Chapter 04 - Time Value of Money 1: Analyzing Single Cash Flows

Unit 3 answers

CHAPTER 4 – TIME VALUE OF MONEY 1: ANALYZING SINGLE CASH FLOWS

Questions

LG3 3. Would you prefer to have an investment earning 5 percent for 40 years or an investment
earning 10 percent for 20 years? Explain.

Investments of $1 will grow to $7.04 in 40 years (= $1.0540) and $1 will grow to $6.73 in 20
years (= $1.1020). The 5 percent investment for 40 years is worth more. This example
illustrates the importance of time in building wealth.

Problems

LG4 4-14 Present Value with Different Discount Rates Compute the present value of $5,000
paid in two years using the following discount rates: 8 percent in the first year and 7 percent
in the second year.

PV = FV / [(1 + i) (1 + j) ]
PV = $5,000 / [(1 + 0.08) × (1 + 0.07)]
= $5,000 / [1.08 × 1.07]
= $5,000 / 1.15560
= $4,326.76

LG5 4-25 Moving Cash Flows What is the value in year 3 of a $700 cash flow made in year 6 if
interest rates are 10 percent?

PV3 = FV6 / (1 + i)N

PV3 = $700 / (1 + 0.10)(6-3)
= $700 / 1.3310
= $525.92
Or N=3, I=10, PMT=0, FV=−700, CPT PV == 525.92

LG2&4 4-40 General TVM Ten years ago, Hailey invested $3,000 and locked in an 8 percent
annual interest rate for 30 years (end 20 years from now). Aidan can make a 20-year
investment today and lock in a 10 percent interest rate. How much money should he invest
now in order to have the same amount of money in 20 years as Hailey?

First determine how much Hailey will have.

FV20 = PV-10 × (1 + i)30
FV20 = $3,000 × (1 + 0.08)30
= $3,000 × 10.062657
= $30,187.97 (Hailey’s FV in 30 years)

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 Chapter 04 - Time Value of Money 1: Analyzing Single Cash Flows

Or N=30, I=8, PV=−3000, PMT=0, CPT FV == 30,187.97

So Aidan will have to deposit:

PV = FV20 / (1 + i)N
PV = $30,187.97 / (1 + 0.10)20
= $30,187.97 / 6.72750 = $4,487.25
Or N=20, I=10, PMT=0, FV=30,187.97, CPT PV == −4,487.249

CHAPTER 5 – TIME VALUE OF MONEY 2: ANALYZING ANNUITY CASH

FLOWS

Problems

LG4 5-24 Present Value of Multiple Annuities A small business owner visits his bank to ask for
a loan. The owner states that he can repay a loan at $1,500 per month for the next three years
and then $500 per month for two years after that. If the bank is charging customers 8.5
percent APR, how much would it be willing to lend the business owner?

Break the annuity into two streams of payments: $500 monthly for five years and $1,000 for
three years. Use equation 5-4 for each annuity and add the results:

1 1

PVA 60+ PVA 36=$500× [ 1−

( 1+0.085/12 )
0.085/12 ] [
60

Or N=5x12, I=8.5/12, PMT=−500, FV=0, CPT PV == 24,370.59

+ $1,000×
1−

0.085/12 ]
( 1+0.085/12 )36
=$ 24,370.59+$31,678.11=$56,048.70

and N=3x12, I=8.5/12, PMT=−1000, FV=0, CPT PV == 31,678.11

sum the FVs to get $56,048.70

LG7-LG8 5-46 EAR of Add-on Interest Loan To borrow $700, you are offered an add-on
interest loan at 9 percent with 12 monthly payments. First, compute the 12 equal payments
and then compute the EAR of the loan:

The total interest cost is $700 x 0.09 = $63. Added to the principle, this becomes $763. The
12 monthly payments are therefore $763 / 12 = $63.58.

The APR of the loan is N = 12, PV = 700, PMT = -63.58, FV = 0; CPT I = 1.3505%
So APR = 1.3505% x 12 = 16.21% (not the 9% advertised!)

The EAR is:

12
0. 1621
EAR= 1+( 12 )
−1=0 .1747=17 . 47 %

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Chapter 04 - Time Value of Money 1: Analyzing Single Cash Flows

Combined chapter 4 and chapter 5 problems

4&5-6 Present Value and Annuity Payments A local furniture store is advertising a deal in
which you buy a $5,000 living room set with three years before you need to make any
payments (no interest cost is incurred). How much money would you have to deposit now in
a savings account earning 4 percent APR, compounded monthly, to pay the $5,000 bill in
three years? Alternatively, how much would you have to deposit in the savings account each
month to be able to pay the bill?

Use equation 5-3 and solve for the lump sum payment:

PV  $5,000   1  0.04 /12 

36
 $4, 435.49
or N=36, I=4/12, PMT=0, FV=−5,000, CPT PV == 4,435.49

Use equation 5-2 and solve for the annuity payment:

 1  0.04/12 
36
1
$5,000  PMT   PMT  $130.95
0.04/12
or: N=3x12, I=4/12, PV=0, FV=5000, CPT PMT = −130.95

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McGraw-Hill Education.