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Chapter 3: The Time Value of Money

ANSWERS TO QUESTIONS
1. Simple interest is interest that is paid (earned) on only the original amount, or principal,
borrowed (lent).
2. With compound interest, interest payments are added to the principal and both then earn
interest for subsequent periods. Hence interest is compounded. The greater the number of
periods and the more times a period interest is paid, the greater the compounding and future
value.
3. The answer here will vary according to the individual. Common answers include a savings
account and a mortgage loan.
4. An annuity is a series of cash receipts of the same amount over a period of time. It is worth
less than a lump sum equal to the sum of the annuities to be received because of the time
value of money.
5. Interest compounded continuously. It will result in the highest terminal value possible for a
given nominal rate of interest.
6. In calculating the future (terminal) value, we need to know the beginning amount, the
interest rate, and the number of periods. In calculating the present value, we need to know
the future value or cash-flow, the interest or discount rate, and the number of periods. Thus,
there is only a switch of two of the four variables.
7. They facilitate calculations by being able to multiply the cash-flow by the appropriate
discount factor. Otherwise, it is necessary to raise 1 plus the discount rate to the nth power
and divide. Prior to electronic calculators, the latter was quite laborious. With the advent of
calculators, it is much easier and the advantage of present value tables is lessened.
8. Interest compounded as few times as possible during the five years. Realistically, it is likely
to be at least annually. Compounding more times will result in a lower present value.
9. For interest rates likely to be encountered in normal business situations the Rule of 72 is
a pretty accurate money doubling rule. Since it is easy to remember and involves a
calculation that can be done in your head, it has proven useful.
10. Decreases at a decreasing rate. The present value equation, 1/(1 +i)n, is such that as you
divide 1 by increasing (linearly) amounts of i, present value decreases towards zero, but at a
decreasing rate.
11. Decreases at a decreasing rate. The denominator of the present value equation increases at
an increasing rate with n. Therefore, present value decreases at a decreasing rate.
12. A lot. Turning to FVIF Table 3.3 in the chapter and tracing down the 3 percent column to
25 years, we see that he will increase his weight by a factor of 2.09 on a compound basis.
This translates into a weight of about 418 pounds at age 60.

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SOLUTIONS TO PROBLEMS
1. a. FVn = P0(1 + i)n
(i) FV3 = $100(2.0)3 = $100(8)

= $800

(ii) FV3 = $100(1.10)3 = $100(1.331)

= $133.10

(iii) FV3 = $100(1.0)3 = $100(1)

= $100

b. FVn = P0(1 + i) ; FVAn = R[([1 + i] 1)/i]


(i) FV5 = $500(1.10)5 = $500(1.611)

= $ 805.50

FVA5 = $100[([1.10]5 1)/(0.10)]


= $100(6.105)

610.50
$1,416.00

(ii) FV5 = $500(1.05) = $500(1.276)

= $ 638.00

FVA5 = $100[([1.05]5 1)/(0.05)]


= $100(5.526)

552.60
$1,190.60

(iii) FV5 = $500(1.0)5 = $500(1)


FVA5 = $100(5)*

= $ 500.00
=

500.00
$1,000.00

*[Note: We had to invoke lHospitals rule in the special case where i = 0; in short,
FVIFAn = n when i = 0.]
c. FVn = P0(1 + i)n; FVADn = R[([1 + i]n 1)/i][1 + i]
(i) FV6 = $500 (1.10)6 = $500(1.772)

$ 886.00

FVAD5 = $100 [([1.10]5 1)/(.10)] [1.10]


= $100(6.105)(1.10) =

671.55
$1,557.55

(ii) FV6 = $500(1.05)6 = $500(1.340)

$ 670.00

580.23

FVAD5 = $100[([1.05]5 1)/(0.05)] [1.05]


= $100(5.526)(1.05)

$1,250.23
(iii) FV6 = $500(1.0)6 = $500(1)
FVAD5 = $100(5)

$ 500.00

500.00
$1,000.00

d. FVn = PV0(1 + [i/m])

mn

(i) FV3 = $100(1 + [1/4])12 = $100(14.552)

= $1,455.20

(ii) FV3 = $100(1 + [0.10/4])12 = $100(1.345)

= $ 134.50

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Chapter 3: The Time Value of Money

e. The more times a year interest is paid, the greater the future value. It is particularly
important when the interest rate is high, as evidenced by the difference in solutions
between Parts 1.a. (i) and 1.d. (i).
f.

FVn = PV0(1 + [i/m])mn; FVn = PV0(e)in


(i) $100(1 + [0.10/1])10 = $100(2.594) = $259.40
(ii) $100(1 + [0.10/2])20 = $100(2.653) = $265.30
(iii) $100(1 + [0.10/4])40 = $100(2.685) = $268.50
(iv) $100(2.71828)1 = $271.83

2. a. P0 = FVn[1/(1 + i)n]
(i) $100[1/(2)3] = $100(0.125)

$12.50

(ii) $100[1/(1.10) ] = $100(0.751)

$75.10

(iii) $100[1/(1.0)3] = $100(1)

$100

b. PVAn = R[(1 [1/(1 + i) ])/i]


(i) $500[(1 [1/(1 + .04)3])/0.04] =

$500(2.775)

$1,387.50

(ii) $500[(1 [1/(1 + 0.25)3])/0.25

$500(1.952)

$ 976.00

c. P0 = FVn[1/(1 + i) ]
(i) $100[1/(1.04)1] = $100(0.962)
500[1/(1.04)2] = 500(0.925)
3

1,000[1/(1.04) ] = 1,000(0.889)

= $

96.20

462.50

889.00
$1,447.70

(ii) $100[1/(1.25)1] = $100(0.800)

= $

80.00

320.00

512.00

500[1/(1.25) ] = 500(0.640)
1,000[1/(1.25) ] = 1,000(0.512)

$ 912.00
1

d. (i) $1,000[1/(1.04) ]

$1,000(0.962) = $ 962.00

500[1/(1.04) ]

500(0.925)

462.50

100[1/(1.04)3]

100(0.889)

88.90

$1,513.40
1

(ii) $1,000[1/(1.25) ] = $1,000(0.800)


500[1/(1.25)2] = 500(0.640)
3

100[1/(1.25) ] = 100(0.512)

$ 800.00

320.00

51.20
$1,171.20

e. The fact that the cash flows are larger in the first period for the sequence in Part (d)
results in their having a higher present value. The comparison illustrates the desirability
of early cash flows.

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructors Manual

3. $25,000 = R(PVIFA6%,12) = R(8.384)


R = $25,000/8.384 = $2,982
4. $50,000 = R(FVIFA8%,10) = R(14.486)
R = $50,000/14.486 = $3,452
5. $50,000 = R(FVIFA8%,10)(1 + 0.08) = R(15.645)
R = $50,000/15.645 = $3,196
6. $10,000 = $16,000(PVIFx%,3)
(PVIFx%, 3) = $10,000/$16,000 = 0.625
Going to the PVIF table at the back of the book and looking across the row for n = 3, we
find that the discount factor for 17 percent is 0.624 and that is closest to the number above.
7. $10,000 = $3,000(PVIFAx%,4)(PVIFAx%,4) = $10,200/$3,000 = 3.4 Going to the PVIFA
table at the back of the book and looking across the row for n = 4, we find that the discount
factor for 6 percent is 3.465, while for 7 percent it is 3.387. Therefore, the note has an
implied interest rate of almost 7 percent.
8. Year

Sales

$ 600,000

$ 500,000(1.2)

720,000

600,000(1.2)

864,000

720,000(1.2)

1,036,800

864,000(1.2)

1,244,160

1,036,800(1.2)

1,492,992

1,244,160(1.2)

9.
Amount
$1,200
2,000
2,400
1,900
1,600
Subtotal (a)
110 (annuity)
1,400
15 (annuity)
1,400
Subtotal (b)
Year
1
2
3
4
5

Present Value
Factor at 14%
0.877
0.769
0.675
0.592
0.519
.................................
5.216
3.433
.................................

Present Value
$1,052.40
1,538.00
1,620.00
1,124.80
830.40
$6,165.60
$7,302.40
4,806.20
$2,496.20

Total Present Value (a + b) .................................

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$8,661.80

Chapter 3: The Time Value of Money

10. Amount

Present Value Interest Factor

$1,000

1/(1 + .10)

1,000

Present Value

0.386

$386

1/(1 + .025)40 =

0.372

372

1/e(.10)(10)

1,000
11.

10

$1,000,000
(1 + x%)100

= 0.368

$1,000(1 + x%)100

$1,000,000/$1,000 = 1,000

368

Taking the square root of both sides of the above equation gives
(1 + x%)50

(FVIFAx%, 50) = 31.623

Going to the FVIF table at the back of the book and looking across the row for n = 50, we
find that the interest factor for 7 percent is 29.457, while for 8 percent it is 46.901.
Therefore, the implicit interest rate is slightly more than 7 percent.
12. a. Annuity of $10,000 per year for 15 years at 5 percent. The discount factor in the PVIFA
table at the end of the book is 10.380.
Purchase price = $10,000 10.380 = $103,800
b. Discount factor for 10 percent for 15 years is 7.606
Purchase price = $10,000 7.606 = $76,060
As the insurance company is able to earn more on the amount put up, it requires a lower
purchase price.
c. Annual annuity payment for 5 percent = $30,000/10.380 = $2,890
Annual annuity payment for 10 percent = $30,000/7.606 = $3,944
The higher the interest rate embodied in the yield calculations, the higher the annual
payments.
13. $190,000 = R(PVIFA17%, 20) = R(5.628)
R = $190,000/5.628 = $33,760

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Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructors Manual

14. a. PV0 = $8,000 = R(PVIFA1%,36)


= R[(1 [1/(1 + .01)36])/(0.01)] = R(30.108)
Therefore, R = $8,000/30.108 = $265.71
End of
Month

(1)
Installment
Payment

--

(2)
Monthly Interest
(4)t1 0.01
--

(3)
Principal
Payment
(1) (2)
--

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36

$ 265.71
$ 80.00
$ 185.71
265.71
78.14
187.57
265.71
76.27
189.44
265.71
74.37
191.34
265.71
72.46
193.25
265.71
70.53
195.18
265.71
68.58
197.13
265.71
66.60
199.11
265.71
64.61
201.10
265.71
62.60
203.11
265.71
60.57
205.14
265.71
58.52
207.19
265.71
56.44
209.27
265.71
54.35
211.36
265.71
52.24
213.47
265.71
50.11
215.60
265.71
47.95
217.76
265.71
45.77
219.94
265.71
43.57
222.14
265.71
41.35
224.36
265.71
39.11
226.60
265.71
36.84
228.87
265.71
34.55
231.16
265.71
32.24
233.47
265.71
29.91
235.80
265.71
27.55
238.16
265.71
25.17
240.54
265.71
22.76
242.95
265.71
20.33
245.38
265.71
17.88
247.83
265.71
15.40
250.31
265.71
12.90
252.81
265.71
10.37
255.34
265.71
7.82
257.89
265.71
5.24
260.47
265.88*
2.63
263.25
$9,565.73
$1,565.73
$8,000.00
*The last payment is slightly higher due to rounding throughout.
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(4)
Principal Amount
Owing At Month
End (4)t1 (3)
$8,000.00
7,814.29
7,626.72
7,437.28
7,245.94
7,052.69
6,857.51
6,660.38
6,461.27
6,260.17
6,057.06
5,851.92
5,644.73
5,435.46
5,224.10
5,010.63
4,795.03
4,577.27
4,357.33
4,135.19
3,910.83
3,684.23
3,455.36
3,224.20
2,990.73
2,754.93
2,516.77
2,276.23
2,033.28
1,787.90
1,540.07
1,289.76
1,036.95
781.61
523.72
263.25
0.00

Chapter 3: The Time Value of Money

b. PV0 = $184,000 = R(PVIFA10%, 25)


= R(9.077)
Therefore, R = $184,000/9.077 = $20,271.01

End of
Year
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25

(1)
Installment
Payment

(2)
Annual
Interest
(4)t1 0.10

-$ 20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,271.01
20,262.76*
$506,767.00

-$ 18,400.00
18,212.90
18,007.09
17,780.70
17,531.67
17,257.73
16,956.40
16,624.94
16,260.34
15,859.27
15,418.09
14,932.80
14,398.98
13,811.78
13,165.86
12,455.34
11,673.77
10,814.05
9,868.35
8,828.09
7,683.80
6,425.07
5,040.48
3,517.43
1,842.07
$322,767.00

(3)
Principal
Payment
(1) (2)
-$ 1,871.01
2,058.11
2,263.92
2,490.31
2,739.34
3,013.28
3,314.61
3,646.07
4,010.67
4,411.74
4,852.92
5,338.21
5,872.03
6,459.23
7,105.15
7,815.67
8,597.24
9,456.96
10,402.66
11,442.92
12,587.21
13,845.94
15,230.53
16,753.58
18,420.69
$184,000.00

(4)
Principal Amount
Owing At Year End
(4)t1 (3)
$ 184,000.00
182,128.99
180,070.88
177,806.96
175,316.65
172,577.31
169,564.03
166,249.42
162,603.35
158,592.68
154,180.94
149,328.02
143,989.81
138,117.78
131,658.55
124,553.40
116,737.73
108,140.49
98,683.53
88,280.87
76,837.95
64,250.74
50,404.80
35,174.27
18,420.69
0.00

*The last payment is somewhat lower due to rounding throughout.


15. $14,300 = $3,000(PVIFA15% ,n)
(PVIFA15%,n) = $14,300/$3,000 = 4.767
Going to the PVIFA table at the back of the book and looking down the column for i = 15%,
we find that the discount factor for 8 years is 4.487, while the discount factor for 9 years is
4.772. Thus, it will take approximately 9 years of payments before the loan is retired.
16. a. $5,000,000 = R[1 + (0.20/1)]5 = R(2.488)
R = $5,000,000/2.488 = $2,009,646

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b. $5,000,000 = R[1 + (0.20/2)]10 = R(2.594)


R = $5,000,000/2.594 = $1,927,525
c. $5,000,000 = R[1 + (0.20/4)]20 = R(2.653)
R = $5,000,000/2.653 = $1,884,659
d. $5,000,000 = R(e)(0.20) (5) = R(2.71828)(1)
R = $5,000,000/2.71828 = $1,839,398
17. FV of Earls plan = ($2,000) (FVIFA7%,10) (FVIF7%,35)
= ($2,000) (13.816) (10.677)
= $295,027
FV of Ivanas plan = ($2,000) (FVIFA7%, 35)
= ($2,000) (138.237)
= $276,474
Earls investment program is worth ($295,027 $276,474) = $18,553 more at retirement
than Ivanas program.
18. Tip: First find the future value of a $1,000-a-year ordinary annuity that runs for 25 years.
Unfortunately, this future value overstates our true ending balance because three of the
assumed $1,000 deposits never occurred. So, we need to then subtract three future values
from our trial ending balance: (1) the future value of $1,000 compounded for 25 5 = 20
years; (2) the future value of $1,000 compounded for 25 7 = 18 years; and (3) the future
value of $1,000 compounded for 25 11 = 14 years. After collecting terms, we get the
following:
FV25 = $1,000[(FVIFA5%, 25) (FVIF5%, 20) (FVIF5%, 18) (FVIF5%,14)]
= $1,000[(47.727) (2.653) (2.407) (1.980)]
= $1,000[40.687] = $40,687
19. There are many ways to solve this problem correctly. Here are two:
Cash withdrawals at the END of year ...

Alt. %1

This above pattern is equivalent to ...

PVA9
-- minus -PVA3

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Chapter 3: The Time Value of Money

PVA9
R(PVIFA05, 9)
R(7.108)

PVA3
R(PVIFA05, 3)
R(2.723)
R(4.385)
R= $100,000/(4.385)

=
=
=
=
=

$100,000
$100,000
$100,000
$100,000
$22,805.02

Cash withdrawals at the END of year ...

Alt. %2

This above pattern is equivalent to ...

PVA6
R(PVIFA05, 6)
R(5.076)
R(4.386)
R

(PVIF.05, 3)
(PVIF.05, 3)
(.864)

=
=
=
=

$100,000
$100,000
$100,000
$100,000

$100,000/(4.386)

$22,799.82

NOTE: Answers to Alt. #1 and Alt. #2 differ slightly due to rounding in the tables.
20. Effective annual interest rate = (1 + [i/m])m 1
= (1 + [0.096/1])1 1

a. (annually)

0.0960

b. (semiannually)

= (1 + [0.096/2]) 1

0.0983

c. (quarterly)

= (1 + [0.096/4])4 1

0.0995

0.1003

0.1007

=
=

(e)i 1
0.1008

d. (monthly)

12

= (1 + [0.096/12]) 1

e. (daily)
= (1 + [0.096/365])
Effective annual interest
rate with continuous compounding
f. (continuous)
= (2.71828).096 1

365

21. (Note: You are faced with determining the present value of an annuity due. And, (PVIFA8%, 40)
can be found in Table IV at the end of the textbook, while (PVIFA8%, 39) is not listed in the
table.)
Alt. 1: PVAD40 = (1 + 0.08)($25,000)(PVIFA8%, 40)
= (1.08)($25,000)(11.925) = $321,975
Alt. 2: PVAD40 = ($25,000)(PVIFA8%, 39) + $25,000
= ($25,000)[(1 [1/(1 + 0.08)39])/0.08] + $25,000
= ($25,000)(11.879) + $25,000 = $321,950
NOTE: Answers to Alt. 1 and Alt. 2 differ slightly due to rounding.
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