent?
A. $18,561
B. $17,844
C. $20,003
D. $21,345
Level of difficulty: Medium
Solution: A.
PV=$10,000,000/(1.15)45=10,000,000/538.7693=$18,561
Or using a financial calculator (TI BAII Plus),
N=45, I/Y=15, PMT=0, FV=10,000,000, CPT PV= 18,561

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4. Which of the following is false?
A. The longer the time period, the smaller the present value, given a $100 future value and
holding the interest rate constant.
B. The greater the interest rate, the greater the present value, given a $100 future value and
holding the time period constant.
C. A future dollar is always less valuable than a dollar today if interest rates are positive.
D. The discount factor is the reciprocal of the compound factor.
Level of difficulty: Medium
Solution: B. The greater the interest rate, the smaller the present value, given a $100 future
value and holding time period constant.

5. Maggie deposits $10,000 today and is promised a return of $17,000 in eight years. What is the
implied annual rate of return?
A. 6.86 percent
B. 7.06 percent
C. 5.99 percent
D. 6.07 percent
Level of difficulty: Medium
Solution: A.
FV=PV(1+k)n
17,000=10,000(1+ k)8
8ln(1+k)=ln(1.7), therefore k=6.86%
Or using a financial calculator (TI BAII Plus),
N=8, PV= 10,000, PMT=0, FV=17,000, CPT I/Y=6.86%

6. To triple $1 million, Mika invested today at an annual rate of return of 9 percent. How long
will it take Mika to achieve his goal?
A. 15.5 years
B. 13.9 years
C. 12.7 years
D. 10 years
Level of difficulty: Medium
Solution : C.
FV=PV(1+k)n
(3)(1,000,000)=1,000,000(1.09) n
ln(3)=(n)ln(1.09)
n=12.7 years
Or using a financial calculator (TI BAII Plus),
I/Y=9, PV= 1,000,000, PMT=0, FV=3,000,000, CPT N=12.7

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7. Which of the following concepts is incorrect?
A. An ordinary annuity has payments at the end of each year.
B. An annuity due has payments at the beginning of each year.
C. A perpetuity is considered a perpetual annuity.
D. An ordinary annuity has a greater PV than an annuity due, if they both have the same
periodic payments, discount rate and time period.
Level of difficulty: Medium
Solution: D. The annuity due has a greater PV because it pays one year earlier than ordinary
annuity.

8. Jan plans to invest an equal amount of $2,000 in an equity fund every year-end beginning this
year. The expected annual return on the fund is 15 percent. She plans to invest for 20 years. How
much could she expect to have at the end of 20 years?
A. $237,620
B. $176,424
C. $204,887
D. $178,424
Level of difficulty: Difficult
Solution: C.
(1 k )20 1 (1 .15)20 1
FV20 PMT =$ 2,000 2,000(102.4436) $204,887
k .15
Or using a financial calculator (TI BAII Plus),
N=20, I/Y=15, PV=0, PMT= -2,000, CPT FV=204,887

9. In Problem 8, what is the present value of Jans investments?


A. $12,625
B. $12,519
C. $14,396
D. $12,396
Level of difficulty: Medium
Solution: B.
1 1
1 (1 k )n 1 (1.15)20
PV0 PMT $2,000 2,000(6.25933) $12,519
k .15

Or using a financial calculator (TI BAII Plus),


N=20, I/Y=15, FV=0, PMT= 2,000, CPT PV=12,519

10. What is the present value of a perpetuity with an annual year-end payment of $1,500 and

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expected annual rate of return equal to 12 percent?
A. $14,000
B. $13,500
C. $11,400
D. $12,500
Level of difficulty: Easy
Solution: D.
PV0=PMT/k=$1,500/.12=$12,500

Practice Problems
11. After a summer of travelling (and not working), a student finds himself $1,500 short for this
years tuition fees. His parents have agreed to loan him the money for three years at a simple
interest rate of 6 percent, with interest due at the end of each year.
A. How much interest will he owe his parents after one year?
B. How much will he owe, in total, after three years?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
A. In one year you will own P x k = $1500 x 6% = $90 of interest.
B. After three years, the total (principal and interest) owing will be: P + (n x P x k) = $1500 +
(3 x $1500 x 6%) = $1770.

12. Your sister has been forced to borrow money to pay her tuition this year. If she makes annual
payments on the loan at year end for the next three years, and the loan is for $2,500 at a
simple interest rate of 6 percent, how much will she pay each year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
As the exact amount of interest owing each year will be paid, there is no compounding.
The amount of each annual payment will be P x k = $2500 x 6% = $150. Unfortunately, these
payments never reduce the principal owing, so the loan will never be paid off!

13. Khalils summer job has given him $1,200 more than he needs for tuition this year. The local
bank pays simple interest at a rate of 0.5 percent per month. How much interest will he earn
in one year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
Khalil will be paid interest each month for 12 months, but without compounding. The total
interest earned is (n x P x k) = (12 x $1200 x 0.5%) = $72.

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14. A new Internet bank pays compound interest of 0.5 percent per month on deposits. How
much interest will Khalils summer savings of $1,200 earn in one year with this online bank
account?
Topic: Compound Interest
Level of difficulty: Easy
Solution:
The payment of compound interest means that we must compound (or find the future value)
of the amount invested (the present value):
FV12 months $1200 (1 0.005)12 $1274.01
Of this amount, $1,200 was the original amount invested, so $74.01 of interest will be
earned.

15. History tells us that a group of Dutch colonists purchased the island of Manhattan from the
Native American residents in 1626. Payment was made with wampum (likely glass beads and
trinkets), which had an estimated value of $24. Suppose the Dutch had invested this money
back home in Europe and earned an average return of 5 percent per year. How much would
this investment be worth today, 380 years later, using:
A. Simple interest?
B. Compound interest?
Topic: Simple and Compound Interest
Level of difficulty: Easy
Solution:
A. Value = P + (n x P x k) = $24 + (380 x $24 x 5percent) = $480

B. FV
$
380
24
(
10
.
years)
05$
2
,
704
,
860
,
602
.
74 380

16. David has been awarded a scholarship that will pay $2,500 one year from now. However, he
really needs the money today, and has decided to take out a loan. If the interest rate is 8
percent, how much can he borrow so that the scholarship will just pay off the loan?
Topic: Discounting
Level of difficulty: Easy
Solution:
The future value of the loan (the amount to be repaid) is $2,500. The amount that can be
borrowed is the present value amount, calculated as:
1 1
PV0 FV1 $2500 $2314.81
(1 k )1
(1 .08)1
Or using a financial calculator (TI BAII Plus),
N=1, I/Y=8, PMT=0, FV= -2500, CPT PV=2314.81

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17. Grace, a retired librarian, would like to donate some money to her alma mater to endow a
$4,000 annual scholarship. The university will manage the funds, and expects to earn 7
percent per year. How much will Grace have to donate so that the endowment fund never
runs out?
Topic: Perpetuities
Level of difficulty: Easy
Solution:
Present value of the perpetual scholarship payment:


1
1

PV
0

PMT$
4000

$
57
,
142
.
86


k
0
.
07

18. Grace decides that creating a perpetual scholarship is too costly (see Problem 17Error!
Reference source not found.). Instead, she would like to support the education of her
favourite grand-nephew, Stephen, who plans to begin university in three years. How much
will Grace have to invest today, at 7 percent, to be able to give Stephen $4,000 at the end of
each year for four years?
Topic: Ordinary Annuities
Level of difficulty: Easy
Solution:
Find the present value of the four-year annuity at year 3:
1 1
1 (1 k ) n 1 (1 0.07) 4
PV3 PMT $4000 $13,548.85
k 0.07

Now, find the present value of this amount today:


1 1
PV0 FV 3
$13,548.85 3
$11,059.90
(1 k ) (1.07)

19. Bank A pays 7.25 percent interest compounded semi-annually, Bank B pays 7.20 percent
compounded quarterly, and Bank C pays 7.15 percent compounded monthly. Which bank
pays the highest effective annual rate?
Topic: Effective Annual Rates
Level of difficulty: Easy
Solution:
2
0 .
0725

For Bank A, k
1
17
.38
%
2

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4
0 .
0720

For Bank B, k
1
17
.40
%
4
12
0.
0715

For Bank C, k
1
17
.39
%
12
Bank B pays the highest effective annual rate.

20. Jimmie is buying a new car. His bank quotes a rate of 9.5 percent per year for a car loan.
Calculate the effective annual rate if the compounding occurs:
A. Annually
B. Quarterly
C. Monthly
Topic: Determining Effective Annual Rates
Level of difficulty: Easy
Solution:
A. For annual compounding, the effective annual rate will be the same as the quoted rate. To
check this:
m 1
QR
9.
5%

k
1
1

1 9.
5%
m 1
B. With quarterly compounding, set m=4,
4
9.5%
k 1 1 9.84%
4
C. With monthly compounding, set m=12,
12
9.5%
k 1 1 9.92%
12

21. If Alysha puts $50,000 in a savings account paying 6 percent per year, how much money will
she have in total at the end of the first year if interest is compounded:
A. Annually?
B. Monthly?
C. Daily?
Topic: Effective vs. Quoted Rates
Level of difficulty: Easy
Solution:
A. k Quoted Rate 6% FV1 year PV0 (1 k ) $50,000 (1.06) $53,000

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12
QR
B. k 1 1 6.1678% FV1 year $50,000 (1.061678) $53,083.90
12
365
QR
C. k 1 1 6.1831% FV1 year $50,000 (1.061831) $53,091.55
365

22. Tony started a small business and was too busy to consider saving for retirement. Tony sold
the business for $550,000 when he was 55 years old. He thought he could fund his retirement,
because this was a lot more than his friend had amassed in his account. Tony can invest this
total sum and earn 10 percent per year. How much will his investment be worth in five years?
Topic: Investing Early
Level of difficulty: Easy
Solution:
FV5 years $550,000 (1 0.10) 5 $885,780.50
Tony will have less than his friend in five years because he is not adding more savings to his
account.

23. Public corporations have no fixed life span; as such, they are often viewed as entities that
will pay dividends to their shareholders in perpetuity. Suppose KashKow Inc. pays a
dividend of $2 per share every year. If the discount rate is 12 percent, what is the present
value of all the future dividends?
Topic: Perpetuities
Level of difficulty: Easy
Solution:
The value of any perpetual stream of payments can be valued as a perpetuity:
PMT $2
PV0 $16.67
k 0.12
Each share is worth $16.67.

24. Mary-Beth is planning to live in a university residence for four years while completing her
degree. The annual cost for food and lodging is $5,800 and must be paid at the start of each
school year. What is the total present value of Mary-Beths residence fees if the discount rate
(interest rate) is 6 percent per year?
Topic: Annuities Due
Level of difficulty: Easy
Solution:
Because the fees are paid at the start of the year, this is not an ordinary annuity, but rather, an
annuity due.

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1
1 (1 0.06)4
PV0 $5800 (1 0.06) $21,303.47
0.06

25. Calculate the effective annual rates for the following:


A. 24 percent, compounded daily
B. 24 percent, compounded quarterly
C. 24 percent, compounded every four months
D. 24 percent, compounded semi-annually
E. 24 percent, compounded continuously
F. Calculate the effective monthly rate for A to D.
Level of difficulty: Medium.
Solution:
.24 365
A. m = 365: k (1 ) 1 27.11%.
365
.24 4
B. m = 4: k (1 ) 1 26.25%.
4
.24 3
C. m = 3: k (1 ) 1 25.97%.
3
.24 2
D. m = 2: k (1 ) 1 25.44%.
2
E. Continuous compounding: k e.24 1 27.12%.
F. The effectively monthly rate is:
m 365
QR f .24 12
A. m=365, f=12 k (1 ) 1= (1 ) 1=2.02%
m 365
m 4
QR f .24 12
B. m=4, f=12. k (1 ) 1= (1 ) 1 =1.96%
m 4
m 3
QR f .24 12
C. m=3, f=12. k (1 ) 1= (1 ) 1 =1.94%
m 3
m 2
QR f .24 12
D. m=2, f=12. k (1 ) 1= (1 ) 1 =1.91%
m 2

26. On the advice of a friend, Gilda invests $20,000 in a mutual fund which has earned 10
percent per year, on average, in recent years. If this rate of return continues, how much will
her investment be worth in:

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A. one year?
B. five years?
C. ten years?
Topic: Compound Interest
Level of difficulty: Medium
Solution:
A. FV1 year $20,000 (1 0.10)1 $22,000.00

B. FV5 years $20,000 (1 0.10)5 $32,210.20

C. FV10 years $20,000 (1 0.10)10 $51,874.85

27. Your investment research has turned up an interesting mutual fund. It has had an average
annual return 0.5 percent greater than the one Gildas friend recommended (see Problem 26).
For each time period from Problem 26, calculate how much better off Gilda would be if she
invested $20,000 in this mutual fund.
Topic: Compound Interest
Level of difficulty: Medium
Solution:
First find the value of the investment after each period of time, and then compare to the
values from Problem 26 to determine how much difference a small change in the interest rate
can make.
A. FV1 year $20,000 (1 0.105) $22,100.00 . You are ($22,100 $22,000) = $100 better off
1

after one year.

B. FV5 years $20,000 (1 0.105) $32,948.94 . You are ($32,948.94 $32,210.20) = $738.74
5

better off after five years.

C. FV10 years $20,000 (1 0.105) $54,281.62 You are ($54,281.62 $51,874.85) = $2,406.77
10

better off after 10 years.

28. When Jon graduates in three years, he wants to throw a big party, which will cost $800. To
have this amount available, how much does he have to invest today if he can earn a
compound return of 5 percent per year?
Topic: Discounting
Level of difficulty: Medium
Solution:
Jon needs $800 in three years; that is the future value amount. The present value equivalent
is:

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1 1
PV0 FV3 $800 $691.07
(1 k ) 3
(1 .05)3
Or using a financial calculator (TI BAII Plus),
N=3, I/Y=5, PMT=0, FV= -800, CPT PV=691.07

29. In Problem 28, suppose Jon had only $500 to invest. How much can he plan to spend on the
graduation party in three years, if the return on the investment will be:
A. simple interest at 5 percent per year?
B. compound interest at 5 percent per year?
Topic: Simple and Compound Interest
Level of difficulty: Medium
Solution:
A. Jon will earn $500 5% $25 per year in interest. The value of his investment (or the
amount available to spend on the party) will be:
Value P (n P k ) $500 (3 500 0.05) $575

B. The interest earned grows (compounds) each year; the total available in three years is:
FV3 PV0 (1 k )3 $500 (1 .05)3 $578.81

30. At the age of 10, Felix decided that he wanted to attend a very prestigious (and expensive)
university. How much will his parents have to save each year to accumulate $40,000 by the
time Felix needs the funds in eight years? Assume Felixs parents can earn 7 percent
(compounded annually) on their savings, and that each years savings are deposited at the end
of the year.
Topic: Ordinary Annuities
Level of difficulty: Medium
Solution:
The future value amount is $40,000. The amount to be saved each year is really the payment
on an ordinary annuity:
(1 0.07)8 1
$40,000 PMT PMT $3898.71
0.07
Or using a financial calculator (TI BAII Plus),
N=8, I/Y=7, PV=0, FV= -40,000, CPT PMT= 3898.71

31. Felixs parents can only afford to save $3,000 per year for his university education, which
begins in eight years. What rate of return would they require on these savings if they must
accumulate $40,000?
Topic: Ordinary Annuities (Solving for IRR)

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Level of difficulty: Medium
Solution:
Solve for the interest rate (or internal rate of return) on an ordinary annuity. This is quite
difficult to do algebraically, but is easily handled with a financial calculator (TI BAII Plus).
Note that we must use a negative sign for the annual payment (savings) or the future value
amount, but not both.
N=8, PMT = 3,000, PV=0, FV= 40,000, CPT I/Y=14.2067%

32. Shortly after John was born, his parents began to put money in a savings account to pay for
his post-secondary education. They save $1,000 each year, and earn a return of 9 percent per
year. However, the interest income is taxed each year at a rate of 30 percent. How much will
Johns account be worth after 17 years?
Topic: Ordinary Annuity (Future Value)
Level of difficulty: Medium
Solution:
Taxation of the interest income has the effect of reducing the rate of return. In
effect: k 9% (1 0.30) 6.3% . Using this rate of return we find the future value of Johns

(1 0.063)17 1
account to be : FV17 $1000 $28,973.11
0.063

33. Johns parents used a regular savings account to save for his post-secondary education. Based
on the amount accumulated (from your answer in Problem 320), how much can John
withdraw from the account at the beginning of each year for his four years at university? The
account will continue to earn 9 percent per year, but interest income is taxed at a rate of 30
percent.
Topic: Annuities Due
Level of difficulty: Medium
Solution:
As in Problem 32, k 9% (1 0.30) 6.3% because of taxation. Johns withdrawals at the

beginning of each year are essentially payments on an annuity due:


1
1 (1 0.063)4
28,973.11 PMT (1 0.063) PMT $7919.95
0.063

34. Janes parents save $1,000 per year for 17 years to pay for her university tuition costs. They
deposit the money into a Registered Education Savings Plan (RESP) account so that no tax is

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payable on the interest income. This RESP account provides a return of 6 percent per year.
A. How much will Janes account be worth when she begins her university studies?
B. As an incentive to save for higher education, the government will add 20 percent to any
money contributed to an RESP each year. Including these grants, how much will Jane have in
her account?
Topic: Ordinary Annuity (Future Value)
Level of difficulty: Medium
Solution:
A. The future value of Janes account will be:
(1 0.06)17 1
FV17 $1000 $28,212.88
0.06
B. The grant has the effect of increasing the amount saved from $1,000 to $1,200. The future
value of the account will now be:
(1 0.06)17 1
FV17 $1200 $33,855.46
0.06

35. Janes parents used an RESP account to save for her post-secondary education. Based on the
amount accumulated (from your answer in Problem 340), Jane would like to withdraw the
same amount of money at the beginning of each year of her four-year degree program. All
funds (interest and principal) withdrawn from this account are taxed at a rate of 15 percent,
and the account will earn 6 percent per year on any remaining funds. How much will Jane
have available for tuition each year?
Topic: Annuities Due
Level of difficulty: Medium
Solution:
Each year, Jane can withdraw:
1
1 (1 0.06)4
33,855.46 PMT (1 0.06) PMT $9217.36
0.06

However, this amount will be subject to income tax at a rate of 15%. The net amount that
Jane will have available for tuition is then:
9217.36% (1 0.15) $7834.75

36. Stephen has learned that his great-aunt (see Problem 18Error! Reference source not found.)
intends to give him $4,000 each year he is studying at university. Tuition must be paid in
advance, so Stephen would like to receive his payments at the beginning of each school year.

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How much will his great-aunt have to invest today at 7 percent, to make the four annual
(start-of-year) payments?
Topic: Annuities Due
Level of difficulty: Medium
Solution:
Find the present value of the four-year annuity due:
1 1
1 (1 k )n 1 (1 0.07)4
PV0 PMT (1 k ) $4000 (1 0.07) $14,497.26
k 0.07

Now, discount this amount back three years:


1 1
PV0 FV 3
$14,497.26 3
$11,834.08
(1 k ) (1.07)
37. Rather than give her grand-nephew some money each year while he is studying, Stephens
great-aunt has decided to save the money and pay off Stephens student loans when he
finishes his degree. The total amount owing at that time will be $16,000. How much will she
have to save each year until that time if her investments earn a return of 7 percent per year?
Topic: Ordinary Annuities
Level of difficulty: Medium
Solution:
Assuming the savings are invested at the end of each year, find the payment (amount to be
saved) for an ordinary annuity with a future value of $16,000.
(1 0.07) 7 1
FV4 $16,000 PMT PMT $1,848.85
0.07

38. Jimmies new car (see Problem 20) will cost $29,000. How much will his monthly car
payments be if he obtains a loan that is amortized over 60 months, and the nominal interest
rate is 8.5 percent per year with monthly compounding?
Topic: Effective Interest Rates and Loan Arrangements
Level of difficulty: Medium
Solution:
First, find the effective interest corresponding to the frequency of Jimmies car payments (f
=12); with monthly compounding, set m=12,
m 12
QR f
8.5% 12
kmonthly 1 1 1 1 0.7083%
m 12
The 60 car payments form an annuity whose present value is the amount of the loan (the
price of the car):

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1
1 (1 0.007083)60
$29,000 PMT PMT $594.98
0.007083

39. Create an amortization schedule for Jimmies car loan (see Problem 38Error! Reference
source not found.). What portion of the first monthly payment goes towards repaying the
principal amount of the loan? What portion of the last monthly payment goes towards the
principal?
Topic: Loan Arrangements
Level of difficulty: Medium
Solution:
Use the effective monthly interest rate from Problem 38, k=0.7083%

(4)
(3) Ending
(1) Principal (2) Principal
Period Interest Principal
Outstanding Payment Repayment
=k*(1) = (1)-(4)
= (2)-(3)
1 29,000.00 594.98 205.42 389.56 28,610.44
2 28,610.44 594.98 202.66 392.32 28,218.12
3 28,218.12 594.98 199.88 395.10 27,823.01
4 27,823.01 594.98 197.08 397.90 27,425.11
5 27,425.11 594.98 194.26 400.72 27,024.40
6 27,024.40 594.98 191.42 403.56 26,620.84
7 26,620.84 594.98 188.56 406.42 26,214.42
8 26,214.42 594.98 185.69 409.29 25,805.13
9 25,805.13 594.98 182.79 412.19 25,392.94
10 25,392.94 594.98 179.87 415.11 24,977.82
11 24,977.82 594.98 176.93 418.05 24,559.77
12 24,559.77 594.98 173.97 421.01 24,138.76
13 24,138.76 594.98 170.98 424.00 23,714.76
...
35 14,083.18 594.98 99.76 495.22 13,587.95
36 13,587.95 594.98 96.25 498.73 13,089.22
37 13,089.22 594.98 92.72 502.26 12,586.96
...
59 1,177.43 594.98 8.34 586.64 590.79
60 590.79 594.98 4.18 590.79 0.00

The first monthly payment repays $389.56 of the principal amount of the loan and the last
payment repays $590.79.

40. Using the amortization schedule from Problem 39, determine how much Jimmie still owes on
the car loan after three years of payments on the five-year loan. What is the present value of
this amount?
Solutions Manual 15 Chapter 5
Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Topic: Loan Arrangements and Discounting
Level of difficulty: Medium
Solution:
After three years, or 36 monthly payments, the principal outstanding is $13,089.22 (from the
amortization table). The present value of this amount is:

1
PV0 $13,089.22 $10,152.30
36
(1 0.007083)

41. Jimmie would like to pay off his car loan in three years (see Problem 38), but can only afford
monthly payments of $594.98. How big a down-payment must Jimmie make on the $29,000
car if the nominal interest rate is 8.5 percent with monthly compounding?
Topic: Loan Arrangements
Level of difficulty: Medium
Solution:
Use the effective monthly interest rate from Problem 38, k=0.7083%
Find the present value of Jimmies 36 payments:
1
1 (1 0.007083)36
PV0 $594.98 $18,847.95
0.007083

Therefore, Jimmie must make a down payment of


$29,000.00 $18,847.95 $10,152.05

42. Jimmie is offered another loan of $29,000 that requires 60 monthly payments of $588.02 (see
Problem 38Error! Reference source not found.). What is the effective annual interest rate
on this loan? What would the quoted rate be?
Topic: Loan arrangements and Effective Annual Rates
Level of difficulty: Medium
Solution:
The 60 monthly payments form an annuity whose present value is $29,000. Finding the
interest rate is most easily done with a financial calculator (TI BAII Plus):
N=60, PMT=588.027, PV= -29,000, CPT I/Y = 0.6667%
Note that we used N=60 months, so the solution is a monthly interest rate, however, the
problem asks for the effective annual rate.
k (1 kmonthly )12 1 (1 0.006667)12 1 8.30%

The quoted rate would be:

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1 1
QR m [(1 k ) 12
1] 12 (1 0.0830) 12
1 8.00%

Or simply: QR m kmonthly 12 0.006667 8.00%

43. To start a new business, Su Mei intends to borrow $25,000 from a local bank. If the bank
asks her to repay the loan in five equal annual instalments of $6,935.24, determine the banks
effective annual interest rate on the loan transaction. With annual compounding, what
nominal rate would the bank quote for this loan?
Topic: Determining Rates of Return and Effective Interest Rates
Level of difficulty: Medium
Solution:
Solve the annuity equation to find k, the interest rate:
1
1 (1 k )5
$25,000.00 $6935.24 k ?
k

The calculations are most easily done with a financial calculator (TI BAII Plus),
PV = -25,000, PMT=6935.24, N= 5, FV=0, CPT I/Y = 12%
The effective annual interest rate is 12 percent. With annual compounding, the nominal rate
(or quoted rate) will also be 12 percent per year.

44. The Business Development Bank is willing to loan Su Mei the $25,000 she needs to start her
new company. The loan will require monthly payments of $556.11 over five years.
A. What is the effective monthly rate on this loan?
B. With monthly compounding, what is the nominal (annual) interest rate on this loan?
Topic: Determining Rates of Return and Effective Interest Rates
Level of difficulty: Medium
Solution:
A. There will be 5 x 12 = 60 monthly payments. The calculations are most easily done with a
financial calculator (TI BAII Plus),

PV = 25,000, PMT=556.11, N= 60, CPT I/Y = 1.0%


Because we used monthly payments, and months as the time period, 1.0% is the effective
monthly rate.

B. The compounding period matches the payment frequency, so the nominal rate, or quoted
rate, is:
QR m kmonthly 12 1.0% 12.0% per year.

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45. Compare the loans in problems 043 and 440. Which is the better deal, and why?
Topic: Effective Interest Rates
Level of difficulty: Medium
Solution:
The two loans have the same principal amount; one requires monthly payments, the other
annual, so they cannot be compared on that basis. We need an effective rate for the same
period of time for comparison. In Problem 43, the effective annual rate was 12%. For
Problem 44, the effective annual rate is:
k (1 kmonthly )12 1 (1 0.01)12 1 12.7% .
Clearly, the loan in Problem 43 is a better deal because the effective interest rate charged is
lower.

46. After losing money playing on-line poker, Scott visits a loan shark for a $750 loan. To avoid
a visit from the collection agency, he will have to repay $800 in just one week.
A. What is the nominal interest rate per week? Per year?
B. What is the effective annual interest rate?
Topic: Effective Interest Rates
Level of difficulty: Medium
Solution:
A. You will pay interest of (800750) = $50 after one week. This implies a nominal interest
rate of 50/750 = 6.67% per week. With 52 weeks in the year, the nominal rate per year is then
52 x 6.67% = 346.67%.
B. The effective annual interest rate is k (1 0.0667) 52 1 27.7210 2,772.10%
2,872.1% 1=2,772.1%

47. Josephine needs to borrow $180,000 to purchase her new house in Yarmouth, Nova Scotia.
She would like to pay off the mortgage in 20 years, making monthly payments. For the initial
three-year term, Providence Bank has offered her a quoted annual rate of 6.40 percent.
A. What is the effective annual interest rate?
B. What is the effective monthly interest rate?
C. How much will Josephines monthly mortgage payments be?

Topic: Mortgage Loans and Effective Interest Rates


Level of difficulty: Medium
Solution:
A. In Canada, fixed-rate mortgages use semi-annual compounding of interest, so m=2. The
effective annual rate is therefore:

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Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
m 2
QR 0.064
k 1 1 1 1 6.5024%
m 2
B. With monthly payments, f=12. We can find the effective monthly interest rate from the
effective annual rate, k:
kmonthly 1 k 1 1 6.5024% 12 1 0.5264%
1 1
f

C. The amortization period is 20 years, or 20 x1 2 = 240 months. Josephines monthly


payments can be computed as:
1
1 (1 0.005264) 240
$180,000 PMT PMT $1,322.69
0.005264

48. The Yarmouth Credit Union will provide Josephine with a mortgage at a rate of 6.36 percent,
but unlike most Canadian mortgages, the compounding will occur monthly. Should
Josephine take out the mortgage loan from the Credit Union, or from Providence Bank (see
Problem 470)? Can you answer this question without calculating the monthly mortgage
payment?
Topic: Mortgage Loans and Effective Interest Rates
Level of difficulty: Medium
Solution:
With monthly compounding and payments, the effective monthly interest rate is:
m 12
QR f
0.0636 12
kmonthly 1 1 1 1 0.530%
m 12
Even though the quoted rate is lower at the Credit Union than at the Bank (see Problem 470),
the effective rate is higher. Josephine should take the mortgage loan from the Bank in this
case. The monthly payment for the Credit Union mortgage would be $1,327.24, which, as
expected, is higher than that at the Bank.

49. Assume Josephine chose the Providence Bank option (see Problem 470). If Josephine can get
the same interest rate for a second three-year term as she did originally, how much will her
monthly payments be now?
Topic: Mortgage Loans
Level of difficulty: Medium
Solution:
If we assume that Josephine does not change the amortization period (now 17 years), then the
same interest rate will result in making the same monthly payments. We can confirm this by
computing the payment for a mortgage with a principal amount equal to the amount now

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outstanding ($165,172.38 based on Problem 47), that lasts 204 months (17 years):
1
1 (1 0.005264)204
$165,172.38 PMT PMT $1322.69
0.005264

50. A lakefront house in Kingston, Ontario is for sale with an asking price of $499,000. The
real-estate market has been quite active, so the house will almost certainly attract several
offers, and may sell for more than the asking price. Charlie is very eager to purchase this
house, but is concerned that he may not be able to afford it. He has $130,000 available for a
down payment, and can pay up to $1,950.00 per month on a mortgage loan. As a long-time
customer, Charlies bank has offered him a great mortgage rate of 3.90 percent on a one-year
term. If the loan will be amortized over 25 years, what is the most that Charlie can afford to
pay for the house?
Topic: Mortgage Loans
Level of difficulty: Medium
Solution:
With semi-annual compounding (the norm in Canada) and monthly payments, m=2 and f=12.
The effective monthly rate is:
m 2
QR f
0.039 12
kmonthly 1 1 1 1 0.3224%
m 2
The present value of the mortgage payments over the amortization period (25 years x 12 =
300 months) is:
1
1 (1 0.003224)300
PV0 $1950.00 $374,553.72
0.003224

In addition, Charlie has $130,000 available as a down payment; the most he can pay for the
house is, therefore, $374,553.72 + $130,000 = $504,553.72.

51. Timmy sets himself a goal of amassing $1 million in his retirement fund by the time he turns
61. He begins saving $3,000 each year, starting on his 21st birthday (40 years of saving).
A. If his savings earn 10 percent per year, will Timmy achieve his goal?
B. Will Timmy be able to retire before he turns 60? That is, at what age will the value of his
savings plan be worth $1 million?
Topic: Investing Early
Level of difficulty: Medium
Solution:

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A. Timmys savings extend right to age 61 (end of each year), so this is an ordinary annuity.
(1 0.10) 40 1
FV40 $3,000 $1,327,777.67
0.10
Yes, Timmy will achieve his goal by a comfortable margin.

B. In the equation for part A set FV=$1,000,000, and solve for the number of years, n. This
is easiest done with a financial calculator (TI BAII Plus),
FV = 1,000,000, I/Y = 10, PMT = 3000, CPT N = 37.1.

Timmy will hit the $1 million dollar mark in just over 37 years, or shortly after his 58 th
birthday.

52. Tommy set the same retirement goal as his friend Timmy (see Problem 510). However, there
always seemed to be a reason not to save money, so he put it off for many years. Finally, with
just 15 years to retirement, he began to save. Fortunately, Tommys executive-level job
allowed him to save $30,000 per year. If these savings earn 10 percent per year, will Tommy
achieve his $1million goal at the desired time?
Topic: Investing Early
Level of difficulty: Medium
Solution:
This is an ordinary annuity.
(1 0.10)15 1
FV15 $30,000 $953,174.45
0.10
No, Tommy will not quite achieve his goal by age 61.

53. Jack is 28 years old now and plans to retire in 35 years. He works in a local bank and has an
annual after-tax income of $45,000. His expected annual expenditure is $36,000 and the rest
of his income will be invested at the beginning of each of the next 35 years at an expected
annual rate of return of 12.6 percent. Calculate the amount Jack will receive when he retires.
Level of difficulty: Difficult.
Solution:
Annual investment = Annual income Annual expenditure = $45,000 $36,000 = $9,000.
This is an annuity due.
(1 k )n 1
FVn PMT (1 k )
k

(1 .126)35 1
9,000 (1.126) (9,000)(497.2749)(1.1 2 6) $5,0 3 9,3 8 4
.126

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Or using a financial calculator (TI BAII Plus),
Hit [2nd] [BGN] [2nd] [Set]
N=35, I/Y=12.6, PV=0, PMT= -9,000, CPT FV=5,039,384

54. In Problem 53, if Jack prefers to invest a lump-sum amount today instead of investing
annually, but still expects to receive the same amount of money when he retires, how much
should he invest today?
Level of difficulty: Difficult
Solution: There are two ways to get the answer:
1). PV=FV/(1+k)n=5,039,384/(1.126)35=5,039,384/63.6566=$79,165
Or using a financial calculator (TI BAII Plus),
N=35, I/Y=12.6, PMT=0, FV=5,039,384, CPT PV= - 79,165
2).
1
1 (1 k )n
PV0 PMT (1 k )
k

1
1 (1.126)35
$9,000 (1.126) (9,000)(7.8118311)(1.126) $79,165
.126

Or using a financial calculator (TI BAII Plus),


Hit [2nd] [BGN] [2nd] [Set]
N=35, I/Y=12.6, PMT= -9,000, FV=0, CPT PV=79,165

55. In Problem 53, if Jack invests the same annual amount at the end of each of the next 35 years
instead of at the beginning of the years, how much he will receive when he retires? Explain
why this amount is greater or smaller than the result calculated in Problem 53.
Level of difficulty: Difficult
Solution: Now it is an ordinary annuity.
(1 k )35 1 (1 .126) 35 1
FV35 P M T = 9,000 9,000(497.2749) $4,475,474
k .126
Or using a financial calculator (TI BAII Plus),
N=35, I/Y=12.6, PV=0, PMT= 9,000, CPT FV= 4,475,474.
So, 4,475,474<5,039,384.

As expected, FV of an ordinary annuity is less than an otherwise identical annuity due.


Because each annual investment is compounded one year less in an ordinary annuity, where

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Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
the annual investment is at each year-end, while in the annuity due this amount is invested at
the beginning of each year. Alternatively, we can look at Equation 5-4 and Equation 5-6. The
difference is due to the compound factor (1+k).

56. A. Determine the month-end payment for a $200,000, 10-year loan with an interest rate of 12
percent, compounded monthly. (Assume there is no down payment)
B. Calculate the outstanding loan amount after 18 months.
C. Redo part A, assuming it is a mortgage loan with monthly payments.

A. Level of difficulty: difficult.


Solution:
PV=200,000, monthly rate=12%/12=1%, N = (10)(12)=120 months
1
1 (1 .01)120
200,000 PMT
.01

1
1
(1 .01)120
PMT 200,000 /
.01

So, PMT=$2,869
Or using a financial calculator (TI BAII Plus),
N=120, I/Y=1, PV=-200,000, FV=0, CPT PMT=2,869

B. Remaining months to pay=120 18=102 months


1
1
(1 .01)102
PV0 2,869 =$182,920
.01

Or using a financial calculator (TI BAII Plus),


N=102, I/Y=1, PMT=- 2,869, FV=0, CPT PV=182,920

2
.12 12
C. kmonthly= (1 ) 1 =.9759%
2

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1
1 (1 .009759)120
200,000 PMT
.009759

1
1 (1 .009759)120
PMT 200,000 /
.009759

So, PMT=$2,836
Or using a financial calculator (TI BAII Plus),
N=120, I/Y=.9759, PV=-200,000, FV=0, CPT PMT=2,836

57. Investor A just turned 20 years old and currently has no investments. She plans to invest
$5,500 at the end of each eight years, beginning in five years. The rate of return on her
investment is 15 percent, continuously compounded. Investor B is 40 years old and he just
started to invest at the beginning of every year an equal amount of money starting today. He
will invest for 10 years. The rate of return on his investment is 16 percent, compounded
quarterly. Determine the yearly payment Investor B has to make in order to have the same
present value as Investor A.
Level of difficulty: Difficult
Solution:
Investor A:
k=e.15 1=16.183424%.
1st, consider an ordinary annuity and the present value of the investment when A turns 25
years old is:
1
1 (1 .16183424)8
PV25 5,500 =$23,749.19
.16183424

Or using a financial calculator (TI BAII Plus),


N=8, I/Y=16.183424, PMT=5,500, FV=0, CPT PV=- 23,749.19

2nd, discount this amount for five years back to today when she is 20.
PV=FV/(1+k)5=23,749.19/(1.16183424)5=$11,218.3231
Or, N=5, I/Y=16.183424, PMT=0, FV=- 23,749.19, CPT PV=11,218.3231

Investor B:

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Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
.16 4
k= (1 ) 1=16.985856%
4
1
1 (1 .16985856)10
11,218.3231 PMT (1.16985856)
.16985856

PMT=$2,057.38
Or using a financial calculator (TI BAII Plus),
Hit [2nd] [BGN] [2nd] [Set]
N=10, I/Y=16.985856, PV=11,218.3231, FV=0, CPT PMT= - 2,057.38
Therefore, Investor B has to make an equal amount of $2,057.38 so that the present value of
the two investments is the same.

58. Paul and Maria want to have enough money to travel around the world when they retire.
They just turned 30 and will retire when they turn 60. They earn a total of $9,000 after taxes
each month. Their monthly expenditures include $3,000 in mortgage payments, $850 in car
payments, and $1,450 in other expenses. They approached a fund manager and decided to
invest the rest of their income at the end of each year. They expect to earn a 10 percent
expected annual rate of return for each of the next 30 years. When they retire, they will sell
their cottage for an expected price of $50,000.
A. Determine how much they will have when they retire.
B. How much can Paul and Maria withdraw annually at the beginning of the year for
travelling after they retire if they expect to live until they are 90?

A. Level of difficulty: Difficult


Solution:
1st Calculate their yearly income available for investment
Monthly income available=$9,000 $3,000 $850 $1,450=$3,700
Yearly available=$(3,700)(12)=$44,400
2nd Calculate the FV of their investment when they retire:
(1 .1)30 1
FV30 44,400 =$7,303,535
.1
Or using a financial calculator (TI BAII Plus),
N=30, I/Y=10, PV=0, PMT=- 44,400, CPT FV=7,303,535
3rd Calculate the amount they will have when they retire:
$7,303,535 + $50,000 = $7,353,535

B. Level of difficulty: Difficult


Solution:

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This is an annuity due problem.
PV=7,353,535, k=10%, n=30
1
1 (1 .1)30
7,353,535 PMT (1 .1)
.1

So, PMT=709,143
Or using a financial calculator (TI BAII Plus),
Hit [2nd] [BGN] [2nd] [Set]
N=30, I/Y=10, PV=- 7,353,535, FV=0, CPT PMT=709,143

59. Veda has to choose between two investments that have the same cost today. Both investments
will ultimately pay $1,300 but at different times, as shown in the table below. If Veda doesnt
choose one of these investments, she could leave the funds in a bank account paying 5
percent per year. Which investment should Veda choose?

Year Investment A Investment B


1 $0 $200
2 $500 $400
3 $800 $700

Topic: Discounting
Level of difficulty: Difficult
Solution:
Find the present value of the money paid back to Veda by each investment, using the interest
rate on the alternative (the bank account) as the discount rate.
$500 $800
For Investment A: PV0 $453.51 $691.07 $1144.58
(1 0.05) (1 0.05)3
2

For Investment B:
200 400 700
PV0 190.48 362.81 604.69 $1157.98
(1 0.05) (1 0.05) (1 0.05)3
1 2

Veda would prefer Investment B, because it has the higher present value.

60. If the cost of each investment in Problem 59 0 is $1,000, should Veda invest in one of them,
or simply leave the money in the bank account? Would her decision change if the
investments cost $1,200 each?
Topic: Discounting and Determining Rates of Return
Level of difficulty: Difficult

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Solution:
Observe that the present value of the money returned by both investments, using the 5
percent discount rate, is greater than the $1,000 cost (see Problem 59). Therefore, they both
have a positive net present value. On this basis, either investment would be preferable to
the bank account (returning 5%); Investment B is more preferable.
If the cost of the investments was $1,200, neither would be acceptable, as the present
value of the money returned is less than the cost (they have a negative net present value).

61. Instead of a $40,000 lump sum, Felix will need $10,000 per year for four years to pay for
tuition (see Problem 30). How much will Felixs parents have to invest at the end of each
year for the eight years before he begins his studies if their savings earn compound interest at
7 percent per year? Assume the tuition payments also occur at the end of each year.
Topic: Ordinary Annuities
Level of difficulty: Difficult
Solution:
We have two separate annuities to consider: the tuition payments, and the savings amounts.
First, find the present value of the four annual tuition payments (at time 8, when Felix is due
to begin university studies):
1
1
(1 0.07)4
PV8 10,000 $33,872.11
0.07


This is the amount of savings required at time 8. From the perspective of time 0, this is a
future value amount (replaces the $40,000 in Problem 0.) Next, find the annual savings
amount:
(1 0.07) 8 1
$33,872.11 PMT PMT $3,301.44
0 .07

62. Repeat Problem 61 0assuming the tuition payments occur at the beginning of each year (the
savings are still invested at the end of each year).
Topic: Annuities Due
Level of difficulty: Difficult
Solution:
This problem can be solved in the same two step manner used in Problem 61. However, the
first step involves an annuity due, as the tuition payments occur at the start of each year:

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1
1
(1 0.07)4
PV8 10,000 (1 0.07) $36,243.16
0.07


Or using a financial calculator (TI BAII Plus),
Hit [2nd] [BGN] [2nd] [Set]
N=4, I/Y=7, PMT=10,000, FV=0, CPT PV= 36,243.16

This answer is used as the future value amount in the second step:

(1 0.07)8 1
$36,243.16 PMT PMT $3532.54
0.07
Or using a financial calculator (TI BAII Plus),
(Remember to clear the calculator, or turn off BGN mode for this step, as this is an
ordinary annuity, not an annuity due)
N=8, I/Y=7, PV=0, FV= -36,243.16, CPT PMT= 3532.54

63. Roger has his eye on a new car that will cost $20,000. He has $15,000 in his savings account,
earning interest at a rate of 0.5 percent per month.
A. How long (to the nearest month) will it be before he can buy the car?
B. How long will it be before Roger can buy the car if, in addition to his existing savings, he
can save $250 per month?
Topic: Determining Holding Periods
Level of difficulty: Difficult
Solution:
A. We know the future value and present value amounts, as well as the monthly interest rate.
Finding the number of time periods (months) is most easily done with a financial calculator
(TI BAII Plus),
PV = 15,000, FV = -20,000, I/Y = 0.5, CPT N = 57.68
It will take nearly 58 months, or close to 5 years before Roger can afford to buy the car!
B. Solving the following equation for n we get:
15,000 (1.005) n 1
20,000 250 .005 n= 14.86.
(1.005) n
Or using a financial calculator (TI BAII Plus),
I/Y=0.5, PV=15,000, FV= -20,000, PMT = 250, CPT n = 14.86

64. How many years will it take for an investment to double in value if the rate of return is 9
percent, and compounding occurs:

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A. annually?
B. quarterly?
Topic: Effective Interest Rates and Holding Periods
Level of difficulty: Difficult
Solution:
Lets assume the present value of the investment is $1. The future value, after doubling is
then $2.
A. Annually: With annual compounding, the effective rate is the same as the quoted rate, 9%.
Using a financial calculator (TI BAII Plus),
PV = 1, FV = 2, I/Y = 9, CPT N = 8.04
So the investment will double in just over 8 years.
B. Quarterly: With quarterly compounding, the effective annual rate is,
0.09 4
k (1 ) 1 9.308% , and a financial calculator allows us to find:
4

PV = -1, FV = 2, I/Y = 9.308, CPT N = 7.79


The higher effective rate means that only 7.79 years are needed to double the value of the
investment.

65. Assume Josephine chose the Providence Bank option (see Problem 47). The three-year term
on Josephines mortgage is now over, and she must renew the loan for another term. How
much of the original $180,000 principal amount does she still owe?
Topic: Mortgage Loans
Level of difficulty: Difficult
Solution:
The principal outstanding at any time is the present value of the remaining payments. After
three years, there are 17 years remaining of the original 20-year amortization period, or 17 x
12 = 204 monthly payments remaining. Based on Problem 47, the payment amount is
$1,322.69. Therefore:
1
1 (1 0.005264)204
PV3 years $1322.69 $165,172.38
0.005264

66. How much interest did Josephine pay over the three-year term of her mortgage loan (see
Problem 470)?
Topic: Mortgage Loans
Level of difficulty: Difficult
Solution:
Josephine has made 3 x 12 = 36 payments, of $1322.69. The total amount she has paid over

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Copyright 2008 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
the three years is therefore, 36 x $1,322.69 = $47,616.84.
Based on the solution to Problem 0, she has paid off ($180,000 $165,172.38) = $14,827.62
of the principal amount of the mortgage loan.

Therefore, of her total payments, ($47,616.84 $14,827.62) = $32,789.22 was interest.

67. A year has passed since Charlie purchased his house (see Problem 500). Assume the original
mortgage amount (from your answer in Problem 500) was to be amortized over 25 years,
with an initial one-year term at 3.90 percent. If the interest rate on a one-year term has
increased to 5.35 percent, what will be Charlies new monthly mortgage payments?
Topic: Mortgage Loans
Level of difficulty: Difficult
Solution:
There are 24 years, or 24 x 12 = 288 months remaining on the mortgage. Using the effective
monthly interest rate from Problem 50, the outstanding principle amount is:
1
1 (1 0.003224) 288
PV1 year $1,950.00 $365,484.77
0.003224

The new effective monthly interest rate is:


2
0.0535 12
kmonthly 1 1 0.4409% .
2
Using this rate, and the outstanding principal, the new mortgage payment will be:
1
1 (1 0.004409) 288
$365,484.77 PMT PMT $2,243.31
0.004409

68. The new and higher mortgage payments calculated in Problem 670 creates a big problem for
Charlie, because he can afford to pay only $1,950.00 per month. Rather than sell the house,
Charlie has convinced his bank to extend the amortization period on the loan, which will
reduce the monthly payments. How long must the amortization period be for this mortgage
so that Charlie can afford to make the payments?
Topic: Mortgage Loans
Level of difficulty: Difficult
Solution:
Here we must solve the annuity equation to find the amortization period required:

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1
1 (1 0.004409)n
$365,484.77 $1950.00 n?
0.004409

This can be done algebraically if you are familiar with the logarithm function:

$365,484.77 0.004409
n Ln1 1 Ln(1 0.004409) 397.98
$1950.00
An easier method is to use a financial calculator (TI BAII Plus),
I/Y=0.4409, PMT=1950, PV= -365,484.77, FV=0, CPT N= 397.98

We have used a monthly interest rate, so our solution is in terms of months, not years. Our
final answer is that Charlie must extend the amortization period to at least 398 months (or 33
years and 2 months) so that he can still afford the monthly payments.

69. Cline has just won a lottery. She will receive a payment of $6,000 each year for nine years.
As an alternative, she can choose an immediate payment of $50,000.
A. Which alternative should she pick if the interest rate is 5 percent?
B. What would the interest rate have to be for Cline to be indifferent about the two
alternatives0?
C. The lottery offers a third alternative for lottery prize payments: Cline can opt to receive
annual payments of $3,000 per year for the rest of her life. Should Cline choose this option
to the $50,000 lump sum payment today, if the interest rate is 5 percent per year?

Topics: Ordinary Annuities, Determining Rates of Return, Perpetuities


Level of difficulty: Difficult
Solution:
A. The present value of the annual payments can be found with a financial calculator, (TI
BAII Plus), N=9, PMT = -6000, I/Y = 5.0, FV=0, CPT PV = 42,646.93
As this is less than $50,000, the immediate payment alternative is better.

B. This problem can be solved by trial and error, but the task is much easier with a financial
calculator, (TI BAII Plus), N=9, PMT = 6,000, PV = 50,000, FV=0, CPT I/Y = 1.5675%. At
an interest rate below 1.5675% per year, the nine-year annuity would be preferable; above the
rate the immediate payment is better.

C. This alternative is a perpetuity. Its present value is:


PMT $3,000
PV0 $60,000 .
k 0.05
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Clearly this is preferable to a $50,000 lump sum payment.

70. After 20 years, the lottery company in Problem 69 goes out of business, and Clines
payments of $3,000 annually, which were supposed to continue for the rest of her life, stop.
A. What is the present value of the lost payments?
B. How much were these lost payments worth 20 years ago when Cline won the prize?
C. Had she been able to predict that the lottery company would go out of business, should
Cline have chosen the perpetual payments, or the $50,000 lump sum?
Topic: Perpetuities and Discounting
Level of difficulty: Difficult
Solution:
A. Even after 20 years, the remaining payments form a perpetuity.
PMT $3,000
PV20 years $60,000
k 0.05
B. We must discount the figure from part (a) back 20 years:
$60,000
PV0 $22,613.37
(1 0.05)20
C. The value of 20 years of $3,000 payments (an annuity) can be easily found using a
financial calculator (TI BAII Plus), N=20, PMT = -3000, I/Y = 5.0, FV=0, CPT PV =
37,386.63.

In hindsight, the $50,000 lump-sum payment would have been preferable. The same result
could be found by subtracting the result in part B from that in A; this demonstrates that an
annuity can be thought of as the difference between two perpetuities!

71. Alysha has decided to use her $50,000 to make a down payment on a house. She will live in
the house for the next two years while still at university, and then sell it when she graduates.
The bank has offered her a mortgage rate of 5.1 percent compounded semi-annually on a
two-year term, with an amortization period of 25 years. The house she is interested in
purchasing costs $280,000.
A. If two friends will rent rooms from Alysha for $475 per room, payable at the end of each
month, how much additional money must she pay to meet her monthly mortgage payments?
B. In two years, Alysha wants to sell the house for a high enough price to cover the
remaining principal amount on the mortgage, and return her down payment. What is the
minimum sale price she should accept?
Topic: Mortgage Loans
Level of difficulty: Difficult
Solution:
A. The effective monthly interest rate is,

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2
0.051 12
kmonthly 1 1 0.4206%
2
The amount of the mortgage loan will be ($280,000 $50,000) = $230,000, and there will be
12 x 25 = 300 monthly payments, the value of which can be found with a financial calculator,
(TI BAII Plus), N=300, PV = 230,000, I/Y = 0.4206, CPT PMT = 1350.89. Alyshas two
friends will be paying 2 x $475 = $950 in rent, so she will need an additional $1,350.81
$950 = $400.81 to make the mortgage payments.

B. In two years, Alysha will have made 24 payments, leaving 276. The present value of these
payments is the outstanding value of the mortgage loan. Using the calculator again, N=276,
I/Y = 0.4206, PMT = 1350.89, CPT PV = 220,336.58. To pay off the loan, and recoup her
down payment, Alysha would have to sell the house for at least $220,336.58 + $50,000 =
$270,336.58.

72. How much will Tommy have to earn on his savings (see Problem 520) to be able to amass $1
million in 15 years?
Topic: Investing Early
Level of difficulty: Difficult
Solution:
In the equation for Problem 52, set FV=$1,000,000, and solve for the interest rate. This is
easiest done with a financial calculator (TI BAII Plus),
N = 15, PV=0, FV = -1,000,000, PMT = 30,000, CPT I/Y = 10.603
It will take only a little higher return, 10.6%, for Tommy to reach his goal.

73. KashKow Inc. has just declared that its dividend next year will be $3 per share. That rate of
payment will continue for an additional four years, after which the dividends will fall back to
their usual $2 per share (see Problem 230). What is the present value of all the future
dividends?
Topic: Multiple Annuities
Level of difficulty: Difficult
Solution:
The dividends for the first five years form an ordinary annuity. Starting in year 6, the reduced
dividend stream can be thought of as a perpetuity. However, the value of this perpetuity, as
determined by our formula, occurs at year 5 (one year before the first $2 dividend), and must
be discounted to the present:
1
1
PV0 $3.00
(1 0.12)5 $2.00 1
10.81 16.67 0.5674 $20.27
5
0.12 (1 0.12)
0.12

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74. After one year living in a university residence, Mary-Beth (see Problem 24) decides to rent
an apartment for the remaining three years of her degree. She has found a nice location that
will cost $450 per month; rent for the first and last month must be paid up front. How much
money would Mary-Beth need to have in her bank account right now to be sure she will
always have enough for rent? The bank account pays 3.75 percent interest, compounded
monthly.
Topic: Annuities Due
Level of difficulty: Difficult
Solution:
0.0375
kmonthly 0.3125%
12
Rent payments are typically made at the start of each month (so this is an annuity due). Over
three years, we would expect 36 monthly rent payments. However, the last months rent must
be paid up front, so the annuity includes only 35 payments; the present value of the last
months rent is $450 because it will be paid today.
1
1 (1 0.003125)35
PV0 $450 (1 0.003125) $450 $15,393.77
0.003125

75. Suppose that Mary-Beth plans to return home for four months each summer, and will sub-let
her apartment for the same amount she pays in rent (see Problem 740). In other words, she
will pay $450 rent, but for only eight months of the year, during each of three years. In this
situation, how much would she need to have in her bank account, earning 3.75 percent
compounded monthly? (Assume that rent payments are made at the start of each month.)
Topic: Annuities Due and Multiple Annuities
Level of difficulty: Difficult
Solution:
As in Problem 74, kmonthly 0.3125% .

Consider one year, or 8 months of rent payments made at the start of each month:
1
1 (1 0.003125) 8
PV0 $450 (1 0.003125) $3,560.99
0.003125

Mary-Beth will need to have this sum now, plus the same amount one year from now, and
again two years from now. In essence, this is a three-year annuity due, whose value must be
calculated using the effective annual interest rate.

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12
0.0375
k 1 1 3.8151%
12

1
1 (1 0.038151) 3
PV0 $3,560.99 (1 0.038151) $10,295.19
0.038151

76. A 65-year-old man intends to use his retirement funds to purchase an annuity from a life
insurance company. Given the amount of money the man has available to invest, the
insurance company is able to offer two alternatives. The first option is to receive $2,785 each
month for as long as he lives; the second option is to receive $3,500 each month, but for only
20 years (payments will be made to his estate if he should die before that time). The relevant
interest rate is 6 percent per year. How long must the man live so that the first option is a
better deal?
Topic: Ordinary Annuities and Multiple Annuities
Level of difficulty: Difficult
Solution:
It is tempting to view the first option as a perpetuity, but this would be incorrect as the man
will die at some time, and the payment will then cease. Thus, option one is an ordinary
annuity, with an uncertain number of payments. Option two is much easier to value; it
includes exactly 240 monthly payments.

0.06
kmonthly 0.5%
12

Using a financial calculator (TI BAII Plus),


N = 240, PMT = 3500, I/Y = 0.5, FV=0, CPT PV = 488,532.70

For the first option to be a better deal, it must include enough payments so that its present
value is at least as great as for option two. Again using the calculator,
PV = 488,532.70, PMT = 2785, I/Y = 0.5, CPT N = 420.3
So option one must continue for 420.3 monthly payments to equal the value of option two, or
421 payments to surpass it. This is just over 35 years. Hence, the man must live to be at least
100 years old for option one to be a better deal!

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