Solution Manual for Corporate Finance 1st Edition by

Booth Cleary Drake ISBN 0470444649 9780470444641

Full download link at:
Test bank: https://testbankpack.com/p/test-bank-for-corporate-finance-1st-edition-by-booth-cleary-
drake-isbn-0470444649-9780470444641/

Solution manual: https://testbankpack.com/p/solution-manual-for-corporate-finance-1st-edition-by-

booth-cleary-drake-isbn-0470444649-9780470444641/

Test Bank Chapter 5

Bloom’s Taxonomy

Create
Evaluate
Analyze

Apply
Describe / Understand
Remember

Multiple Choice

LO 5.1
1. The concept that a unit of currency today is not worth the same as a unit of currency in another
time period is best described as the:
A. rate of money.
B. capital use rate.
C. time value of money.
D. economic measure of money.

Answer B
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Remember
 AACSB Analytical skills
Feedback Related to the opportunity cost of funds and
the cost of capital.

2. If we convert a future value into a present value, this process is best described as:
A. discounting.
B. compounding.

Answer A
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Related to the opportunity cost of
funds and the cost of capital.

3. Suppose you invest $1,000 today in an account that pays 3% interest, compounded annually. The
balance in the account at the end of ten years, if you make no withdrawals, is closest to:
A. $744
B. $1,000
C. $1,300
D. $1,344

Answer D
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 (1.03)10 = $1,343.92

4. If you invest $10,000 today in an account that pays 4% interest, compounded quarterly, the balance
in the account at the end of ten years, if you make no withdrawals, is closest to:
A. $14,000.00
B. $14,802.44
C. $14,888.64
D. $14,918.25

Answer D
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 (1.01)40 = $14,888.64

5. Suppose you invest $1,000 today in an account that pays 5% interest, compounded annually. The
balance in the account at the end of five years, if you make no withdrawals, is closest to:
A. $784
 B. $1,000
C. $1,250
D. $1,276

Answer D
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 (1.05)5 = $1,343.92

6. Calculating the present value of a future value, considering the time value of money is best
described as:
A. annuitizing.
B. discounting.
C. compounding.

Answer B
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Discounting - calculating the present value of a future value,
considering the time value of money

7. Consider a deposit of $4,000 in an account that promises 6% interest, compounded annually. By the
end of five years, the interest on interest is closest to:
A. $152.90
B. $240.00
C. $352.90

Answer A
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $4,000 (1.06)5 = $5,352.90
FVsimple = $4,000 + ($4,000 × 0.06 × 5 ) = $5,200
Interest on interest = $5,352.90  5,200 = $152.90

8. Consider a deposit of $10,000 in an account that promises 5% interest, compounded continuously.

By the end of five years, the interest on interest is closest to:
A. $340.25
B. $250.00
C. $840.25

Answer A
 Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $10,000 e25 = $12,840.25
FVsimple = $10,000 + ($10,000 × 0.05 × 5 ) = $12,500
Interest on interest = $12,840.25  12,500 = $340.25

9. Consider a deposit of $2,000 in an account that promises 4% interest, compounded annually. By the
end of five years, the interest on interest is closest to:
A. $33.31
B. $80.00
C. $93.51
D. $433.31

Answer A
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $2,000 (1.04)5 = $2,433.31
FVsimple = $2,000 + ($2,000 × 0.04 × 5 ) = $2,400.00
Interest on interest = $2,433.31 - $2,400.00 = $33.31

10. Consider a deposit of $1,000 in an account that promises 6% interest, compounded annually. By the
end of five years, the interest on interest is closest to:
A. $38.23
B. $60.00
C. $75.75
D. $300.00

Answer A
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $1,000 (1.06)5 = $1,338.23
FVsimple = $1,000 + ($1,000 × 0.06 × 5 ) = $1,300
Interest on interest = $1,338.23 - $1,300 = $38.23

11. A retired person has been earning 4.5% on a tax-free bond, which is called. He has the opportunity
to invest in a new tax-free bond earning 50 basis points less. The rate on the new bond offering is
closest to:
A. 4.00%
B. 4.50%
C. 5.00%
 Answer A
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution 4.5% -.5% = 4.00%
Feedback Note: One-hundredth of 1% = basis point

12. If you invest $1,000 in a security that provides a return of 4% the first year, 0% the second year, and
6% the third year, the value of your investment at the end of the third years is closest to:
A. $0
B. $1,102.40
C. $1,157.63
D. $1,092.73

Answer B
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 × 1.04 × 1 × 1.06 = $1,102.40

13. If you invest $1,000 in a security that provides a return of 3% the first year, 4% the second year, and
5% the third year, the value of your investment at the end of the third years is closest to:
A. $0
B. $1,000.00
C. $1,124.76
D. $1,200.00

Answer C
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 × 1.03 × 1.04 × 1.05 = $1,124.76

14. Suppose an account promises interest at the rate of 5% the first two years and then 3% thereafter.
If $2,000 is deposited in the account today, the balance in the account at the end of 10 years from
today if you make no withdrawals is closest to:
A. $2,000.00
B. $2,793.23
C. $2,794.06
D. $3,257.79

Answer B
Difficulty Difficult
 Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $2,000 × 1.052 × 1.038 = $2,793.23

15. Suppose an account promises interest at the rate of 8% the first five years and then 10% thereafter.
If $3,000 is deposited in the account today, the balance in the account at the end of 10 years from
today if you make no withdrawals is closest to:
A. $3,000.00
B. $6,476.77
C. $7,099.10
D. $7,781.23

Answer C
Difficulty Difficult
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $3,000 × 1.085 × 1.105 = $7,099.10

16. Suppose an account promises interest at the rate of 5% the first two years and then increases 100
basis points thereafter. If $1,000 is deposited in the account today, the balance in the account at
the end of 10 years from today if you make no withdrawals is closest to:
A. $1,000.00
B. $1,628.89
C. $1,757.22
D. $1,790.85

Answer C
Difficulty Difficult
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $1,000 × 1.052 × 1.068 = $1,757.22

LO 5.2
17. An apartment lease where the payments are due at the beginning of each month would be an
example of a(n):
A. perpetuity.
B. annuity due.
C. ordinary annuity.
D. deferred annuity.

Answer B
Difficulty Easy
Learning outcome LO 5.2
 Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Annuity due - annuity for which the payments are made at the
beginning of each period

18. Which financial math approach would you use to analyze equipment lease payments, made at the
end of each month for five years?
A. Present Value of a Lump Sum
B. Present Value of an Annuity Due
C. Present Value of an Ordinary Annuity

Answer C
Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Key: end of each month
Ordinary annuity – equal payments from an investment over a
fixed number of years, with the payments made at the end of
each period

19. Which financial math approach would you use to analyze a gym membership of $45 per month, paid
at the beginning of each month for one year?
A. Present Value of a Lump Sum
B. Present Value of an Annuity Due
C. Present Value of an Ordinary Annuity

Answer B
Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Key: beginning of each month
Annuity due - annuity for which the payments are made at the
beginning of each period

20. Which financial math approach would you use to analyze a legal settlement’s value in the future?
The settlement is paid in twenty-five annual installments, beginning today, settlement date?
A. Future Value of a Lump Sum
B. Future Value of an Annuity Due
C. Future Value of an Ordinary Annuity

Answer B
Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Apply
 AACSB Analytical skills
Feedback Key: beginning of each month
Annuity due - annuity for which the payments are made at the
beginning of each period

21. The Powerball Lottery pays out winnings in twenty payments, with the first payment immediate,
and the rest following once per year. This is an example of a(n):
A. lump-sum.
B. annuity due.
C. ordinary annuity.
D. deferred annuity.

Answer B
Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Describe
AACSB Analytical skills
Feedback Key: First payment is immediate.

22. The present value of a perpetuity with an annual year-end payment of $12,000 and expected annual
rate of return equal to 7% is closest to:
A. $144,000.00.
B. $148,908.49.
C. $171,428.57.

Answer C
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV0 = $12,000.00  0.07 = $171,428.57

23. The present value of a perpetuity with an annual year-end payment of : $2,000 and expected annual
rate of return equal to 7% is closest to:
A. $24,000.00
B. $24,818.08
C. $28,571.43

Answer C
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV0 = $2,000.00  0.07 = $28,571.43
24. The present value of a perpetuity with an annual year-end payment of $1,000 and expected annual
rate of return equal to 0.5% is closest to:
A. $20,000
B. $100,000
C. $200,000

Answer B
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV0 = $1,000.00  0.005 = $100,000

25. The value today of a perpetuity with an annual, year-end payments of $500 each and an expected
annual rate of return equal to 1% is closest to:
A. $5
B. $500
C. $5,000
D. $50,000

Answer D
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV0 = $500  0.01 = $50,000

26. Consider an investment that promises $1,000 at the end of each of the next four years, and $2,000
per year thereafter, forever. If the discount rate is 5%, the present value of this investment is
closest to:
A. $32,908.10
B. $36.454.05
C. $40,000.00
D. $43,545.95

Answer B
Difficulty Difficult
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback This is the sum of the annuity of $1,000, plus the discounted
value of the perpetuity of $2,000 per year.
Solution Annuity portion: PV0 = $3,545.95
Perpetuity portion: PV4 = $2,000.00  0.05 = $40,000

PV of investment = $3,545.95 + [$40,000  (1 + 0.05)4]

= $3,545.95 + 32,908.10
 = $36,454.05

27. Consider an investment that promises $2,000 at the end of each of the next four years, and $3,000
per year thereafter for four years. If the discount rate is 5%, the present value of this investment is
closest to:
A. $10,737.85
B. $15,843.69
C. $17,729.75

Answer B
Difficulty Difficult
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback This is the sum of the annuity of $2,000, plus the discounted
value of the annuity of $3,000 per year.

Solution First annuity: PV0 = $7,091.90

Second annuity: PV4 = $10,637.85

PV of investment = $7,091.90 + [$10,637.85  (1 + 0.05)4]

= $7,091.90 + 8,751.79
= $15,843.69

LO 5.3
28. A borrower is offered a loan of $10,000 for three years. She is given a choice on how the interest is
to be calculated. Which method of interest calculation would be most beneficial to the borrower?
A. Simple interest
B. Interest compounded annually
C. Interest compounded monthly

Answer A
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback The frequency of compounding increases the future value.

29. Hunter wants to borrow money from the mortgage company with the lowest effective annual rate
(EAR). Which of the following loan offers will meet his objectives:
A. 10% compounded daily
B. 10% compounded monthly
 C. 10% compounded annually
D. 10% compounded continuously

Answer C
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback The more frequent the compounding within a year, the
greater is the difference between the EAR and the APR.

30. Under which circumstance is EAR equal to APR?

A. If interest is compounded daily
B. If interest is compounded annually
C. If interest is compounded quarterly
D. If interest is compounded continuously

Answer B
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback If interest is compounded annually, the EAR is equal to the
APR.

31. The more frequent the compounding within a year:

A. It makes no difference on EAR and APR.
B. The lesser the difference between the EAR and APR.
C. The greater the difference between the EAR and APR.

Answer C
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback The more frequent the compounding, the greater the interest
on interest with the year, greater the difference between the
EAR and APR.

32. Marie needs to take out a loan for her new business and has decided to go with the loan that has
the lowest effective annual rate. Which of the following would meet her stated objective?
A. 8.00% compounded daily
B. 8.00% compounded monthly
C. 8.00% compounded continuously

Answer B
Difficulty Easy
 Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Compounding more often yields a higher effective annual rate.

33. An equipment lease where the payments are due at the end of each month would be an example of
a(n):
A. perpetuity.
B. annuity due.
C. ordinary annuity.
D. deferred annuity.

Answer C
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Ordinary annuity – equal payments from an
investment over a fixed number of years, with the
payments made at the end of each period

34. The consumer finance office wants its’ loan officers to make loans at the highest effective annual
rate. Which of the following credit terms will have the highest effective annual rate?
A. 17.00% compounded daily
B. 17.00% compounded monthly
C. 17.00% compounded continuously

Answer B
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Compounding more often yields a higher effective annual rate.

35. A family member is considering an annuity with either cash flows of 30 years or cash flows forever.
Both options have cash flows of $5,000 occurring at the end of each period and an interest rate of
7%. The difference in the present values of the annuities is closest to:
A. $9,383.37
B. $62,045.21
C. $71,428.58
D. $133,473.78

Answer A
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
 AACSB Analytical skills
Solution PV0 = $5,000.00  0.07 = $71,428.58
PV0 = $5,000.00  0.07 = $62,045.21
Difference = $71,428.58 - $62,045.21 = $9,383.37

36. The present value of an annuity with cash flows forever of $12,000 at the end of each year and an
interest rate of 10% is closest to what amount? What is the present value if the annuity is instead
for 25 years?
A. $11,075.52
B. $108,924.48
C. $120,000.00
D. $228,924.48

Answer A
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV0 = $12,000.00  0.10 = $120,000.00
PV0 = $12,000.00  0.10 = $108,924.48
Difference = $120,000.00 - $108,924.48 = $11,075.52

37. With a discount rate of .25% per month, which investment would have the highest present value
today – Investment A: Beginning today, has a cash flow of $1,500 per month for 60 months or
Investment B: Beginning one month from today, has a cash flow of $1,540 per month for 59
months?
A. Investment A
B. Investment B
C. Investment A and B have the same present value

Answer B
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Investment A = $77,976.28
Investment B = $78,515.65

38. With a discount rate of .25% per month, which investment would have the highest present value
today –
 Investment A: Beginning today, has a cash flow of $1,500 per month for 60 months, or
 Investment B: Beginning one month from today, has a cash flow of $1,525 per month for 59
months?
A. Investment A
B. Investment B
C. Investment A and B have the same present value
 Answer A
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Investment A = $77,976.28
Investment B = $77,750.89
Investment A has a larger PV.

39. Consider a deposit of $100,000 that can be made into one of four banks. Which of the following
provides the largest balance by the end of five years?
A. Bank A: 4.7% compounded continuously
B. Bank B: 4.8% compounded monthly
C. Bank C: 5% compounded annually
D. Bank D: 5.1% simple interest

Answer C
Difficulty Difficult
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Bank A: FV = $126,488.96
Bank B: FV = $127,064.07
Bank C: FV = $127,628.16
Bank D: FV = $125,500.00

40. Consider a deposit of $100,000 that can be made into one of four banks. Which of the following
provides the largest balance by the end of five years?
A. Bank A: 5.0% compounded continuously
B. Bank B: 5.2% compounded monthly
C. Bank C: 6.0% simple interest
D. Bank D: 5.4% compounded annually

Answer A
Difficulty Difficult
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Bank A: FV = $128,400.34
Bank B: FV = $129,620.18
Bank C: FV = $130,000.00
Bank D: FV = $130,077.76

41. Consider a deposit of $50,000 that can be made into one of four banks. Which of the following
provides the largest balance by the end of five years?
A. Bank A: 8.0% compounded continuously
 B. Bank B: 8.0% compounded monthly
C. Bank C: 8.2% compounded annually
D. Bank D: 8.2% simple interest

Answer A
Difficulty Difficult
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Bank A: FV = $74,587.97
Bank B: FV = $74,492.29
Bank C: FV = $74,149.17
Bank D: FV = $70,500.00

LO 5.4
42. A twenty year-old college student decides to forgo coffee at Starbucks and instead invest the saved
$600 per year into a mutual fund earning 6% compounding annually. The amount he would have in
the fund by age 65 is closest to:
A. $30,696.07
B. $315,515.24
C. $1,798,973.08

Answer B
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $600 (1.06)45 = $315,515.24

43. A couple nearing retirement plans to increase their retirement savings by investing an equal amount
of $20,000 in Roth IRAs each year end, beginning this year. The expected return on the IRAs is 7%.
They plan to invest for 10 years. The amount the couple expects to have at the end of ten years is
closest to:
A. $39,343.03.
B. $189,743.42.
C. $276,328.96.

Answer B
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $20,000 (1.07)10 = $276,328.96
44. Caroline’s roof is aging. To plan for the eventual roof replacement, she puts $1,000 at the end of
each year, starting with this year, into a certificate of deposit (CD) paying 4%. Caroline plans to do
this for seven years. The amount Caroline should have at the end of seven years for roof
replacement is closest to:
A. $1,315.93
B. $6,002.05
C. $7,898.29

Answer C
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $1,000 (1.04)7 = $7,898.29

45. Javier starts a college savings account for his child and places $500 into it every year end, beginning
this year. His expected annual return on the account is 2%. He plans to invest for twelve years and
then turn over the money to the child for college. The amount he expects to have at the end of the
twelve years is closest to:
A. $6,000.00.
B. $6,120.00.
C. $6,706.04.

Answer C
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FVcompound = $500 (1.02)12 = $6,706.04

46. The process of determining how much of each payment is interest and principal repayment best
describes the following:
A. mortgage.
B. amortization.
C. present value.
D. balloon payment.

Answer B
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Amortization - process of determining how much of each
payment is interest and principal repayment
47. After making their mortgage payment, the Browns wonder how much their loan balance was
reduced by the payment they just made. They should consult a(n):
A. mortgage.
B. amortization schedule.
C. balloon payment schedule.
D. lump sum payment schedule.

Answer B
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Amortization schedule - breakdown of each
payment of an amortized loan into interest and
principal components

48. Consider a 5% loan of $150,000 for thirty years, with monthly payments and a balloon payment of
$50,000 at the end of thirty years. The monthly payment on this loan is closest to:
A. $599.55
B. $849.55
C. $899.33
D. $1,149.33

Answer B
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution Monthly payments on $100,000 at 5% for 30 years are
$599.55.
Interest only on Balloon payment of $50,000 at 5% is $250.00.
Total payment: $599.55 + $250.00 = $849.55

49. Consider an 8% loan of $300,000 for twenty years, with monthly payments and a balloon payment
of $100,000 at the end of twenty years. The monthly payment on this loan is closest to:
A. $10,714.72
B. $11,381.39
C. $16,072.09
D. $16,738.75

Answer B
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution Monthly payments on $200,000 at 8% for 20 years are
$10,714.72.
 Interest only on Balloon payment of $100,000 at 8% is
$666.67.
Total payment = $10,714.72 + $666.67 = $11,381.39

50. Consider a mortgage of $175,000 that is to be repaid over 360 months. If the annual percentage
rate on this mortgage is 4%, the monthly mortgage payments are closest to:
A. $252.14
B. $583.33
C. $835.48
D. $7,000.00

Answer C
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution Monthly payments on $175,000 at 4% for 30 years are $835.48

51. Consider a mortgage loan of $300,000, to be amortized over thirty years with monthly payments. If
the annual percentage rate on this mortgage is 4%, the amount of principal and interest in the
second month’s mortgage payment is closest to:
A. Principal repayment is $1,000.00, and interest paid is $432.25.
B. Principal repayment is $432.25, and interest paid is $1,000.00.
C. Principal repayment is $998.56, and interest paid is $433.69.
D. Principal repayment is $433.69, and interest paid is $998.56.

Answer D
Difficulty Difficult
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution Monthly payments on $300,000 at 4% for 30 years are
$1,432.25 and for the second payment the principal
repayment is $433.69, and interest paid is $998.56.

52. Vincent would like to have $50,000 per year to live off in his retirement. He expects to retire on his
65th birthday, make his first retirement withdrawal on his 66th birthday, and to live until his 85th
birthday. He is celebrating his 30th birthday today and will make his first savings deposit one year
from today. If he can earn 4% per year on his savings, the amount he must save each year to meet
his goal, with the last savings deposit on his 65th birthday, is closest to:
A. $7,257.59.
B. $7,547.90.
C. $7,849.81.

Answer B
Difficulty Difficult
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution 65th birthday balance:
PMT = $50,000; N = 15; i = 4%
PV65 = $555,919.37

Annual savings
FV65 = $555,919.37; N = 35; i = 4%
PMT = $7,547.90
True-False

LO 5.1
1. Discounting is the mathematical conversion of a present value into a future value.
A. True
B. False

Answer A
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback PV into a FV is compounding.
FV into a PV is discounting.

2. If the interest rate is equal to 0%, the present value of an amount is equal to the future value of that
amount.
A. True
B. False

Answer A
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback FV = PV (1 + i)n
If i = 0, FV = PV

3. The difference between future value with compound interest and future value with simple interest
is interest-on –interest.
A. True
B. False

Answer A
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Interest-on-interest - interest earned on previously
accumulated interest

4. If you know the present value of an investment is $5,000 and the interest rate is 5%, you can
calculate future value?
A. True
 B. False

Answer B
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback FVn = PV0(1 + i)n
Would also need n, number of periods

5. A seasoned investor wants to triple her investment in twenty years. To accomplish her objectives,
she will have to earn 3.526% on her investment.
A. True
B. False

Answer B
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback 3 = 1 (1 + i)
20

False because 3 = 1 (1 + i)20 = 2.00 not 3.00

LO 5.2
6. Future values represent a special type of cash flow stream that involve equal payments at the same
interval, with the same interest rate being applied throughout the period.
A. True
B. False

Answer B
Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Annuity - regular payments from an investment that are for
the same amount and are paid at regular intervals of time

7. An annuity that provides periodic payments forever would best be described as a perpetuity.
A. True
B. False

Answer A
 Difficulty Easy
Learning outcome LO 5.2
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Perpetuity - annuity that provides periodic payments forever.

8. If each periodic cash flow is the same amount, occurring at the same intervals of time, the present
value of a perpetuity will be greater than the present value of a 100-year ordinary annuity.
A. True
B. False

Answer A
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Analyze
AACSB Analytical skills
Feedback The cash flows of a perpetuity are infinite, whereas those of an
ordinary annuity are finite.

LO 5.3
9. If interest is compounded more than once a year, the annual percentage rate is also the effective
interest rate.
A. True
B. False

Answer A
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback EAR = (1 + APR/1)1 – 1 = APR

10. The nominal rate or stated rate is also referred to as annual percentage rate (APR).
A. True
B. False

Answer A
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Annual percentage rate (APR) or stated rate or nominal rate -
stated rate of interest, calculated as the product of the
 interest rate per compounding period and the number of
compounding periods.

11. The nominal rate or stated rate is also referred to as effective annual rate (EAR).
A. True
B. False

Answer B
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Remember
AACSB Analytical skills
Feedback Annual percentage rate (APR) or stated rate or nominal rate -
stated rate of interest, calculated as the product of the
interest rate per compounding period and the number of
compounding periods.

12. Continuous compounding is going to lead to the smallest difference between the effective annual
rate (EAR) and annual percentage rate (APR).
A. True
B. False

Answer B
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback The largest difference between the EAR and APR is when
interest is compounded continuously.

13. The effective annual rate on an account that pays 5% interest, compounded quarterly, is greater
than the effective annual rate on an account that pays 4.8% interest, compounded continuously.
A. True
B. False

Answer A
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback 5% quarterly: EAR = 5.0945%
4.8% continuously: EAR = 4.9171%
14. The effective annual rate on an account that pays 10% interest, compounded semiannually, is
greater than the effective annual rate on an account that pays 9.9% interest, compounded
continuously.
A. True
B. False

Answer B
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback 10% quarterly: EAR = 10.25%
9.9% continuously: EAR = 10.4066%

LO 5.4
15. A loan, usually for real estate, that involves level, periodic payments consisting of interest and
principal repayment over a specified payment period is best described as a mortgage.
A. True
B. False

Answer A
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Describe
AACSB Analytical skills
Feedback Mortgage - loan, usually for real estate, that involves level,
periodic payments consisting of interest and principal
repayment over a specified payment period.

16. A monthly payment is the payment that represents repayment of some amount of the principal of
the loan above and beyond what is paid as part of the amortized loan payments.
A. True
B. False

Answer B
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Understand
AACSB Analytical skills
Feedback Balloon payment - payment that represents repayment of
some amount of the principal of loan above and beyond what
is paid as part of the amortized loan payments.

17. Suppose a homeowner is evaluating two mortgages, both of which are arrangements for repaying a
loan of $200,000. Mortgage A requires quarterly payments at the end of each quarter for 15 years
 at a stated annual rate of 5%. Mortgage B has quarterly payments, paid at the beginning of each
quarter for 18 years, at a stated annual rate of 5.5%. Mortgage A has a higher periodic payment
than Mortgage B.
A. True
B. False

Answer A
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Analyze
AACSB Analytical skills
Feedback Mortgage A:
N = 15 x 4 = 60; i = 1.25%; PV = $200,000
Quarterly payment is $4,757.99

Mortgage B:
N = 18 x 4 = 72; I = 5.5%  4 = 1.375%; PV = $200,000
Quarterly payment = $4,334.02

18. Suppose a homeowner is evaluating two mortgages, both of which are arrangements for repaying a
loan of $200,000. Mortgage C requires monthly payments at the end of each month for 15 years at
a stated annual rate of 6%. Mortgage D has monthly payments, paid at the beginning of each month
for 18 years, at a stated annual rate of 5.5%. Mortgage C has a higher periodic payment than
Mortgage D.
A. True
B. False

Answer B
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Analyze
AACSB Analytical skills
Feedback Mortgage C:
N = 15 x 12 = 180; i = 6%  12 =0.5%; PV = $200,000
Monthly payment is $1,687.71

Mortgage D:
N = 18 x 12 = 216; i = 7.5%  12 = 0.625%; PV = $200,000
Monthly payment = $1,689.95

19. Suppose a company borrows $1 million and pays off this 10-year, 5% interest loan in end-of-year
payments of $113,603.66 each. This loan is fully amortized at the end of the ten years.
A. True
B. False
 Answer B
Difficulty Difficult
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback PV = $1,000,000; N = 10; i = 5%; PMT = $113,603.66
There would be a balloon payment of $200,000 required at the
end of the ten years to pay off this loan in full.

20. A company that borrows $10 million and pays this off with a 10-year, 5% interest loan in end-of-year
payments of $1,295,045.75 each has a zero balance remaining on this loan at the end of 10 years.
A. True
B. False

Answer A
Difficulty Difficult
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback PV = $10,000,000; N = 10; i = 5%; PMT = $1,295,045.75
This loan is fully amortized over the 10-year period.

Short Answer

LO 5.1
1. If you deposit $5,000 in an account that pays 3% interest, compounded annually, what balance
would you have at the end of four year?

Answer $5,625.54
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $5,000 × (1 + 0.03)4 = $5,625.54

2. What is the future value of $3,000 five years from now if interest is earned at a rate of 4% per year?

Answer $3,649.96
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution FV = $3,000 × (1 + 0.04)5 = $3,649.96
3. What is the present value of $5,000 to be received five years from now if the discount rate is 6% per
year?

Answer $3,736.29
Difficulty Easy
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV = $5,000  (1 + 0.06)5 = $3,736.29

4. An investor invests $25,000 today for a five-year term and receives 4% annual compound interest.
A. How much would the investor have after five years?
B. How much interest-on-interest would the investor earn during the five years?

Answer A. $30,416.32
B. $ 416.32
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution A. FV = $25,000 × (1 + 0.04)5 = $30,416.32
B. FVsimple = $25,000 + ($25,000 × 0.04 × 5) = $30,000.00
Interest on interest = $30,416.32 – $30,000.00 = $ 416.32

5. An investor invests $10,000 today for a four-year term and receives 5% annual compound interest.
A. How much would the investor have after four years?
B. How much interest-on-interest would the investor earn during the four years?

Answer A. $12,155.06
B. $ 155.06
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution A. FV = $10,000 × (1 + 0.05)4 = $12,155.06
B. FVsimple = $10,000 + ($10,000 × 0.05 × 4) = $12,000.00
Interest on interest = $12,155.06 – $12,000.00 = $ 155.06

6. Suppose you are considering an investment that promises $25,000 in five years. If you determine
that the appropriate discount rate for this investment, considering its risk, is 8%, what is this
investment worth to you today?

Answer $17,014.58
Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
 Solution PV = 1  (1 + i)N = ($25,000 X 1)  (1 + 0.08)5 = $17,014.58

7. A friend’s broker promises that they will double their money in five years with Investment A. A
comparable investment, Investment B, has a return of 7% per year. Which investment promises the
highest return?

Answer Investment A is better.

Difficulty Moderate
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback Assuming $1,000 investment, Investment A = $2,000
Investment B = FV = $1,000 × (1 + 0.07)5 = $1,402.55

8. Complete the following table:

Number of Interest rate
Present value Future value periods per year
A. $1,000 $2000 5
B. $1,000 $3,000 7%
C. $150 5 10%
D. $8,000 6 7%
E. $6,000 3 3%

Answer A. 14.87%
B. 16.24 periods
C. $241.58
D. $5,330.74
E. $6,556.36
Difficulty Difficult
Learning outcome LO 5.1
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution A. FV/PV = 1 / (1 + i)N = $2,000/$1,000 = 1 / (1 + i)5 = 14.87%
B. N = (ln FV – ln PV) / ln (1+i) = 16.24 Periods
C. FV = $150 × (1 + 0.10)5 = $241.58
D. PV = 1 / (1 + i)N = $8,000 X 1 / (1 + 7%)6 = $5,330.74
E. FV = $6,000 × (1 + 0.03)3 = $6,556.36

LO 5.2
9. Complete the following table:

Payment per Number of Interest rate

year years per year Future value
A. $1,200 4 2%
B. $1,500 9 4%
 C. $10,000 10 6%
D. $400 15 4%

Answer A. $4,945.93
B. $13,821.34
C. $131,807.95
D. $8,009.44
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback

FVA = $1,200 [((1+.02)4 – 1)  0.02 = $4,945.93

FVB = $1,500 [((1+.04)8 – 1)  0.04 = $13,821.34
FVC = $10,000 [((1+.06)10 – 1)  0.06 = $131,807.95
FVD = $400 [((1+.04)15 – 1)  0.04 = $8,009.44

10. Complete the following table:

Payment per Number of Interest rate Present

year years per year value
A. $1,800 3 3%
B. $1,500 5 6%
C. $18,000 12 12%
D. $4,000 15 9%

Answer A. $5,563.62
B. $8,455.64
C. $434,396.40
D. $117,443.66
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback

FVA = $1,800 [((1+.03)3 – 1)  0.03 = $5,563.62

FVB = $1,500 [((1+.06)5 – 1)  0.06 = $8,455.64
FVC = $18,000 [((1+.12)12 – 1)  0.12 = $434,396.40
FVD = $4,000 [((1+.09)15 – 1)  0.09 = $117,443.66

11. Complete the following table:

 Payment per Number of Interest rate Present
year years per year value
A. $100 4 1%
B. $750 6 6%
C. $3,000 11 9%
D. $14,000 11 11%

Answer A. $390.20
B. $3,687.99
C. $20,415.57
D. $86,891.21
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback

PVA = $100 [(1-(1(1+.01)4))  0.01 = $390.20

PVB = $750 [(1-(1(1+.01)4))  0.01 = $3,687.99
PVC = $3,000 [(1-(1(1+.01)4))  0.01 = $20,415.57
PVD = $14,000 [(1-(1(1+.01)4))  0.01 = $86,891.21

12. Complete the following table:

Number of Present
Payment periods Interest rate value
A. $180 3 4%
B. $1,600 6 5%
C. $7,000 9 8%
D. $23,000 10 9%

Answer A. $499.52
B. $8,121.11
C. $43,728.22
D. $147,606.13
Difficulty Moderate
Learning outcome LO 5.2
Bloom’s taxonomy Apply
AACSB Analytical skills
Feedback

PVA = $180 [(1-(1(1+.04)3))  0.04 = $499.52

 PVB = $1,600 [(1-(1(1+.05)6))  0.05 = $8,121.11
PVC = $7,000 [(1-(1(1+.08)9))  0.08 = $43,728.22
PVD = $23,000 [(1-(1(1+.09)10))  0.09 = $147,606.13

LO 5.3

13. What is the effective annual rate of interest for a nominal rate of 4%, compounded quarterly?

Answer 4.0604%
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

EAR = ((1+(0.04/4)4)-1 = 4.0604%

14. What is the effective annual rate of interest for a nominal rate of 10%, compounded semi-annually?

Answer 10.25%
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

EAR = ((1+(0.10/2)2)-1 = 10.25%

15. A furniture company charges 18% on outstanding balances. If interest is compounded monthly,
what is the effective interest rate that the furniture company charges?

Answer 19.56%
Difficulty Easy
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

EAR = ((1+(0.1812)12)-1 = 19.56%

16. A furniture company charges 16% on outstanding balances. If interest is compounded continuously,
what is the effective interest rate that the furniture company charges?

Answer 17.3511%
 Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution EAR = e 0.16 – 1 = 17.3511%

17. A national cellular company discourages carrying a balance by charging 20% interest compounded
daily on unpaid balances. What is the effective interest rate that the cellular phone company
charges?

Answer 22.13%
Difficulty Moderate
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

EAR = ((1+(0.20  365)365)-1 = 22.13%

18. The Big Bank would like to charge, effectively, 20% on the credit card debt of its customers. If the
bank uses continuous compounding in calculating the interest charges on its cards, what nominal
rate should the Big Bank be advertising?

Answer 18.2322%
Difficulty Difficult
Learning outcome LO 5.3
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution 0.20 = e APR – 1
1.20 = e APR
Ln 1.20 = APR
APR = 18.2322%

LO 5.4

19. How much is the monthly mortgage payment on a 30-year loan of $400,000 at a stated rate of 5%?

Answer $2,147.29
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV = $400,000; N = 360; i = 0.41667%
Solve for PMT
PMT = $2,147.29
20. How much is the quarterly payment on a 15-year loan of $500,000 at a stated rate of 8%?

Answer $14,383.98
Difficulty Easy
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV = $500,000; N = 60; i = 2%
Solve for PMT
PMT = $14,383.98

21. How much is the monthly mortgage payment on a 30-year loan of $400,000 at a stated rate of 6%
and a balloon payment of $50,000?

Answer $2,348.43
Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution PV = $400,000; N = 360; FV = $50,000; i = 0.5%
Solve for PMT
PMT = $2,348.43

22. A homeowner is anxious to pay off their mortgage. After sending in their payment this month they
are curious what the remaining principal balance will be. The bank’s system is down so they ask you
to calculate it for them. If the beginning mortgage balance was $3,000 and they made a $750
payment, with an annual interest rate of 6%. What is the remaining principal balance after the
payment? What will the remaining principal balance be after two payments? Show your work.

Answer $2,420.00 balance after first payment, $1,824.80 balance after

second
payment. Commented [DH1]: I solved using the table. To use the
formula, I would have to have N (number of years remaining).

Difficulty Moderate
Learning outcome LO 5.4
Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

Remaining principal balance = $3,000 [(1 + 0.06)?- (1 + 0.06)1] 

(1 + 0.06)? = $2,420.00
Remaining principal balance = $2,420 [(1 + 0.06)?- (1+ 0.06)2] 
(1 + 0.035)? = $1,824.80
23. A college graduate looks forward to paying off her student loan. Her balance is $1,500 and she
makes a $350 loan payment with an annual interest rate of 3.5%. What is the remaining principal
balance after the payment? What will the remaining principal balance be after three payments?
Show your work.

Answer $1202.50 balance after first payment, $894.59 balance after second
payment. Commented [DH2]: I solved using the table. To use the
Difficulty Moderate formula, I would have to have N (number of years remaining).

Learning outcome LO 5.4

Bloom’s taxonomy Apply
AACSB Analytical skills
Solution

Remaining principal balance = $1,500 [(1 + 0.035)?- (1 + 0.035)1] 

(1 + 0.035)?
= $1,202.50
Remaining principal balance = $1,202.50 [(1 + 0.035)?- (1 + 0.035)3] 
(1 + 0.035)?
= $894.59

24. Your grandmother hears you are a finance major and asks for your help in planning for her
retirement. She wants to begin saving an amount each year, starting two years from now, to
provide for her retirement in five years. Her goal is to save $75,000 five years from today and then
live off of her savings for the eight years after her retirement. You feel she will be able to earn 5%
on her money.
A. How would you determine how much she needs to save each year to meet her goal?
B. How would you determine how much she would have to spend each year in retirement?

Answer A. Solve for the PMT in a 3-cash flow FV annuity due.

B. Solve for the PMT in a 8-cash flow PV ordinary annuity

Difficulty Difficult
Learning outcome LO 5.4
Bloom’s taxonomy Understand
AACSB Analytical skills
Solution A. Take present value of an ordinary annuity to figure out the
present value at period 2. Then discount this number 2
periods to solve for the value today. Use this information
to solve for payment using the formula:
 B. Run an amortization schedule for 7 years, 5%, on a
$75,000 amount to determine how much she will have to
spend each year, or use a spread sheet or financial
calculator to solve for payment.

25. Bank A would like to set its interest rate on its CDs to be competitive with Bank B’s CD. Bank B’s CD
earns 4% interest per year, compounded quarterly. What rate would Bank A have to advertise to be
equivalent to Bank B’s, if Bank A’s CDs have interest compounded continuously?

Answer 3.9801%
Difficulty Difficult
Learning outcome LO 5.3
Bloom’s taxonomy Analyze
AACSB Analytical skills
Solution Bank A: EAR = (1 + 0.01)4 -1 = 4.0604%
Bank B:
0.040604 = eAPR – 1
1.040604 = eAPR
Taking logs of both sides,
APR = ln(1.040604) = 3.9801%