Chapter 5 Time Value of Money 183 Self-Test Questions and Problems ra pres tee nests ms caret BI FOE REN FeMgPCFvAg eee a aera a ae ee eee ere (hare panera cah nope aca 9 ee remem ee ee ST-2 FUTURE VALUE It is now January 1, 2018. Today you will deposit $1,000 into a savings account that pays 8%. 4. Ifthe bank compounds interest annually, how much will you have in your account on January 1, 2021? . What will your January 1, 2021, balance be ifthe bank uses quarterly compounding? ©. Suppose you deposit $1,000 in three payments of $333.333 each on January 1 of 2019, 2020, and 2021. How much will you have in your account on January 1, 2021, based on. {8% annual compounding? 4. How much will be in your account ifthe three payments begin on January 1, 2018? «©. Suppose you deposit three equal payments into your account on January 1 of 2019, 2020, and 2021. Assuming an 8% interest rate, how large must your payments be to hhave the same ending balance as in part a? ST-3 TIMEVALUE OF MONEY It is now January 1, 2018, and you will need $1,000 on January 1, 2022, in 4 years. Your bank compounds interest at an 8% annual rate a. How much must you deposit today to have a balance of $1,000 on January 1, 2022? b. Ifyou want to make four equal payments on each January 1 from 2019 through 2022 ‘to accumulate the $1,000, how lange must each payment be? (Note that the payments begin a year from today) IF your father offers to make the payments calculated in part b ($221.92) orto give you {$750 on January 1, 2019 (a year from today), which would you choose? Explain. 4. IF you have only $750 on January 1, 2019, what interest rate, compounded annually for 3 Years, must you earn to have $1,000 on January 1, 2022? {. Suppose you can deposit only $200 each January 1 from 2019 through 2022 (4 years). ‘What interest rate, with annual compounding, must you earn to end up with $1,000 on January 1, 20227 £ Your father offers to give you $400 on January 1, 2019. You will then make six addi- tional equal payments each 6 montis from July 2019 through January 2022. If your bank pays 8% compounded semiannually, how large must each payment be for you to end up with $1,000 on January 1, 2022? ‘g What is the EAR, or EFP%, earned on the bank account in part f2 What is the APR. ‘earned on the account? ST-4 EFFECTIVE ANNUAL RATES Bank A offers loans at an 8% nominal rate (its APR) but requires that interest be paid quarterly; that is, it uses quarterly compounding. Bank B wants to charge the same effective rate on its loans, but it wants to collect interest on a monthly basis, that is, to use monthly compounding. What nominal rate must Bank Beet?Part 2 Fundamental Concepts in Financial Management Questions 54 52 54 55 57 58 Problems What is an opportunity cost? How is this concept used in TVM analysis, and where is it shown on a time line? Is a single number used in al situations? Explain. Explain whether the following statement is true or false: $100 a year for 10 years is an. annuity, but $100 in Year 1, $200 in Year 2, and $400 in Years 3 through 10 does not consti- tute an annuity. However, the second series contains an annuity Ifa firm’s earings per share grew from $1 to $2 over a 10-year period, the fotal growth would be 100%, But the annual growth rate would be less than 10%. True or false? Explain, (Hint If you aren’t sure, plug in some numbers and check it out) ‘Would you rather have a savings account that pays 5% interest compounded semiannually tr one that pays 5% interest compounded daily? Explain. ‘To find the present value of an uneven series of cash flows, you must find the PVs of the individual cash flows and then sum them. Annuity procedures can never be of use, even when some of the cash flows constitute an annuity, because the entire series isnot an ann ity. True o false? Explain, ‘The present value of a perpetuity is equal to the payment on the annuity, PMT, divided by the interest rate, 1: PV = PMT/I. Whats the future value of a perpetuity of PMT dollars per year? (Hint: The answer is infinity, but explain why.) Banks and other lenders are required to disclose a rate called the APR. What is this rate? ‘Why did Congress require that it be disclosed? Is it the same as the effective annual rate? If you were comparing the costs of loans from different lenders, could you use their APRs to determine the loan with the lowest effective interest rate? Explain. What isa loan amortization schedule, and what are some ways these schedules are used? Easy 54 Problems 18 Bq 53 5-4 55 56 57 FUTURE VALUE If you deposit $2,000 in a bank account that pays 6% interest annually, ‘how much will be in your account after 5 years? PRESENT VALUE What is the present value of a security that will pay $29,000 in 20 years if securities of equal risk pay 5% annually? FINDING THE REQUIRED INTEREST RATE Your parents will retire in 19 years. They cur- rently have $350,000 saved, and they think they will need $800,000 at retirement. What anniia interest rate must they earn to reach their goal, assuming they don't save any addi- tional funds? ‘TIME FOR A LUMP SUMTO DOUBLE If you deposit money today in an account that pays 4% annual interest, how long will it take to double your money? ‘TIMETO REACH AFINANCIAL GOAL You have $33,556.25 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals, $220,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal? FUTURE VALUE: ANNUITY VERSUS ANNUITY DUE What's the future value of a 5% 5-year ordinary annuity that pays $800 each year? If this was an annuity due, what would its future Value be? PRESENT AND FUTURE VALUES OF ACASH FLOW STREAM An investment will pay $150 at the end of each of the next 3 years, $250 a the end of Year 4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of equal risk earn 11% annually, what i its present value? Its future value?58 Intermediate 5-9 Problems 926 5-10 Chapter 5 Time Value of Money 185 LOAN AMORTIZATION AND EAR You want to buy a car, and a local bank will lend you ‘$40,000, The loan will be fully amortized over 5 years (60 months), and the nominal interest rate will be 8% with interest paid monthly. What will be the monthly loan payment? What ‘will be the loan’s EAR? PRESENT AND FUTURE VALUES FOR DIFFERENT PERIODS ind the following values using the equations and then a financial calculator. Compounding/discounting occurs annually. ‘2. An initial $600 compounded for I year at 6% b, An initial $600 compounded for 2 years at 6% The present value of $600 due in 1 year at a discount rate of 6% . The present value of $600 due in 2 years at a discount rate of 6% PRESENT AND FUTURE VALUES FOR DIFFERENT INTEREST RATES Find the following val- ues. Compounding /discounting occurs annually An initial $200 compounded for 10 years at 4% An initial $200 compounded for 10 years at 8% ‘The present value of $200 due in 10 years at 4% ‘The present value of $1,870 due in 10 years at 8% and at 4% Define present value and illustrate it using a time line with data from part d. How are present values affected by interest rates? apogee GROWTH RATES Sawyer Corporation's 2017 sales were $5 million. Its 2012 sales were $25 million. a, At what rate have sales been growing? ', Suppose someone made this statement: "Sales doubled in 5 years. This represents a ‘growth of 100% in 5 years; so dividing 100% by 5, we find the growth rate to be 20% per year.” Is the statement correct? EFFECTIVE RATE OF INTEREST Find the interest rates earned on each of the following: 1 You borrow $720 and promise to pay back $792 a the end of 1 year ». You lend $720 and the borrower promises to pay you §792 a the end of 1 year {You borrow $65,000 and promise to pay back $98,319 atthe end of 14 years 4. You borrow $15,000 and promise to make payments of $4058.60 atthe end ofeach year for 5 year. TIME FOR A LUMP SUMTO DOUBLE How Jong will it take $300 to double if it ears the following rates? Compounding occurs once a year. a. 6% b. 13% © 21% 4. 100% FUTURE VALUE OF AN ANNUITY Find the future values of these ortinary annuities. Compounding occurs once a yeas ‘a. $500 per year for 8 years at 14% b. $250 per year for 4 years at 7% . $700 per year for 4 years at 0% Rework parts a, b, and c assuming they are annuities due PRESENT VALUE OF AN ANNUITY Find the present oulwes of these ordinary annuities. Discounting occurs once a year. a. $600 per year for 12 years at 8% . $300 per year for 6 years at 4% $500 per year for 6 years at 0% 4. Rework parts a, b, and c assuming they are annuities due,186 Part Fundamental Concepts in Financial Management 5-20 521 5-22 PRESENT VALUE OF A PERPETUITY What is the present value of a $600 perpetuity if the interest rate is 5%? If interest rates doubled to 10%, what would its present value be? EFFECTIVE INTEREST RATE You borrow $230,000; the annual loan payments are $20,430.31 for 30 years. What interest rate are you being charged? UNEVEN CASH FLOW STREAM a. Find the present valus of the following cash flow streams ata 5% discount rate ° 1 2 3 4 5 -_—+-—__+—__+—__ +4 StreamA $0 $150. -$450«=«$450-«=«<$450-—«=«§50 Stream B $0 $250 $450, $450 $450 $150, 'b. What are the PVs of the streams at a 0% discount rate? FUTURE VALUE OF AN ANNUITY Your client is 26 years old. She wants to begin saving for retirement, withthe first payment to come ane year from now. She can save $8,000 per Year, and you advise her to invest it in the stock market, which you expect to provide an average retum of 10"% in the future. 4. If she follows your advice, how much money will she have at 65? 'b, How much will she have at 70? . She expects to live for 20 years if she retires at 65 and for 15 years if she retires at 7, If her investments continie to eam the same rate, how much will she be able to with- draw at the end of each Year after retirement at each retirement age? PV OF A CASH FLOW STREAM A rookie quarterback is negotiating his first NFL contract. His opportunity cost is 7%. He has been offered three possible 4-year contracts. Payments are guaranteed, and they would be made at the end of each year. Terms of each contract are as follows: 1 2 3 4 -_—_+____+_____; Contract! $3,000.00 $3,000.00 $3,000,000 $3,000,000 Contract2 $2,000.00 $3,000.00 $4,500,000 $5,500,000 Contract’3 $7,000000 $1,000.00 $1,000,000 $1,000,000 As his adviser, which contract would you recommend that he accept? EVALUATING LUMP SUMS AND ANNUITIES Kristina just won the lottery, and she must choose among three award options. She can elect to receive a lump sum today of $62 million, to receive 10 end-of-year payments of $9.5 million, or to receive 30 end-of-year payments of $5.6 million. ‘If she thinks she can earn 7% annually, which should she choose? », Lf she expects to earn 8% annually, which is the best choice? . Ishe expects to earn 9% annually, which option would you recommend? . Explain how interest rates influence her choice. LOAN AMORTIZATION Jan sold her house on December 31 and took a $10,000 mortgage as part of the payment. The 10-year mortgage has a 10% nominal interest rate, but it calls for semiannual payments beginning next june 30. Next year Jan must report on Schedule B of ‘her IRS Form 1040 the amount of interest that was inclided in the two payments she received during the year. ‘a, What is the dollar amount of each payment Jan receives? >, How much interest was included in the first payment? How much repayment of prin- cipal was included? How do these values change for the second payment? How much interest must Jan report on Schedule B for the first year? Will her interest income be the same next year? . Ifthe payments are constant, why does the amount of interest income change over time?5:23 5-24 525 5-26 Challenging 5-27 Problems 27-40 5-28 5-29 5-30 Chapter 5 Time Value of Money FUTURE VALUE FOR VARIOUS COMPOUNDING PERIODS. Find the amount to which $500 will grow under each of these conditions: 12% compounded annually for 5 years 12% compounded semiannually for 5 years 12% compounded quarterly for 5 years 12% compounded monthly for 5 years 12% compounded daily for 5 years Why does the observed pattern of FVs occur? PRESENT VALUE FOR VARIOUS DISCOUNTING PERIODS Find the present value of $500 due in the Future under each of these conditions: ‘2, 12% nominal rate, semiannual compounding, discounted back 5 years . 12% nominal rate, quarterly compounding, discounted back 5 years 12% nominal rate, monthly compounding, discounted back 1 year 4. Why do the differences in the PVs occur? FUTUREVALUE OF ANANNUITY Find the future values ofthe following ordinary annuities: 4. FV of $400 paid each 6 months for 5 years at a nominal rate of 12% compounded semiannually b. EV of $200 paid each 3 months for 5 years, quarterly These annuities receive the same amount of cash during the 5-year period and earn interest at the same nominal rate, yet the annuity in part b ends up larger than the one in part a, Why does this occur? nominal rate of 12% compounded PVANDLOANELIGIBILITY You have saved $4,000 for a down payment on a new car: The largest monthly payment you can afford is $350. The loan will have a 12% APR based on. end/-of-month payments, What is the most expensive car you can afford if you finance it for 48 months? For 60 months? EFFECTIVE VERSUS NOMINAL INTEREST RATES Bank A pays 2% interest compounded annually on deposits, while Bank B pays 1.75% compounded daily 1a. Based on the EAR (or EFF%), which bank should you use? . Could your choice of banks be influenced by the fact that you might want to withdraw ‘your funds during the year as opposed to at the end of the year? Assume that your funds must be left on deposit during an entire compounding period in order to receive any interest. NOMINAL INTEREST RATE AND EXTENDING CREDIT Asa jewelry store manager, you want to offer credit, with interest on outstanding balances paid monthly. To carry receivables, you must borrow funds from your bank at a nominal 9%, monthly compounding. To offset Your overhead, you want to charge your customers an EAR (or EFE%) that is 37% more than, the bank is charging you. What APR rate should you charge your customers? BUILDING CREDIT COST INTO PRICES. Your firm sells for cash only, but itis thinking of offering credit, allowing customers 90 days to pay, Customers understand the time value of money, so they would all wait and pay on the 90th day. To carry these receivables, you would have to borrow funds from your bank at a nominal 9%, daily compounding based, on a 360-day year. You want to increase your base prices by exactly enough to offset your bank interest cost. To the closest whole percentage point, by how much should you raise your product prices? REACHING A FINANCIAL GOAL Allison and Leslie, who are twins, just received $10,000 each for their 25th birthday. They both have aspirations to become millionaires. Each plans to make a $5,000 annual contribution to her “early retirement fund” on her birthday, ‘beginning a year from today. Allison opened an account with the Safety First Bond Fund, ‘a mutual fund that invests in high-quality bonds whose investors have earned 8% per year in the past. Leslie invested in the New Issue Bio-Tech Fund, which invests in small, newly issued bio-tech stocks and whose investors have eamed an average of 13% per year in the fund's relatively short history 187188 Part Fundamental Concepts in Financial Management 5-31 5-32 5-33 5-34 5-35 5-36 5.37 4. Ifthe two women's funds earn the same returns in the future as inthe past, how old will each be when she becomes a millionaire? ». How large would Allison’s annual contributions have to be for her to become a rillionaire at the same age as Leslie, assuming their expected returns are realized? . Isit rational or irrational for Allison to invest in the bond fund rather than in stocks? REQUIRED LUMP SUM PAYMENT Starting next year, you will need $5,000 annwally for 4 years to complete your education. (One year from today you will withdraw the first $5,000,) Your uncle deposits an amount foday in a bank paying 6% annual interest, which will pro vide the needed $5,000 payments. ‘a. How large must the deposit be? ». How much willbe in the account immediately after you make the first withdrawal? REACHING AFINANCIALGOAL Six years from today you need $10,000. You plan to deposit $1,500 annually, with the first payment to be made a year from today, in an account that pays a 5% effective annual rate. Your last deposit, which will occur at the end of Year 6, ‘will be for less than $1,500 if less is needed to reach $10,000. How large will your last pay: ment be? FV OF UNEVEN CASH FLOW You want to buy a house within 3 years, and you are cur- rently saving for the down payment. You plan to save $9,000 at the end of the first yeas, and you anticipate that your annual savings will increase by 5% annually thereafter. Your expected annual return is 8%. How much will you have for a down payment at the end of Year 3? AMORTIZATION SCHEDULE 4 Set up an amortization schedule for a $19,000 loan to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 8% compounded annwally. 'b, What percentage of the payment represents interest and what percentage represents principal for each of the 3 years? Why do these percentages change over time? AMORTIZATION SCHEDULE WITH A BALLOON PAYMENT You want to buy a house that costs $140,000. You have $14,000 for a down payment, but your credit is such that mort- gage companies will not lend you the required $126,000. However, the realtor persuades the seller to take a $126,000 mortgage (called a seller take-back mortgage) ata rate of 5%, provided the loan is paid off in full in 3 years. You expect to inherit $140,000 in 3 years, but right now all you have is $14,000, and you can afforei to make payments of no more than, $23,000 per year given your salary. (The loan would call for monthly payments, but assume end-of-year annual payments to simplify things.) 4. Ifthe loan was amortized over 3 years, how large would each annual payment be? Could you afford those payments? ». Ifthe loan was amortized over 30 years, what would each payment be? Could you afford those payments? To satisfy the seller, the 30-year mortgage loan would be written asa balloon note, ‘which means that atthe end of the third year, you would have to make the regular ‘payment plus the remaining balance on the loan, What would the loan balance be at the end of Year 3, and what would the balloon payment be? NONANNUAL COMPOUNDING ‘a. You plan to make five deposits of $1,000 each, one every 6 months, with the fist pay- ‘ment being made in 6 months. You will then make no more deposits. Ifthe bank pays 6% nominal interest, compounded semiannually, how much will be in your account after 3 years? . One year from today you must make a payment of $4,000. To prepare for this pay ‘meni, you plan to make two equal quarterly deposits (at the end of Quarters 1 and 2) in a bank that pays 6% nominal interest compounded quarterly. How large must each of the two payments be? PAYING OFF CREDIT CARDS Simon recently received a credit card with an 18% nominal interest rate. With the card, he purchased an Apple iPhone 7 for $372.71. The minimum payment on the card is only S10 per month,