Appendix II Compound Interest and The Concept of Present Value

Appendix II
Compound Interest and the Concept of Present Value
Multiple Choice Questions
1. The main idea behind the time value of money is that:
A. cash flows received in the distant future are less valuable than cash flows received in the near-
term future.
B. cash received in year 3, say, $80,000, has the same value as $40,000 received in year 3 plus
$40,000 received in year 4.
C. cash flows received in different years are treated as equal in value.
D. cash payments made in the future have the same value as payments made today.
E. timing considerations of cash flows have little value in decision making.
2. The procedure used to compute the future value of a series of cash flows is known as:
A. compounding.
B. the annuity method.
C. discounting.
D. the future-cost approach.
E. indexing.
App II-1
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.
3. Norton Company has a 12% compound annual interest rate. If the firm invests $60,000 today, how
much will have accumulated by the end of eight years?
A. $117,600.
B. $148,560.
C. $298,080.
D. $738,000.
E. None of the other answers are correct.
4. Lawson Company invests $60,000 today and has $148,560 by the end of eight years. What is the
firm's compound annual interest rate?
A. 10.00%.
B. 12.00%.
C. 18.45%.
D. 40.39%.
5. The procedure used to compute the present value of a series of cash flows is known as:
A. compounding.
C. discounting.
D. the present-cost approach.
E. indexing.
App II-2
6. All other things being equal, which of the following would be the most attractive to an investor?
A. A cash inflow of $10,000 in five years.
B. A cash inflow of $2,000 each year for the next five years.
C. A cash inflow of $5,000 in year 1 and $5,000 in year 5.
D. A cash inflow of $10,000 today.
E. All of these would be equally attractive to an investor.
7. All other things being equal, which of the following would be most attractive to an investor?
A. A cash outflow of $60,000 in six years.
B. A cash outflow of $10,000 each year for the next six years.
C. A cash outflow of $30,000 in year 1 and $30,000 in year 6.
D. A cash outflow of $60,000 today.
8. A series of equal cash flows is called a (n):
A. ongoing cash flow.
B. payback.
C. accrual.
D. cash accumulation.
E. annuity.
App II-3
9. The sum of the discount factors applicable to individual cash flows in a series of equal cash flows is
called the:
A. single-sum, present-value factor.
B. total discount factor.
C. annuity discount factor.
D. compound discount factor.
E. internal rate discount factor.
10. Consider the following items of information:
I. The target recovery period.

II. The discount rate.
III. The timing (i.e., year) of a cash flow.
Which of the above items would be needed to calculate the present value of a cash flow?
A. I only.
B. II only.
C. I and II.
D. II and III.
E. I, II, and III.
App II-4
11. You desire to invest $3,000 at the end of each year for the next five years to accumulate the funds
needed for a down payment on a home. Which table factor(s) should be used to most efficiently
determine the amount accumulated by the end of the five-year period?
A. Future value of $1.
B. Future value of a $1 annuity.
C. Present value of $1.
D. Present value of a $1 annuity.
E. Both Future value of $1 and Future value of a $1 annuity.
12. Uncle Roscoe, a wealthy relative, has given you a choice of receiving $10,000 today or $3,000 at the
end of each year for the next four years. Which table factor(s) should be used to most efficiently
determine the "value" of the $3,000 cash-flow stream?
E. Both Present value of $1 and Present value of a $1 annuity.
App II-5
13. You are a sports agent who is representing Jack Lofton, a star football player, in contract
negotiations with the New York Landmarks. The Landmarks have offered Lofton a four-year
contract, with annual raises and performance bonuses that will result in a growing cash-flow stream
for Lofton each year. Which table factor(s) should you use to most efficiently determine the "value"
of the contract?
14. How much money must be invested today in order to have $25,000 at the end of four years if the
rate of return is 12% compounded annually?
A. $15,900.
B. $17,100.
C. $19,900.
D. $22,300.
App II-6
15. You estimate that it will take five years to complete your college education. Your parents want to
invest enough money today at an interest rate of 8% compounded annually to allow you to
withdraw $10,000 at the end of each year for the next five years, with nothing left at the end. The
amount of money to invest today is:
A. $14,690.
B. $34,050.
C. $39,930.
D. $50,000.
16. You received a $5,000 loan at the end of each of your four years of college. Aunt Rose agreed to
pay off your loans at the end of your fourth year of school. How much will she have to pay?
Assume a 4% interest rate compounded annually on student loans.
A. $20,000.
B. $21,235.
C. $39,930.
D. $50,000.
App II-7
17. You received a $5,000 loan at the end of each of your four years of college. Your grandparents
agreed to pay off your loans at the end of your fourth year of school. Assume a 4% annual
compound interest rate on student loans. How much will they have to deposit when you start
school so that they will have enough money to pay off your loans after four years? Their interest
rate is 6% compounded annually.
A. $20,000.
B. $21,235.
C. $16,818.
D. $15,000.
18. You want to buy a new car in five years. You want to have saved $25,000 by then. You can invest
$4,000 at the end of each of the next five years at an interest rate of 6% compounded annually. Will
you have enough money at the end of the fifth year?
A. No. You are short $2,452.
B. Yes. You have $1,532 more than you need.
C. No. You are short $1,532.
D. Yes. You have $2,452 more than you need.
App II-8
19. Green Company owes White Company money for the purchase of equipment. White has given
Green the following payment options:
I. Immediate payment in full of $38,000.

II. Annual payments of $15,000 made at the end of each of the next three years.
III. A single payment of $48,000 made at the end of three years.
Green uses a 10% annual compound interest rate and will choose the option with the lowest
present value. Which option should Green choose, and what is the present value of that option?
A. Option I, $34,542.
B. Option I, $38,000.
C. Option II, $37,305.
D. Option III, $34,164.
E. Option III, $36,048.
20. Nelson Company owes money to Nash Company for the purchase of equipment. Nash Company
has given Nelson the following payment options:
Assume that both Nelson and Nash use a 10% interest rate compounded annually. What option
would Nash prefer, and what is the present value of that option?
A. Option I, $34,542.
B. Option I, $38,000.
App II-9
Essay Questions
21. Future value and present value are two key business tools.
Required:
Ignoring income taxes, answer the following independent questions:
A. Your best friend won the state lottery and has offered to give you $15,000 at the end of eight
years (after he has made his first million). You figure that if you had the money now, you could
invest it at a rate of 10% compound annually. What is the value today of your friend's future gift?
B. Suppose that you invest $11,000 today in an account that bears interest at the rate of 6%
compounded annually. What will your investment grow to at the end of seven years?
C. Suppose that your best friend won the state lottery and promised to give you $9,000 per year for
five years. The first payment will be made at the end of 20x1. Using a 12% annual compound
discount rate, what is the value of these payments at the beginning of 20x1?
D. Suppose that you invest $2,000 at the end of each year for nine years in an investment that
provides a return of 8% compounded annually. What will be the value of your investment at the
end of nine years?
App II-10
22. Your Uncle Otto has struck it rich by investing in racehorses and desires to share some of his
newfound wealth with you. Assume that you must choose from among the following three options:
Receive a lump sum of $400,000 in 20 years.

Receive $20,000 at the end of each year for the next 10 years.
Receive $90,000 now.
Required:
A. Why is it inappropriate to compare $400,000 (no. 1) vs. $200,000 (no. 2) vs. $90,000 (no. 3) and
conclude that no. 1 is the best option? Explain.

B. What should you do to determine which option is the best? What does this process do?
C. If Uncle Otto agreed to revise option no. 1 so that you could receive $200,000 in 10 years and the
remaining $200,000 in another 10 years, would you likely prefer the revision or the option as
originally stated? Why?
D. What is an annuity? Do any of the options involve an annuity?
App II-11
23. The time value of money and present value are important business concepts.
Required:
Briefly explain these concepts to someone with a limited business background.
Required:
Differentiate between the concepts discounting and compounding.
App II-12
Appendix II Compound Interest and the Concept of Present Value Answer
Key
Multiple Choice Questions
1. The main idea behind the time value of money is that:
A. cash flows received in the distant future are less valuable than cash flows received in the
near-term future.
B. cash received in year 3, say, $80,000, has the same value as $40,000 received in year 3 plus
$40,000 received in year 4.
C. cash flows received in different years are treated as equal in value.
D. cash payments made in the future have the same value as payments made today.
E. timing considerations of cash flows have little value in decision making.
AACSB: Reflective Thinking

AICPA BB: Critical Thinking
AICPA FN: Measurement
Blooms: Understand
Difficulty: 2 Medium
Learning Objective: II-01 Explain the importance of the time value of money in capital-budgeting decisions.
App II-13
2. The procedure used to compute the future value of a series of cash flows is known as:
A. compounding.
C. discounting.
D. the future-cost approach.
E. indexing.

Blooms: Understand
Learning Objective: II-02 Compute the future value and present value of cash flows occurring over several time periods.
3. Norton Company has a 12% compound annual interest rate. If the firm invests $60,000 today,
how much will have accumulated by the end of eight years?
A. $117,600.
B. $148,560.
C. $298,080.
D. $738,000.

Blooms: Apply
Difficulty: 3 Hard
App II-14
4. Lawson Company invests $60,000 today and has $148,560 by the end of eight years. What is the
firm's compound annual interest rate?
A. 10.00%.
B. 12.00%.
C. 18.45%.
D. 40.39%.

Blooms: Apply
Difficulty: 3 Hard
5. The procedure used to compute the present value of a series of cash flows is known as:
A. compounding.
C. discounting.
D. the present-cost approach.
E. indexing.
AACSB: Analytic
Blooms: Understand
App II-15
6. All other things being equal, which of the following would be the most attractive to an investor?
A. A cash inflow of $10,000 in five years.
B. A cash inflow of $2,000 each year for the next five years.
C. A cash inflow of $5,000 in year 1 and $5,000 in year 5.
D. A cash inflow of $10,000 today.
AACSB: Analytic
Blooms: Understand
7. All other things being equal, which of the following would be most attractive to an investor?
A. A cash outflow of $60,000 in six years.
B. A cash outflow of $10,000 each year for the next six years.
C. A cash outflow of $30,000 in year 1 and $30,000 in year 6.
D. A cash outflow of $60,000 today.
AACSB: Analytic
Blooms: Understand
App II-16
8. A series of equal cash flows is called a (n):
A. ongoing cash flow.
B. payback.
C. accrual.
D. cash accumulation.
E. annuity.
AACSB: Analytic
Blooms: Understand
9. The sum of the discount factors applicable to individual cash flows in a series of equal cash flows
is called the:
A. single-sum, present-value factor.
B. total discount factor.
C. annuity discount factor.
D. compound discount factor.
E. internal rate discount factor.
AACSB: Analytic
Blooms: Remember
Difficulty: 1 Easy
App II-17
10. Consider the following items of information:
I. The target recovery period.

II. The discount rate.
III. The timing (i.e., year) of a cash flow.
Which of the above items would be needed to calculate the present value of a cash flow?
A. I only.
B. II only.
C. I and II.
D. II and III.
E. I, II, and III.
AACSB: Analytic
Blooms: Understand
11. You desire to invest $3,000 at the end of each year for the next five years to accumulate the
funds needed for a down payment on a home. Which table factor(s) should be used to most
efficiently determine the amount accumulated by the end of the five-year period?
E. Both Future value of $1 and Future value of a $1 annuity.
AACSB: Analytic
App II-18
Blooms: Apply
Difficulty: 3 Hard
12. Uncle Roscoe, a wealthy relative, has given you a choice of receiving $10,000 today or $3,000 at
the end of each year for the next four years. Which table factor(s) should be used to most
efficiently determine the "value" of the $3,000 cash-flow stream?
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
App II-19
13. You are a sports agent who is representing Jack Lofton, a star football player, in contract
negotiations with the New York Landmarks. The Landmarks have offered Lofton a four-year
contract, with annual raises and performance bonuses that will result in a growing cash-flow
stream for Lofton each year. Which table factor(s) should you use to most efficiently determine
the "value" of the contract?
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
14. How much money must be invested today in order to have $25,000 at the end of four years if
the rate of return is 12% compounded annually?
A. $15,900.
B. $17,100.
C. $19,900.
D. $22,300.
AACSB: Analytic
Blooms: Apply
App II-20
Difficulty: 3 Hard
15. You estimate that it will take five years to complete your college education. Your parents want to
invest enough money today at an interest rate of 8% compounded annually to allow you to
withdraw $10,000 at the end of each year for the next five years, with nothing left at the end. The
amount of money to invest today is:
A. $14,690.
B. $34,050.
C. $39,930.
D. $50,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
16. You received a $5,000 loan at the end of each of your four years of college. Aunt Rose agreed
to pay off your loans at the end of your fourth year of school. How much will she have to pay?
Assume a 4% interest rate compounded annually on student loans.
A. $20,000.
B. $21,235.
C. $39,930.
D. $50,000.
AACSB: Analytic
App II-21
Blooms: Apply
Difficulty: 3 Hard
17. You received a $5,000 loan at the end of each of your four years of college. Your grandparents
agreed to pay off your loans at the end of your fourth year of school. Assume a 4% annual
compound interest rate on student loans. How much will they have to deposit when you start
school so that they will have enough money to pay off your loans after four years? Their interest
rate is 6% compounded annually.
A. $20,000.
B. $21,235.
C. $16,818.
D. $15,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
App II-22
18. You want to buy a new car in five years. You want to have saved $25,000 by then. You can invest
$4,000 at the end of each of the next five years at an interest rate of 6% compounded annually.
Will you have enough money at the end of the fifth year?
A. No. You are short $2,452.
B. Yes. You have $1,532 more than you need.
C. No. You are short $1,532.
D. Yes. You have $2,452 more than you need.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
App II-23
19. Green Company owes White Company money for the purchase of equipment. White has given
Green the following payment options:

Green uses a 10% annual compound interest rate and will choose the option with the lowest
present value. Which option should Green choose, and what is the present value of that option?
A. Option I, $34,542.
B. Option I, $38,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
App II-24
20. Nelson Company owes money to Nash Company for the purchase of equipment. Nash
Company has given Nelson the following payment options:

Assume that both Nelson and Nash use a 10% interest rate compounded annually. What option
would Nash prefer, and what is the present value of that option?
A. Option I, $34,542.
B. Option I, $38,000.
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
Essay Questions
App II-25
21. Future value and present value are two key business tools.
Required:
Ignoring income taxes, answer the following independent questions:
A. Your best friend won the state lottery and has offered to give you $15,000 at the end of eight
years (after he has made his first million). You figure that if you had the money now, you could
invest it at a rate of 10% compound annually. What is the value today of your friend's future gift?
B. Suppose that you invest $11,000 today in an account that bears interest at the rate of 6%
compounded annually. What will your investment grow to at the end of seven years?
C. Suppose that your best friend won the state lottery and promised to give you $9,000 per year
for five years. The first payment will be made at the end of 20x1. Using a 12% annual compound
discount rate, what is the value of these payments at the beginning of 20x1?
D. Suppose that you invest $2,000 at the end of each year for nine years in an investment that
provides a return of 8% compounded annually. What will be the value of your investment at the
end of nine years?
A. Present value: $15,000 × 0.467 = $7,005
B. Future value: $11,000 × 1.504 = $16,544
C. Present value: $9,000 × 3.605 = $32,445

D. Future value: $2,000 × 12.488 = $24,976
AACSB: Analytic
Blooms: Apply
Difficulty: 3 Hard
App II-26
22. Your Uncle Otto has struck it rich by investing in racehorses and desires to share some of his
newfound wealth with you. Assume that you must choose from among the following three
options:
Receive a lump sum of $400,000 in 20 years.

Receive $20,000 at the end of each year for the next 10 years.
Receive $90,000 now.
Required:
A. Why is it inappropriate to compare $400,000 (no. 1) vs. $200,000 (no. 2) vs. $90,000 (no. 3)
and conclude that no. 1 is the best option? Explain.
B. What should you do to determine which option is the best? What does this process do?
C. If Uncle Otto agreed to revise option no. 1 so that you could receive $200,000 in 10 years and
the remaining $200,000 in another 10 years, would you likely prefer the revision or the option as
originally stated? Why?
D. What is an annuity? Do any of the options involve an annuity?
A. The cash flows do not occur at the same points in time, and such an analysis disregards the
time value of money. Dollars received in earlier years are worth more than dollars received in the
future.
B. The cash flows should be discounted, and the option with the highest present value should be
selected. Such a process integrates the time value of money into the decision process.
C. The revision should be preferred. Both options involve the same total dollars; however,
because significant inflows occur sooner with the revision, this option would have a higher
present value.
D. An annuity is a series of uniform cash inflows or outflows over a period of years. Option no. 2
involves an annuity.
App II-27
AACSB: Analytic
AICPA FN: Research
Blooms: Understand
Required:
Briefly explain these concepts to someone with a limited business background.
The time value of money recognizes that a dollar received today is worth more than a dollar
received in the future. Such monies can be invested to earn additional returns for the individual
and/or firm. Present value, an approach that is based on time values, weights dollars in earlier
years of an investment more heavily than dollars of later years. The result is present value,
namely, the amount that a company (or individual) should be willing to pay today to secure a
future cash flow at a given rate of return.
AACSB: Analytic
AICPA FN: Research
Blooms: Understand
App II-28
Required:
Differentiate between the concepts discounting and compounding.
Discounting refers to the mathematical process whereby we calculate the present value of a
future amount. Compounding refers to the mathematical process whereby we calculate the
future value of a present amount.

Both terms recognize that a dollar received today is worth more than a dollar received in the
future. The end result of the calculations will depend on the length of time of the investment
and the interest rate used.
AACSB: Analytic
AICPA FN: Research
Blooms: Understand
App II-29

Appendix II Compound Interest and The Concept of Present Value

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Appendix II Compound Interest and The Concept of Present Value

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Appendix II

Compound Interest and the Concept of Present Value

Multiple Choice Questions

1. The main idea behind the time value of money is that:

C. cash flows received in different years are treated as equal in value.

E. timing considerations of cash flows have little value in decision making.

B. the annuity method.

D. the future-cost approach.

much will have accumulated by the end of eight years?

E. None of the other answers are correct.

E. None of the other answers are correct.

B. the annuity method.

D. the present-cost approach.

A. A cash inflow of $10,000 in five years.

C. A cash inflow of $5,000 in year 1 and $5,000 in year 5.

D. A cash inflow of $10,000 today.

E. All of these would be equally attractive to an investor.

A. A cash outflow of $60,000 in six years.

C. A cash outflow of $30,000 in year 1 and $30,000 in year 6.

D. A cash outflow of $60,000 today.

E. All of these would be equally attractive to an investor.

8. A series of equal cash flows is called a (n):

A. ongoing cash flow.

A. single-sum, present-value factor.

B. total discount factor.

C. annuity discount factor.

D. compound discount factor.

E. internal rate discount factor.

10. Consider the following items of information:

I. The target recovery period.

III. The timing (i.e., year) of a cash flow.

E. I, II, and III.

A. Future value of $1.

B. Future value of a $1 annuity.

C. Present value of $1.

D. Present value of a $1 annuity.

E. Both Future value of $1 and Future value of a $1 annuity.

determine the "value" of the $3,000 cash-flow stream?

A. Future value of $1.

B. Future value of a $1 annuity.

C. Present value of $1.

D. Present value of a $1 annuity.

E. Both Present value of $1 and Present value of a $1 annuity.

A. Future value of $1.

B. Future value of a $1 annuity.

C. Present value of $1.

D. Present value of a $1 annuity.

E. Both Present value of $1 and Present value of a $1 annuity.

E. None of the other answers are correct.

E. None of the other answers are correct.

E. None of the other answers are correct.

rate is 6% compounded annually.

E. None of the other answers are correct.

A. No. You are short $2,452.

B. Yes. You have $1,532 more than you need.

C. No. You are short $1,532.

D. Yes. You have $2,452 more than you need.

E. None of the other answers are correct.

Green the following payment options:

I. Immediate payment in full of $38,000.

C. Option II, $37,305.

D. Option III, $34,164.

E. Option III, $36,048.