Chapter 5: Time Value of Money

I.True/False Questions

1 In an annuity due, the cash flows occur at the beginning of the period
The concept of the time value of money is that money today is worth more than the
2 same amount in the future
3 If the discount rate decreases, the present value of a given future amount decreases
Interest earned on the reinvestment of previous interest payments is called complex
4 interest.
A saving account at Bank A pays 6 percent interest, compounded annually. Bank B's
savings account pays 6 percent compounded semiannually. Bank B is paying twice as
5 much interest.

II.Short answer

Question 1: What is the concept of the time Value of Money?

Question 2: Which annuity has a higher future value: An annuity due or a similar ordinary
annuity? Explain.

Question 3: What is the Difference between Simple Interest and Compound Interest?

Question 4: You are considering two annuities, both of which pay a total of $50,000 over the
life of the annuity. Annuity A pays $5,000 at the end of each year for the next 10 years.
Annuity B pays $1,000 at the end of each year for the next 50 years. Which annuity has the
greater value today? Explain without calculation

III. Multiple Choice Question

1. You plan to analyze the value of an ordinary annuity investment by calculating the sum of
the present values of its expected cash flows. Which of the following would lower the
calculated value of the investment? Assume a positive interest rate.

A. The discount rate decreases.

B. The riskiness of the investment’s cash flows decreases.

C. Reducing the size of the annual payments by half (e.g., reducing the annual payment from
$100 to $50) while doubling the number of annual payments (e.g., doubling the number of
annual payments from 10 to 20).

D. Doubling the size of the annual payments (e.g., doubling the annual payment from $100 to
$200) while reducing the number of annual payments by half (e.g., reducing the number of
annual paymentsfrom 10 to 5)

2. Which of the following statements is CORRECT?

B. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the
series is by definition an annuity.

C. The cash flows for an ordinary annuity remain constant from period to period and they
occur at the end of each period.

D. If a series of equal cash flows occurs at regular intervals, such as once per year, then the
series must not be an annuity.

3. By increasing the number of compounding periods in a year, while holding the stated
annual interest rate constant, you will.....

A. decrease the effective annual rate

B. increase the effective annual rate

C. not change the effective annual rate

D. There is not enough information to answer the question

4. Which of the following statements is TRUE?

Statement I: The future value of a lump sum and the future value of an annuity will both
increase as you increase the interest rate.

Statement II: As you increase the length of time from now until the time of receipt of a lump
sum, the present value of the lump sum increases.

Statement III: The present value of a lump sum to be received at some point in the future
decreases as you increase the interest rate, but the present value of an annuity increases as you
increase the interest rate.

A. Statement I only

B. Statement II only

C. Statement III only

D. Statements I and II only

5. Which of the following best describes the structure of an annuity?

A. a series of payments to be received during a period of time.

B. a series of payments to be received at a common interval during a period of time.

D. the present value of a set of payments to be received during a future period of time.

6. Your bank account pays a 6% stated annual interest rate (or APR). The interest is
compounded quarterly.Which of the following statements is CORRECT?

A. The quarterly interest rate is 1.5% and the effective annual interest rate is 3%.

B. The quarterly interest rate is 6% and the effective annual interest rate is greater than 6%.

C. The quarterly interest rate is 1.5% and the effective annual interest rate is greater than 6%.

D. The quarterly interest rate is 3% and the effective annual interest rate is 6%.

7. Which of the following investments would have the highest future value at the end of 10
years? Assumethat the effective annual interest rate for all investments is the same and is
greater than zero.

A. Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10
payments).

B. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of
20 payments).

C. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a
total of 20payments).

D. Investment D pays $2,500 at the end of 10 years (just one payment).

8. Which of the following cannot be calculated?

A. The future value of an annuity at the end of its life.

B. The present value of an annuity.

C. The future value of a perpetuity at the end of its life.

D. The present value of a perpetuity.

9. What is the total amount accumulated after three years if someone invests $1,000 today
with a simple annual interest rate of 5 percent? With a compound annual interest rate of 5
percent?

A. $1,150, $1,103

B. $1,110, $1,158

C. $1,150, $1,158
D. $1,110, $1,103

10. Suppose an investor wants to have $10 million to retire 45 years from now. How much
would she have to invest today with an annual rate of return equal to 15 percent?

A. $18,561

B. $17,844

C. $20,003

D. $21,345

11. Which of the following is false?

A. The longer the time period, the smaller the present value, given a $100 future value and
holding the interest rate constant.

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

C. A future dollar is always less valuable than a dollar today if interest rates are positive.

D. The discount factor is the reciprocal of the compound factor.

12. Which of the following concepts is incorrect?

A. An ordinary annuity has payments at the end of each year.

B. An annuity due has payments at the beginning of each year.

C. A perpetuity is considered a perpetual annuity.

D. An ordinary annuity has a greater PV than an annuity due, if they both have the
same periodic payments, discount rate and time period.

13. Jan plans to invest an equal amount of $2,000 in an equity fund every year-end beginning
this year. The expected annual return on the fund is 15 percent. She plans to invest for 20
years. How much could she expect to have at the end of 20 years?

A. $237,620

B. $176,424

C. $204,887

D. $178,424

14. To triple $1 million, Mika invested today at an annual rate of return of 9 percent. How
long will it take Mika to achieve his goal?

A. 15.5 years

B. 13.9 years
C. 12.7 years

D. 10 years

15. Time value of money indicates that

A. A unit of money obtained today is worth more than a unit of money obtained in future

B. A unit of money obtained today is worth less than a unit of money obtained in future

C. There is no difference in the value of money obtained today and tomorrow

D. None of the above

16. Time value of money supports the comparison of cash flows recorded at different time
period by

A. Discounting all cash flows to a common point of time

B. Compounding all cash flows to a common point of time

C. Using either a or b

D. None of the above.

17. If the nominal rate of interest is 10% per annum and there is quarterly compounding, the
effective rate of interest will be:

A. 10% per annum

B. 10.10 per annum

C. 10.25%per annum

D. 10.38% per annum

18. Relationship between annual nominal rate of interest and annual effective rate of interest,
if frequency of compounding is greater than one:

A. Effective rate > Nominal rate

B. Effective rate < Nominal rate

C. Effective rate = Nominal rate

D. None of the above

A. Rs 19500

B. Rs 19400

C. Rs 19310

D. None of the above

20. If nominal rate of return is 10% per annum and annual effective rate of interest is 10.25%
per annum, determine the frequency of compounding:

A. 1

B. 2

C. 3

D. None of the above

22. In a typical loan amortization schedule, the dollar amount of interest paid each period...

A. increases with each payment

B. decreases with each payment

C. remains constant with each payment

D. A or C

23. In a typical loan amortization schedule, the total dollar amount of money paid each
period...

A. increases with each payment

B. decreases with each payment

C. remains constant with each payment

D. A or C

24. In 3 years you are to receive $5,000. If the interest rate were to suddenly increase, the
present value of that future amount to you would

A. Fall.
B. Rise.

C. Remain unchanged.

D. cannot be determined without more information.

25. With continuous compounding at 10 percent for 30 years, the future value of an initial
investment of 2000 is closest to

A. 34,898

B. 40,141

C. 164,500

D. 111,990

IV. Excersice

1. Janky Real Estate is considering selling an apartment property that it owns. A buyer is
willing to pay $2,000,000 for the property, all of which would be paid to Janky upfront
(today). Determine what Janky should do under the following scenarios.

a. Janky expects the property to generate a cash inflow of $150,000 every year, forever, with
the first cash flow occurring one year from today. The applicable discount rate is 10%.

b. Janky expects the property to generate a cash inflow of $150,000 one year from today, and
this amount will grow by approximately 3% every year thereafter, forever. The applicable
discount rate is 10%.

2. To supplement your planned retirement in exactly 42 years, you estimate that you need to
accumulate $1million by the end of 42 years from today. You plan to make equal annual end-
of-year deposits into an account paying 4 percent annual interest.

a. How large must the annual deposits be to create the $1 million amount by the end of 42
years?

b. If you can afford to deposit only $5,000 per year into the account, how much will you have
accumulated by the end of the forty-second year?

3. Mr. Weasley is borrowing $600,000 to buy a car. The terms of the loan call for equal
annual payments for 5 years at 8% interest. What is the amount of each payment?

4. Assume that you just won the state lottery. Your prize can be taken either in the form of
$40,000 at the end of each of the next 25 years or as a single payment of $500,000 paid
immediately.

a. If you expect to be able to earn 5 percent annually on your investments over the next 25
years (i.e. 5percent is the appropriate discount rate), ignoring taxes and other considerations,
which alternative should you take? Assume that your only decision criteria is selecting the
option with the highest present value.
b. Would your decision in part (a) be altered if you could earn 7 percent rather than 5 percent
on your investments over the next 25 years?