Chapter 5: Time Value of Money Problems

Book Title: Fundamentals of Financial Management

Printed By: Gaby Maldonado Martin (gm57@illinois.edu)
© 2022 Cengage Learning, Cengage Learning

Chapter Review
Problems

Easy Problems 1-8

5-1. 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?

5-2. 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?

5-3. FINDING THE REQUIRED INTEREST RATE Your parents will retire in 19
years. They currently have $350,000 saved, and they think they will need
$800,000 at retirement. What annual interest rate must they earn to reach
their goal, assuming they don’t save any additional funds?

5-4. TIME FOR A LUMP SUM TO DOUBLE If you deposit money today in an
account that pays 4% annual interest, how long will it take to double your
money?

5-5. TIME TO REACH A FINANCIAL 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?

5-6. 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?

5-7. PRESENT AND FUTURE VALUES OF A CASH FLOW STREAM An

investment will pay $150 at the end of each of the next 3 years, $250 at 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 is its present value?
Its future value?

5-8. 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?

Intermediate Problems 9-26

5-9. PRESENT AND FUTURE VALUES FOR DIFFERENT PERIODS Find the
following values using the equations and then a financial calculator.
Compounding/discounting occurs annually.

a. An initial $600 compounded for 1 year at 6%

b. An initial $600 compounded for 2 years at 6%

c. The present value of $600 due in 1 year at a discount rate of 6%

d. The present value of $600 due in 2 years at a discount rate of 6%

5-10. PRESENT AND FUTURE VALUES FOR DIFFERENT INTEREST RATES
Find the following values. Compounding/discounting occurs annually.

a. An initial $200 compounded for 10 years at 4%

b. An initial $200 compounded for 10 years at 8%

c. The present value of $200 due in 10 years at 4%

d. The present value of $1,870 due in 10 years at 8% and at 4%

e. Define present value and illustrate it using a time line with data from part d.
How are present values affected by interest rates?

5-11. GROWTH RATES Sawyer Corporation’s 2020 sales were $5 million. Its
2015 sales were $2.5 million.

a. At what rate have sales been growing?

b. 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?

5-12. EFFECTIVE RATE OF INTEREST Find the interest rates earned on each
of the following:

a. You borrow $720 and promise to pay back $792 at the end of 1 year.

b. You lend $720, and the borrower promises to pay you $792 at the end of 1
year.

c. You borrow $65,000 and promise to pay back $98,319 at the end of 14
years.

d. You borrow $15,000 and promise to make payments of $4,058.60 at the

end of each year for 5 years.

5-13. TIME FOR A LUMP SUM TO DOUBLE How long will it take $300 to
double if it earns the following rates? Compounding occurs once a year.

a. 6%

b. 13%

c. 21%

d. 100%

5-14. FUTURE VALUE OF AN ANNUITY Find the future values of these

ordinary annuities. Compounding occurs once a year.

a. $500 per year for 8 years at 14%

b. $250 per year for 4 years at 7%

c. $700 per year for 4 years at 0%

d. Rework parts a, b, and c assuming they are annuities due.

5-15. PRESENT VALUE OF AN ANNUITY Find the present values of these

ordinary annuities. Discounting occurs once a year.

a. $600 per year for 12 years at 8%

 a. $600 per year for 12 years at 8%

b. $300 per year for 6 years at 4%

c. $500 per year for 6 years at 0%

d. Rework parts a, b, and c assuming they are annuities due.

5-16. 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?

5-17. 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?

5-18. UNEVEN CASH FLOW STREAM

a. Find the present values of the following cash flow streams at a 5% discount
rate.

b. What are the PVs of the streams at a 0% discount rate?

5-19. FUTURE VALUE OF AN ANNUITY Your client is 26 years old. She wants
to begin saving for retirement, with the first payment to come one 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 return of 10% in the
future.

a. If she follows your advice, how much money will she have at 65?

b. How much will she have at 70?

c. She expects to live for 20 years if she retires at 65 and for 15 years if she
retires at 70. If her investments continue to earn the same rate, how much
will she be able to withdraw at the end of each year after retirement at each
retirement age?

5-20. 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:

As his adviser, which contract would you recommend that he accept?

5-21. 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.

a. If she thinks she can earn 7% annually, which should she choose?

b. If she expects to earn 8% annually, which is the best choice?

 b. If she expects to earn 8% annually, which is the best choice?

c. If she expects to earn 9% annually, which option would you recommend?

d. Explain how interest rates influence her choice.

5-22. 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 included in the two payments she received during
the year.

a. What is the dollar amount of each payment Jan receives?

b. How much interest was included in the first payment? How much
repayment of principal was included? How do these values change for the
second payment?

c. How much interest must Jan report on Schedule B for the first year? Will
her interest income be the same next year?

d. If the payments are constant, why does the amount of interest income
change over time?

5-23. FUTURE VALUE FOR VARIOUS COMPOUNDING PERIODS Find the

amount to which $500 will grow under each of these conditions:

a. 12% compounded annually for 5 years

b. 12% compounded semiannually for 5 years

c. 12% compounded quarterly for 5 years

d. 12% compounded monthly for 5 years

e. 12% compounded daily for 5 years

f. Why does the observed pattern of FVs occur?

5-24. PRESENT VALUE FOR VARIOUS DISCOUNTING PERIODS Find the

present value of $500 due in the future under each of these conditions:

a. 12% nominal rate, semiannual compounding, discounted back 5 years

b. 12% nominal rate, quarterly compounding, discounted back 5 years

c. 12% nominal rate, monthly compounding, discounted back 1 year

d. Why do the differences in the PVs occur?

5-25. FUTURE VALUE OF AN ANNUITY Find the future values of the following
ordinary annuities:

a. FV of $400 paid each 6 months for 5 years at a nominal rate of 12%

compounded semiannually

b. FV of $200 paid each 3 months for 5 years at a nominal rate of 12%

compounded quarterly

c. 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?
 up larger than the one in part a. Why does this occur?

5-26. PV AND LOAN ELIGIBILITY 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?

Challenging Problems 27-40

5-27. EFFECTIVE VERSUS NOMINAL INTEREST RATES Bank A pays 2%

interest compounded annually on deposits, while Bank B pays 1.75%
compounded daily.

a. Based on the EAR (or EFF%), which bank should you use?

b. 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.

5-28. NOMINAL INTEREST RATE AND EXTENDING CREDIT As a 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 EFF%) that is 3% more than the bank is
charging you. What APR rate should you charge your customers?

5-29. BUILDING CREDIT COST INTO PRICES Your firm sells for cash only, but
it is 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?

5-30. 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 earned an average of
13% per year in the fund’s relatively short history.

a. If the two women’s funds earn the same returns in the future as in the past,
how old will each be when she becomes a millionaire?

b. How large would Allison’s annual contributions have to be for her to

become a millionaire at the same age as Leslie, assuming their expected
returns are realized?

c. Is it rational or irrational for Allison to invest in the bond fund rather than in
stocks?

5-31. REQUIRED LUMP SUM PAYMENT Starting next year, you will need
$5,000 annually for 4 years to complete your education. (One year from today
 $5,000 annually for 4 years to complete your education. (One year from today
you will withdraw the first $5,000.) Your uncle deposits an amount today in a
bank paying 6% annual interest, which will provide the needed $5,000
payments.

a. How large must the deposit be?

b. How much will be in the account immediately after you make the first
withdrawal?

5-32. REACHING A FINANCIAL GOAL 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 payment be?

5-33. FV OF UNEVEN CASH FLOW You want to buy a house within 3 years,
and you are currently saving for the down payment. You plan to save $9,000
at the end of the first year, 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?

5-34. AMORTIZATION SCHEDULE

a. 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 annually.

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?

5-35. 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 mortgage 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) at a 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 afford to make payments of no
more than $22,000 per year given your salary. (The loan would call for
monthly payments, but assume end-of-year annual payments to simplify
things.)

a. If the loan was amortized over 3 years, how large would each annual
payment be? Could you afford those payments?

b. If the loan was amortized over 30 years, what would each payment be?
Could you afford those payments?

c. To satisfy the seller, the 30-year mortgage loan would be written as a

balloon note, which means that at the 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?

5-36. NONANNUAL COMPOUNDING

a. You plan to make five deposits of $1,000 each, one every 6 months, with
the first payment being made in 6 months. You will then make no more
 deposits. If the bank pays 6% nominal interest, compounded semiannually,
how much will be in your account after 3 years?

b. One year from today you must make a payment of $4,000. To prepare for
this payment, 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?

5-37. PAYING OFF CREDIT CARDS Simon recently received a credit card with
an 18% nominal interest rate. With the card, he purchased an Apple iPhone
11 for $700. The minimum payment on the card is $20 per month.

a. If Simon makes the minimum monthly payment and makes no other

charges, how many months will it be before he pays off the card?

b. If Simon makes monthly payments of $70, how many months will it be

before he pays off the debt?

c. How much more in total payments will Simon make under the $20-a-month
plan than under the $70-a-month plan? Make sure you use three decimal
places for N.

5-38. PV AND A LAWSUIT SETTLEMENT It is now December 31, 2020 ,

and a jury just found in favor of a woman who sued the city for injuries
sustained in a January 2019 accident. She requested recovery of lost wages
plus $300,000 for pain and suffering plus $60,000 for legal expenses. Her
doctor testified that she has been unable to work since the accident and that
she will not be able to work in the future. She is now 62, and the jury decided
that she would have worked for another 3 years. She was scheduled to have
earned $36,000 in 2019. (To simplify this problem, assume that the entire
annual salary amount would have been received on December 31, 2019.) Her
employer testified that she probably would have received raises of 3% per
year. The actual payment for the jury award will be made on December 31,
2021. The judge stipulated that all dollar amounts are to be adjusted to a
present value basis on December 31, 2021, using an 8% annual interest rate
and using compound, not simple, interest. Furthermore, he stipulated that the
pain and suffering and legal expenses should be based on a December 31,
2020, date. How large a check must the city write on December 31, 2021?

5-39. REQUIRED ANNUITY PAYMENTS Your father is 50 years old and will
retire in 10 years. He expects to live for 25 years after he retires, until he is 85.
He wants a fixed retirement income that has the same purchasing power at
the time he retires as $50,000 has today. (The real value of his retirement
income will decline annually after he retires.) His retirement income will begin
the day he retires, 10 years from today, at which time he will receive 24
additional annual payments. Annual inflation is expected to be 4%. He
currently has $90,000 saved, and he expects to earn 8% annually on his
savings. How much must he save during each of the next 10 years (end-of-
year deposits) to meet his retirement goal?

5-40. REQUIRED ANNUITY PAYMENTS A father is now planning a savings

program to put his daughter through college. She is 13, plans to enroll at the
university in 5 years, and should graduate 4 years later. Currently, the annual
cost (for everything—food, clothing, tuition, books, transportation, and so
forth) is $12,000, but these costs are expected to increase by 6% annually.
The college requires total payment at the start of the year. She now has
$10,000 in a college savings account that pays 9% annually. Her father will
 $10,000 in a college savings account that pays 9% annually. Her father will
make six equal annual deposits into her account; the first deposit today and
the sixth on the day she starts college. How large must each of the six
payments be? (Hint: Calculate the cost [inflated at 6%] for each year of
college and find the total present value of those costs, discounted at 9%, as of

the day she enters college. Then find the compounded value of her initial
$10,000 on that same day. The difference between the PV of costs and the
amount that would be in the savings account must be made up by the father’s
deposits, so find the six equal payments that will compound to the required
amount.)

Chapter 5: Time Value of Money Problems

Book Title: Fundamentals of Financial Management
Printed By: Gaby Maldonado Martin (gm57@illinois.edu)
© 2022 Cengage Learning, Cengage Learning

© 2024 Cengage Learning Inc. All rights reserved. No part of this work may by reproduced or used in any form or by any means -
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