LECTURE 3

CHAPTER 5

Answers to Concepts Review and Critical Thinking Questions

1. Value [LO2] The basic present value equation has four parts. What are they?

Answer:
The four parts are the present value (PV), the future value (FV), the discount rate
(r), and the life of the investment (t).

2. Compounding [LO1, 2] What is compounding? What is discounting?

Answer:
Compounding refers to the growth of a dollar amount through time via
reinvestment of interest earned. It is also the process of determining the future
value of an investment. Discounting is the process of determining the value today of
an amount to be received in the future.

8. Time Value of Money [LO2] Would you be willing to pay $24,099 today in exchange
for $100,000 in 30 years? What would be the key considerations in answering yes or
no? Would your answer depend on who is making the promise to repay?

Answer:
The key considerations would be: (1) Is the rate of return implicit in the offer
attractive relative to other, similar risk investments? and (2) How risky is the
investment; i.e., how certain are we that we will actually get the $100,000? Thus, our
answer does depend on who is making the promise to repay.

Solutions to Questions and Problems

1. Simple Interest versus Compound Interest [LO1] First City Bank pays 7 percent
simple interest on its savings account balances, whereas Second City Bank pays 7
percent interest compounded annually. If you made a $6,000 deposit in each bank,
how much more money would you earn from your Second City Bank account at the
end of nine years?

Answer:
The time line for the cash flows is:

0 9
$6,000 FV

The simple interest per year is:

$6,000 × .07 = $420

So after 9 years you will have:

$420 × 9= $3,780 in interest.

The total balance will be $6,000 + 3,780 = $9,780

With compound interest we use the future value formula:

FV = PV(1 + r)t
FV = $6,000(1.07)9 = $ 11,030

The difference is:

$11,030 – $9,780= $1,250

2. Calculating Future Values [LO1] For each of the following, compute the future
value:

Present Value Years Interest Rate Future Value

$ 2,250 11 13%
8,752 7 9
76,355 14 12
183,796 8 6

Answer
FV = PV(1 + r)t

0 11
$2,250 FV

FV = $2,250(1.13)11 = $8,630.69

0 7
$8,752 FV

FV = $8,752(1.09)7 = $15,999

0 14
$76,355 FV

FV = $76,355(1.12)14 = $737,155.46

0 8
$183,796 FV

FV = $183,796(1.06)8 = $292,942.90
3. Calculating Present Values [LO2] For each of the following, compute the present
value:
Present Value Years Interest Rate Future Value
13 7% $ 15,451
4 13 51,557
29 14 886,073
40 9 550,164

Answer
To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

0 13
PV $15,451

PV = $15,451 / (1.07)13 = $6,411.62

0 4
PV $51,557

PV = $51,557 / (1.13)4 = $31,620.87

0 29
PV $886,073

PV = $886,073 / (1.14)29 = $19,825.71

0 40
PV $550,164

PV = $550,164 / (1.09)40 = $17,515.89

6. Calculating Interest Rates [LO3] Assume the total cost of a college education will
be $300,000 when your child enters college in 18 years. You presently have $65,000
to invest. What annual rate of interest must you earn on your investment to cover
the cost of your child’s college education?

Answer:

The time line is:

7. 0 18
– $300,000
$65,000
To answer this question, we can use either the FV or the PV formula. Both will give
the same answer since they are the inverse of each other. We will use the FV formula,
that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($300,000 / $65,000)1/18 – 1
r = .0887, or 8.87%

7. Calculating the Number of Periods [LO4] At 6.5 percent interest, how long does it
take to double your money? To quadruple it?

Answer

To find the length of time for money to double, triple, etc., the present value and future
value are irrelevant as long as the future value is twice the present value for doubling,
three times as large for tripling, etc. To answer this question, we can use either the FV
or the PV formula. Both will give the same answer since they are the inverse of each
other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for t, we get:

t = ln(FV / PV) / ln(1 + r)

The length of time to double your money is:

0 ?
–$1 $2

FV = $2 = $1(1.065)t
t = ln 2 / ln 1.065 = 11 years

The length of time to quadruple your money is:

0 ?
–$1 $4

FV = $4 = $1(1.065)t
t = ln 4 / ln 1.065 = 22 years

Notice that the length of time to quadruple your money is twice as long as the time
needed to double your money (any difference in these answers is due to rounding).
This is an important concept of time value of money.
11. Calculating Present Values [LO2] You have just received notification that you
have won the $1 million first prize in the Centennial Lottery. However, the prize will be
awarded on your 100th birthday (assuming you’re around to collect), 80 years from
now. What is the present value of your windfall if the appropriate discount rate is 9
percent?

Answer

The time line is:

0 80
PV $1,000,0
00

To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = $1,000,000 / (1.09)80 = $1,013.63

18. Calculating Future Values [LO1] You have just made your first $5,000
contribution to your retirement account. Assuming you earn an 11 percent rate
of return and make no additional contributions, what will your account be worth
when you retire in 45 years? What if you wait 10 years before contributing?
(Does this suggest an investment strategy?)

Answer:

To find the FV of a lump sum, we use:

FV = PV(1 + r)t

0 45
$5,000 FV

FV = $5,000(1.11)45 = $547,651.20

0 35
$5,000 FV

FV = $5,000(1.11)35 = $192,874.26

Better start early!