LECTURE 3 (2)

CHAPTER 6

Answers to Concepts Review and Critical Thinking Questions

1. Annuity Factors [LO1] There are four pieces to an annuity present value. What are
they?

Answer:
The four pieces are the present value (PV), the periodic cash flow (C), the
discount rate (r), and the number of payments, or the life of the annuity, t.

6. Present Value [LO1] Suppose two athletes sign 10-year contracts for $80 million. In
one case, we’re told that the $80 million will be paid in 10 equal installments. In the
other case, we’re told that the $80 million will be paid in 10 installments, but the
installments will increase by 5 percent per year. Who got the better deal?

Answer:
The better deal is the one with equal installments.

Solutions to Questions and Problems

1. Future Value and Multiple Cash Flows [LO1] Toadies, Inc., has identified an
investment project with the following cash flows. If the discount rate is 8 percent,
what is the future value of these cash fl ows in Year 4? What is the future value at a
discount rate of 11 percent? At 24 percent?
Year Cash Flow
1 $1,375
2 1,495
3 1,580
4 1,630

Solution

The time line is:

0 1 2 3 4
$1,375 $1,495 $1,580 $1,630

To solve this problem, we must find the FV of each cash flow and add them. To find
the FV of a lump sum, we use:

FV = PV(1 + r)t

FV@8% = $1,375(1.08)3 + $1,495(1.08)2 + $1,580(1.08) + $1,630 = $6,812.27

 FV@11% = $1,375(1.11)3 + $1,495(1.11)2 + $1,580(1.11) + $1,630 =
$7,106.28

FV@24% = $1,375(1.24)3 + $1,495(1.24)2 + $1,580(1.24) + $1,630 =

$8,509.52

Notice, since we are finding the value at Year 4, the cash flow at Year 4 is simply
added to the FV of the other cash flows. In other words, we do not need to
compound this cash flow.

2. Calculating Annuity Present Value [LO1] An investment offers $6,100 per year
for 15 years, with the first payment occurring one year from now. If the required
return is 6 percent, what is the value of the investment? What would the value be if
the payments occurred for 40 years? For 75 years? Forever?

Solution
To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r) t] } / r )

0 1 … 15
PV $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100

PVA@15 yrs: PVA = $6,100{[1 – (1/1.06)15 ] / .06} = $59,244.72

0 1 … 40
PV $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100

PVA@40 yrs: PVA = $6,100{[1 – (1/1.06)40 ] / .06} = $91,782.41

0 1 … 75
PV $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100

PVA@75 yrs: PVA = $6,100{[1 – (1/1.06)75 ] / .06} = $100,380.67

To find the PV of a perpetuity, we use the equation:

PV = C / r

0 1 … ∞
PV $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100
PV = $6,100 / .06 = $101,666.67

Notice that as the length of the annuity payments increases, the present value of the
annuity approaches the present value of the perpetuity. The present value of the
75-year annuity and the present value of the perpetuity imply that the value today
of all perpetuity payments beyond 75 years is only $1,286.

6. Calculating Annuity Values [LO1] Your company will generate $68,000 in annual
revenue each year for the next seven years from a new information database. If the
appropriate interest rate is 8.5 percent, what is the present value of the savings?

Solution
The timeline is:

0 1 2 3 4 5 6 7
C C C C C C C
C=68,000

To find the PVA, we use the equation:

PVA = C({1 – [1 / (1 + r) t] } / r )
PVA = $68,000{[1 – (1 / 1.0857) ] / .085} = $348,058.92

7. Calculating Annuity Values [LO1] If you deposit $5,000 at the end of each of the
next 20 years into an account paying 10.8 percent interest, how much money will
you have in the account in 20 years? How much will you have if you make deposits
for 40 years?

Solution
Here we need to find the FVA. The equation to find the FVA is:
FVA = C{[(1 + r)t – 1] / r}

0 1 20
…
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

FVA for 20 years = $5,000[(1.10820 – 1) / .108] = $313,736

0 1 40
…
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

FVA for 40 years = $5,000[(1.10840 – 1) / .108] = $2,753,565.95

Notice that because of exponential growth, doubling the number of periods does
not merely double the FVA.
8. Calculating Annuity Values [LO1] You want to have $75,000 in your savings
account 12 years from now, and you’re prepared to make equal annual deposits
into the account at the end of each year. If the account pays 6.8 percent interest,
what amount must you deposit each year?

Solution:

The time line is:

0 1 … 12
$75,000
C C C C C C C C C

Here we have the FVA, the length of the annuity, and the interest rate. We want to
calculate the annuity payment. Using the FVA equation:

FVA = C{[(1 + r)t – 1] / r}

$75,000 = $C[(1.06812 – 1) / .068]

We can now solve this equation for the annuity payment. Doing so, we get:

C = $75,000 / 17.679283 = $4,242.25

9. Calculating Annuity Values [LO2] Dinero Bank offers you a $60,000, five-year
term loan at 7.5 percent annual interest. What will your annual loan payment be?

Solution:
The time line is:

0 1 2 3 4 5
$60,000 C C C C C

Here we have the PVA, the length of the annuity, and the interest rate. We want to
calculate the annuity payment. Using the PVA equation:

PVA = C({1 – [1/(1 + r)t] } / r)

$60,000 = C{[1 – (1/1.0755) ] / .075}

We can now solve this equation for the annuity payment. Doing so, we get:

C = $60,000 / 4.04588 = $14,829.88

10. Calculating Perpetuity Values [LO1] The Maybe Pay Life Insurance Co. is trying
to sell you an investment policy that will pay you and your heirs $30,000 per
year forever. If the required return on this investment is 5.8 percent, how much
will you pay for the policy?
 Solution

The time line is:

0 1 … ∞
PV $30,00 $30,00 $30,00 $30,00 $30,00 $30,00 $30,00 $30,00 $30,00
0 0 0 0 0 0 0 0 0

This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $30,000 / .058 = $517,241.38

12. Calculating EAR [LO4] Find the EAR in each of the following cases:
Stated Rate (APR) Number of Times Compounded Effective Rate (EAR)
9% Quarterly
18 Monthly
14 Daily
11 Infinite

Solution

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

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.09/ 4)]4 – 1 = .0931, or 9.31%

EAR = [1 + (.18/ 12)]12 – 1 = .1956, or 19.56%

EAR = [1 + (.14 / 365)]365 – 1 = .1502, or 15.02%

To find the EAR with continuous compounding, we use the equation:

EAR = e0.11 – 1
EAR = e0.11 – 1 = .1163, or 11.63%

20. Calculating Loan Payments [LO2, 4] You want to buy a new sports coupe for
$83,500, and the finance office at the dealership has quoted you a 6.5 percent APR
loan for 60 months to buy the car. What will your monthly payments be? What is
the effective annual rate on this loan?

Solution
The time line is:

0 1 … 60
$83,500 C C C C C C C C C
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:

PVA = C({1 – [1 / (1 + r)t] } / r)

$83,500 = $C[1 – {1 / [1 + (.065 / 12)]60} / (.065 / 12)]

Solving for the payment, we get:

C = $83,500 / 51.10868 = $1,633.77

To find the EAR, we use the EAR equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.065 / 12)]12 – 1 = 0.066972, or 6.70%

55. Amortization with Equal Payments [LO3] Prepare an amortization schedule for
a five-year loan of $63,000. The interest rate is 8 percent per year, and the loan
calls for equal annual payments. How much interest is paid in the third year? How
much total interest is paid over the life of the loan?

Solution:
The payment for a loan repaid with equal payments is the annuity payment with the
loan value as the PV of the annuity. So, the loan payment will be:

PVA = $63,000 = C {[1 – 1 / (1 + .08)5] / .08}

C = $15,778.76

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:

Beginning Total Interest Principal Ending

Year Balance Payment Payment Payment Balance
63,000 15,778 5,040. 52,261.2
1 .00 .76 00 10,738.76 4
52,261 15,778 4,180. 40,663.3
2 .24 .76 90 11,597.86 8
40,663 15,778 3,253. 28,137.6
3 .38 .76 07 12,525.69 9
28,137 15,778 2,251. 14,609.9
4 .69 .76 02 13,527.74 4
14,609 15,778 1,168.
5 .94 .76 80 14,609.96 (0)

In the third year, $3,253.07 of interest is paid.

Total interest over life of the loan = 15,893.78