Chapter 5

5.9 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%

a. FV

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = $600(1 + 6%)1 = $636

b. FV

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = $600(1 + 6%)2 = $674.16

c. PV
𝐹𝑉 $600
𝑃𝑉 = 𝑛
= = $566.03
(1 + 𝑖) (1 + 6%)1
d. PV
𝐹𝑉 $600
𝑃𝑉 = 𝑛
= = $534
(1 + 𝑖) (1 + 6%)2

5.10 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?

a. FV

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = $200(1 + 4%)10 = $296.05

b. FV

𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 = $200(1 + 8%)10 = $431.78

c. PV
 𝐹𝑉 $200
𝑃𝑉 = 𝑛
= = $135.11
(1 + 𝑖) (1 + 4%)10
d. PV of $1,870 due in 10 years at 8%
𝐹𝑉 $1,870
𝑃𝑉 = 𝑛
= = $866.17
(1 + 𝑖) (1 + 8%)10
PV of $1,870 due in 10 years at 4%
𝐹𝑉 $1,870
𝑃𝑉 = 𝑛
= = $1,263.3
(1 + 𝑖) (1 + 4%)10
e. Timeline of $1,870 due in 10 years at 8%

Timeline of $1,870 due in 10 years at 4%

The worth of money is different at different time intervals. The value of $1 is different from the value of
$1 after some time (Future). The discounting method is used to calculate the present value of the
money, and compounding is used to calculate the future value of the money. The future value will be
higher at higher interest rate and lower at lower interest rate.

The present value will be lower at higher discount rate, and higher at lower discount rate because the
higher the discounting factor in denominator of the formula, lower will be the value.

5.11 Sawyer Corporation’s 2017 sales were $5 million. Its 2012 sales were $2.5 million.
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?

a. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛
 ↔ $5,000,000 = $2,500,000(1 + 𝑖)5 ↔ $2,500,000(1 + 𝑖)5 = $5,000,000 ↔ (1 + 𝑖)5 = 2
1 1
↔ 1 + 𝑖 = 25 ↔ 𝑖 = 25 − 1 = 0.1486 = 14.86%
b. The statement if not correct

5.12 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

a. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $792 = $720(1 + 𝑖)1 ↔ $720(1 + 𝑖) = $792 ↔ 1 + 𝑖 = 1.1 ↔ 𝑖 =

1.1 − 1 = 0.1 = 10%

b. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $792 = $720(1 + 𝑖)1 ↔ $720(1 + 𝑖) = $792 ↔ 1 + 𝑖 = 1.1 ↔ 𝑖 =

1.1 − 1 = 0.1 = 10%

c. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $98,319 = $65,000(1 + 𝑖)14 ↔ $65,000(1 + 𝑖)14 = $98,319 ↔

1 1
(1 + 𝑖)14 = 1.51 ↔ 1 + 𝑖 = 1.5114 ↔ 𝑖 = 1.5114 − 1 = 0.03 = 3%

1 1
1− 1−
(1+𝑖)𝑛 (1+𝑖)5
d. 𝑃𝑉𝐴𝑁 = 𝑃𝑀𝑇 [ 𝑖
] ↔ $15,000 = $4,058.6 × [ 𝑖
] ↔ 𝑖 = 0.11 = 11%

5.13 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%
 a. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $600 = $300(1 + 6%)𝑛 ↔ (1 + 6%)𝑛 = 2 ↔ 𝑛 ln(1 + 6%) =
ln⁡(2)
ln(2) ↔ 𝑛 = ln⁡(1+6%) = 11.9 (years)
b. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $600 = $300(1 + 13%)𝑛 ↔ (1 + 13%)𝑛 = 2
ln⁡(2)
↔ 𝑛 ln(1 + 13%) = ln(2) ↔ 𝑛 = ln⁡(1+13%) = 5.67 (years)
c. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $600 = $300(1 + 21%)𝑛 ↔ (1 + 21%)𝑛 = 2
ln⁡(2)
↔ 𝑛 ln(1 + 21%) = ln(2) ↔ 𝑛 = ln⁡(1+21%) = 3.64 (years)
d. 𝐹𝑉 = 𝑃𝑉(1 + 𝑖)𝑛 ↔ $600 = $300(1 + 100%)𝑛 ↔ (1 + 100%)𝑛 = 2
ln⁡(2)
↔ 𝑛 ln(1 + 100%) = ln(2) ↔ 𝑛 = ln⁡(1+100%) = 1 (year)

5.14 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.

(1+𝑖)𝑛 −1 (1+14%)8 −1
a. 𝐹𝑉𝐴8 = 𝑃𝑀𝑇 × [ ] = $500 × [ ] = $6,616.38
𝑖 14%
(1+𝑖)𝑛 −1 (1+7%)4 −1
b. 𝐹𝑉𝐴4 = 𝑃𝑀𝑇 × [ ] = $250 × [ ] = $1,109.98
𝑖 7%
c. 𝐹𝑉𝐴4 = $700 × 4 = $2,800
d. $500 per year for 8 years at 14%

(1 + 𝑖)𝑛 − 1 (1 + 14%)8 − 1
𝐹𝑉𝐴8 = 𝑃𝑀𝑇 × [ ] × (1 + 𝑖) = $500 × [ ] × (1 + 14%) = $7,542.67
𝑖 14%

$250 per year for 4 years at 7%

(1 + 𝑖)𝑛 − 1 (1 + 7%)4 − 1
𝐹𝑉𝐴4 = 𝑃𝑀𝑇 × [ ] × (1 + 𝑖) = $250 × [ ] × (1 + 7%) = $1,187.68
𝑖 7%

$700 per year for 4 years at 0%

𝐹𝑉𝐴4 = $700 × 4 = $2,800

5.15 Find the present values of these ordinary annuities. Discounting occurs once a year.
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.
 1 1
1−(1+𝑖)𝑛 1−
(1+8%)12
a. 𝑃𝑉𝐴 = 𝑃𝑀𝑇 × [ 𝑖
] = $600 × [ 8%
] = $4,521.65
1 1
1−(1+𝑖)𝑛 1−
(1+4%)6
b. 𝑃𝑉𝐴 = 𝑃𝑀𝑇 × [ 𝑖
] = $300 × [ 4%
] = $1,572.64
c. 𝑃𝑉𝐴 = $500 × 6 = $3,000
d. $600 per year for 12 years at 8%
1 1
1− 1−
(1 + 𝑖)𝑛 (1 + 8%)12
𝑃𝑉𝐴𝑑𝑢𝑒 = 𝑃𝑀𝑇 × [ ] × (1 + 𝑖) = $600 × [ ] × (1 + 8%) = $4,883.38
𝑖 8%

$300 per year for 6 years at 4%

1 1
1− 1−
(1 + 𝑖)𝑛 (1 + 4%)6
𝑃𝑉𝐴𝑑𝑢𝑒 = 𝑃𝑀𝑇 × [ ] × (1 + 𝑖) = $300 × [ ] × (1 + 4%) = $1,635.55
𝑖 4%

$500 per year for 6 years at 0%

𝑃𝑉𝐴 = $500 × 6 = $3,000

5.16 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?
𝑃𝑀𝑇 $600
𝑃𝑉 = = = $12,000
𝑖 5%
𝑃𝑀𝑇 $600
𝑃𝑉 = = = $6,000
𝑖 10%
So when the interest rate doubled, the present value of perpetuities halved.

5.17 You borrow $230,000; the annual loan payments are $20,430.31 for 30 years. What interest
rate are you being charged?
1 1
1− 1−
(1 + 𝑖)𝑛 (1 + 𝑖)30
𝑃𝑉𝐴𝑁 = 𝑃𝑀𝑇 [ ] ↔ $230,000 = $20,430.31 × [ ] ↔ 𝑖 = 0.08 = 8%
𝑖 𝑖
 $150 $450 $450 $450 $250
a. Stream A: 𝑃𝑉 = + + + + = $1,505.84
(1+5%)1 (1+5%)2 (1+5%)3 (1+5%)4 (1+5%)5
$250 $450 $450 $450 $150
Stream B: 𝑃𝑉 = (1+5%)1
+ (1+5%)2 + (1+5%)3 + (1+5%)4 + (1+5%)5 = $1,522.73
$150 $450 $450 $450 $250
b. Stream A: 𝑃𝑉 = (1+0%)1
+ (1+0%)2 + (1+0%)3 + (1+0%)4 + (1+0%)5 = $1,750
$250 $450 $450 $450 $150
Stream B: 𝑃𝑉 = + + + + = $1,750
(1+0%)1 (1+0%)2 (1+0%)3 (1+0%)4 (1+0%)5

5.19 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?

a. FV

PMT = $8,000

I = 10%

N = 65 – 26 = 39

(1 + 𝑖)𝑛 − 1 (1 + 10%)39 − 1
𝐹𝑉𝐴 = 𝑃𝑀𝑇 × [ ] = $8,000 × [ ] = $3,211,582.22
𝑖 10%
 b. FV

PMT = $8,000

I = 10%

N = 70 – 26 = 44

(1 + 𝑖)𝑛 − 1 (1 + 10%)44 − 1
𝐹𝑉𝐴 = 𝑃𝑀𝑇 × [ ] = $8,000 × [ ] = $5,221,126.09
𝑖 10%

c. If she retires at 65 years old

PV = $3,211,582.22

I = 10%

N = 20
1 1
1− 1−
(1 + 𝑖)𝑛 (1 + 10%)20
𝑃𝑉𝐴𝑁 = 𝑃𝑀𝑇 [ ] ↔ $3,211,582.22 = 𝑃𝑀𝑇 [ ] ↔ 𝑃𝑀𝑇 = $377.231.24
𝑖 10%

If she retires at 70 years old

PV = $5,221,126.09

I = 10%

N = 15
1 1
1− 1−
(1 + 𝑖)𝑛 (1 + 10%)15
𝑃𝑉𝐴𝑁 = 𝑃𝑀𝑇 [ ] ↔ $5,221,126.09 = 𝑃𝑀𝑇 [ ] ↔ 𝑃𝑀𝑇 = $686.441.17
𝑖 10%
Contract 1: PV
1 1
1− 𝑁 1−
(1 + 𝐼) (1 + 7%)4
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $3,000,000 × [ ] = $10,161,633.77
𝐼 7%

Contract 2: PV

Contract 3: PV
 1 1
1− 𝑁 1−
(1 + 𝐼) (1 + 7%)3
𝑃𝑉1 = 𝑃𝑀𝑇 × [ ] = $1,000,000 × [ ] = $2,624,316.04
𝐼 7%

𝐹𝑉 $9,624,316.04
𝑃𝑉 = 𝑁
= = $8,994,687.89
(1 + 𝐼) (1 + 7%)1

 Since present worth of payments in contract 2 is highest, hence contract 2 should be accepted.

5.21 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?
c. If she expects to earn 9% annually, which option would you recommend?
d. Explain how interest rates influence her choice.

a. If I = 7%

Option 1: PV = $62,000,000

Option 2:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 7%)10
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $9,500,000 × [ ] = $66,724,024.64
𝐼 7%

Option 3:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 7%)30
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $5,600,000 × [ ] = $69,490,630.63
𝐼 7%

 If I = 7%, she should choose option 3 with 30 end-of-year payments of $5.6 million because PV
of this option is the highest.

b. If I = 8%
Option 1: PV = $62,000,000

Option 2:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 8%)10
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $9,500,000 × [ ] = $63,745,773.29
𝐼 8%

Option 3:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 8%)30
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $5,600,000 × [ ] = $63,043,586.72
𝐼 8%

 If I = 8%, she should choose option 2 with 10 end-of-year payments of $9.5 million because PV
of this option is the highest.

c. If I = 9%

Option 1: PV = $62,000,000

Option 2:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 9%)10
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $9,500,000 × [ ] = $60,967,748.16
𝐼 9%

Option 3:
1 1
1− 1−
(1 + 𝐼)𝑁 (1 + 9%)30
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] = $5,600,000 × [ ] = $657,532,462.64
𝐼 9%

 If I = 9%, she should choose option 1 with a lump sum today of $62 million because PV of this
option is the highest.
d. If the interest rate is low, then longer period annuities are the best option for receiving
payments in terms of annuities. But if interest rates are high then it is better to take the lump
sum payment today and invest those funds herself and earn higher interest.

5.22 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 receiving?
 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?

a. PMT

N = 10 x 2 = 20
10%
I= = 5%
2

PV = $10,000
1 1
1− 𝑁 1−
(1 + 𝐼) (1 + 5%)20
𝑃𝑉 = 𝑃𝑀𝑇 × [ ] ↔ 10,000 = 𝑃𝑀𝑇 × [ ] ↔ 𝑃𝑀𝑇 = $802.43
𝐼 5%

b. Interest
𝑃𝑉×10% $10,000⁡×10%
Interest of first payment = 2
= 2
= $500

Payment of principal of first payment = Payment – Interest = $802.43 - $500 = $302.43

𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔⁡𝑏𝑎𝑙𝑎𝑛𝑐𝑒⁡×10% ($10,000−$302.43)×10%
Interest of second payment = = = $484.88
2 2

Payment of principal of second payment = $802.43 - $484.88 = $317.55

c. Total interest amount that is paid in the first year = Interest of first payment + Interest of second
payment = $500 + $484.88 = $984.88

The interest amount decreases as the periods increase. Therefore, it does not remains constant.

d. Since the loan is amortized as the number of periods increase, the principal amount is also
repaid along with the interest payment. So, the principal amount decreases period after period.
Since, we calculate the interest on the principal amount, the amount of interest income also
changes.

5.23 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?

a. 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼)𝑁 = $500 × (1 + 12%)5 = $881.17

b. 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼)𝑁 = $500 × (1 + 12%)2×5 = $895
c. 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼)𝑁 = $500 × (1 + 12%)4×5 = $903.06
d. 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼)𝑁 = $500 × (1 + 12%)12×5 = $908.34
e. 𝐹𝑉 = 𝑃𝑉 × (1 + 𝐼)𝑁 = $500 × (1 + 12%)365×5 = $910.97
f. This increasing pattern occurs because the number of compounding periods are increasing and
also the compound interest takes into account all the previous interests earned. Hence higher
the compounding period higher would the interest leading to higher Future Value.

5.24 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?

𝐹𝑉 $500
a. 𝑃𝑉 = = 12% 2×5 = $279.19
(1+𝐼)𝑁 (1+ )
2
𝐹𝑉 $500
b. 𝑃𝑉 = (1+𝐼)𝑁 = 12% 4×5 = $276.84
(1+ )
4
𝐹𝑉 $500
c. 𝑃𝑉 = (1+𝐼)𝑁 = 12% 12 = $443.72
(1+ )
12
d. Differences are due to the time value of money, the longer the period, the lower the present
value of investment will be. It also changes for number of times compounded.
5.25 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?

a. FV
 12%
(1 + 𝐼)𝑁 − 1 (1 + 2 )5×2 − 1
𝐹𝑉 = 𝑃𝑀𝑇 × ( ) = $400 × ( ) = $5,272.32
𝐼 12%
2
b. FV
12%
(1 + 𝐼)𝑁 − 1 (1 + 4 )5×4 − 1
𝐹𝑉 = 𝑃𝑀𝑇 × ( ) = $200 × ( ) = $5,374.08
𝐼 12%
4
c. The annuity in part b ends up higher because the compounding is done more frequently (four
times a year as compared to twice a year). Hence, although the total cash invested and nominal
rate are same, the future value accumulated will be more in option b because the speed of
earning interest is faster.

5.26 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?

48 months

N = 48
12%
I= = 1%
12

PMT = $350
1 1
1− 𝑁 1−
(1 + 𝑖) (1 + 1%)48
𝑃𝑉𝐴 = 𝑃𝑀𝑇 [ ] = 350 [ ] = $13,290.89
𝑖 1%

Most expensive car amount = Down payment + PV = $4,000 + $13,290.89 = $17,290.89

 The most expensive car that the individual can afford for 48 months is worth $17,290.89

60 months

N = 60
12%
I= 12
= 1%

PMT = $350
1 1
1− 1−
(1 + 𝑖)𝑁 (1 + 1%)60
𝑃𝑉𝐴 = 𝑃𝑀𝑇 [ ] = 350 [ ] = $15,734.26
𝑖 1%
Most expensive car amount = Down payment + PV = $4,000 + $15,734.26 = $19,734.26

 The most expensive car that the individual can afford for 60 months is worth $19,734.26

5.27 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.

a. Bank A:

EAR = 2%

Bank B:

1+1.75% 365
(1 + EAR) = ( 365
) = 1.7654%

 Interest on deposit from Bank A is higher; Bank should be opted.

b. When withdrawal happened at middle of the period, Bank A does not provide any interest in
that period; however, bank B does provide return because of daily compounding period.
Drawback based on how many times withdrawal expected need to be considered and
considering net effect on interest payment, bank will be opted. Most probably Bank B would be
better in such scenario.