Chapter 4

CHAPTER 4: Time Value of Money

PROBLEMS

The general formula is FVAn, i% = PMT(FVIFAi,n) = PMT* [(1+i)^n -1]/i.

0 10%1 2 3 4 5 6 7 8 9 10
| | | | | | | | | | |
400 400 400 400 400 400 400 400 400 400
FV = ?

FVA10 = ($400)15.9374 = $6,374.96.

The general formula is PVA n = PMT(PVIFA i,n) = PMT* [1 -1/(1+i)^n/i ] { Payment is made at the end of
the period]

0 10% 1 2 3 4 5 6 7 8 9 10
| | | | | | | | | | |
PV = ? 400 400 400 400 400 400 400 400 400 400

PVA = $400 (6.1446) = $2,457.83.

0 1 2 3 4 5 6 7 8 9 10
| | | | | | | | | | |
400 400 400 400 400 400 400 400 400 400 PV = ?

PVAn (Annuity due) = PMT(PVIFAi,n)(1 + i). Therefore,

$400(6.1446)(1.10) = $2,703.62.

4-4 a. ?
| |

FV = PV(1+i)^n
$400 = $200 (FVIF7%,n) ; { FVif = future value interest factor]
FV = 400 = 200(1.07)^n
400/200 = (1.07)^n
2 =(1.07)^n
(1.07)^n = 2
Nln(1.07) = ln(2)
N = ln(2)/ln(1.07) = 10 years
2|Page

4-14 a. Cash Stream A Cash Stream B

0 1 2 3 4 5 0 1 8%2 3 4 5
| | 8%| | | | | | | | | |
PV = ? 100 400 400 400 300 PV = ? 300 400 400 400 100

a) Find: PV = FV/(1+i)^n = 100/(1.08)^1+…+300/(1.08)^5

FV = PV(1+i)^n -1 =100(1.08)^5-1+…………..+300(1.08)^5-5 = ………….

b). PVA = FV/ (1+i)^n = 100/(1+0)^1+…..+ 300/(1+0)^5

= $100 + $400 + $400 + $400 + $300 = $1,600.
PVB = $300 + $400 + $400 + $400 + $100 = $1,600

4-19 a. Universal Bank: Effective rate = 7%. [ Yearly]

Regional Bank: [ Quarterly compounding]

Effective rate = (1+Inom/m)^m - 1

4
 0.06 
= 1   - 1.0 = (1.015)4 – 1.0
 4 
= 1.0614 – 1.0 = 0.0614 = 6.14%.

b. If funds must be left on deposit until the end of the com pounding period (1 year for Universal and 1
quarter for Regional), and you think there is a high probability that you will make a withdrawal
during the year, the Regional account might be preferable. For example, if the withdrawal is made
after 10 months, you would earn nothing on the Universal account but (1.015)3 - 1.0 = 4.57% on the
Regional account.
 Chapter 4

4-20 [See the power point formula : Installment = [Principal amount /1 – 1/(1+i1)^n/i]

a. N = 5, i = 10%, Loan = Taka 25000, Instalment = $6,594.94 = [25000/1 – 1/(1.1)^5/0.1]

Repayment Remaining
Year Payment Interest of Principal Balance
1 $ 6,594.94 $2,500.00 $ 4,094.94 $20,905.06*
2 6,594.94 2,090.51 4,504.43 16,400.63
3 6,594.94 1,640.06 4,954.88 11,445.75
4 6,594.94 1,144.58 5,450.36 5,995.39
5 6,594.93* 599.54 5,995.39 0
$32,974.69 $7,974.69 $25,000.00

*The last payment must be smaller to force the ending balance to zero.

b. Here the loan size is doubled, so the payments also double in size to $13,189.87. [ n
= 5, Loan = Taka 50,000]

c. The annual payment on a $50,000, 10-year loan at 10 percent interest would be

$8,137.27 [ Installment]. Because the payments are spread out over a longer time
period, more interest must be paid on the loan, which raises the amount of each
payment. The total interest paid on the 10-year loan is $31,372.70 versus interest
of $15,949.37 on the 5-year loan.

Workings:
For 5 years loan Interest payment = $13,189.87*5 – 50, 000 = $15,949.37
For 10 years loan Interest payment = $8,137.27 *10 – 50, 000 = $ $31,372.70

[ The longer the duration of loan payment , higher the interest burden is.]

4-25 0 1 2 ?
| 9% | |    |
12,000 -1,500 -1,500 -1,500

PVA n  PMT (PVIFA i, n ).

$12,000  $1,500(PVIFA 9%,n )
PVIFA 9%,n  8.000.

PVA = PMT * [ 1- 1/(1+i)^n/i]

12000 = 1500 *1- 1/1.09)^n/0.09
12000/1500 = 1- 1/1.09)^n/0.09
8 = ( 1- 1/1.09)^n/0.09
8*0.09 = 1- 1/1.09)^n
0.72 = 1- 1/1.09)^n
4|Page

0.72 -1 = -1/1.09)^n
-0.28 = -1/1.09)^n
0.28 = 1/1.09)^n
0.28(1.09)^n = 1
1.09^n = 1/.28 = 3.57
nln(1.09) = ln(3.57)
n = ln(3.57)/ ln(1.09) = 15.18 Years = 15 Years

4 -24

0 1 2 3 4
a. r = 7%
10,000 10,000 10,000 10,000

1  (1.07
1
)4

PVA  10,000    10,000(3.38721)  33,872.11
 0.07 
 

b. (1) At this point, we have a three-year $10,000 annuity at 7 percent. Input N = 3 to

override the number of years from part a in your calculator’s TVM register, and you
will find PV = 26,243.16.

You can also think of the problem as follows:

$33,872.11(1.07) ─ $10,000 = $26,243.16 [ end of first year]

$26,243.16 (1.07) – 10, 000 = 18080 [ end of 2nd year]

18080 (1.07) -10, 000 = 9345 [ end of 3nd year]
9345(1.07) -10,000 = 0 [ end of 4th year; Graduated]

Or,

1  (1.07
1
)3

PVA  10,000   10,000( 2.624316)  26,243.16
 0.07 
 

(2) Zero after the last withdrawal.

4-25
 Chapter 4
12,000 -1,500 -1,500 -1,500 -1,500

1  1 n 
PVA  PMT  
(1 r )
 r 
 
1  1

 (1.09 ) n 
12,000  1,500
 0.09 
 

N = 14.77 ≈ 15 years

4-26. You need to accumulate $10,000. To do so, you plan to make deposits of $1,750 per year,
with the first payment being made one year from today, in a bank account that pays 6 percent
annual interest. Your last deposit will be more than $1,750 if more is needed to round out to
$10,000. How many years will it take you to reach your $10,000 goal, and how large will the
last deposit be?

0 1 2 n-1 n
4-26 r = 6% …

-1,750 -1,750 -1,750 PMT = ?

FVA = 10,000
 (1  r ) n  1 
FVA  PMT  
 r 
 (1.06) n  1 
10,000  1,750  
 0.06 
compute N = 5.06.

Now find the FV of $1,750 for 5 years at 6 percent; it is $9,864.91.

 (1.06) 5  1 
FVA  1,750   1,750(5.63709)  9,864.91
 0.06 
So the payment at the end of Year 5 will include an additional $135.09 = $10,000 - $9,864.91,
which means the last investment will total $1,885.09 = $1,750 + $135.09.
6|Page

PENSION FUND: [ Not in Book]

Jack just discovered that he holds the winning ticket for the $87 million mega lottery in
Missouri. Now he needs to decide which alternative to choose: (1) a $44 million lump-sum
payment today or (2) a payment of $2.9 million per year for 30 years; the first payment will be
made today (beginning). If Jack’s opportunity cost is 5 percent, which alternative should he
choose?
ANS:
The $2.9 million 30-year payment represents an annuity due. Therefore, compute the present
value of the annuity due.

PVA (due) =PMT* [ 1-1/(1+i)^n] * (1+i)

 1  
1   
 (1.05 ) 30  1.05  
PVA (DUE )  ($2.9 million)    ($2.9 million)(16.141074)  $46,809,11 3
  0.05  
  
  
Because PVA(DUE) = $46,809,113, which is greater than the lump-sum payment of $44 million,
the annuity option should be chosen.