TODAY:

• Chapter 2 (TVM) continued (non-annual

compounding, EAR)

PROBLEM 8 (Chapter 2)
You want to buy a car, and a local bank will lend you
$20,000. The loan would be fully amortized over 5 years (60
months), and the nominal interest rate would be 12 percent,
with interest paid monthly. What would be the monthly loan
payment? What would be the loan’s EAR?

Unless you’re told otherwise, assume that the compounding

frequency corresponds to the payment frequency – if you are
dealing with monthly payments, interest is also compounded
monthly. Recall that we set the calculators to P/Y = 1. What
it implies is that we’ll be dealing with periodic payments and
periodic interest rates in all our calculations.

If the nominal annual interest rate (APR) is 12 percent, the

periodic rate (monthly in this case) is simply 12%/12 = 1%.

To calculate the monthly loan payment….

N = 60
I/Y = 1
PV = 20,000
FV = 0
CPT PMT = -444.89

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Now, the Effective Annual Rate (EAR) is given by the
following formula:

M
⎛ I ⎞
⎜⎜1 + NOM ⎟⎟ 12
EAR = ⎝ M ⎠ – 1.0 = (1.01) – 1.0 = 12.68%

PROBLEM 22 (Chapter 2)
Jan sold her house on December 31 and took a $10,000
mortgage as part of the payment. The 10-year mortgage has
a 10 percent nominal interest rate, but it calls for semiannual
payments beginning next June 30. Next year, Jan must
report on Schedule B of her IRS form 1040 the amount of
interest that was included in the 2 payments she received
during the year.

a. What is the dollar amount of each payment Jan receives?

N = 10 x 2 = 20
I/Y = 10/2 = 5
PV = -10,000
FV = 0
CPT PMT = 802.43

b. How much interest was included in the first payment?

How much repayment of principal? How do these values
change for the second payment?

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The first payment included the interest payable on the whole
principal ($10,000) for the six month period – i.e. 0.05 x
$10,000 = $500. The second payment included the interest
payable on the outstanding balance ($10,000 – ($802.43-
$500) = $9,697.57) for the six month period – i.e. 0.05 x
$9,697.57= $484.88

Alternatively, we can construct an amortization table to

compute how much out of each payment goes toward
interest as opposed to paying back the loan.
Beginning Payment of Ending
Period Balance Payment Interest Principal Balance
1 $10,000.00 $802.43 $500.00 $302.43 $9,697.57
2 9,697.57 802.43 484.88 317.55 9,380.02
$984.88

c. How much interest must Jan report on Schedule B for the

first year? Will her interest income be the same next year?

She must report $984.88 in interest income. The interest

income will decrease next year since more and more out of
each payment will go toward paying back the principle vs.
paying for the interest charges.

d. If the payments are constant, why does the amount of

interest change over time?

Note that interest is payable only on the amount that is owed

(the balance of the loan). This balance decreases as the
loan is gradually paid back (note that the payment is always
larger than the interest charges). Thus, the amount of
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interest payable decreases accordingly (even though the
semi-annual payments remain fixed).

PROBLEM 25 (Chapter 2)
Find the future values of the following ordinary annuities:

a. FV of $400 paid each 6 months for 5 years at a nominal

rate of 12 percent, compounded semiannually

N = 2 x 5 = 10
I/Y = 12/2 = 6
PV = 0
PMT = -400
CPT FV = 5,272.32

b. FV of $200 paid each 3 months for 5 years at a nominal

rate of 12 percent, compounded quarterly

N = 4 x 5 = 20
I/Y = 12/4 = 3
PV = 0
PMT = -200
CPT FV = 5,374.07

c. These annuities receive the same amount of cash during

the 5 year period and earn interest at the same nominal rate,
yet the annuity in part b ends up larger than the one in part
a. Why does this occur?

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First, note that the money stays in the account longer in (b)
than in (a). For instance, the first payment gets deposited 3
months sooner in (b) than in (a)

Second, since the compounding frequency in (b) is higher

than in (a), the EAR is higher as well. Thus, more interest is
earned in (b).

PROBLEM 26 (Chapter 2)
You have saved $4,000 for a down payment on a new car.
The largest monthly payment you can afford is $350. The
loan would have a 12 percent APR based on end of month
payment. What is the most expensive car you could afford if
you finance it for 48 months? For 60 months?

Remember that the amount of a loan has to be equal to the

PV of loan payments.

Assuming a 48-month loan…

N=48
I/Y = 12/1 = 1
PMT = -350
FV = 0
CPT PV = 13,290.88

With $4,000, we can buy a car for $17,290.88

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Now, assuming a 60-month loan…
N=60
I/Y = 12/1 = 1
PMT = -350
FV = 0
CPT PV = 15,734.26

With $4,000, we can buy a car for $19,734.26

PROBLEM 29 (Chapter 2)
Your firm sells for cash only, but it is thinking of offering
credit, allowing customers 90 days to pay. Customers
understand the time value of money, so they would wait and
pay on the 90th day. To carry these receivables, you would
have to borrow funds from your bank at a nominal rate of 12
percent, daily compounding based on a 360-day year. You
want to increase your prices by exactly enough to offset your
bank interest cost. To the closest whole percentage point, by
how much should you raise your product prices?

You need to find the FV of $1 90 days from today using 12%

APR and daily compounding.
N = 90
I/Y = 12/360 = 0.03333333….
PV = 1
PMT = 0
CPT FV = -1.030449383
You need to increase your prices by roughly 3%
(3.0449383%).

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PROBLEM 36 (Chapter 2)
a. You plan to make 5 deposits of $1,000 each, once every 6
months, with the first payment being made in 6 months. You
will then make no more deposits. If the bank pays 4 percent
nominal interest, compounded semiannually, how much
would be in your account after 3 years?

Your last deposit will take place 2.5 years from now. The
balance of your account in 2.5 years will be…
N=5
I/Y = 4/2 = 2
PV = 0
PMT = -1000
CPT FV = 5,204.04

The above amount will continue earning interest for another

6 months (at a semiannual rate of 2%). In three years, the
balance of your account will then be

5,204.04 x 1.02 = 5,308.12

b. One year from today you must make a payment of

$10,000. To prepare for this payment, you plan to make 2
equal quarterly deposits, in 3 and 6 months, in a bank that
pays 4 percent nominal interest, compounded quarterly. How
large must each of these payments be?

There is more than one way to approach this problem. It is

probably the easiest to proceed as follows:

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1. Find the PV of $10,000 one year from today

PV = $10,000/1.014 = $9,609.80
(remember, we assume quarterly compounding)

2. Find the value of an annuity with 2 quarterly payments

that corresponds to the above PV.

N=2
I/Y = 1
PV = 9609.80
FV = 0
CPT PMT = -4877.09

Alternatively, we can do the following:

1. Discount $10,000 by 2 quarters

PV = $10,000/1.012 = $9,802.96

2. Find the value of an annuity with 2 quarterly payments

whose FV is equal to the PV above.

N=2
I/Y = 1
PV = 0
FV = 9802.96
CPT PMT = -4,877.09