Chapter 5: Time Value of Money

I.True/False Questions

1 Finding the present value is simply the reverse of compounding. TRUE

The concept of the time value of money is a means to bring together the present and
2 the future. TRUE
3 If the discount rate decreases, the present value of a given future amount decreases FALSE
4 The present value interest factor for a dollar on hand today is 0. FALSE
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. FALSE

II. Short answer

Question 01: What is the Time Value of Money?

Answer: In general, the concept of the time value of money refers to the idea that the value of
money received today is greater than the value of money received a few days later or that the
value of money received in the future is less than the value of money received now.

From a financial standpoint, the value of money changes with time, so a $100 now and $100
four years later is not the same. A hundred dollars of that time is more valuable. It’s a concept
known as the time value of money.

Question 2: What are the Features of Future Value?

Answer: The top six features of future value are as follows:

● The future value is determined by adding interest to the current value.
● The value of money increases according to the future value.
● If the number of compounds increases, the amount of future value will increase.
● If the number of years increases, the amount of value will increase in the future.
● The higher the interest rate, the higher the future value.

Question 3: What is the Difference between Present Value and Future Value?

Answer: The top 3 differences between and future value are as follows:

The present value is the amount of money that needs to be invested in receiving a certain
amount of money in the future. On the other hand, if you deposit a certain amount of money
at present, the amount of money available after a certain period in the future is called future
value.

The purpose of present value is to save money at current prices to save a certain amount of
money in the future. On the other hand, the main purpose of future value is to deposit a
certain amount of money to perform a task.
The present value concept is called discounting, while the method of determining future value
is called compounding.

Question 4: What is the Difference between Simple Interest and Compound Interest?

Answer: The top 3 differences between simple interest and compound interest are as follows:

Simple interest is the interest charged on the principal amount at a fixed rate every year. On
the other hand, compound interest is the addition of interest to the principal sum of a loan or
deposit, or in other words, interest on interest.

In the case of simple interest, interest is charged only on the principal amount. On the other
hand, compound interest is always charged at a fixed rate on the principal plus interest in
compound interest.

In the case of simple interest, the amount of interest is comparatively less. On the other hand,
in the case of compound interest, interest is higher than simple interest.

Question 5: What is the Main Similarities and Differences between Annual Rate and
Effective Annual Rate (EAR)?

Answer: The main similarities between the annual rate and effective annual rate (EAR) are
nominal and effective interest rates are always equal in annual compounding.

The main difference between the annual rate and the effective annual rate (EAR) is that the
effective interest rate increases when the number of compounding increases.

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?

A. The cash flows of an annuity due occur at the end of each period.

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
futuredecreases 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.

C. a series equal 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

19. Mr. X takes a loan of Rs 50,000 from HDFC Bank. The rate of interest is 10% per annum.
The first installment will be paid at the end of year 5. Determine the amount of equal annual
installments if Mr. X wishes to repay the amount in five installments.

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

21. You can use … to roughly estimate how many years a given sum of money must earn at a
given compound annual interest rate in order to double that initial amount .

A.Rule 415

B.the Rule of 72

C. the Rule of 78

D. Rule 144

22. In a typical loan 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. Jill Chew is a retired nurse and wishes to choose the best of four immediate retirement
annuities available to her. In each case, in exchange for paying a premium today (i.e., some
single amount today), she will receive equal annual end-of-year cash flows for a specified
number of years. She considers the annuities to be equally risky and is not concerned about
their differing lives. Her decision will be based solely on the rate of return she will earn on
each annuity. The key terms of each of the four annuities are shown in the following table.

Annuit PremiumPaid Today Annual Cash Flow Life(years)

y

A $30,000 $3,100 20

B 25,000 3,900 10
 C 40,000 4,200 15

D 35,000 4,000 12

a. Calculate to the annual rate of return on each of the four annuities Jill is considering.

b. Given Jill’s stated decision criterion, which annuity would you recommend?

Solution:

a. Annuity A

Calculator:

PV = -30,000

PMT = 3,100

N = 20

FV = 0

Solve for I/Y = 8.19%

Annuity B

Calculator:

PV = -25,000

PMT = 3,900

N = 10

FV = 0

Solve for I/Y = 9.03%

Annuity C

Calculator:

PV = -40,000

PMT = 4,200

N = 15

FV = 0

Solve for I/Y = 6.30%

Annuity D
Calculator:

PV = -35,000

PMT = 4,000N = 12FV = 0

Solve for I/Y = 5.23%

b. Annuity B gives the highest rate of return at 9.03% and would be the one selected based
upon Jill’s criteria.

2. 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%.

a. In this case, the property can be valued as a perpetuity with constant annual payment of
$150,000.

Using the constant perpetuity formula, we compute the present value of the property as:

150,000/0.1 = $1,500,000

This is less than the $2,000,000 that the buyer is willing to pay, so Janky should take the
buyer’s offer and sell today for $2,000,000.

b. In part b we have a growing perpetuity.

The present value of the growing perpetuity is calculated as follows:

150,000/(0.1 – 0.03) = $2,142,857

In this case, the present value of the cash flows generated by the property is higher than the
offer from the buyer. So Janky should not sell the property.

3. 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?

Solution

a. Using the calculator:

N=42

I/Y=4

FV=1,000,000

PV=0

Solve for PMT => PMT=9,540.20

So, you would need to invest $9,540.20 at the end of each year for 42 years in order to reach
your goal of $1 million.

b. N=42

I/Y=4

PMT=5,000

Solve for FV = 524,097.99

With annual end-of-year deposits of $5,000, you would have $524,097.99 at the end of 42
years.

4. Suppose you have $10,000 to invest today. Use your calculator to find the annual rates of
return (interest rates) required to do the following. Assume annual compounding.

a. Double the investment in 4 years (so that you have $20,000 in four years)

b. Triple the investment in 10 years

Solution

a. N=4

PV= -10000

FV= 20000

PMT= 0

Solve for I/Y => I/Y = 18.92%

b. N=10

PV= -10000

FV= 30000

PMT= 0

Solve for I/Y => I/Y = 11.61%

5. 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?

Solution

a. Finding the present value of this annuity on the calculator:

N=25

I/Y=5

PMT=40,000

FV=0

(*Note: Here I am setting FV to zero because we are not using it. If you cleared the TVM
registers prior to beginning the problem, FV should already be set to zero and you don’t have
to manually set it to zero. To clear your TVM registers, hit the 2nd button and then hit the FV
button.)

Solve for PV => PV=563,758

At 5%, taking the award as an annuity is better because its present value of $563,578 is larger
than the $500,000 single-payment amount.

b. N=25

I/Y=7

PMT=40,000

FV=0

Solve for PV => PV=466,143

At 7%, taking the award as a lump sum is better because the present value of the annuity of
$466,144 is less than the $500,000 lump-sum payment.

*Note: You could also solve this kind of problem by calculating future values (instead of
present values as we’ve done here), and you would always arrive at the same answer if you
pick the option with the higher future value.