Homework Solutions : TVM and DCF

Solutions
1. (RWJ Essentials 5ed Ch5 Problem6) [Calculating Annuity Values]

(Answer)

To find the PVA, we use the equation:

  t 
1
1 − 1+r
PVA = C 
 
r


  9 
1
1 − 1.0825
= $60, 000   = $370, 947.84
 
0.0825

The present value of the revenue is greater than the cost, so your company can afford the
equipment.

2. (RWJ Essentials 5ed Ch5 Problem14) [EAR]

(Answer)

For discrete compounding, to find the EAR, we use the equation:

APR m
  
EAR = 1 + −1
m

So, for each bank, the EAR is:

First National : EAR = [1 + (0.131/12)]12 − 1 = 13.92%

First United : EAR = [1 + (0.134/2)]2 − 1 = 13.85%

For a borrower, First United would be preferred since the EAR of the loan is lower.

3. (RWJ Essentials 5ed Ch5 Problem15) [EAR]

(Answer)

(a) The reported rate is the APR, so we need to convert the EAR to an APR as follows:

APR m
  
EAR = 1 + −1
m
h i
⇒ APR = m (1 + EAR)1/m − 1
h i
= 365 (1 + 0.17)1/365 − 1 = 15.70%

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 (b) This is deceptive because the borrower is actually paying annualized interest of 17%
per year, not the 15.70% reported on the loan contract.

4. (RWJ Essentials 5ed Ch5 Problem20) [Loan Payments]

(Answer)

(a) We first need to find the annuity payment. We have the PVA, the length of the annuity,
and the interest rate. Using the PVA equation:
  t 
1
1 − 1+r
PVA = C 
 
r


  60 
1
1 − 1+0.082/12
⇒ $62, 500 = C 

0.082/12


⇒ C = $1, 273.27

(b) To find the EAR, we use the EAR equation:

APR m
  
EAR = 1 + −1
m
0.082 12
  
⇒ EAR = 1 + −1
12
= 8.52%

5. (RWJ Essentials 5ed Ch5 Problem22) [EAR]

(Answer)

(a) Here we are trying to find the interest rate when we know the PV and FV. Using the
FV equation:

FV = PV (1 + r )
⇒ $5 = $4 (1 + r )
⇒ r = $5/$4 − 1 = 0.25 (or 25% per week)

The interest rate is 25% per week. To find the APR, we multiply this rate by the
number of weeks in a year, so:

APR = 25% × 52 = 1, 300%

(b) And using the equation to find the EAR, we find:

APR m
  
EAR = 1 + −1
m
= [1 + 0.25]52 − 1
= 10, 947, 544.25%

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6. (RWJ Essentials 5ed Ch5 Problem23) [Perpetuities

(Answer)

(a) Here we need to find the interest rate that equates the perpetuity cash flows with the
PV of the cash flows. Using the PV of a perpetuity equation:

C
PV =
r
300
⇒ 17, 500 =
r
⇒ r = 0.0171 (or 1.71% per month)

(b) To find the APR, we multiply this rate by the number of months in a year, so:

APR = 1.71% × 12 = 20.57%

(c) And using the equation to find the EAR, we find:

APR m
  
EAR = 1 + −1
m
EAR = [1 + 0.0171]12 − 1 = 0.2263 ( or 22.63%)

7. (RWJ Essentials 5ed Ch5 Problem24) [Annuity FV]

(Answer)

This problem requires us to find the FVA. The equation to find the FVA is:
" #
(1 + r ) t − 1
FVA = C
r
" #
(1 + 0.11/12)360 − 1
= 200 = $560, 903.95
0.11/12

8. (RWJ Essentials 5ed Ch5 Problem26) [Annuity PV]

(Answer)

The cash flows are simply an annuity with four payments per year for four years, or 16
payments. We can use the PVA equation:
  t 
1
 1 − 1+r 
PVA = C 
r


  16 
1
1 − 1+0.0075
= $2, 000   = $30, 048.63

0.0075

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 9. (RWJ Essentials 5ed Ch5 Problem30) [Annuity Due]

(Answer)

We need to use the PVA due equation, which is:

PVAdue = (1 + r ) PVA
  t 
1
1 − 1+r
= (1 + r ) × C 

r


  60 
1
1 − 1+0.0815/12
⇒ 56, 000 = (1 + 0.0815/12) × C 

0.0815/12


⇒ C = 1, 131.82

10. (RWJ Essentials 5ed Ch5 Problem35) [Comparing CF streams]

(Answer)

Monthly rate = 0.08 / 12 = 0.0067 or 0.67%

The value today of the $6,200 monthly salary is:
  t 
1
1 − 1+r
PVA1 = C 
 
r


  24 
1
1 − 1+0.0067
= $6, 200 

0.0067


= $137, 085.37

To find the value of the second option, we find the present value of the monthly payments
and add the bonus. We can add the bonus since it is paid today. So:
  t 
1
1 − 1+r
PVA2 = C   + $30, 000
 
r
  24 
1
1 − 1+0.0067
= $4, 900   + $30, 000

0.0067

= $108, 341.66 + $30, 000

= $138, 341.66

So, the second option is the better choice.

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11. (RWJ Essentials 5ed Ch5 Problem39) [Number of Payments]

(Answer)

" #
(1 + r ) t − 1
FVA = C
r
" #
(1 + 0.12/12)t − 1
⇒ $35, 000 = $140
0.12/12
" #
(1 + 0.01)t − 1
⇒ 250 =
0.01
⇒ 3.5 = 1.01t
ln 3.5
⇒t= = 125.90 payments
ln 1.01

12. (RWJ Essentials 5ed Ch5 Problem45) [Discount Interest Loans]

(Answer)

To find the APR and EAR, we need to use the actual cash flows of the loan. In other words,
the interest rate quoted in the problem is only relevant to determine the total interest under
the terms given. The cash flows of the loan are the $12,000 you must repay in one year,
and the $10,680 you borrow today. The interest rate of the loan is:

$12, 000 = $10, 560(1 + r )

⇒ r = ($12, 000/10, 560) − 1
= 0.1364 or 13.64%

Because of the discount, you only get the use of $10,560, and the interest you pay on that
amount is 13.64%, not 12%.

13. (RWJ Essentials 5ed Ch5 Problem48) [PV]

(Answer)

Semiannual rate = 0.12/2 = 0.06. Now, we can use the present value of an annuity equation.
Doing so, we get:
  t 
1
1 − 1+r
PVA = C 
 
r


  10 
1
1 − 1.06
= 7, 000   = 51, 520.61

0.06

This is the present value one period before the first payment. The first payment occurs
nine and one-half years from now, so this is the value of the annuity nine years from now.

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 (a) The value of this annuity five years from now :
FV
PV =
(1 + r ) t
51, 520.61
= = 32, 324.67
(1 + 0.06)8
(b) And the value of the annuity three years from now is:
FV
PV =
(1 + r ) t
51, 520.61
= = 25, 604.16
(1 + 0.06)12
(c) And the value of the annuity today is:
FV
PV =
(1 + r ) t
51, 520.61
= = 18, 049.93
(1 + 0.06)18

14. (RWJ Essentials 5ed Ch5 Problem50) [Variable Interest Rates]

(Answer)

Here, we have an annuity with two different interest rates. To answer this question, we
simply need to find the present value in multiple steps.
(a) The present value of the last six years payments at an 8% interest rate is:
  t 
1
 1 − 1+r 
PVA = C 
r


  72 
1
1 − 1+0.08/12
= 1, 300   = 74, 144.88

0.08/12

(b) We can now discount this value back to time zero. We must be sure to use the number
of months as the periods since interest is compounded monthly. We also need to use
the interest rate that applies during the first four years. Doing so, we find:
FV
PV =
(1 + r ) t
74, 144.88
= = 47, 847.81
(1 + 0.11/12)48
(c) Now we can find the present value of the annuity payments for the first four years.
The present value of these payments is:
  t 
1
1 − 1+r
PVA = C 
 
r


  48 
1
1 − 1+0.11/12
= 1, 300   = 50, 298.85

0.11/12

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 (d) So, the total present value of the cash flows is:

PV = 47, 847.81 + 50, 298.85 = 98, 146.66

15. (RWJ Essentials 5ed Ch5 Problem52) [Present Value of a Perpetuity]

(Answer)

Here we need to find the present value of a perpetuity at a date before the perpetuity
begins. We will begin by find the present value of the perpetuity. Doing so, we find:

C
PVP =
r
1, 390
= = $25, 504.59
0.0545
This is the present value of the perpetuity at year 14, one period before the payments begin.
So, using the present value of a lump sum equation to find the value at year 9, we find:

FV
PV =
(1 + r ) t
25, 504.59
= = $19, 560.74
(1 + 0.0545)5

16. (RWJ Essentials 5ed Ch5 Problem53) [Finding Interest rate and EAR]

(Answer)

(a) Here we are given the PVA, number of periods, and the amount of the annuity. We
need to solve for the interest rate. We need must be careful to use the cash flows of
the loan. Using the present value of an annuity equation, we find:
  t 
1
 1 − 1+r 
PVA = C 
r


  12 
1
1 − 1+r
=⇒ 20, 000 = 1, 883.33 

r


Then, r = 0.01932 or 1.932%. This is the monthly interest rate. To find the APR with
a monthly interest rate, we simply multiply the monthly rate by 12, so the APR is:

APR = 0.01932 × 12 = 0.2319 or 23.19%

(b) And the EAR is:

EAR = [1 + ( APR/m)]m − 1 = [1 + 0.01932]12 − 1 = 0.2582 or 25.82%

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17. (RWJ Essentials 5ed Ch5 Problem55) [Amortization with Equal Payments]

(Answer)

The loan payment will be:

  t 
1
1 − 1+r
PVA = C 

r


  3 
1
1 − 1+0.11
=⇒ 45, 000 = C 

0.11


=⇒ C = 18, 414.59

The interest payment is the beginning balance times the interest rate for the period, and the
principal payment is the total payment minus the interest payment. The ending balance
is the beginning balance minus the principal payment. The ending balance for a period is
the beginning balance for the next period. The amortization table for an equal payment is:
Year Beginning Balance Total Payment Interest Payment Principal Payment Ending Balance
1 45,000.00 18,414.59 4,950.00 13,464.59 31,535.41
2 31,535.41 18,414.59 3,468.90 14,945.69 16,589.72
3 16,589.72 18,414.59 1,824.87 16,589.72 0
In the third year, 1, 824.87 of interest is paid. Total interest over life of the loan = 4, 950.00 +
3, 468.90 + 1, 824.87 = 10, 243.76.