Time Value of Money: Solutions

1. Mr. Vinay plans to send his son for higher studies abroad after 10 years. He expects the cost
of these studies to be Rs. 10,00,000. How much should he save annually to have a sum of Rs.
10,00,000 at the end of 10 years, if the interest rate is 12%?

Soln.
Annuity savings

FV = Rs 1000,000

Annuity PMT (12%, 10) = ?

(1+𝑘)𝑛−1
Future value of annuity, FVA = PMT x FV annuity factor (12%, 10) = 𝑃𝑀𝑇[ 𝑘
]
 1000,000 = PMT x 17.5487
 PMT = Rs 56,984

2. At the time of retirement Mr. Jingo is given a choice between two alternatives: (a) an annual
pension of Rs. 10,000 as long as he lives, and (b) a lump sum amount Rs. 50,000. If Mr.
Jingo expects to live for 15 years and the interest rate is 15%, which option appears more
attractive?

Soln.
Comparing PV of two alternatives
Alt b) = Rs 50,000 Alt a) = Annuity PMT (15%, 15) of Rs 10,000
at time 0

1−(1+𝑘)−𝑛
Alt a): PV of Annuity, PVA = PMT x PV annuity factor (15%, 15) = 𝑃𝑀𝑇[ 𝑘
]
= 10,000 x 5.8474 = Rs 58,474
Alt b) Rs 50,000
 Alternative a), annuity payment of Rs 10,000 for 15 years at 15% is preferred.
Note: You can also compare the alternatives by taking their future values. In this case estimating
present value is more efficient because you need not do any calculation for alternative b.

3. You are looking for a housing loan and you have communicated to housing finance company
that you can pay a maximum of Rs. 1,00,000 per annum as instalment, if maturity of the loan
is 20 years and the interest charged by HFC is 9%, calculate the amount of loan you are
eligible for?
Soln.
Amount of loan = PV of annuity

PVA = ?

Annuity PMT (9%, 20) of Rs 100,000

PVA = PMT x annuity factor (9%, 20) = 100,000 X 9.128546 = Rs 9,12,855

4. You are planning to take a loan of Rs. 50,00,000 for purchasing a new house. The bank is
going to charge an interest of 9% and the tenor of the loan is going to be 20 years. What is
going to be the annual instalment you are supposed to pay?

Soln.
Annual instalment
PVA = 50,00,000

Annuity PMT (9%, 20) = ?

PVA = PMT x PV annuity factor (9%, 20)

 50,00,000 = PMT x 9.128546

 PMT = Rs 5,47,732

5. Mr. Cool has just completed 40 years. He is planning to retire at the end of 60 years and
expected to live for further 20 years. How much he needs to save every year in order to
withdraw Rs. 100,000 at the end of every year from year 61 onwards in a manner that he
does not leave any balance in his account at the end of his life. How will your answer change
if he want to leave a sum of Rs. 50,00,000 for his children after he dies. The rate of return
expected during this entire period is 10% per annum.

Soln.
Retirement planning problem
 2. Annuity = 100,000 x annuity (10%, 20) 3. FVA = 50,00,000
(20)

Age: 40 Age: 60 Age: 80

1. Annuity PMT (10%, 20) = ?

Part 1:

FV of Annuity Savings = PV of Annuity Required

 PMT x FV annuity factor (10%,20) = 1,00,000 x PV annuity factor (10%,20) = 8,51,356.37

 PMT = 851356.37/FVA factor (10%,20) = 851356.37/57.274999
 PMT = Rs 14,864

Part 2

FV of Annuity Savings = PV of Annuity Required + PV of 50,00,000 required

 PMT x FV annuity factor (10%,20) = 8,51,356.37 + 50,00,000 x PV discount factor (10%,20) =

15,94,574.14
 PMT = Rs 27,841

6. Pipe India owns an oil pipeline which will generate Rs. 20 crore of cash flow in the coming
year. It has a very long life with virtually negligible operating costs. The volume of the oil
shipped, however, will decline over time and hence cash flows will decrease by 3% per year.

Soln.
The discount rate is 12%.
𝑃𝑀𝑇
PV of growing perpetuity = 𝑘−𝑔
PMT for first year = 20 crore
 PVGP = 20/(12% - (-3%)) = Rs 133.33 crore

* Note that in growing perpetuity or growing annuity, PMT refers to PMT of year 1 (not
current/recent year)

7. An oil well presently produces 100,000 barrels per year. It will last for 20 years more.
However, the production will fall by 5% per year. Oil prices are expected to increase by 4%
per year. The present price of a barrel of oil is $70. What is the present value of the well’s
production if the discount rate is 15%?

Soln.
Annual growth rate in cash flows g = (1-5%) x (1+4%) – 1 = - 1.2%
Cash flow for first year, PMT = 100,000 x 70 x (1 - 1.2%) = $ 6,916,000
 𝑃𝑀𝑇 (1+𝑔)𝑛
PV of growing annuity = [1 − (1+𝑘)𝑛 ]
𝑘−𝑔
 PVGA = 6,916,000/(15%-(-1.2%)) x 0.952007 = $ 40,642,452

* Note that in growing perpetuity or growing annuity, PMT refers to PMT of year 1 (not
current/recent year)

8. You want to buy a 285 litre refrigerator of Rs. 10,000 on an instalment basis. A distributor of
various makes of refrigerators is prepared to do so. He states that the payments will be made
in four years., interest rate being 13%. The annual payments would be as follows.
Rs.
Principal 10,000
Four year interst@13% 5,200
Annual payments 3,800
What is the rate of return distributor is earning?

Soln.
PV of Annuity = PMT x PVA
10,000 = 3,800 x PV annuity factor (k%, 4)
 PVA (k%, 4) = 10000/3800 = 2.6316
 K = 19% approx. using trial and error; or 19.14% using excel (RATE function)

* Note that the 13% interest rate mentioned in the problem is redundant misinformation stated by
the distributor. The distributor may have estimated it as 3,800 x 4 instalments – 10,000 = 5200 total
interest. Annual interest payment as per this miscalculation = 5200/4 = 1300 => 13% of 10,000.

9. Phoenix Company borrows Rs. 500,000 at an interest rate of 14%. The loan is to be repaid in
4 equal annual instalments payable at the end of each of the next 4 years. Prepare the loan
amortization schedule.

Soln.

0 k = 14% 1 2 3 4

Rs 5 Lakhs PMT PMT PMT PMT

5,00,000 = PMT x PV annuity factor (14%,4)

 PMT = 500,000/2.913712 = Rs 1,71,602.39

Loan amortization schedule

Year Beginning Annual Interest Principal Ending
Balance Instalment Payment Repayment Balance
1 5,00,000 1,71,602.39 70,000 1,01,602.39 3,98,397.61
2 3,98,397.61 1,71,602.39 55,775.67 1,15,826.72 2,82,570.89
3 2,82,570.89 1,71,602.39 39,559.92 1,32,042.47 1,50,528.42
4 1,50,528.42 1,71,602.39 21,073.98 1,50,528.41 -
Text Book Chapter 2. Solutions

12.

a. PV = 500,000 x PV discount factor (5% for 5 years) = ₹ 391,763

b. PV of annuity = 600,000 x PV annuity factor (8%, 6) = ₹ 2,773,728

c. Amount remaining excluding PV of annuity = 3,000,000-2,773,728 = ₹ 226,272

FV = 226,272 x 1.08^6 = ₹ 359,065

1
13. a. DF1 = = 0.905  r1 = 0.1050 = 10.50%.
1+ r1

1 1
b. DF2 = = = 0.819.
(1 + r2 ) 2
(1.105)2

c. AF2 = DF1 + DF2 = 0.905 + 0.819 = 1.724.

d. PV of an annuity = C  [annuity factor at r% for t years].

Here:

$24.65 = $10  [AF3]

AF3 = 2.465

e. AF3 = DF1 + DF2 + DF3 = AF2 + DF3

2.465 = 1.724 + DF3

DF3 = 0.741

19. a. PV = $100,000.
 b. PV = $180,000/1.125 = $102,136.83.

c. PV = $11,400/0.12 = $95,000.

 1 1 
d. PV = $19,000   − 10 
= $107,354.24.
 0.12 0.12  (1.12) 

e. PV = $6,500/(0.12 − 0.05) = $92,857.14.

Prize (d) is the most valuable because it has the highest present value.

20. Ms. Kaur is investing `10 lakhs now, which is its present value. The unknown is the annual
payment. Using the present value of an annuity formula, we have:

1 1 
PV = C   − t 
 r r  (1+ r) 

 1 1 
` 10 = C   − 12 
 0.095 0.095  (1.095) 

 1 1 
C = ` 10  −  = ` 1.43
 0.095 0.095  (1.095)12 

21. Assume the Zhangs will put aside the same amount each year. One approach to solving this
problem is to find the present value of the cost of the boat and then equate that to the present
value of the money saved. From this equation, we can solve for the amount to be put aside
each year.
PV(boat) = $20,000/(1.10)5 = $12,418

 1 1 
PV(savings) = annual savings   − 5
 0.10 0.10  (1.10) 

Because PV(savings) must equal PV(boat):

 1 1 
Annual savings   − 5
= $12,418
 0.10 0.10  (1.10) 

 1 1 
Annual savings = $12,418  − 5 
= $3,276
 0.10 0.10  (1.10) 
 Another approach is to use the future value of an annuity formula:

 (1 + .10)5 − 1
Annual savings    = $20,000
 .10 
 
Annual savings = $ 3,276

22. The fact that Kangaroo Autos is offering “free credit” tells us what the cash payments are; it
does not change the fact that money has time value. A 10% annual rate of interest is equivalent
to a monthly rate of 0.83%:
rmonthly = rannual /12 = 0.10/12 = 0.0083 = 0.83%
The present value of the payments to Kangaroo Autos is:

 1 1 
$1,000 + $300   − 30 
= $8,938
 0.0083 0.0083  (1.0083) 

A car from Turtle Motors costs $9,000 cash. Therefore, Kangaroo Autos offers the better
deal, i.e., the lower present value of cost.

29. Because the cash flows occur every six months, we first need to calculate the equivalent
semiannual rate. Thus, 1.08 = (1 + r/2)2 => r = 7.846 semiannually compounded APR. Therefore
the rate for six months is 7.846/2, or 3.923%:

 1 1 
PV = $100,000 + $100,000   − 9 
= $846,147
 0.03923 0.03923  ( 1.03923 ) 

30. a. Each installment is: $9,420,713/19 = $495,827.

 1 1 
PV = $495,827  − 19 
= $4,761,724
 0.08 0.08  (1.08) 

b. If ERC is willing to pay $4.2 million, then:

1 1 
$4,200,000 = $495,827  − 19 
 r r  (1 + r) 
Using Excel or a financial calculator, we find that r = 9.81%.
  1 1 
31. a. PV = ` 70,000   − 8
= ` 402,264.73
 0.08 0.08  (1.08) 
b.
Beginning-of- Year-End Total
Amortization End-of-Year
Year Year Balance Interest on Year-End
of Loan (`) Balance (`)
(`) Balance (`) Payment (`)

1 402,264.73 32,181.18 70,000.00 37,818.82 364,445.91

2 364,445.91 29,155.67 70,000.00 40,844.33 323,601.58

3 323,601.58 25,888.13 70,000.00 44,111.87 279,489.71

4 279,489.71 22,359.18 70,000.00 47,640.82 231,848.88

5 231,848.88 18,547.91 70,000.00 51,452.09 180,396.79

6 180,396.79 14,431.74 70,000.00 55,568.26 124,828.54

7 124,828.54 9,986.28 70,000.00 60,013.72 64,814.82

8 64,814.82 5,185.19 70,000.00 64,814.81 0.01

32. This is an annuity problem with the present value of the annuity equal to `2 million (as of
your retirement date), and the interest rate equal to 8% with 15 time periods. Thus, your
annual level of expenditure (C) is determined as follows:
1 1 
PV = C   − t 
 r r  (1+ r) 

 1 1 
` 2,000,000 = C   − 15 
 0.08 0.08  (1.08) 

 1 1 
C = ` 2,000,000  −  = ` 233,659
 0.08 0.08  (1.08)15 

With an inflation rate of 4% per year, we will still accumulate $2 million as of our retirement
date. However, because we want to spend a constant amount per year in real terms (R,
constant for all t), the nominal amount (Ct) must increase each year. For each year t: R = Ct /(1 +
inflation rate)t
Therefore:
 PV [all Ct ] = PV [all R  (1 + inflation rate)t] = `2,000,000

 (1 + 0.04)1 (1 + 0.04)2 (1 + 0.04)15 

R  + + + = ` 2,000,000
(1+ 0.08)15 
. . .
 (1+ 0.08) (1 + 0.08)
1 2

R  [0.9630 + 0.9273 + . . . + 0.5677] = `2,000,000

R  11.2390 = `2,000,000

R = `177,952
(1 + 0 .08)
Alternatively, consider that the real rate is − 1 = .03846. Then, redoing the steps
(1+ 0.04)
above using the real rate gives a real cash flow equal to:
 1 1 
C = ` 2,000,000  −  = ` 177,952
 0.03846 0.03846  (1.03846)15 

Thus C1 = (`177,952  1.04) = `185,070, C2 = `192,473, etc.

 1 1 
33. a. PV = $50,000   − 12 
= $430,925.89
 0.055 0.055  (1.055) 

b. The annually compounded rate is 5.5%, so the semiannual rate is:

(1.055)(1/2) – 1 = 0.0271 = 2.71%
Since the payments now arrive six months earlier than previously:
PV = $430,925.89 × 1.0271 = $442,603.98

34. In three years, the balance in the mutual fund will be:
FV = $1,000,000 × (1.035)3 = $1,108,718
The monthly shortfall will be: $15,000 – ($7,500 + $1,500) = $6,000.
Annual withdrawals from the mutual fund will be: $6,000 × 12 = $72,000.
Assume the first annual withdrawal occurs three years from today, when the balance in the
mutual fund will be $1,108,718. Treating the withdrawals as an annuity due, we solve for t as
follows:

1 1 
PV = C   − t 
 (1 + r)
 r r  (1 + r) 
  1 1 
$1,108,718 = $72,000   − t
 1.035
 0.035 0.035  (1.035) 
Using Excel or a financial calculator, we find that t = 21.38 years.

35. a. PV = 2/.12 = $16.667 million.

 1 1 
b. PV = $2   − 20 
= $14.939 million.
 0.12 0.12  (1.12) 

c. PV = 2/(.12-.03) = $22.222 million

 1 1.0320 
d. PV = $2   − 20 
= $18.061 million.
 (0.12 - .03) (0.12 - .03) (1.12) 

36. a. First we must determine the 20-year annuity factor at a 6% interest rate.
20-year annuity factor = [1/.06 – 1/.06(1.06)20) = 11.4699.
Once we have the annuity factor, we can determine the mortgage payment.
Mortgage payment = $200,000/11.4699 = $17,436.91.
b.
Total Year-
Beginning Balance Year-End End Payment Amortization End-of-Year
Year ($) Interest ($) ($) of Loan ($) Balance ($)

1 200,000.00 12,000.00 17,436.91 5,436.91 194,563.09

2 194,563.09 11,673.79 17,436.91 5,763.13 188,799.96

3 188,799.96 11,328.00 17,436.91 6,108.91 182,691.05

4 182,691.05 10,961.46 17,436.91 6,475.45 176,215.60

5 176,215.60 10,572.94 17,436.91 6,863.98 169,351.63

6 169,351.63 10,161.10 17,436.91 7,275.81 162,075.81

7 162,075.81 9,724.55 17,436.91 7,712.36 154,363.45

8 154,363.45 9,261.81 17,436.91 8,175.10 146,188.34

9 146,188.34 8,771.30 17,436.91 8,665.61 137,522.73

10 137,522.73 8,251.36 17,436.91 9,185.55 128,337.19

11 128,337.19 7,700.23 17,436.91 9,736.68 118,600.51

 12 118,600.51 7,116.03 17,436.91 10,320.88 108,279.62

13 108,279.62 6,496.78 17,436.91 10,940.13 97,339.49

14 97,339.49 5,840.37 17,436.91 11,596.54 85,742.95

15 85,742.95 5,144.58 17,436.91 12,292.33 73,450.61

16 73,450.61 4,407.04 17,436.91 13,029.87 60,420.74

17 60,420.74 3,625.24 17,436.91 13,811.67 46,609.07

18 46,609.07 2,796.54 17,436.91 14,640.37 31,968.71

19 31,968.71 1,918.12 17,436.91 15,518.79 16,449.92

20 16,449.92 986.99 17,436.91 16,449.92 0.00

b. Nearly 69% of the initial loan payment goes toward interest ($12,000/$17,436.79
= .6882). Of the last payment, only 6% goes toward interest (987.24/17,436.79 =
.06).
After 10 years, $71,661.21 has been paid off ($200,000 – remaining balance of
$128,338.79). This represents only 36% of the loan. The reason that less than half
of the loan has paid off during half of its life is due to compound interest.