Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

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CHAPTER 5 – TIME VALUE OF MONEY 2: ANALYZING ANNUITY CASH FLOWS

Questions

LG1 5-1 How can you add a cash flow in year 2 and a cash flow in year 4 in year 7?

To add cash flows, they need to be moved to the same time period. The cash flows in years 2 and
4 should be moved forward with interest to year 7, then they can be added together.

LG2 5-2 People can become millionaires in their retirement years quite easily if they start saving early
in employer 401(k) or 403(b) programs (or even if their employers don’t offer such programs).
Demonstrate the growth of a $250 monthly contribution for 40 years earning 9 percent APR.

Using equation 5-2, we have:

FVA 40 = $250 
(1 + 0.09 / 12) 480
−1
= $1,170,330.07
0.09/12

LG3 5-3 When you discount multiple cash flows, how does the future period that a cash flow is paid
affect its present value and its contribution to the value of all the cash flows?

Discounting reduces a future cash flow to a smaller present value. Cash flows far into the future
become very small when discounted to the present. Thus, cash flows in distant future periods have
small impacts on present values.

5-1
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG4 5-4 How can you use the present value of an annuity concept to determine the price of a house you
can afford?

Mortgages are typically for a large enough amount of money that borrowing is required to purchase
a home. The amount that one can afford for a home is a function of their current state of wealth.
Mortgages allow consumers to spread the expense of a home over a longer period, typically 15 or
30 years. This allows consumers to put a smaller portion of wealth into the home (for example, a
20 percent down payment) and borrow the balance over the life of the loan. Due to the effect of
annuity compounding, the payments for such a long- lived debt make the monthly payments of a
manageable nature so that they can be paid from current income.

LG5 5-5 Since perpetuity payments continue forever, how can a present value be computed? Why isn’t
the present value infinite?

Equation 5-5 is used to calculate the present value of a perpetuity. It is a limiting version of
equation 5-4 in which the period N grows infinitely large. As this occurs the expression following
the “1” in equation 5-4 drives to the value 0 and the numerator simply become

5-2
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

“1.” The present value is not infinite since the terms following the PMT in equation 5-4 converge
to a finite limit of 1/i. This also demonstrates how payments far into the future have infinitesimal
value today.

LG6 5-6 Explain why you use the same adjustment factor, (1 + i), when you adjust annuity due
payments for both future value and present value.

Adjusting an annuity due calculation involves shifting the entire series of payments forward one
period. This is accomplished by multiplying by (1 + i) irrespective of whether it is a future value
or present value calculation.

LG7 5-7 Use the idea of compound interest to explain why EAR is larger than APR.

The annual percentage rate does not take into account the frequency of interest compounding.
Equation 5-8 illustrates the conversion from APR to EAR. The effective annual rate converts the
annual percentage rate to a rate that can be compared to other annual rates.

LG8 5-8 Would you rather pay $10,000 for a 5-year $2,500 annuity or a 10-year $1,250 annuity? Why?

The effective annual rates for these two payment streams are 7.93 percent and 4.28% percent
respectively. I would rather pay $10,000 for a 5-year $2,500 annuity as it earns a higher effective
annual rate of interest.

LG9 5-9 The interest on your home mortgage is tax deductible. Why are the early years of the mortgage
more helpful in reducing taxes than in the later years?

Mortgage payments at the beginning of the amortization schedule are predominantly interest with
little principal. In later years, interest payments decline and principal payments make up an ever
increasing part of the payments. Thus, the tax deductible part (the interest payment) is larger in
the beginning years.

LG10 5-10 How can you use the concepts illustrated in computing the number of payments in an annuity
to figure how to pay off a credit card balance? How does the magnitude of the payment impact
the number of months?

Utilizing equation 5-4, you can declare the present balance for the credit card and set that equal to
the PVA. The interest is the APR, which is the value to put into “i” in equation 5-4. You then
decide when you want to have the credit card paid off and convert this to a monthly value of N in
equation 5-4. Solving for PMT will yield the amount needed to pay the credit card off in the time
frame you desire, assuming that no additional charges are made to the credit card and that the
interest rate remains level. The higher the payment amount, the fewer the number of months
required to pay off the balance.

5-3
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Problems

Basic problems

LG1 5-1 Future Value Compute the future value in year 8 of a $2,000 deposit in year 1 and
another $1,500 deposit at the end of year 3 using a 10 percent interest rate.

Use equation 5-1:

FV8 = $2,000 × (1 + 0.10)7 + $1,500× (1 + 0.10)5 = $3,897.43 + $2,415.77 = $6,313.20

LG1 5-2 Future Value Compute the future value in year 7 of a $2,000 deposit in year 1 and another
$2,500 deposit at the end of year 4 using an 8% interest rate.

Use equation 5-1:

FV7 = $2,000 × (1 + 0.08)6 + $2,500 × (1 + 0.08)3 = $3,173.75 + $3,149.28 = $6,323.03

LG2 5-3 Future Value of an Annuity What is the future value of a $900 annuity payment over five
years if interest rates are 9 percent?

Use equation 5-2:

FVA 5 = $900 
(1 + 0.09)5 − 1 = $900  5.9847 = $5,386.24
0.09

LG2 5-4 Future Value of an Annuity What is the future value of a $700 annuity payment over six
years if interest rates are 10 percent?

Use equation 5-2:

FVA 6 = $700 
(1 + 0.10) 6
−1
= $700  7.7156 = $5,400.93
0.10

LG3 5-5 Present Value Compute the present value of a $2,000 deposit in year 1 and another $1,500
deposit at the end of year 3 if interest rates are 10 percent.

Use equation 5-3:

PV = $2,000 ÷ (1 + 0.10)1 + $1,500 ÷ (1 + 0.10)3 = $1,818.18 + $1,126.97 = $2,945.15

LG3 5-6 Present Value Compute the present value of a $2,000 deposit in year 1 and another $2,500
deposit at the end of year 4 using an 8 percent interest rate.

Use equation 5-3:

PV = $2,000 ÷ (1 + 0.08)1 + $2,500 ÷ (1 + 0.08)4 = $1,851.85 + $1,837.57 = $3,689.43

5-4
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG4 5-7 Present Value of an Annuity What’s the present value of a $900 annuity payment over five
years if interest rates are 9 percent?

Use equation 5-4:

 1 
1 − (1 + 0.09)5 
PVA 5 = $900    = $900  3.889651 = $3,500.69
 0.09 
 
 

LG4 5-8 Present Value of an Annuity What’s the present value of a $700 annuity payment over six
years if interest rates are 10 percent?

Use equation 5-4:

 1 
1 − (1 + 0.10)6 
PVA 6 = $700    = $700  4.355261 = $3,048.68
 0.10 
 
 

LG5 5-9 Present Value of a Perpetuity What’s the present value, when interest rates are 7.5 percent,
of a $50 payment made every year forever?

Use equation 5-5:

$50
PV of a perpetuity = = $666.67
0.075

LG5 5-10 Present Value of a Perpetuity What’s the present value, when interest rates are 8.5 percent,
of a $75 payment made every year forever?

Use equation 5-5:

$75
PV of a perpetuity = = $882.35
0.085

5-5
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG6 5-11 Present Value of an Annuity Due If the present value of an ordinary, 7-year annuity is
$6,500 and interest rates are 8.5 percent, what’s the present value of the same annuity due?

Use equation 5-7:

PVA7 due = $6,500 × (1 + 0.085) = $7,052.50

LG6 5-12 Present Value of an Annuity Due If the present value of an ordinary, 6-year annuity is
$8,500 and interest rates are 9.5 percent, what’s the present value of the same annuity due?

Use equation 5-7:

PVA6 due = $8,500 × (1 + 0.095) = $9,307.50

LG6 5-13 Future Value of an Annuity Due If the future value of an ordinary, 7-year annuity is $6,500
and interest rates are 8.5 percent, what is the future value of the same annuity due?

Use equation 5-6:

FVA7 due = $6,500 × (1 + 0.085) = $7,052.50

(Note this is the same answer as problem 5-11, as expected)

LG6 5-14 Future Value of an Annuity Due If the future value of an ordinary, 6-year annuity
is $8,500 and interest rates are 9.5 percent, what’s the future value of the same annuity due?

Use equation 5-6:

FVA6 due = $8,500 × (1 + 0.095) = $9,307.50

(Note this is the same answer as problem 5-12, as expected)

LG7 5-15 Effective Annual Rate A loan is offered with monthly payments and a 10 percent APR.
What’s the loan’s effective annual rate (EAR)?

Use equation 5-8:

12
 0.10 
EAR = 1 +  − 1 = 0.1047 = 10.47%
 12 

5-6
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG7 5-16 Effective Annual Rate A loan is offered with monthly payments and a 13 percent APR.
What’s the loan’s effective annual rate (EAR)?

Use equation 5-8:

12
 0.13 
EAR = 1 +  − 1 = 0.1380 = 13.80%
 12 

intermediate problems

LG1 5-17 Future Value Given a 4 percent interest rate, compute the year 6 future value of deposits
made in years 1, 2, 3, and 4 of $1,000, $1,200, $1,200, and $1,500.

Use equation 5-1:

FV6 = $1,000 × (1 + 0.04)5 + $1,200 × (1 + 0.04)4 + $1,200 × (1 + 0.04)3 + $1,500 × (1 + 0.04)2

FV6 = $1,216.65 + $1,403.83 + $1,349.84 + $1,622.40 = $5,592.72

LG1 5-18 Future Value Given a 5 percent interest rate, compute the year 6 future value of deposits
made in years 1, 2, 3, and 4 of $1,000, $1,300, $1,300, and $1,400.

Use equation 5-1:

FV6 = $1,000 × (1 + 0.05)5 + $1,300 × (1 + 0.05)4 + $1,300 × (1 + 0.05)3 + $1,400 × (1 + 0.05)2

FV6 = $1,276.28 + $1,580.16 + $1,504.91 + $1,543.50 = $5,904.85

LG2 5-19 Future Value of Multiple Annuities Assume that you contribute $200 per month to a
retirement plan for 20 years. Then you are able to increase the contribution to $400 per month for
another 30 years. Given a 7 percent interest rate, what is the value of your retirement plan after
the 50 years?

Break the annuity streams into a level stream of payments of $200 for 50 years and another level
stream of payments of $200 for the last 30 years. Use equation 5-2 for each payment stream and
add the results:

FVA 50 + FVA 30 = $200 

(1 + 0.07 / 12)
600
−1
+ $200 
(1 + 0.07 / 12)
360
−1
= $200  5,448.0709 + $200  1,219.9710 = $1,333,608.38
0.07/12 0.07/12

LG2 5-20 Future Value of Multiple Annuities Assume that you contribute $150 per month to a
retirement plan for 15 years. Then you are able to increase the contribution to $350 per month for
the next 25 years. Given an 8 percent interest rate, what is the value of your retirement plan after
the 40 years?

5-7
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Break the annuity streams into a level stream of payments of $150 for 40 years and another level
stream of payments of $200 for the last 25 years. Use equation 5-2 for each payment stream and
add the results:

FVA 40 + FVA 25 = $150 

(1 + 0.08 / 12)480 − 1 + $200  (1 + 0.08 / 12)300 − 1 = $150  3,491.0078 + $200  951.0264 = $713,856.45
0.08/12 0.08/12
LG3 5-21 Present Value Given a 6 percent interest rate, compute the present value of payments made
in years 1, 2, 3, and 4 of $1,000, $1,200, $1,200, and $1,500.

Use equation 5-3:

PV = $1,000 ÷ (1 + 0.06)1 + $1,200 ÷ (1 + 0.06)2 + $1,200 ÷ (1 + 0.06)3 + $1,500 ÷ (1 + 0.06)4

PV = $943.40 + $1,068.00 + $1,007.54 + $1,188.14 = $4,207.08

LG3 5-22 Present Value Given a 7 percent interest rate, compute the present value of payments made
in years 1, 2, 3, and 4 of $1,000, $1,300, $1,300, and $1,400.

Use equation 5-3:

PV = $1,000 ÷ (1 + 0.07)1 + $1,300 ÷ (1 + 0.07)2 + $1,300 ÷ (1 + 0.07)3 + $1,400 ÷ (1 + 0.07)4

PV = $934.58 + $1,135.47 + $1,061.19 + $1,068.05 = $4,199.29

LG4 5-23 Present Value of Multiple Annuities A small business owner visits her bank to ask for a
loan. The owner states that she can repay a loan at $1,000 per month for the next three years and
then $2,000 per month for two years after that. If the bank is charging customers 7.5 percent APR,
how much would it be willing to lend the business owner?

Break the annuity streams into a level stream of payments of $2,000 for 5 years and another level
stream of payments of $1,000 for the first 3 years. Use equation 5-4 for each payment stream and
subtract the results:

 1   1 
1 − (1 + 0.075 / 12)60  1 − (1 + 0.075 / 12)36 
PVA 60 − PVA 3 6 = $2,000    − $1,000    = $99,810.6164 − $32,147.9132 = $67,662.70
 0.075/12   0.075/12 
   
   

LG4 5-24 Present Value of Multiple Annuities A small business owner visits his bank to ask for a
loan. The owner states that he can repay a loan at $1,500 per month for the next three years and
then $500 per month for two years after that. If the bank is charging customers 8.5 percent APR,
how much would it be willing to lend the business owner?

Break the annuity into two streams of payments: $500 monthly for five years and $1,000 for three
years. Use equation 5-4 for each annuity and add the results:

5-8
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

 1   1 
1 − (1 + 0.085 / 12)60  1 − 
 + $1,000   (1 + 0.085 / 12)
36

PVA 60 + PVA 36 = $500    = $24,370.59 + $31,678.11 = $56,048.70

 0.085/12   0.085/12 
   
   

LG4 5-25 Present Value You are looking to buy a car. You can afford $450 in monthly payments for
four years. In addition to the loan, you can make a $1,000 down payment. If interest rates are 7%
APR, what price of car can you afford?

Find the loan value of the monthly payments and add the down payment:

 1 
1 − (1 + 0.07 / 12 )48 
PVA 48 = $450    + $1,000 = $18,792.09 + $1,000 = $19,792.09
 0.07/12 
 

LG4 5-26 Present Value You are looking to buy a car. You can afford $650 in monthly payments for
five years. In addition to the loan, you can make a $750 down payment. If interest rates are 8%
APR, what price of car can you afford?

Find the loan value of the monthly payments and add the down payment:

 1 
1 − (1 + 0.08 / 12 )60 
PVA60 = $650    + $750 = $32,056.98 + $750 = $32,806.98
 0.08/12 
 

LG5 5-27 Present Value of a Perpetuity A perpetuity pays $100 per year and interest rates are 7.5
percent. How much would its value change if interest rates increased to 9 percent? Did the value
increase or decrease?

Use equation 5-5:

$100
PV of a perpetuity = = $1,333.33
0.075

$100
PV of a perpetuity = = $1,111.11
0.09

The difference between these perpetuities is $222.22. The value of the perpetuity decreased with
an increase in the interest rate.

5-9
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG5 5-28 Present Value of a Perpetuity A perpetuity pays $50 per year and interest rates are 9 percent.
How much would its value change if interest rates decreased to 7.5 percent? Did the value increase
or decrease?

Use equation 5-5:

$50
PV of a perpetuity = = $555.56
0.09

$50
PV of a perpetuity = = $666.67
0.075

The difference between these perpetuities is $111.11. The value of the perpetuity increased with
a decrease in the interest rate.

LG6 5-29 Future and Present Value of an Annuity Due If you start making $50 monthly
contributions today and continue them for five years, what’s their future value if the compounding
rate is 10 percent APR? What is the present value of this annuity?

Compute the future value using equation 5-2:

FVA 60 = $50 
(1 + 0.10 / 12) 60
−1
 (1 + 0.10 / 12) = $50  77.437072  1.008333 = $3,904.12
0.10/12

Compute the present value using equation 5-4:

 1 
1 − (1 + 0.10 / 12)60 
PVA 60 = $50     1.008333 = $50  47.065369  1.008333 = $2,372.88
 0.10/12 
 
 

LG6 5-30 Future and Present Value of an Annuity Due If you start making $75 monthly
contributions today and continue them for four years, what is their future value if the compounding
rate is 12 percent APR? What is the present value of this annuity?

First calculate the future values and present values, using equations 5-2 and 5-4, respectively.
Using these results, the annuity due values can be computed using equations 5-6 and 5-7,
respectively.

FVA 48 = $75 
(1 + 0.12 / 12) 48
−1
= $75  61.2226 = $4,591.695 = $4,591.70
0.12/12

FVA48 due = $4,591.695 × (1 + 0.12/12) = $4,637.61

 1 
1 − (1 + 0.12 / 12)48 
PVA 48 = $75    = $75  37.973959 = $2,848.05
 0.12/12 
 
 

PVA48 due = $2,848.05 × (1 + 0.12/12) = $2,876.53

5-10
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG7 5-31 Compound Frequency Payday loans are very short-term loans that charge very high interest
rates. You can borrow $225 today and repay $300 in two weeks. What is the compounded annual
rate implied by this 33.33 percent rate charged for only two weeks?

33.33 percent for two weeks needs to be compounded 26 times to form a year:

(1 + i)26 – 1 = (1 + 0.3333)26 – 1 = 1770.77 = 177,077%

Note: Use the unrounded percent of increase in the computation.

LG7 5-32 Compound Frequency Payday loans are very short-term loans that charge very high interest
rates. You can borrow $500 today and repay $590 in two weeks. What is the compounded annual
rate implied by this 18 percent rate charged for only two weeks?

18 percent for two weeks needs to be compounded 26 times to form a year:

(1 + i)26 – 1 = (1 + 0.18)26 – 1 = 72.9490 = 7,294.90%

LG8 5-33 Annuity Interest Rate What’s the interest rate of a 5-year, annual $5,000 annuity with
present value of $20,000?

Use equation 5-4 and solve for i:

1
1−
(1 + i ) 5
$20,000 = $5,000   i = 7.93%
i

or TVM calculator: N=5, PV=-20,000, PMT=5,000, FV=0, CPT I = 7.93%

LG8 5-34 Annuity Interest Rate What’s the interest rate of a 7-year, annual $4,000 annuity with
present value of $20,000?

Use equation 5-2 and solve for i:

1
1−
(1 + i ) 7
$20,000 = $4,000   i = 9.20%
i
or TVM calculator: N=7, PV=-20,000, PMT=4,000, FV=0, CPT I = 9.20%

LG8 5-35 Annuity Interest Rate What annual interest rate would you need to earn if you wanted a
$1,000 per month contribution to grow to $75,000 in six years?

Use equation 5-2 and solve for i:

$75,000 = $1,000 
(1 + i / 12) 72
−1
 i = 1.37%
i/12

5-11
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

or TVM calculator: N=72, PV=0, PMT=-1,000, FV=75,000, CPT I = 0.1143%

Now convert the monthly interest rate to an annual rate by multiplying by 12 which yields 1.37
percent.

LG8 5-36 Annuity Interest Rate What annual interest rate would you need to earn if you wanted a
$600 per month contribution to grow to $45,000 in six years?

Use equation 5-2 and solve for i:

$45,000 = $600 
(1 + i / 12) 72
−1
 i = 1.37.%
i/12

or TVM calculator: N=72, PV=0, PMT=-600, FV=45,000, CPT I = 0.1143%

Now convert the monthly interest rate to an annual rate by multiplying by 12 which yields 1.37
percent.

LG8 5-37 Add-on Interest Payments To borrow $500, you are offered an add-on interest loan at 8
percent. Two loan payments are to be made, one at six months and the other at the end of the
year. Compute the two equal payments.

The total interest to be paid is $500 x 0.08 = $40. Add this to the principle to get $540. Each of
the two payments will be $540 / 2 = $270

LG8 5-38 Add-on Interest Payments To borrow $800, you are offered an add-on interest loan at 7
percent. Three loan payments are to be made, one at four months, another at eight months, and
the last one at the end of the year. Compute the three equal payments.

The total interest to be paid is $800 x 0.07 = $56. Add this to the principle to get $856. Each of
the three payments will be $856 / 3 = $285.33.

LG9 5-39 Loan Payments You wish to buy a $25,000 car. The dealer offers you a 4-year loan with a
10 percent APR. What are the monthly payments? How would the payment differ if you paid
interest only? What would the consequences of such a decision be?

Use equation 5-9:

 
 .10 / 12 
PMT48 = $25,000    = $25,000  0.025362583 = $634.06
 1 
1 − (1 + .10 / 12)48 
 

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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

If you only paid interest over the length of the loan and your principal balance was repaid at the
end of the 48 months, your payment would be $208.33 per month (= $25,000 × 0.10 ÷ 12) for
interest only and you would owe $25,000 at the end of the 48 months, too.

LG9 5-40 Loan Payments You wish to buy a $10,000 dining room set. The furniture store offers you
a 3-year loan with an 11 percent APR. What are the monthly payments? How would the payment
differ if you paid interest only? What would the consequences of such a decision be?

Use equation 5-9:

 
 .11 / 12 
PMT36 = $10,000    = $10,000  0.03279 = $327.39
 1 
1 − (1 + .11 / 12)36 
 

If you only paid interest over the length of the loan and your principal balance was repaid at the
end of the 36 months, your payment would be $91.67 per month (= $10,000 × 0.11 ÷ 12) for
interest only and you would owe $10,000 at the end of the 36 months, too.

LG10 5-41 Number of Annuity Payments Joey realizes that he has charged too much on his credit card
and has racked up $5,000 in debt. If he can pay $150 each month and the card charges 17 percent
APR (compounded monthly), how long will it take him to pay off the debt?

Rewrite equation 5-9 in terms of N:

ln $150 
 $(150 − $5,000  0.17 / 12)
N= = 45.43 months
ln(1 + 0.17 / 12)

or TVM calculator: PV = 5,000, PMT = -150, FV = 0, I = 1.417; CPT N = 45.43 months

LG10 5-42 Number of Annuity Payments Phoebe realizes that she has charged too much on her credit
card and has racked up $6,000 in debt. If she can pay $200 each month and the card charges 18
percent APR (compounded monthly), how long will it take her to pay off the debt?

Rewrite equation 5-9 in terms of N:

ln $200 
 ($200 − $6,000  0.18 /12)
N= = 40.15 months
ln(1 + 0.18 / 12)

or TVM calculator: PV = 6,000, PMT = -200, FV = 0, I = 1.50; CPT N = 40.15 months

5-13
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Advanced problems

LG1 5-43 Future Value Given an 8 percent interest rate, compute the year 7 future value if deposits
of $1,000 and
$2,000 are made in years 1 and 3, respectively, and a withdrawal of $700 is made in year 4.

Use equation 5-1:

FV7 = $1,000 × (1 + 0.08)6 + $2,000 × (1 + 0.08)4 - $700 × (1 + 0.08)3 = $1,586.87 + $2,720.98 –

$881.80 = $3,426.05

LG1 5-44 Future Value Given a 9 percent interest rate, compute the year 6 future value if deposits of
$1,500 and $2,500 are made in years 2 and 3, respectively, and a withdrawal of $600 is made in
year 5.

Use equation 5-1:

FV6 = $1,500 × (1 + 0.09)4 + $2,500 × (1 + 0.09)3 - $600 × (1 + 0.09)1 = $2,117.37 + $3,237.57 –

$654.00 = $4,700.94

LG7 – LG8 5-45 EAR of Add-on Interest Loan To borrow $2,000, you are offered an add-on
interest loan at 10 percent with 12 monthly payments. First, compute the 12 equal payments and
then compute the EAR of the loan:

The total interest cost is $2,000 x 0.10 = $200. Added to the principle, this becomes $2,200. The
12 monthly payments are therefore $2,200 / 12 = $183.33.

The APR of the loan is N = 12, PV = 2,000, PMT = -183.33, FV=0; CPT I = 1.4977%
So APR = 1.4977% x 12 = 17.97% (not the 10% advertised!)

The EAR is:

12
 0.1797 
EAR = 1 +  − 1 = 0.1953 = 19.53%
 12 

LG7-LG8 5-46 EAR of Add-on Interest Loan To borrow $700, you are offered an add-on interest
loan at 9 percent with 12 monthly payments. First, compute the 12 equal payments and then
compute the EAR of the loan:

The total interest cost is $700 x 0.09 = $63. Added to the principle, this becomes $763. The 12
monthly payments are therefore $763 / 12 = $63.58.

The APR of the loan is N = 12, PV = 700, PMT = -63.58, FV = 0; CPT I = 1.3505%
So APR = 1.3505% x 12 = 16.21% (not the 9% advertised!)

5-14
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

The EAR is:

12
 0.1621 
EAR = 1 +  − 1 = 0.1747 = 17.47%
 12 

LG4 5-47 Low Financing or Cash Back? A car company is offering a choice of deals. You
LG9 can receive $500 cash back on the purchase, or a 3 percent APR, 4-year loan. The price of the car
is $15,000 and you could obtain a 4-year loan from your credit union, at 7 percent APR. Which
deal is cheaper?

Compare two cases. The first case is to elect the 3 percent APR and fully finance $15,000 over 48
months. Using equation 5-9, the payment under this scenario would be:

 
 0.03 / 12 
PMT 48 = $15,000    = $332.01
 1 
1 −
 (1 + 0.03/12)48 
 

The second case is to take the $500 cash back, apply it to the purchase and finance only $14,500
through your credit union at 7 percent. The payment under this scenario would be:

 
 0.07 / 12 
PMT48 = $14,500    = $347.22
1 − 1 
 (1 + 0.07/12)48 
 

The lower payment represents the more advantageous scenario that you should choose, electing
the 3 percent financing through the car dealer.

LG4 5-48 Low Financing or Cash Back? A car company is offering a choice of deals. You
LG9 can receive $1,000 cash back on the purchase, or a 2 percent APR, 5-year loan. The price of the
car is $20,000 and you could obtain a 5-year loan from your credit union, at 7 percent APR. Which
deal is cheaper?

Compare two cases. The first case is to elect the 2 percent APR and fully finance $20,000 over 60
months. Using equation 5-9, the payment under this scenario would be:

 
 0.02 / 12 
PMT60 = $20,000    = $350.56
 1 
1 −
 (1 + 0.02/12)60 
 

The second case is to take the $1,000 cash back, apply it to the purchase and finance only $19,000
through your credit union at 7 percent. The payment under this scenario would be:

 
 0.07 / 12 
PMT60 = $19,000    = $376.22
 1 
1 −
 (1 + 0.07/12)60 
 

5-15
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

The lower payment represents the more advantageous scenario that you should choose, electing
the 2 percent financing through the car dealer.

LG9 5-49 Amortization Schedule Create the amortization schedule for a loan of $15,000, paid monthly
over three years using a 9 percent APR.

 
 0.09 / 12 
PMT36 = $15,000    = $477.00
1 − 1 
 (1 + 0.09 / 12) 36 

Beginning Total Interest Principal Ending

Month Balance Payment Paid Paid Balance
1 $15,000.00 $477.00 $112.50 $364.50 $14,635.50
2 14,635.50 477.00 109.77 367.23 14,268.27
3 14,268.27 477.00 107.01 369.98 13,898.29
4 13,898.29 477.00 104.24 372.76 13,525.53
5 13,525.53 477.00 101.44 375.55 13,149.98
6 13,149.98 477.00 98.62 378.37 12,771.61
7 12,771.61 477.00 95.79 381.21 12,390.40
8 12,390.40 477.00 92.93 384.07 12,006.33
9 12,006.33 477.00 90.05 386.95 11,619.38
10 11,619.38 477.00 87.15 389.85 11,229.53
11 11,229.53 477.00 84.22 392.77 10,836.76
12 10,836.76 477.00 81.28 395.72 10,441.03
13 10,441.03 477.00 78.31 398.69 10,042.35
14 10,042.35 477.00 75.32 401.68 9,640.67
15 9,640.67 477.00 72.31 404.69 9,235.98
16 9,235.98 477.00 69.27 407.73 8,828.25
17 8,828.25 477.00 66.21 410.78 8,417.47
18 8,417.47 477.00 63.13 413.86 8,003.60
19 8,003.60 477.00 60.03 416.97 7,586.63
20 7,586.63 477.00 56.90 420.10 7,166.54
21 7,166.54 477.00 53.75 423.25 6,743.29
22 6,743.29 477.00 50.57 426.42 6,316.87
23 6,316.87 477.00 47.38 429.62 5,887.25
24 5,887.25 477.00 44.15 432.84 5,454.41
25 5,454.41 477.00 40.91 436.09 5,018.32
26 5,018.32 477.00 37.64 439.36 4,578.96
27 4,578.96 477.00 34.34 442.65 4,136.31
28 4,136.31 477.00 31.02 445.97 3,690.33
29 3,690.33 477.00 27.68 449.32 3,241.02
30 3,241.02 477.00 24.31 452.69 2,788.33
31 2,788.33 477.00 20.91 456.08 2,332.24
32 2,332.24 477.00 17.49 459.50 1,872.74
33 1,872.74 477.00 14.05 462.95 1,409.79
34 1,409.79 477.00 10.57 466.42 943.37
35 943.37 477.00 7.08 469.92 473.45
36 473.45 477.00 3.55 473.45 0.00

5-16
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

LG9 5-50 Amortization Schedule Create the amortization schedule for a loan of $5,000, paid monthly
over two years using an 8 percent APR.

 
 0.08 / 12 
PMT24 = $5,000    = $226.14
1 − 1 
 (1 + 0.08 / 12) 24 

Beginning Total Interest Principal Ending

Month Balance Payment Paid Paid Balance
1 $5,000.00 $226.14 $33.33 $192.80 $4,807.20
2 4,807.20 $226.14 $32.05 194.09 4,613.11
3 4,613.11 $226.14 $30.75 195.38 4,417.73
4 4,417.73 $226.14 $29.45 196.68 4,221.04
5 4,221.04 $226.14 $28.14 198.00 4,023.04
6 4,023.04 $226.14 $26.82 199.32 3,823.73
7 3,823.73 $226.14 $25.49 200.64 3,623.08
8 3,623.08 $226.14 $24.15 201.98 3,421.10
9 3,421.10 $226.14 $22.81 203.33 3,217.77
10 3,217.77 $226.14 $21.45 204.68 3,013.09
11 3,013.09 $226.14 $20.09 206.05 2,807.04
12 2,807.04 $226.14 $18.71 207.42 2,599.62
13 2,599.62 $226.14 $17.33 208.81 2,390.81
14 2,390.81 $226.14 $15.94 210.20 2,180.61
15 2,180.61 $226.14 $14.54 211.60 1,969.01
16 1,969.01 $226.14 $13.13 213.01 1,756.00
17 1,756.00 $226.14 $11.71 214.43 1,541.57
18 1,541.57 $226.14 $10.28 215.86 1,325.71
19 1,325.71 $226.14 $8.84 217.30 1,108.42
20 1,108.42 $226.14 $7.39 218.75 889.67
21 889.67 $226.14 $5.93 220.21 669.46
22 669.46 $226.14 $4.46 221.67 447.79
23 447.79 $226.14 $2.99 223.15 224.64
24 224.64 $226.14 $1.50 224.64 0.00

LG4 5-51 Investing for Retirement Monica has decided that she wants to build enough
LG9 retirement wealth that, if invested at 8 percent per year, will provide her with $3,500 of monthly
income for 25 years. To date, she has saved nothing, but she still has 30 years until she retires.
How much money does she need to contribute per month to reach her goal?

First, calculate the amount you would need to have in 30 years time to yield the $3,500 monthly
payments for an additional 25 years. Use equation 5-4 to calculate this present value:

5-17
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

 1 
1 − (1 + 0.08 / 12 )300 
PVA = $3,500    = $453,475.83
 0.08/12 
 
 
This amount will become the future value in the next calculation, assuming 8 percent interest and
360 level monthly payments. Use equation 5-2 and solve for the monthly payment:

$453,475.83 = PMT 
(1 + 0.08 / 12)360 − 1  PMT = $304.27
0.08/12

LG4 5-52 Investing for Retirement Ross has decided that he wants to build enough retirement
LG9 wealth that, if invested at 7 percent per year, will provide him with $3,000 of monthly income for
30 years. To date, he has saved nothing, but he still has 20 years until he retires. How much money
does he need to contribute per month to reach his goal?

First, calculate the amount you would need to have in 20 years time to yield the $3,000 monthly
payments for an additional 30 years. Use equation 5-4 to calculate this present value:

 1 
1 − (1 + 0.07 / 12 )360 
PVA = $3,000    = $450,922.70
 0.07/12 
 
 

This amount will become the future value in the next calculation, assuming 7 percent interest and
240 level monthly payments. Use equation 5-2 and solve for the monthly payment:

$450,922.70 = PMT 
(1 + 0.07 / 12)240 − 1  PMT = $865.62
0.07/12

LG9 5-53 Loan Balance Rachel purchased a $15,000 car three years ago using an 8 percent, 4-year
loan. She has decided that she would sell the car now, if she could get a price that would pay off
the balance of her loan. What is the minimum price Rachel would need to receive for her car?

First calculate the monthly payment that she has been paying using equation 5-9:

 
 0.08 / 12 
PMT48 = $15,000    = $366.19
1 − 1 
 (1 + 0.08/12 )48 
 

The loan balance is the principal amount outstanding. The duration of remaining payments is 12,
the interest rate is 8 percent annual and the monthly payment is $366.19 from the previous
calculation. Use these values to calculate the present value of the loan using equation 5-4:

5-18
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

 1 
1 − (1 + 0.08 / 12 )12 
PVA = $366.19    = $4,209.64
 0.08/12 
 
 

This is the minimum price the car needs to be sold for and it represents her break even price.

LG9 5-54 Loan Balance Hank purchased a $20,000 car two years ago using a 9 percent, 5-year loan.
He has decided that he would sell the car now, if he could get a price that would pay off the balance
of his loan. What’s the minimum price Hank would need to receive for his car?

First calculate the monthly payment that he has been paying using equation 5-9:

 
 0.09 / 12 
PMT60 = $20,000    = $415.17
1 − 1 
 (1 + 0.09/12 )60 
 

The loan balance is the principal amount outstanding. The duration of remaining payments is 36,
the interest rate is 9 percent annual and the monthly payment is $415.17 from the previous
calculation. Use these values to calculate the present value of the loan using equation 5-4:

 1 
1 − (1 + 0.09 / 12)36 
PVA = $415.17    = $13,055.77
 0.09/12 
 

This is the minimum price the car needs to be sold for and it represents his break even price.

LG9 5-55 Teaser Rate Mortgage A mortgage broker is offering a $183,900, 30-year mortgage with a
teaser rate. In the first two years of the mortgage, the borrower makes monthly payments on only
a 4 percent APR interest rate. After the second year, the mortgage interest rate charged increases
to 7 percent APR. What are the monthly payments in the first two years? What are the monthly
payments after the second year?

Use equation 5-9 to calculate the payment using the teaser rate:

 
 0.04 / 12 
PMT360 = $183,900    = $877.97
1 − 1 
 (1 + 0.04 / 12 )360 

Now calculate the outstanding loan balance after the first 24 payments using equation 5-4:

 1 
1 − (1 + 0.04 / 12 )336 
PVA 336 = $877.97    = $177,291.63
 0.04/12 
 
 

5-19
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 Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Now use this amount for the present value, the new interest rate of 7% over the remaining 336
payments in equation to calculate the new payment amount after expiration of the teaser rate, using
equation 5-9:

 
 0.07 / 12 
PMT336 = $177,291.63    = $1,204.89
1 − 1 
 (1 + 0.07 / 12 )336 
 

LG9 5-56 Teaser Rate Mortgage A mortgage broker is offering a $279,000, 30-year mortgage with a
teaser rate. In the first two years of the mortgage, the borrower makes monthly payments on only
a 4.5 percent APR interest rate. After the second year, the mortgage interest rate charged increases
to 7.5 percent APR. What are the monthly payments in the first two years? What are the monthly
payments after the second year?

Use equation 5-9 to calculate the payment using the teaser rate:

 
 0.045 / 12 
PMT360 = $279,000    = $1,413.65
1 − 1 
 (1 + 0.045 / 12 )360 

Now calculate the outstanding loan balance after the first 24 payments using equation 5-4:

 1 
1 − (1 + 0.045 / 12 )336 
PVA336 = $1,413.65    = $269,791.04
 0.045/12 
 

Now use this amount for the present value, the new interest rate of 7.5 percent over the remaining
336 payments in equation to calculate the new payment amount after expiration of the teaser rate,
using equation 5-9:

 
 0.075 / 12 
PMT336 = $269,791.04    = $1,923.25
1 − 1 
 (1 + 0.075 / 12 )336 

LG2 LG95-57 Spreadsheet Problem Consider a person who begins contributing to a retirement
plan at age 25 and contributes for 40 years until retirement at age 65. For the first ten years, she
contributes $3,000 per year. She increases the contribution rate to $5,000 per year in years 11
through 20. This is followed by increases to $10,000 per year in years 21 through 30 and to
$15,000 per year for the last ten years. This money earns a 9 percent return. First compute the
value of the retirement plan when she turns age 65. Then compute the annual payment she would
receive over the next 40 years if the wealth was converted to an annuity payment at 8 percent.

5-20
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Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

End of
Age Contribution Total Wealth
25 $3,000.00 $3,000.00
26 3,000.00 6,270.00
27 3,000.00 9,834.30
28 3,000.00 13,719.39
29 3,000.00 17,954.13
30 3,000.00 22,570.00
31 3,000.00 27,601.30
32 3,000.00 33,085.42
33 3,000.00 39,063.11
34 3,000.00 45,578.79
35 5,000.00 54,680.88
36 5,000.00 64,602.16
37 5,000.00 75,416.35
38 5,000.00 87,203.83
39 5,000.00 100,052.17
40 5,000.00 114,056.87
41 5,000.00 129,321.98
42 5,000.00 145,960.96
43 5,000.00 164,097.45
44 5,000.00 183,866.22
45 10,000.00 210,414.18
46 10,000.00 239,351.45
47 10,000.00 270,893.08
48 10,000.00 305,273.46
49 10,000.00 342,748.07
50 10,000.00 383,595.40
51 10,000.00 428,118.99
52 10,000.00 476,649.70
53 10,000.00 529,548.17
54 10,000.00 587,207.50
55 15,000.00 655,056.18
56 15,000.00 729,011.23
57 15,000.00 809,622.25
58 15,000.00 897,488.25
59 15,000.00 993,262.19
60 15,000.00 1,097,655.79
61 15,000.00 1,211,444.81
62 15,000.00 1,335,474.84
63 15,000.00 1,470,667.58
64 15,000.00 $1,618,027.66

PMT = ($135,688.06)

5-21
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Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Research it!
Retirement Income Calculators
The Internet provides some excellent retirement income calculators. You can find one by
Googling “retirement income calculator.” Many of the calculators allow you to determine your
predicted annual income from a retirement nest egg under different assumptions. For example,
you can spend only the investment income generated from the nest egg. Most retirees try not to
touch the principal. Or, you can spend both the income and the nest egg itself. These calculators
let you input the size of the retirement wealth and the investment return to be earned. They then
make time value computations to determine the annual income the nest egg will provide.

Go to a retirement income calculator like the one at MSN Money. Use the calculator to create a
retirement scenario. Use the TVM equations or a financial calculator to check the Internet results.

http://money.msn.com/retirement/retirement-calculator.aspx

SOLUTION: Assuming the principal amount is exhausted and the amount of savings at my
retirement at age 65, here is what the calculator gives.

Summary

Given a certain amount of savings, how much can I spend annually during
retirement?

Your annual income is estimated to be $70,000.

Information entered
1. Savings
Amount saved $1,000,000
Rate of return 7%
Inflation rate 3.8%
Average effective tax rate 22.6%

2. Retirement years
Retirement age 65 years
Life expectancy 85 years
Estate amount $0

Using a financial calculator, the following inputs are needed to determine the projected annual
payment:

N = 20 years
I = 1.07/1.038 -1 = 3.083%
PV = $1,000,000

5-22
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Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

CPT PMT = $67,732.56 (The retirement income calculator rounds this amount to the nearest
$10,000 for an estimate of $70,000 gross annually.)

Integrated Minicase: Paying on your Stafford loan

Consider Gavin, a new freshman who has just received a Stafford student loan and started
college. He plans to obtain the maximum loan from Stafford at the beginning of each year.
Although Gavin does not have to make any payments while he is in school, the unsubsidized 6.8
percent interest owed (compounded monthly) accrues and is added to the balance of the loan.

UNSUBSIDIZED Stafford loan limits:

Freshman $6,000
Sophomore 6,000
Junior 7,000
Senior 7,000

After graduation, Gavin gets a 6-month grace period. This means that monthly payments are still
not required, but interest is still accruing. After the grace period, the standard repayment plan is to
amortize the debt using monthly payments for ten years.

a. Show a time line of when the loans will be taken.

b. What will be the loan balance when Gavin graduates after his fourth year of school?
c. What is the loan balance six months after graduation?
d. Using the standard repayment plan and a 6.8 percent APR interest rate, compute the monthly
payments Gavin owes after the grace period.

SOLUTION:
a. Show a time line of when the loans will be taken.

Period 0 6.8% 1 6.8% 2 6.8% 3 6.8% 4 6.8% 5 years

Cash Flows $6,000 $6,000 $7,000 $7,000

b. What will be the loan balance when Gavin graduates after his fourth year of school?

Each payment needs to be moved forward with 6.8 percent interest to the middle of years 4 and 5
to calculate the outstanding accrued loan balance as of the date payments are set to begin:

FV4 = $6,000 × (1.068)4 + $6,000 × (1.068)3 + $7,000 × (1.068)2 + $7,000 × (1.068)1

FV4 = $7,806.14 + $7,309.12 + $7,984.37 + $7,476.00 = $30,575.63

c. What is the loan balance six months after graduation?

5-23
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Each payment needs to be moved forward with 6.8 percent interest to the middle of years 4 and 5
to calculate the outstanding accrued loan balance as of the date payments are set to begin:

Add interest for half a year, $30,575.63 × (1 + 0.068 / 12)6

= $31,630.04

d. Using the standard repayment plan and a 6.8 percent APR interest rate, compute the monthly
payments Gavin owes after the grace period.

Using equation 5-9, the monthly payments will be:

 
 0.068 / 12 
PMT120 = $31,630.04    = $364.00
1 − 1 
 (1 + 0.068 / 12 )120 
 

Combined Chapter 4 and Chapter 5 problems

4&5-1 Future Value Consider that you are 35 years old and have just changed to a new job. You
have $80,000 in the retirement plan from your former employer. You can roll that money into the
retirement plan of the new employer. You will also contribute $3,600 each year into your new
employer’s plan. If the rolled-over money and the new contributions both earn a 7 percent return,
how much should you expect to have when you retire in 30 years?

The future value can be calculated by adding the accumulated value of $80,000 brought forward
with interest for 30 years to a 30-year annuity of $3,600 per year, both using the 7 percent interest
assumption. Use equations 5-1 and 5-2 and add the results:

FVA Age 65 = $80,000  (1 + 0.07 ) + $3,600 

30 (1 + 0.07 )30 − 1 = $608,980.40 + $340,058.83 = $949,039.23
0.07

4&5-2 Future Value Consider that you are 45 years old and have just changed to a new job. You
have $150,000 in the retirement plan from your former employer. You can roll that money into
the retirement plan of the new employer. You will also contribute $7,200 each year into your new
employer’s plan. If the rolled-over money and the new contributions both earn an 8 percent return,
how much should you expect to have when you retire in 20 years?

The future value can be calculated by adding the accumulated value of $150,000 brought forward
with interest for 20 years to a 20-year annuity of $7,200 per year, both using the 8 percent interest
assumption. Use equations 5-1 and 5-2 and add the results:

FVA Age 65 = $150,000  (1 + 0.08) + $7,200 

20 (1 + 0.08)20 − 1 = $699,143.57 + $329,486.14 = $1,028,629.71
0.08

5-24
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

4&5-3 Future Value and Number of Annuity Payments Your client has been given a trust fund
valued at $1 million. He cannot access the money until he turns 65 years old, which is in 25 years.
At that time, he can withdrawal $25,000 per month. If the trust fund is invested at a 5.5 percent
rate, how many months will it last your client once he starts to withdraw the money?

Using equation 5-1, $1 million will accumulate for 25 more years at 5.5 percent interest for a future
value:

FVA Age 65 = $1,000,000  (1 + 0.055) = $3,813,392.35

25

Now, rewrite equation 5-9 in terms of N:

ln  $25,000 
 ($25,000 − $3,813,392.35  0.055 / 12)
N= = 262.65 months
ln (1 + 0.055 / 12 )

Or TVM calculator: PV = $3,813,392.35, PMT = -$25,000, FV = 0, I = 0.458333; CPT N

= 262.65 months

4&5-4 Future Value and Number of Annuity Payments Your client has been given a trust fund
valued at $1.5 million. She cannot access the money until she turns 65 years old, which is in 15
years. At that time, she can withdraw $20,000 per month. If the trust fund is invested at a 5 percent
rate, how many months will it last your client once she starts to withdraw the money?

Using equation 5-1, $1.5 million will accumulate for 15 more years at 5 percent interest for a future
value:

FVA Age 65 = $1,500,000  (1 + 0.05) 15 = $3,118,392.27

Now, rewrite equation 5-9 in terms of N:

ln  $20,000 
 ($20,000 − $3,118,392.27  0.05 / 12)
N= = 252.25 months
ln (1 + 0.05 / 12)

Or TVM calculator: PV = $3,118,392.27, PMT = -$20,000, FV = 0, I = 0.416667; CPT N

= 252.25 months

4&5-5 Present Value and Annuity Payments A local furniture store is advertising a deal in
which you buy a $3,000 dining room set and do not need to pay for two years (no interest cost is
incurred). How much money would you have to deposit now in a savings account earning 5
percent APR, compounded monthly, to pay the $3,000 bill in two years? Alternatively, how much
would you have to deposit in the savings account each month to be able to pay the bill?

5-25
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Use equation 5-3 and solve for the lump sum payment:

PV = $3,000  (1 + 0.05 / 12) = $2,715.08

24

Use equation 5-2 and solve for the annuity payment:

$3,000 = PMT 
(1 + 0.05/12 )24 − 1  PMT = $119.11 per month
0.05/12

4&5-6 Present Value and Annuity Payments A local furniture store is advertising a deal in which
you buy a $5,000 living room set with three years before you need to make any payments (no
interest cost is incurred). How much money would you have to deposit now in a savings account
earning 4 percent APR, compounded monthly, to pay the $5,000 bill in three years? Alternatively,
how much would you have to deposit in the savings account each month to be able to pay the bill?

Use equation 5-3 and solve for the lump sum payment:

PV = $5,000  (1 + 0.04 / 12) = $4,435.49

36

Use equation 5-2 and solve for the annuity payment:

$5,000 = PMT 
(1 + 0.04/12 )36 − 1  PMT = $130.95
0.04/12

4&5-7 House Appreciation and Mortgage Payments Say that you purchase a house for
$200,000 by getting a mortgage for $180,000 and paying a $20,000 down payment. If you get a
30-year mortgage with a 7 percent interest rate, what are the monthly payments? What would the
loan balance be in ten years? If the house appreciates at 3 percent per year, what will be the value
of the house in ten years? How much of this value is your equity?

Use equation 5-9 to calculate your monthly payment:

 
 0.07 / 12 
PMT360 = $180,000    = $1,197.54
1 − 1 
 (1 + 0.07 / 12 )360 
 

In ten years, you will have 240 payments of $1,197.54 left to pay. The present value can be
calculated using equation 5-4:

 1 
1 − (1 + 0.07 / 12 )240 
PVA 240 = $1,197.54    = $154,461.71
 0.07/12 
 
An appreciation of 3 percent per year will result in a forecast future value of the home using the
original purchase price in equation 5-1:

FV10 years = $200,000  (1 + .03) = $268,783.28

10

5-26
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Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

The amount of equity is the difference between the home’s value and the outstanding balance on
the mortgage:

Equity = $268,783.28 - $154,461.71 = $114,321.57

4&5-8 House Appreciation and Mortgage Payments Say that you purchase a house for
$150,000 by getting a mortgage for $135,000 and paying a $15,000 down payment. If you get a
15-year mortgage with a 7 percent interest rate, what are the monthly payments? What would the
loan balance be in five years? If the house appreciates at 4 percent per year, what will be the value
of the house in five years? How much of this value is your equity?

Use equation 5-9 to calculate your monthly payment:

 
 0.07 / 12 
PMT180 = $135,000    = $1,213.42
1 − 1 
 (1 + 0.07 / 12 )180 
 

In 5 years, you will have 120 payments of $1,213.42 left to pay. The present value can be
calculated using equation 5-4:

 1 
1 − (1 + 0.07 / 12 )120 
PVA120 = $1,213.42    = $104,507.44
 0.07/12 
 

An appreciation of 4 percent per year will result in a forecast future value of the home using the
original purchase price in equation 5-1:

FV5years = $150,000  (1 + .04) = $182,497.94

5

The amount of equity is the difference between the home’s value and the outstanding balance on
the mortgage:

Equity = $182,497.94 - $104,507.44 = $77,990.50

4&5-9 Construction Loan You have secured a loan from your bank for two years to build your
home. The terms of the loan are that you will borrow $200,000 now and an additional $100,000
in one year. Interest of 10 percent APR will be charged on the balance monthly. Since no payments
will be made during the 2-year loan, the balance will grow at the 10 percent compounded rate. At
the end of the two years, the balance will be converted to a traditional 30-year mortgage at a 6
percent interest rate. What will you be paying as monthly mortgage payments (principal and
interest only)?

5-27
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 05 - Time Value of Money 2: Analyzing Annuity Cash Flows

Use equation 5-1 to calculate the capitalized value of your mortgage at the end of year 2:

FV2 = $200,000 (1 + 0.10 / 12) + $100,000 (1 + 0.10/12) = $354,549.50

24 12

This is the amount that you will need to finance over 30 years at 6 percent. Use equation 5-9 to
compute the monthly payment:

 
 0.06 / 12 
PMT360 = $354,549.50    = $2,125.70
1 − 1 
 (1 + 0.06 / 12 )360 
 

4&5-10 Construction Loan You have secured a loan from your bank for two years to build your
home. The terms of the loan are that you will borrow $100,000 now and an additional $50,000 in
one year. Interest of 9 percent APR will be charged on the balance monthly. Since no payments
will be made during the 2-year loan, the balance will grow. At the end of the two years, the balance
will be converted to a traditional 15-year mortgage at a 7 percent interest rate. What will you pay
as monthly mortgage payments (principal and interest only)?

Use equation 5-1 to calculate the capitalized value of your mortgage at the end of year 2:

FV2 = $100,000 (1 + 0.09 /12) + $50,000 (1 + 0.09/12) = $174,331.70

24 12

This is the amount that you will need to finance over 15 years at 7 percent. Use equation 5-9 to
compute the monthly payment:

 
 0.07 / 12 
PMT180 = $174,331.70    = $1,566.94
1 − 1 
 (1 + 0.07 / 12 )180 
 

5-28
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.