3 Interest and Equivalence

Multiple Choice Questions

1. $500 today at a 5% per year compounded interest rate is equivalent to which of the
following?
a) $550.00 two years from now
b) $578.81 three years from now
c) $550.00 one year from now
d) $579.63 three years from now

2. What is the idea behind finding economic equivalence?

a) To find the value of a cash-flow series at a particular point in time.
b) To always find the present worth of a cash-flow series.
c) To always find the future worth of a cash-flow series.
d) To always find the annual equivalent value of a cash-flow series.

3. With a loan of $5000 at a compounded interest rate of 8% per year, what is the end-of-year
payment at the end of Year 3 if at the end of each year you pay $1000 plus the interest
accumulated in that year?
a) $1320
b) $3240
c) $1240
d) $1400

4. What is the formula for a future value (F) of a present sum (P) at an interest rate (i) for a
number (n) of periods?
a) P = F(1 + i)n
b) F = P(1 + in)
c) F = P(1 + i)n
d) F = P(1 + n)i

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5. What is the single payment present worth notation?
a) P = F(1 + i)n
b) F = P(1 + i)n
c) P = F(F/P, i, n)
d) P = F(P/F, i, n)

6. Using simple interest of 10% per year, what is the future worth of $4000.00 now after 5
years?
a) $6000.00
b) $20,000.00
c) $6442.04
d) $2000.00

7. A principal sum, P, is invested at a nominal interest rate, r, and compounded m times per
year for n years. What amount, F, will be accumulated at the end of this period?
a) P(1 + r/m)r
b) P(1 + r/m)rm
c) P(1 + r/m)n/m
d) None of the above

8. In the formula, P = F(1 + i)-n, the factor (1 + i)-n is called what?

a) The capital recovery factor
b) The single payment present worth factor
c) The uniform series present worth factor
d) The single payment compound amount factor

9. Klaus wishes to deposit an amount of money now so that at the end of five years $500 will
have been accumulated. With interest at 4% per year, compounded semi-annually, how much
should he deposit now?
a) $337.80
b) $410.15
c) $410.95
d) $609.50

10. What is the future worth of $1000 deposited at time "0" at an interest rate of 5.5%
compounded quarterly for 5 years?
a) $1314
b) $1307
c) $1311
d) $1321

11. What is the effective interest rate of 6% compounded quarterly?

a) 6%
b) 6.09%
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 c) 6.14%
d) 6.17%

12. Which term refers to the annual interest rate not including the effect of any compounding?
a) Simple interest
b) Nominal interest rate
c) Compound interest
d) Effective interest rate

13. How many years will it take for an amount "X" to double if invested at an interest rate of
10% compounded annually?
a) 20.98 years
b) 7.27 years
c) 10 years
d) 15.21 years

14. Which term refers to interest that is charged on unpaid interest?

a) Comparable equivalent value
b) Continuous compounding
c) Simple interest
d) Compound interest

15. Which statement of the following is correct?

a) The interest earned by $1500 for 8 years at 6% simple interest is $720.
b) The interest earned by $1500 for 8 years at 8% compounded annually is $2776.39.
c) Both A and B
d) one of the above

16. For investment plan which option is better for investing $10000 for 10 years period?
a) 6% per year simple interest.
b) 5% compounded annually.

17. Positive cash flows are called ________ and negative flows are called ________.
a) receipts, disbursements.
b) disbursements, receipts.
c) incomes, expenses.
d) revenue, interest expense.

18. Given various options of cash flow series' to choose from, what method do we use to choose
the "best" option?
a) The technique of economic equivalence.
b) The balance sheet method.
c) The income statement method.
d) The future worth method.

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19. You have computed the present worth (PW) of a lengthy cash flow series. You now want to
calculate the future worth (FW) of the same series.
a) One can simply find the FW of the already found PW value.
b) One must calculate FW by going back to the original cash flow values.
c) Once the PW is calculated the FW cannot be calculated.
d) One does not have to calculate anything since FW is always equal to PW.

20. What is the difference between nominal and effective interest rates?
a) The nominal interest rate has not taken into account the compounding period.
b) There is no difference; they are the same.
c) The nominal rate is normally larger than the effective rate.
d) The effective rate means "the rate in name only."

21. What does APR refer to?

a) Annual Percentage Rate
b) Annuity Percentage Regulated
c) Aggregate Percentage Rate
d) Aggressive Percentage Rate

Essay/Short Answer Questions

1. At what annual interest rate is $300 four years ago equivalent to $500 now?
2. If you deposit $5000 now in a saving account that pays 6% interest rate compounded
annually, would you be able to accumulate $15000 at the end of 4 years? If not, how many
years you have to wait?
3. How much you should deposit now in a saving account that earns 6% interest compounded
annually to be able to withdraw the amounts below?

End of the year Amount

3 4000
4 8000
5 1000
6 7000

4. How much can you borrow today if you are willing to pay $1650 three years from now at an
interest rate of 9% per year compounded yearly?
5. What will be the future worth at the end of Year 4 if the following amounts will be saved in a
saving account that earns 7% compounded annually?

End of the year Amount

0 1000
1 3000
2 2000
3 0

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 4 4000
6. Jean deposits $6000 now and $2000 each year into a saving account that pays 7% interest
compounded annually. Determine how much the account balance will be after the seventh
deposit.
7. Draw the cash flow diagram for the following transactions and determine the value of P,
assume i=6% compounded annually.

End of the Period Amount

0 75-P
1 75
2 100
3 100
4 125
5 125
6 150
7 150
8. Your uncle has offered you $10000 to buy a new car. If your uncle charges you an interest
rate 1.5% compounded monthly, what is the nominal and the effective annual interest rate
that your uncle is charging?
9. If you were promised $19546.74 at 5% per year interest and you invested $12000 now, how
long would you have to wait?
10. If you repay a loan after 15 years at simple interest of 3% per year and the payment is
$21750 what was the original amount loaned?
11. Diana borrowed $3000 from Pat and promised to pay him $3405 after 1.5 years. What simple
interest rate did she have in mind?
12. How long does it take to double an investment of $10000 if the investment pays only simple
interest at the rate of 12% per annum?
13. You are planning to send your child to summer camp in nine months. The camp will cost you
$1200 at that time. You have decided to invest a lump sum of money now that will grow to
$1200 by the time it is needed. Assuming the money grows at a nominal annual interest rate
of 12% compounded monthly, how much money should you set aside now to have the funds
available when needed? How long will it take before a sum of money, invested at 5%
compounded annually, doubles in value?
14. How much would you need to invest at 6% interest on 31 December 2002 in order to
accumulate $1850 on 31 December 2009? Present the economic functions required, showing
first the functional notation and then its numerical value.
15. What is the equivalent worth on 31 December 2002 of $1295 deposited on 31 December
1995? Use an interest rate of 6%. Present the economic equivalence function required,
showing first the functional notation and then its numerical value.
16. John loans a friend $10000 at 12% interest for 5 years. At the end of 5 years, John will get
the principal and the accrued simple interest. Calculate the following:
a) The interest rate John got if compounded yearly.
b) The interest rate John got if compounded quarterly.
17. Consider the following cash flows. Find the unknown.
Year Cash Flow

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 0 -2000
1 0
2 -500
3 F
i=9%
18. Linda inherited $50000 from one of her grandparents. She would like to invest in one of the
following three possible investment opportunities for a period of 10 years. Choose the best
one for her.
a) 9% compounded quarterly
b) 8.90% compounded daily
c) 8.95% compounded monthly
19. The following series of four cash flows will retire a loan of $8000 taken at time "0" at an
interest rate of 10%. At a 12% interest rate, what are the series of payments equivalent to at
time "0"?

Year end
Year payment
1 $2,800
2 $2,600
3 $2,400
4 $2,200
20. For the cash flows shown below, if the interest rate is 10% per year, find X.

Year Cash Flow

0 -2000
1 1000
2 X
3 1200
21. Tom Weavers is anxious to have his inheritance of $10000 doubled in 5 years. What interest
rate should he get if the interest rate is compounded monthly?
22. A piece of equipment will cost $200000 10 years from now. What will it cost 5 years from
now if money is worth 12%?
23. What is the key assumption that states that $X today is not worth $X next year? Why is this
assumption reasonable? Are there contexts in which this assumption is not reasonable?
24. How does simple interest differ from compound interest? Which type of interest is assumed
in this text for most of the chapters?
25. With regards to repaying debts, what is the payment plan unless otherwise stated? Each year
how does the amount paid going toward interest or principal change?

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 Answer Key

Multiple Choice Questions

1. b (pp. 70-71) 12. b (p. 79)
2. a (p. 73) 13. b (pp. 79-82)
3. c (pp. 70-71) 14. d (p. 70)
4. c (p. 76) 15. c (pp. 70-71, 76-79)
5. d (p. 77) 16. b (pp. 79-82)
6. a (p. 70) 17. a (p. 67)
7. d (p. 80) 18. a (p. 73)
8. b (p. 78) 19. a (p. 77)
9. b (pp. 79-82) 20. a (p. 79)
10. a (pp. 79-82) 21. a (p. 80)
11. c (pp. 79-82)

Essay/Short Answer Questions

Answers for questions 1 to 22 are found in Chapter 3.

1. 300(1 + i)4 = 500

(1 + i)4 = 500/300
i = 13.622%
2. F =5000(1+0.06)4 = $6312.38
4 years is not enough
F = 15000=5000(1+06)N
3 =1.06N
log 3 = N log 1.06
N = 18.85 years
3. P= $4000(1.06)-3+$8000(1.06)-4+$1000(1.06)-5+$7000(1.06)-6
P= $15377.2

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4. P = F(1 + 0.09)-3
P = 1650(1.09)-3
P = $1274.10
5. F = $1000(1.07)4 + $3000(1.07)3 + $2000(1.07)2 + $4000
F = $11275.7
6. F =F1 + F2
= $6000(F/P,7%,7) + $2000(F/A,7%,6)
= $6000(1.606) + 2000(7.158)
= $23,952

7.
P = $75+[$75(F/A,6%,7)+$25(F/A,6%,6)+$25(F/A,6%,4)+$25(F/A,6%,2)](P/F,6%,7)
P = $75+[$75(8.394)+$25(6.975)+$25(4.375)+$25(2.060)](0.6651)
P = $716.688
8. Nominal interest rate:
r = %1.5 × 12 = 18%
Effective annual interest rate:
ia = (1+0.15)12 -1 = 19.56%
9. F = (1 + i)n
19546.74 = 12000(1.05)n
ln(19546.74/12000) = (n)ln ( 1.05)
n = 10 years
10. F = P + P(n)(i)
21750 = P[1 + (15)(0.03)]
P = $15000 is the original amount loaned
11. P = $3000. F = $3405. N = 1.5 Years.
Interest Earned = F - P = $3405 - $3000 = $405.
For simple interest rate, interest earned = P × i × n.
405 = 3000 × i × 1.5.
i = 405 / 4500 = 0.09 = 9% per year.
12. P = $10000 F = $20000 i =12%
n=?
20000 = 10000 + {10000 × (0.12) × n}
n = 10000 /{(10000) × (0.12)} = 8.33 years.
13. i = 5%. F = 2 × P. 2 × P = P × (1 + i)n. 2 = (1 + i )n. 2 = 1.05n.
n = ln (2) / ln (1.05) = 14.2 Years.
14. F = $1850. n = 12/2002 To 12/2009 = 7 Years. i = 6%.
P = F (P/F, i, n) = $1850 (0.6651) = $ 1230.44
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15. P = $1295. n = 12/1995 To 12/2002 = 7 Years. i = 6%.
F = P (F/P, i, n) = 1295
(F/P, 6%, 7) = 1295 (1.504) = $1947.68.
16. Accrued simple interest for 5 years = $10000 × 0.12 × 5 = $6000
F = Principal + Accrued interest = $10000 + 6000 = $16000
P = F (1 + i )n
$10000 = $16000 (1+ i)5
a = 0.0986 (or) 9.86% compounded annually
b = Accrued interest is still the same.
$10000 = $16000 (1 + i )20
(1 + i )20 = 1.6
i = 0.02378 per quarter
Nominal interest rate / Year = 0.02378 × 4 = 0.0951 or 9.51% per year.
17. F = 2000 (F/P, 9%, 3) + 500 (F/P, 9%, 1) = 2000 (1.295) + 500 (1.090)
= $3135
18. 9% Compounded quarterly
F = $50000 (F/P, 2.25%, 40) = $121759.45

8.90% Compounded daily

F = $50000 {F/P, (8.9/365)%, 3650} = $121743.28

8.95% Compounded monthly

F = $50000 {F/P, (8.95/12)%, 120} = $121961.07
Choose to invest on 8.95% monthly compounding.
19. P = 2800 (P/F, 12%, 1) + 2600 (P/F, 12%, 2) + 2400 (P/F, 12%, 3) + 2200 (P/F, 12%, 4)
= 2800 (0.8929) + 2600 (0.7972) + 2400 (0.7118) + 2200 (1.574)
= $7680.15
20. 2000 = 1000 (P/F, 10%, 1) + X (P/F, 10%, 2) + 1200 (P/F, 10%, 3)
= 1000 (0.9091) + X (0.8264) + 1200 (0.7513)
0.8264 X= 2000 - 1810.66
X = 189.34 / 0.8264 = $229.11
21. P= $100000 F = $20000 n = 60 periods (monthly)
$20000 = $10000 (F/P, i%, 60)
(F/P, i%, 60) = 20000 /10000 = 2

i (F/P, i%, 60)

1% 1.817
1.25% 2.107

Need to interpolate.
i% = 1 + (2.0 -1.817) * 0.25 / (2.107 - 1.817)
= 1.158%

Yearly or Nominal interest rate = 1.158 × 12 % = 13.896%

22. F5 = 200000 (P/F, 12%, 5) = 200000 (0.8227) = $164540

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23. This is the "time-value of money" assumption. This means that typically we assume that the
same dollar amount is worth less as time goes on. This is reasonable because we all know
that prices go up over time (inflation). However, that is not the key assumption of this course.
This is a reasonable assumption because we assume that if you invest money in a project you
expect to be given back (eventually) the money you invested as well as extra (interest) for the
risk you have taken in investing said money. This assumption is not helpful or reasonable in
situations where making money on an investment is not a primary goal (e.g. government
decisions on how to invest in schools, roads, hospitals etc.). (p. 67)
24. Simple interest is simply the interest rate multiplied by the amount invested then multiplied
by how many years one keeps the investment in the bank. Compound interest however takes
into account the interest earned on the previous year's interest. A way of thinking about this
is that compounding interest increases the principal value over time. This means that when
interest compounds the investment will end with a higher value than simple interest. This
course assumes compound interest unless otherwise stated. (p. 70)
25. Unless otherwise stated the borrower should assume that the debt is to be repaid over the
time period with equal payments each year (or whatever the time period is measured in). One
finds this by simply using the formula A = P(A/P, i, N). With this standard assumption each
payment will steadily have a greater portion going toward the initial borrowed principal and
less going toward the interest costs (this is due to the fact that each pay period the balance
owing is reduced). (p. 72)

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