Introduction To Corporate Finance 4th Edition Booth Solutions Manual 1

Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita
INTRODUCTION TO CORPORATE FINANCE

4TH EDITION BOOTH
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Chapter 5: Time Value of Money
Multiple Choice Questions

1. Section: 5.2 Simple Interest; 5.3 Compound Interest
Learning Objective: 5.2; 5.3
Level of difficulty: Basic
Solution: C.
Simple interest rate: $1,000 + ($1,000)(8%)(6) = $1,480
Compound interest rate: $1,000(1+.08)6 = $1,586.87

Level of difficulty: Intermediate
Solution: C
Solutions Manual 1 Chapter 5

Copyright © 2016 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Simple interest: Total interest paid over three years: $6,200 - $5,000 = $1,200
Annual interest = $1,200/3 = $400
$400/$5,000 = 8%
Compound interest:
1⁄
6,200 3
( ) − 1=7.43%
5,000

Solution: B

Solution: D.
A) $1,000 + ($1,000)(10%)(5) = $1,500
B) $1,000 + ($1,000)(8%)(10) = $1,800
C) $1,000(1.08)8 = $1,851
D) $1,000(1.07)10 = $1,967
Therefore, D is the largest.
5. Section: 5.3 Compound Interest

Learning Objective: 5.3
Solution: B.
PV=$15,000,000/(1.05)25=$4,429,541.58
Or using a financial calculator (TI BAII Plus),
N=25, I/Y=5, FV=15,000,000, PMT = 0, CPT PV= –4,429,541.58

Solution: B. The greater the interest rate, the smaller the present value, given a $100 future value
and holding the time period constant.

Solution: D.

FV=PV(1+k)n
16,000=10,000(1+ k)8
8ln(1+k)=ln(1.6), therefore k=6.05%
N=8, PV= –10,000, FV=16,000, PMT = 0, CPT I/Y=6.05%

Solution: C.
FV=PV(1+k)n
Assume that the initial investment is $1.
(3)(1)=1 (1.09) n
ln(3)=(n)ln(1.09)
n=12.7 years
I/Y=9, PV= –1, FV=3, PMT = 0, CPT N=12.7
9. Section: 5.4 Annuities and Perpetuities

Learning objective: 5.4
Solution: D. The annuity due has a greater PV because it pays one year earlier than an ordinary
annuity.

Level of difficulty: Challenging
Solution: C.
 (1 + k ) 20 − 1  (1 + .15) 20 − 1
FV20 = PMT   =$ 2,000   = 2,000(102.4436) = $204,887
 k   .15 
N=20, I/Y=15, PMT= -2,000, PV = 0, CPT FV=204,887

Solution: B.

 1   1 
1 − (1 + k ) n  1 − (1.15) 20 
PV0 = PMT   = $2,000   = 2,000(6.25933) = $12,519
 k   .15 
   

N=20, I/Y=15, PMT= –2,000, FV = 0, CPT PV=12,519

Solution: D.
PV0=PMT/k=$1,500/.12=$12,500

Solution: A.
PV0=PMT/k=$1,500/.12 + $1,500 =$14,000
14. Section: 5.7 Loan or Mortgage Arrangements

Solution: B
PV of annuity of 120 remaining payments at 1% per month.
 1   1 
1 −
 (1 + k ) n  1 −
 (1.01)120 
PV0 = PMT   = $3,303.26   = 3,303.26(69.7005) = $230,238.95
 k   .01 
   
Using a financial calculator (TI BAII Plus),

N = 120, I/Y = 1, PMT = -3,303.26, FV = 0, CPT PV = 230,238.95

Solution: A.
The future value of a perpetuity cannot be computed as it is infinite.
Practice Problems

Basic
16. Section: 5.2 Simple Interest
Solution:
As this is simple interest, Dmitri will earn the same amount of interest each year. The annual
amount of interest is 8% * initial investment = .08 * $25,000 = $2,000.
a. $2,000
b. $2,000

Solution:
a. In one year he will owe P x k = $1,500 x 6% = $90 of interest.
b. After three years, the total (principal and interest) owing will be: P + (n x P x k) = $1,500 + (3
x $1,500 x 6%) = $1,770.

Solution:
As the exact amount of interest owing each year will be paid, there is no “compounding.” The
amount of each annual payment will be P x k = $2,500 x 6% = $150. Unfortunately, these payments
never reduce the principal owing, so the loan will never be paid off.

Solution:
Khalil will be paid interest each month for 12 months, but without compounding. The total interest
earned is (n x P x k) = (12 x $1,200 x 0.5%) = $72.

Solution:
The payment of compound interest means that we must compound (or find the future value of) the
amount invested (the present value):
FV12 months = $1,200  (1 + 0.005)12 = $1,274.01

Of this amount, $1,200 was the original amount invested, so $74.01 of interest will be earned.

Learning outcome: 5.2; 5.3
Solution:
A. Value = P + (n x P x k) = $24 + (389 x $24 x 5%) = $491
B. FV389 years = $24  (1 + 0.05) 389 = $4,196,126,573

Learning outcome: 5.3
Solution:
The future value of the loan (the amount to be repaid) is $5,000. The amount that can be borrowed
is the present value amount, calculated as:
1 1
PV0 = FV1  = $5,000  = $4,716.98
(1 + k )1
(1 + .06)1

N=1, I/Y=6, FV= -5,000, PMT = 0, CPT PV=4,716.98

Solution:
a. FV1 year = $20,000  (1 + 0.10)1 = $22,000.00
b. FV5 years = $20,000  (1 + 0.10)5 = $32,210.20
c. FV10 years = $20,000  (1 + 0.10)10 = $51,874.85

Learning Objectives: 5.3
Solution:
Jon needs $800 in three years; that is the future value amount. The present value equivalent is:
1 1
PV0 = FV3  = $800  = $691.07
(1 + k ) 3
(1 + .05) 3


N=3, I/Y=5, FV= -800, PMT = 0, CPT PV=691.07

Solution:
Present value of the perpetual scholarship payment:
1  1 
PV0 = PMT   = $5000    = $166, 667
k   0.03 
26. Section: 5.6 Quoted versus Effective Rates

Solution:
2
0 . 
0725
=
For Bank A, k+
1 −=
17.
38%
 2
4
0 . 
0720
=
For Bank B, k+
1 −=
17.
40%
 4
12
0 . 
0715
=
For Bank C, k+
1 −=
17.
39%
 12 
Bank B pays the highest effective annual rate.

Solution:
a. For annual compounding, the effective annual rate will be the same as the quoted rate. To check
this:
m 1
 QR   9.5% 
k = 1 +  − 1 = 1 +  − 1 = 9.5%
 m   1 
b. With quarterly compounding, set m=4,
4
 9.5% 
k = 1 +  − 1 = 9.84%
 4 
c. With monthly compounding, set m=12,

12
 9.5% 
k = 1 +  − 1 = 9.92%
 12 

Solution:
a. k = Quoted Rate = 6%  FV1 year = PV0 (1 + k ) = $50,000  (1.06) = $53,000
12
 QR 
b. k = 1 +  − 1 = 6.16778%  FV1 year = $50,000  (1.0616778) = $53,083.89
 12 
365
 QR 
c. k = 1 +  − 1 = 6.18313%  FV1 year = $50,000  (1.0618313) = $53,091.57
 365 

Solution:
The value of any perpetual stream of payments can be valued as a perpetuity:
PMT $2
PV0 = = = $16.67
k 0.12
Each share is worth $16.67.

Solution:
Because the fees are paid at the start of the year, this is an annuity due.
 1 
1 − (1 + 0.06) 3 
PV 0 = $6,500     (1 + 0.06) = $18,417.05
 0.06 
 

Hit [2nd] [BGN] [2nd] [Set]
N=3, I/Y=6, PMT= -6,500, FV = 0, CPT PV=18,417.05


Solution:
The future value amount is $40,000. The amount to be saved each year is really the payment on
an ordinary annuity:
 (1 + 0.07) 8 − 1
$40,000 = PMT    PMT = $3,898.71
 0.07 
N=8, I/Y=7, PV =0, FV= -40,000, CPT PMT= 3,898.71
32. Section: 5.5 Growing Annuities and Perpetuities

Solution:
100
PV = = $1, 666.67 . The most I would be willing to pay for the investment is the present
.09 − .03
value, therefore, $1,666.67.
33. Section: 5.8 Comprehensive Examples

Solution:
Annual investment = Annual income – Annual expenditure = $45,000 – $36,000 = $9,000.
This is an annuity due.
 (1 + k ) n − 1
FVn = PMT   (1 + k )
 k 
 (1 + .126) 35 − 1
= $9,000   (1.126) = (9,000)(497.2749)(1.126) = $5,039,384
 .126 
N=35, I/Y=12.6, PV = 0, PMT= -9,000, CPT FV=5,039,384

Solution:
This is an ordinary annuity.

 (1 + 0.10)15 − 1
FV15 = $30,000    = $953,174.45
 0.10 
No, Tommy will not quite achieve his goal before retirement.
Intermediate
35. Section: 5.1 Opportunity Cost
Solution:
Cost = tuition + textbook + loss of income = $800+$300+$900 = $2,000
The rent and food are expenses that he will be facing regardless of taking the course.
We are, of course, assuming that the extra time he spends studying for the philosophy course will
not have any impact on his grades in his other courses and are not placing any value on his
enjoyment of the subject.

Solution:
Present value of the perpetual scholarship payment at the end of 4 years:
1  1 
PV4 = PMT   = $5000    = $166, 667
k   0.03 
So present value today is $166, 667 / (1.03) 4 = $148, 081 .Grace will need to endow $148,081
today for the scholarship to start in 5 years.

Solution:
Find the present value of the four-year annuity at year 3:
 1   1 
1 − (1 + k ) n  1 − (1 + 0.05) 4 
PV3 = PMT   = $6,000    = $21,275.70
 k   0.05 
   

N=4, I/Y=5, PMT= -6,000, FV = 0, CPT PV= 21,275.70
Now, find the present value of this amount today:

 1   1 
PV0 = FV  3
= $21,275.70   3
= $18,378.75
 (1 + k )   (1.05) 
N=3, I/Y=5, PMT = 0, FV= 21,275.70, CPT PV= 18,378.75

Solution:
To be indifferent between the two options means that the present value of the annuity must equal
$40 million (the immediate payout).
 1 
 1− 10 
40 = 5 
(1 + k ) 
. Solving this using the calculator is the easiest way. N=10, PMT = -5, PV =
 k 
 
 
40, FV = 0, CPT I/Y. We find an interest rate of 4.28%. If the interest rate is greater than 4.28%, I
prefer the immediate payout of $40 million because the present value of the 10-year annuity is
less than $40 million. If the interest rate is less than 4.28%, I prefer the annuity because the
present value will be greater than $40 million.

Solution:
Step 1: determine monthly effective rate
1 / 12
 .09  4 
k monthly = 1 +   − 1 = 0.7444%
 4  
Step 2: given the monthly effective rate, determine the quoted rate compounded monthly.
QR monthly = 12 x 0.7444
= 8.9333%
Therefore, 9% compounded quarterly is equivalent to 8.9333% compounded monthly.


Level of difficulty: Intermediate.
Solution:
a. m = 365: k = (1 + .24 ) 365 − 1 = 27.11%.
365
b. m = 4: .24 4
k = (1 + ) − 1 = 26.25%.
4
c. m = 3: .24 3
k = (1 + ) − 1 = 25.97%.
3
d. m = 2: .24 2
k = (1 + ) − 1 = 25.44%.
2
e. Continuous compounding: k = e .24 − 1 = 27.12%.
f. The effective monthly rates for a. to d. are:
m 365
QR f .24 12
i. m=365, f=12 k = (1 + ) − 1 = (1 + ) − 1 =2.02%
m 365
m 4
QR f .24 12
ii. m=4, f=12. k = (1 + ) − 1 = (1 + ) − 1 =1.96%
m 4
m 3
QR f .24 12
iii. m=3, f=12. k = (1 + ) − 1 = (1 + ) − 1 =1.94%
m 3
m 2
QR f .24 12
iv. m=2, f=12. k = (1 + ) − 1 = (1 + ) − 1 =1.91%
m 2

Solution:
A. The future value of Jane’s account will be:
 (1 + 0.06)17 − 1
FV17 = $1,000    = $28,212.88
 0.06 
B. The grant has the effect of increasing the amount saved from $1,000 to $1,200. The future value
of the account will now be:
 (1 + 0.06)17 − 1
FV17 = $1,200    = $33,855.46
 0.06 


Solution:
Find the present value of the four-year annuity due:
 1   1 
1 − (1 + k ) n  1 − (1 + 0.05) 4 
PV 5 = PMT   (1 + k ) = $5,000     (1 + 0.05) = $18,616.24
 k   0.05 
   

N=4, I/Y=5, PMT= -5,000, FV = 0, CPT PV=18,616.24
Now, discount this amount back five years:

 1   1 
PV 0 = FV   = $18,616 .24   5
= $14,586.31
 (1 + k ) 
5
 (1.05) 
N=5, I/Y=5, PMT =0, FV= 18,616.24, CPT PV=-14,586.31

Solution:
We have two separate annuities to consider: the tuition payments, and the savings amounts. First,
find the present value of the four annual tuition payments (at time 8, when Felix is due to begin
university studies):
 1 
1− 
(1 + 0.07) 4
PV8 = $10,000    = $33,872.11
 0.07 
 
 
This is the amount of savings required at time 8. From the perspective of time 0, this is a future
value amount (replaces the $40,000 in Problem 45.) Next, find the annual savings amount:
 (1 + 0.07) 8 − 1
$33,872.11 = PMT    PMT = $3,301.44
 0.07 


Solution:
100
Present value of Grow: PVGROW = = $10, 000
.05 − .04
1000
Present value of Shrink: PVSHRINK = = $14, 285.71
.05 − (−.02)
Grow exceeds the cost by $9,000 while Shrink exceeds the investment cost by $13,285.71 Shrink
is preferred, as it exceeds the investment cost by the most.

Solution:
= $1,816.67
The most I’d pay is the present value of the investment. In this case the cash flows start
immediately ($100) and then grow by 3% per year. The present value, or the maximum I’d be
willing to pay, is $1,816.67

Solution:
To solve this we need to realize that the present value of a perpetuity (growing or otherwise)
occurs one period prior to the first cash flow. Hence, using the growing perpetuity formula will
give us the value of the cash flows in year 4. We need to discount those back to time 0.

= $1,180.71
The most I’d be willing to pay for this investment is $1,180.71.
47. Section: 5.4 Annuities and Perpetuities 5.6; Quoted versus Effective Rates
Solution:
Solve the annuity equation to find k, the interest rate:
 1 
1 − (1 + k ) 5 
$25,000.00 = $6,935.24   k =?
 k 
 
The calculations are most easily done with a financial calculator (TI BAII Plus),
PV = -25,000, PMT=6,935.24, N= 5, FV = 0, CPT I/Y = 12%
The effective annual interest rate is 12 percent. With annual compounding, the nominal rate (or
quoted rate) will also be 12 percent per year.
48. Section: 5.4 Annuities and Perpetuities; 5.6 Quoted versus Effective Rates
Solution:
a. There will be 5 x 12 = 60 monthly payments. The calculations are most easily done with a
financial calculator (TI BAII Plus),
PV = –25,000, PMT=556.11, N= 60, CPT I/Y = 1.0%

Because we used monthly payments, and months as the time period, 1.0% is the effective
monthly rate.
b. The compounding period matches the payment frequency, so the nominal rate, or quoted rate,
is:
QR = m  kmonthly = 12  1.0% = 12.0% per year.


Solution:
a. Scott will pay interest of ($800–$750) = $50 after one week. This implies a nominal interest rate
of $50/$750 = 6.67% per week. With 52 weeks in the year, the nominal rate per year is then 52 x
6.67% = 346.84%.
b. The effective annual interest rate is k = (1 + 0.0667) 52 − 1 = 27.7210 = 2,772.10%

Solution:
a. In Canada, fixed-rate mortgages use semi-annual compounding of interest, so m=2. The
effective annual rate is therefore:
m 2
 QR   0.064 
k = 1 +  − 1 = 1 +  − 1 = 6.5024%
 m   2 
b. With monthly payments, f=12. We can find the effective monthly interest rate from the
effective annual rate, k:
kmonthly = (1 + k ) − 1 = (1 + 6.5024% ) 12 − 1 = 0.5264%
1 1
f
c. The amortization period is 20 years, or 20 x 12 = 240 months. Josephine’s monthly payments

can be computed as:
 1 
1 − (1 + 0.005264) 240 
$180,000 = PMT    PMT = $1,322.69
 0.005264 
 

N=240, I/Y=.5264, PV=180,000, FV = 0, CPT PMT = -1,322.69
d. With monthly compounding and payments, the effective monthly interest rate is:
m 12
 QR  f
 0.0636  12
kmonthly = 1 +  − 1 = 1 +  − 1 = 0.530%
 m   12 
The monthly payments can be computed using a financial calculator (TI BAII Plus),
N=240, I/Y=.53, PV=180,000, FV = 0, CPT PMT = -1,327.24
Even though the quoted rate is lower at the Credit Union than at the Bank, the effective rate is
higher. Josephine should take the mortgage loan from Providence Bank in this case. The monthly

payment for the credit union mortgage would be $1,327.24, which, as expected, is higher than that
at Providence Bank.

Solution:
With semi-annual compounding (the norm in Canada) and monthly payments, m=2 and f=12.The
effective monthly rate is:
m 2
 QR  f
 0.039  12
kmonthly = 1 +  − 1 = 1 +  − 1 = 0.3224%
 m   2 
The present value of the mortgage payments over the amortization period (25 years x 12 = 300
months) is:
 1 
1 −
 (1 + 0.003224) 300 
PV 0 = $1,950.00    = $374,553.72
 0.003224 
 

N=300, I/Y=.3224, PMT=-1,950, FV = 0, CPT PV = $374,553.72
In addition, Charlie has $130,000 available as a down payment; the most he can pay for the house
is, therefore, $374,553.72 + $130,000 = $504,553.72.

Solution:
a. This is an annuity due. Timmy makes his first payment on his 21st birthday and the last
payment on his 60th birthday. When Timmy turns 61, the value of these 40 annuity payments is:
 (1 + 0.10) 40 − 1
FV 40 = $3,000     (1.10) = $1,460,555.43
 0.10 
Yes, Timmy will achieve his goal by a comfortable margin.
b. In the equation for part A set FV = $1,000,000, and solve for the number of years, n. This is
easiest done with a financial calculator (TI BAII Plus),
FV = –1,000,000, I/Y = 10, PMT = 3,000, PV = 0, CPT N = 37.1.
Timmy will hit the $1 million dollar mark in just over 37 years, or shortly after his 58th birthday.


Solution:
a. 1st Calculate their yearly income available for investment
Monthly income available = $9,000 – $3,000 – $850 –$1,450 = $3,700
Yearly available = $(3,700)(12) = $44,400
2nd Calculate the FV of their investment when they retire:
 (1 + .1)30 − 1
FV30 = 44,400   =$7,303,535
 .1 
N=30, I/Y=10, PV = 0, PMT=- 44,400, CPT FV=7,303,535
3rd Calculate the amount they will have when they retire:
$7,303,535 + $50,000 = $7,353,535
b. This is an annuity due problem.

PV=7,353,535, k=10%, n=30
 1 
1 − (1 + .1)30 
7,353,535 = PMT   (1 + .1)
 .1 
 
So, PMT=$709,143
N=30, I/Y=10, PV=- 7,353,535, FV = 0, CPT PMT=709,143
Challenging
54. Section: 5.1 Opportunity Cost; 5.3 Compound Interest
Solution:
Find the present value of the money paid back to Veda by each investment, using the interest rate
on the alternative (the bank account) as the discount rate.
$500 $800
For Investment A: PV0 = + = $453.51 + $691.07 = $1144.58
(1 + 0.05) 2
(1 + 0.05)3
For Investment B:

$200 $400 $700

PV 0 = + + = $190.48 + $362.81 + $604.69 = $1157.98
(1 + 0.05) 1
(1 + 0.05) 2
(1 + 0.05) 3
Veda would prefer Investment B, because it has the higher present value.

Solution:
The dividends for the first five years form an ordinary annuity. Starting in year 6, the reduced
dividend stream can be thought of as a perpetuity. However, the value of this perpetuity, as
determined by our formula, occurs at year 5 (one year before the first $2 dividend), and must be
discounted to the present:
  1 
 1− 

PV 0 = $3.00 (1 + 0.12) 5  +  $2.00  1 
= $10.81 + $16.67  0.5674 = $20.27
  0.12   0.12  (1 + 0.12) 5 
  
  

Solution:
0.045
k monthly = = 0.375%
12
Rent payments are typically made at the start of each month (so this is an annuity due). Over
three years, we would expect 36 monthly rent payments. However, the last month’s rent must be
paid up front, so the annuity includes only 35 payments; the present value of the last month’s rent
is $550 because it will be paid today.
 1 
1 − (1 + 0.00375) 35 
PV0 = $550     (1 + 0.00375) + $550 = $18,626.17
 0.00375 
 

Solution:

It is tempting to view the first option as a perpetuity, but this would be incorrect as the man will
die at some time, and the payment will then cease. Thus, option one is an ordinary annuity, with
an uncertain number of payments. Option two is much easier to value; it includes exactly 240
monthly payments.
0.06
kmonthly = = 0.5%
12

N = 240, PMT = 3,500, I/Y = 0.5, FV = 0, , CPT PV = –488,532.70
For the first option to be a better deal, it must include enough payments so that its present value
is at least as great as for option two. Again using the calculator,
PV = –488,532.70, PMT = 2,785, I/Y = 0.5, CPT N = 420.29
So option one must continue for over 420 monthly payments to equal the value of option two.
This is just over 35 years. Hence, the man must live to be at least 100 years old for option one to
be a better deal.

Solution:
Step 1: determine Betty’s annual deposits:

 (1 + 0.05) 40 − 1
$1,000,000 = PMT    PMT = $8,278.16
 0.05 
N=40, I/Y=5, FV= -1,000,000, PV = 0, CPT PMT= 8,278.16
Betty will have to make annual deposits of $8,278.16 per year for 40 years at 5% in order to have
$1 million.
Step 2: Abe will be making deposits of 2*8,278.16 = $16,556.32. How many annual deposits will
he need to make in order for the future value to be $1 million? (solve for N) The number of deposits
is: 28.52
1,000,000  .05 
ln  + 1
 (1 + 0.05) − 1 n
 16,556.32  = 28.52
$1,000,000 = 16,556.32   n=
 0.05  ln(1.05)
I/Y=5, PMT= 16,556.32, FV= -1,000,000, PV = 0, CPT N=28.52

Therefore, Abe can afford to wait 11 years before he has to start making his large deposits.
59. Section: 5.1 Opportunity Cost; 5.2 Simple Interest; 5.3 Compound Interest; 5.4 Annuities and
Perpetuities
Learning outcome: 5.1; 5.2; 5.3; 5.4
Solution:
The manager is confused. To make the choice between the two options you should consider the
present value of each set of payments, not the sum of the payments. Summing the payments
assumes that the opportunity cost is zero.
For example, if your opportunity cost is 10%, then the PV of Long is $161,009. The value of the
house if $250,000 but the cost of the loan (to you) is only $161,009 – a net benefit of $88,991.
The PV of the Short option is $216,289 – in this case, with an opportunity cost of 10%, the short
option costs me $55,280 more.
If instead, your opportunity cost is 1%, then the PV of the Long option is $390,647 while the PV
of the Short option is only $333,390. By taking the Short option, you will save $57,257.
Solution:
Step 1: make the payment frequency match the compounding frequency. We need to convert the 6
percent compounded monthly to a quarterly effective rate.
12
 .06 
1 + kannual = 1 + 
 12 
1 + kquarterly = (1 + kannual )
1
4
1
 .06 12  4
=  1 +  
 12  
12 4
 .06 
= 1 + 
 12 
kquarterly = 1.5075%
Step 2: Now we have an annuity of 5*4 = 20 quarterly payments, a present value of $50,000, and
an effective quarterly rate of 1.5075%. Solving for the payments we get $2,914.44.

Solution:
Step 1: make the payment frequency match the compounding frequency. We need to convert the
6% compounded quarterly to a monthly effective rate.
4
 .06 
1 + kannual = 1 + 
 4 
1 + kmonthly = (1 + kannual )
1
12
1
 .06  4  12
=  1 +  
 4  
4 12
 .06 
= 1 + 
 4 
kmonthly = 0.4975%
Step 2: Now we have an annuity of 10*12 = 120 monthly payments, a present value of $250,000
and an effective monthly rate of 0.4975%. Solving for the payments we get $2,771.75.
 1 
1 − (1 + 0.004975)120 
$250,000 = PMT     PMT = $2,771.75
 0.004975 
 

N=120, I/Y=.4975, PV= -250,000, FV = 0, CPT PMT= 2,771.75
62. Section: 5.3 Compound Interest; 5.4 Annuities and Perpetuities

Solution:
a. We know the future value and present value amounts, as well as the monthly interest rate.
Finding the number of time periods (months) is most easily done with a financial calculator (TI
BAII Plus),
PV = 15,000, FV = -20,000, I/Y = 0.5, PMT = 0, CPT N = 57.68
It will take nearly 58 months, or close to 5 years before Roger can afford to buy the car.
b. Solving the following equation for “n” we get:

$15,000  (1.005) n − 1
$20,000 = + $250   n= 14.86.
(1.005) n  .005 
I/Y=0.5, PV=15,000, FV= -20,000, PMT = 250, CPT N = 14.86
63. Section: 5.3 Compound Interest; 5.6 Quoted versus Effective Rates
Solution:
Let’s assume the present value of the investment is $1. The future value, after doubling, is then
$2.
a. Annually: With annual compounding, the effective rate is the same as the quoted rate, 9%.
PV = –1, FV = 2, I/Y = 9, PMT =0, CPT N = 8.04
So the investment will double in just over 8 years.
b. Quarterly: With quarterly compounding, the effective annual rate is,

4
 0.09 
k = 1 +  − 1 = 9.3083% , and a financial calculator allows us to find:
 4 
PV = -1, FV = 2, I/Y = 9.3083, PMT = 0, CPT N = 7.79

The higher effective rate means that only 7.79 years are needed to double the value of the
investment.

Learning Objectives: 5.4
Solution:
a. The present value of the annual payments can be found with a financial calculator, (TI BAII
Plus), N=9, PMT = -6,000, I/Y = 5.0, FV = 0, CPT PV = 42,646.93
As this is less than $50,000, the immediate payment alternative is better.
b. This problem can be solved by trial and error, but the task is much easier with a financial
calculator, (TI BAII Plus), N=9, PMT = –6,000, PV = 50,000, FV = 0, CPT I/Y = 1.5675%. At an
interest rate below 1.5675% per year, the nine-year annuity would be preferable; above the rate
the immediate payment is better.



Solution:
PMT1   1 + g  
n
PV 0 = 1−  
k − g   1 + k  
PMT1   1 + g  
n
FV n = PV 0 (1 + k ) =n
1−   (1 + k )
n

k − g  1+ k  
PMT1   1 + .04  
( )
25
$1,000,000 = 1−   (1 + .06) 25 = PMT1 (1 + .06 )25 − (1 + .04 )25

.06 − .04   1 + .06  
 .02
PMT1
= *1.62603439
.02
The initial deposit is $12,299.86
 (1 + 0.06) 25 − 1
$1,000,000 = PMT    PMT = $18,226.72
 0. 06 
If Xiang made constant deposits (i.e., no growth), he would have to deposit $18,226.72 per year
for the next 25 years.

Solution:
a. The effective monthly interest rate is,
2
 0.051  12
kmonthly = 1 +  − 1 = 0.4206%
 2 
The amount of the mortgage loan will be ($280,000 – $50,000) = $230,000, and there will be 12
x 25 = 300 monthly payments, the value of which can be found with a financial calculator, (TI
BAII Plus), N=300, PV = –230,000, I/Y = 0.4206, FV = 0, CPT PMT = 1,350.89. Alysha’s two
friends will be paying 2 x $475 = $950 in rent, so she will need an additional $1,350.89 – $950 =
$400.89 to make the mortgage payments.
b. In two years, Alysha will have made 24 payments, leaving 276. The present value of these
payments is the outstanding value of the mortgage loan. Use the calculator again: N=276, I/Y =
0.4206, PMT = 1350.89, FV = 0, CPT PV = 220,336.58.To pay off the loan, and recoup her

down payment, Alysha would have to sell the house for at least $220,336.58 + $50,000 =
$270,336.58.
67. Section: 5.6 Quoted versus Effective Rates; 5.7 Loan or Mortgage Arrangements
Solution:
a. First, find the effective interest corresponding to the frequency of Jimmie’s car payments
(f =12); with monthly compounding, set m=12,
m 12
 QR  f  8.5%  12
k monthly = 1 +  − 1 = 1 +  − 1 = 0.70833%
 m   12 
The 60 car payments form an “annuity” whose present value is the amount of the loan (the price
of the car):
 1 
1 − 60 
(1 + 0.0070833) 
$29,000 = PMT   PMT = $594.98
 0.0070833 
 
 
b. Use the effective monthly interest rate from part A, k=0.70833%
(4) Principal
(1) Principal (2) (3) Interest Ending Principal
Period Repayment = (2)-
Outstanding Payment =k*(1) = (1)-(4)
(3)
1 29,000.00 594.98 205.42 389.56 28,610.44
2 28,610.44 594.98 202.66 392.32 28,218.12
3 28,218.12 594.98 199.88 395.10 27,823.01
4 27,823.01 594.98 197.08 397.90 27,425.11
5 27,425.11 594.98 194.26 400.72 27,024.40
6 27,024.40 594.98 191.42 403.56 26,620.84
7 26,620.84 594.98 188.56 406.42 26,214.42
8 26,214.42 594.98 185.69 409.29 25,805.13
9 25,805.13 594.98 182.79 412.19 25,392.94
10 25,392.94 594.98 179.87 415.11 24,977.82
11 24,977.82 594.98 176.93 418.05 24,559.77
12 24,559.77 594.98 173.97 421.01 24,138.76
13 24,138.76 594.98 170.98 424.00 23,714.76
...
35 14,083.18 594.98 99.76 495.22 13,587.95
36 13,587.95 594.98 96.25 498.73 13,089.22

37 13,089.22 594.98 92.72 502.26 12,586.96

...
59 1,177.43 594.98 8.34 586.64 590.79
60 590.79 594.98 4.18 590.79 0.00
The first monthly payment repays $389.56 of the principal amount of the loan and the last payment
repays $590.79.
c. After three years, or 36 monthly payments, the principal outstanding is $13,089.22 (from the
amortization table).The present value of this amount is:
 1 
PV0 = $13,089.22    = $10,152.19
 (1 + 0.0070833) 36 
 
68. Section: 5.6 Quoted versus Effective Rates; 5.7 Loan or Mortgage Arrangements
Learning Objective: 5.6, 5.7
Solution:
The 60 monthly payments form an annuity whose present value is $30,000. Finding the interest
rate is most easily done with a financial calculator (TI BAII Plus):
N=60, PMT=622.75, PV= -30,000, FV =0, CPT I/Y = 0.75%
Note that we used N=60 months, so the solution is a monthly interest rate, however, the problem
asks for the effective annual rate.
k = (1 + k monthly )12 − 1 = (1 + 0.0075)12 − 1 = 9.38%
The quoted rate would be:

1 1
QR = m  [(1 + k ) 12
− 1] = 12  [(1 + 0.0938) 12
− 1] = 9.00%
Or simply:
QR = m  k monthly = 12  0.0075 = 9.00%

Solution:
Part 1: determine the principal outstanding after the 60th payment (i.e., How much will the next
mortgage be for?)
Step 1: determine effective monthly rate:

1
 .06 2  12
kmonthly = 1 +   − 1 = 0.00493862
 2  
Step 2: determine the monthly payments:
 1 
1 − (1 + 0.00493862 ) 300 
$250,000 = PMT   
 0.00493862 
 
PMT = $1,599.5162
N=300, I/Y=.493862, PV=250,000, FV =0, CPT PMT = -1,599.5162
Step 3: determine Present Value of remaining (300 – 60) payments of $1,599.5162

 1 
1 − (1 + 0.00493862 ) 300 −60 
PV = $1,599.5162    = $224,591.7542
 0.00493862 
 

N=240, I/Y=.493862, PMT=-1,599.5162, FV = 0, CPT PV = $224,591.7542
Part 2: determine new payments

Step 1: determine new effective monthly rate
1
 .08 2  12
kmonthly = 1 +   − 1 = 0.00655820
 2  
Step 2: determine the new monthly payment
 1 
1 −
 (1 + 0.00655820 ) 300 −60 
$224,591.7542 = PMT   
 0.00655820 
 
PMT = $1,860.4231
N=240, I/Y=.65582, PV=224,591.7542, FV = 0, CPT PMT = 1,860.4231
Franklin’s new payment is $1,860.4231, an increase of $260.91.


Solution:
a. PV=$200,000, monthly rate=12%/12=1%, N = (10)(12)=120 months

 1 
1 − (1 + .01)120 
200,000 = PMT  
 .01 
 
 1 
1 − (1 + .01)120 
PMT = 200,000 /  
 .01 
 
So, PMT=$2,869
N=120, I/Y=1, PV=-200,000, FV = 0, CPT PMT=2,869
b. Remaining months to pay=120 – 18=102 months

 1 
1 − (1 + .01)102 
PV0 = 2,869   =$182,920
 .01 
 
N=102, I/Y=1, PMT=- 2,869, CPT PV=182,920
2
.12 12
c. kmonthly= (1 + ) − 1 =.9759%
2
 1 
1 − (1 + .009759)120 
200,000 = PMT  
 .009759 
 

 1 
1 − (1 + .009759)120 
PMT = 200,000 /  
 .009759 
 
So, PMT=$2,836
N=120, I/Y=.9759, PV=-200,000, FV = 0, CPT PMT=2,836

Solution:
Investor A:
k=e.15 – 1=16.183424%.
1st, consider an ordinary annuity and the present value of the investment when A turns 25 years
old is:
 1 
1 − 
(1 + .16183424 ) 8
PV 25 = $5,500   =$23,749.19
 .16183424 
 
 
N=8, I/Y=16.183424, PMT=5,500, FV = 0, CPT PV=- 23,749.19
2nd, discount this amount for five years back to today when she is 20.
1 1
PV0 = FV5  = $23,749.19  = $11,218.3231
(1 + k ) 5
(1.16183424 ) 5
Or, N=5, I/Y=16.183424, PMT = 0, FV=- 23,749.19, CPT PV=11,218.3231
Investor B:
.16 4
k= (1 + ) − 1 =16.985856%
4
 1 
1 − 
 (1 + .16985856 )10  (1.16985856 )
$11,218.3231 = PMT
 .16985856 
 
 
PMT=$2,057.38


N=10, I/Y=16.985856, PV=11,218.3231, FV = 0, CPT PMT= - 2,057.38
Therefore, Investor B has to make a yearly payment of $2,057.38 so that the present value of the
two investments is the same.

Answers to Concept Review Questions
5.1 Opportunity Cost
Concept review questions

1. Why does money have a “time value”?
An investor can simply store a dollar (tuck them under the bed!) and spend them in the future, in
this sense a dollar is always worth at least a dollar in the future. However this ignores the fact
that the saver has other uses for that dollar, which in economics we call an “opportunity cost” or
simply an “alternative use.” This results in a “time value” of money.
2. What is an “opportunity cost”?
The opportunity cost of money is the interest rate you can earn by investing the dollar today.
5.2 Simple Interest

1. Explain how simple interest payments are determined.
Simple interest payments are n × p × k, where n is number of periods in years, p is principal and
k is the simple annual interest rate.
2. Why does simple interest take into account the time value of money?
Simple interest can be used to calculate the future value of money assuming that only the
principal in reinvested.
5.3 Compound Interest

1. Explain how to compute future values and present values when using compound interest.
FVn = PV0 (1 + k)n, where PV0 is the present value, k is the compound value interest factor, n is
the number of periods and FVn is the future value in year n.
2. What is the relationship between FVIFs and PVIFs? Why does this make sense?
FVIF=1/PVIF. This relationship make sense because by definition, FVIF = (1 + k) n and PVIF =
1/(1 + k)n.
3. Why does compound interest result in higher future values than simple interest?
Compound interest refers to a process whereby interest is earned on the invested principal
amount and on any accrued interest. However, simple interest is only earned on the principal
amount.
5.4 Annuities and Perpetuities

1. Explain how to calculate the present value and future value of an ordinary annuity and an
annuity due.
 (1 + k ) n − 1
FVn = PMT   gives the future value of an ordinary annuity. Since each flow gets one
 k 
extra period of compounding in an annuity due, the FV (annuity due) = [FV (ordinary
annuity)](1 + k). The present value of both an annuity and an annuity due is PV0 = FVn (1 + k)n.
2. Define “perpetuity”.
Perpetuities are special annuities in that they go on forever so n goes to infinity in the annuity
equation.
3. Why is the present value of $1 million in 50 years’ time worth very little today?
If the required return is 12% a year, the present value of $1 million in 50 years’ time is $3,460.
The small present value is caused by the discounting process.
5.5 Growing Perpetuities and Annuities

1. Explain how to evaluate a growing perpetuity.
Estimate the payment (PMT), the required rate of return (k), and the expected growth rate to
infinity (g), and apply Equation 5A-2.
2. Explain how to calculate the present value of a growing annuity.
Estimate the payment (PMT), the required rate of return (k), the number of years for the annuity
(n), the expected growth rate to infinity (g), and apply Equation 5A-4.
5.6 Quoted versus Effective Rates

1. Why can effective rates often be very different from quoted rates?
If the quoted rates are not annually compounded, the effective rates are different from the quoted
rates because of the different number of compounding periods.
2. Explain how to calculate the effective rate for any period.
m
 QR 
The effective annual rate for any given compounding interval: k = 1 +  − 1 , where k =
 m 
effective annual rate, QR = quoted rate, and m = the number of compounding intervals per year.
Rates for payments that are other than annual payments require an effective period rate. The
m
 QR  f
effective period rate for payments other than annual is given as k = 1 +  − 1 , where k =
 m 
effective period rate, QR is the nominal quoted rate, m = the number of compounding period per
year and f = the frequency of payments per year.

5.7 Loan or Mortgage Arrangements

1. Explain how loan and mortgage payments can be determined using annuity concepts.
Since these loans involve equal payments, at regular intervals based on one fixed interest rate
specified when the loan is taken out, the payments can be viewed as annuities.
2. What complications arise when dealing with mortgage loans in Canada?
In Canada, the interest rates are quoted semi-annually and the payments are made monthly.
Mortgages are amortized over long periods of time; but, the rates are set for terms or periods that
may be shorter than the amortization period. When the term is expired, a new rate of interest
need to be negotiated and interest rates may have increased.
3. Why is a 6 percent U.S. mortgage not the same as a 6 percent Canadian mortgage?
Interest rates are compounded semi-annually in Canada and compounded monthly in U.S.
5.8 Comprehensive Examples

1. Explain how timelines can be used to break a complicated time value of money problem into
manageable components.
You can visualize the problem and break complicated cash flows into its three constituent parts
since you should develop an understanding of what is approximately the right answer.
2. Demonstrate how to solve a typical retirement problem.
There are three steps. First, calculate the present value of retirement funds in the year of
retirement. Second, calculate the cash you need to raise through investment in the year of
retirement. Third, determine the required year-end payments to give you the future value of the
amount that is calculated in the second step.


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Introduction to Corporate Finance, Fourth Edition Booth, Cleary, Rakita

INTRODUCTION TO CORPORATE FINANCE

Full download at link:

Solution Manual: https://testbankpack.com/p/solution-manual-for-

Chapter 5: Time Value of Money

Multiple Choice Questions

2. Section: 5.2 Simple Interest; 5.3 Compound Interest

Solutions Manual 1 Chapter 5

3. Section: 5.2 Simple Interest; 5.3 Compound Interest

4. Section: 5.2 Simple Interest; 5.3 Compound Interest

5. Section: 5.3 Compound Interest

6. Section: 5.2 Simple Interest; 5.3 Compound Interest

7. Section: 5.3 Compound Interest

Solutions Manual 2 Chapter 5

8. Section: 5.3 Compound Interest

9. Section: 5.4 Annuities and Perpetuities

10. Section: 5.4 Annuities and Perpetuities

11. Section: 5.4 Annuities and Perpetuities

Solutions Manual 3 Chapter 5

Or using a financial calculator (TI BAII Plus),

12. Section: 5.4 Annuities and Perpetuities

13. Section: 5.4 Annuities and Perpetuities

14. Section: 5.7 Loan or Mortgage Arrangements

Using a financial calculator (TI BAII Plus),

15. Section: 5.4 Annuities and Perpetuities

Solutions Manual 4 Chapter 5

17. Section: 5.2 Simple Interest

18. Section: 5.2 Simple Interest

19. Section: 5.2 Simple Interest

20. Section: 5.3 Compound Interest

Solutions Manual 5 Chapter 5

21. Section: 5.2 Simple Interest; 5.3 Compound Interest

B. FV389 years = $24  (1 + 0.05) 389 = $4,196,126,573

22. Section: 5.3 Compound Interest

Or using a financial calculator (TI BAII Plus),

23. Section: 5.3 Compound Interest

b. FV5 years = $20,000  (1 + 0.10)5 = $32,210.20

c. FV10 years = $20,000  (1 + 0.10)10 = $51,874.85

24. Section: 5.3 Compound Interest

Solutions Manual 6 Chapter 5

Or using a financial calculator (TI BAII Plus),

25. Section: 5.4 Annuities and Perpetuities

26. Section: 5.6 Quoted versus Effective Rates

27. Section: 5.6 Quoted versus Effective Rates

Solutions Manual 7 Chapter 5

28. Section: 5.6 Quoted versus Effective Rates

29. Section: 5.4 Annuities and Perpetuities

30. Section: 5.4 Annuities and Perpetuities

Or using a financial calculator (TI BAII Plus),

31. Section: 5.4 Annuities and Perpetuities

Solutions Manual 8 Chapter 5

Learning Objective: 5.4

32. Section: 5.5 Growing Annuities and Perpetuities

33. Section: 5.8 Comprehensive Examples

34. Section: 5.8 Comprehensive Examples

Solutions Manual 9 Chapter 5

36. Section: 5.4 Annuities and Perpetuities

37. Section: 5.4 Annuities and Perpetuities

Or using a financial calculator (TI BAII Plus),

Solutions Manual 10 Chapter 5

38. Section: 5.4 Annuities and Perpetuities

39. Section: 5.6 Quoted versus Effective Rates

Therefore, 9% compounded quarterly is equivalent to 8.9333% compounded monthly.