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Chapter 6 Time Value of Money Concepts

True/False Questions

1. Compound interest includes interest earned on interest.

Answer: True Learning Objective: 1 Level of Learning: 1

2. When interest is compounded, the contract rate of interest exceeds the effective rate of
interest.

Answer: False Learning Objective: 1 Level of Learning: 2

3. The calculation of future value requires the removal of interest.

Answer: False Learning Objective: 2 Level of Learning: 1

4. The calculation of present value eliminates interest from future cash flows.

Answer: True Learning Objective: 3 Level of Learning: 1

5. Monetary assets include only cash and cash equivalents.

Answer: False Learning Objective: 9 Level of Learning: 1

6. Most, but not all, liabilities are monetary liabilities.

Answer: True Learning Objective: 9 Level of Learning: 1

7. An annuity consists of level principal payments plus interest on the unpaid balance.

Answer: False Learning Objective: 5 Level of Learning: 1

8. With an annuity due, a payment is made or received on the date the agreement begins.

Answer: True Learning Objective: 5 Level of Learning: 1

9. Other things being equal, the present value of an annuity due will be less than the present
value of an ordinary annuity.

Answer: False Learning Objective: 7 Level of Learning: 1

10. Given identical current amounts owed and identical interest rates, annual payments of an
ordinary annuity will be greater than annual payments of an annuity due.

Answer: True Learning Objective: 5 Level of Learning: 2

11. A deferred annuity is one in which interest charges are deferred for a stated time period.

Answer: False Learning Objective: 7 Level of Learning: 1

12. An annuity is a series of equal periodic payments.

Answer: True Learning Objective: 5 Level of Learning: 1

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Chapter 6 Time Value of Money Concepts

Matching Pair Questions

Use the following to answer questions 13-17:

13-17. Listed below are ten terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term placing the letter designating the best term
in the space provided by the phrase.
Terms:
A. Annuity
B. Future value
C. Future value of an annuity due
D. Future value of an ordinary annuity
E. Monetary asset
F. Nonmonetary asset
G. Present value of a single amount
H. Present value of an annuity due
I. Simple interest
J. Time value of money
Phrases:
13. _____ A dollar now is worth more than a dollar later.
14. _____ A series of equal periodic payments.
15. _____ Accumulation of a series of equal payments with the last payment accruing interest.
16. _____ Accumulation of a series of equal payments with the last payment accruing no
interest.
17. _____ Accumulation of an amount with interest.

Answer: 13-J; 14-A; 15-C; 16-D; 17-B

Use the following to answer questions 18-22:

18-22. Listed below are ten terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term placing the letter designating the best term
in the space provided by the phrase.
Terms:
A. Annuity
B. Future value
C. Future value of an annuity due
D. Future value of an ordinary annuity
E. Monetary asset
F. Nonmonetary asset
G. Present value of a single amount
H. Present value of an annuity due
I. Simple interest
J. Time value of money
Phrases:
18. _____ Amount today equivalent to a specified future amount.
19. _____ Its amount is not fixed or determinable.
20. _____ Based on initial principal only.
21. _____ Claim to a fixed amount of cash.
22. _____ Current worth of a series of equal payments received at the beginning of a period.

Answer: 18-G; 19-F; 20-I; 21-E; 22-H

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Chapter 6 Time Value of Money Concepts

Use the following to answer questions 23-27:

23-27. Listed below are ten terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term placing the letter designating the best term
in the space provided by the phrase.

Terms:
A. Annuity due
B. Compound interest
C. Deferred annuity
D. Effective yield
E. Future value of a single amount
F. Interest
G. Monetary liability
H. Ordinary annuity
I. Present value
J. Present value of an ordinary annuity
Phrases:
23. _____ Current worth of a series of equal payments received at the end of a period.
24. _____ Current worth of future cash flow(s).
25. _____ Fixed obligation to pay an amount in cash.
26. _____ Interest accumulates on interest.
27. _____ Substantive/real interest rate.

Answer: 23-J; 24-I; 25-G; 26-B; 27-D

Use the following to answer questions 28-32:

28-32. Listed below are ten terms followed by a list of phrases that describe or characterize five of
the terms. Match each phrase with the correct term placing the letter designating the best term
in the space provided by the phrase.

Terms:
A. Annuity due
B. Compound interest
C. Deferred annuity
D. Effective yield
E. Future value of a single amount
F. Interest
G. Monetary liability
H. Ordinary annuity
I. Present value
J. Present value of an ordinary annuity
Phrases:
28. _____ Rent for the use of money.
29. _____ Series of equal cash payments received at the beginning of each period.
30. _____ Series of equal cash payments received at the end of each period.
31. _____ Series of equal cash payments with the first cash payment more than one period after
the contract date.
32. _____ The money to which an amount invested will grow with time.

Answer: 28-F; 29-A; 30-H; 31-C; 32-E

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Chapter 6 Time Value of Money Concepts

Use the following to answer questions 33-37:

33-37. Below are listed columns of interest tables for 9% interest, followed by labels for FIVE of the
columns. Match the columns with their appropriate labels by placing the letter designating the
column in the space provided by the label.

(A) (B) (C) (D) (E) (F)


1 1.090 0.917 1.000 0.917 1.000 1.090
2 1.188 1.759 1.917 0.842 2.090 2.278
3 1.295 2.531 2.759 0.772 3.278 3.573

33. _____ Present value of an annuity due of $1


34. _____ Future value of an annuity due of $1
35. _____ Present value of $1
36. _____ Future value of $1
37. _____ Present value of an ordinary annuity of $1

Answer: 33-C; 34-F; 35-D; 36-A; 37-B

Multiple Choice Questions

Use the following to answer questions 38-43:

Below are excerpts from interest tables for 8% interest.

1 2 3 4 5 6
1 1.000 1.000 .926 1.080 1.080 .926
2 1.926 2.080 .857 2.246 1.166 1.783
3 2.783 3.246 .793 3.506 1.260 2.577
4 3.577 4.506 .735 4.867 1.360 3.312

38. Column 1 is an interest table for the:


A) Present value of an ordinary annuity of 1.
B) Future value of an ordinary annuity of 1.
C) Present value of an annuity due of 1.
D) Future value of an annuity due of 1.

Answer: C Learning Objective: 7 Level of Learning: 2

39. Column 2 is an interest table for the:


A) Present value of an ordinary annuity of 1.
B) Future value of an ordinary annuity of 1.
C) Present value of an annuity due of 1.
D) Future value of an annuity due of 1.

Answer: B Learning Objective: 6 Level of Learning: 2

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Chapter 6 Time Value of Money Concepts

40. Column 3 is an interest table for the:


A) Present value of 1.
B) Future value of 1.
C) Present value of an ordinary annuity of 1.
D) Present value of an annuity due of 1.

Answer: A Learning Objective: 3 Level of Learning: 2

41. Column 4 is an interest table for the:


A) Present value of an ordinary annuity of 1.
B) Future value of an ordinary annuity of 1.
C) Present value of an annuity due of 1.
D) Future value of an annuity due of 1.

Answer: D Learning Objective: 6 Level of Learning: 2

42. Column 5 is an interest table for the:


A) Present value of 1.
B) Future value of 1.
C) Present value of an ordinary annuity of 1.
D) Present value of an annuity due of 1.

Answer: B Learning Objective: 2 Level of Learning: 2

43. Column 6 is an interest table for the:


A) Present value of an ordinary annuity of 1.
B) Future value of an ordinary annuity of 1.
C) Present value of an annuity due of 1.
D) Future value of an annuity due of 1.

Answer: A Learning Objective: 7 Level of Learning: 2

44. Reba wishes to know how much would be in her savings account if she deposits a given sum
in an account and leaves it there at 6% interest for five years. She should use a table for the:
A) Future value of an ordinary annuity of 1.
B) Future value of 1.
C) Future value of an annuity of 1.
D) Present value of an annuity due of 1.

Answer: B Learning Objective: 2 Level of Learning: 3

45. LeAnn wishes to know how much she should set aside now at 7% interest in order to
accumulate a sum of $5,000 in four years. She should use a table for the:
A) Present value of 1.
B) Future value of 1.
C) Present value of an ordinary annuity of 1.
D) Future value of an annuity due of 1.

Answer: A Learning Objective: 3 Level of Learning: 3

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Chapter 6 Time Value of Money Concepts

46. Tammy wants to buy a car that costs $10,000 and wishes to know the amount of the monthly
payments, which will be made at the first of the month, with interest of 12% on the unpaid
balance. She should use a table for the:
A) Present value of 1.
B) Present value of an ordinary annuity of 1.
C) Present value of an annuity due of 1.
D) Future value of an annuity due of 1.

Answer: C Learning Objective: 8 Level of Learning: 2

47. George Jones is planning on a cruise for his 70th birthday party. He wants to know how much
he should set aside at the beginning of each month at 6% interest to accumulate the sum of
$4,800 in five years. He should use a table for the:
A) Future value of an ordinary annuity of 1.
B) Future value of an annuity due of 1.
C) Future value of 1.
D) Present value of an annuity due of 1.

Answer: B Learning Objective: 8 Level of Learning: 2

48. Sandra won $5,000,000 in the state lottery which she has elected to receive at the end of each
month over the next thirty years. She will receive 7% interest on unpaid amounts. To
determine the amount of her monthly check, she should use a table for the:
A) Present value of an annuity of 1.
B) Future value of an annuity due of 1.
C) Present value of an ordinary annuity of 1.
D) Future value of an ordinary annuity of 1.

Answer: C Learning Objective: 8 Level of Learning: 2

49. First Financial Auto Loan Department wishes to know the payment required at the first of
each month on a $10,500, 48-month, 11% auto loan. To determine this amount, First Financial
would:
A) Multiply $10,500 by the present value of 1.
B) Divide $10,500 by the future value of an ordinary annuity of 1.
C) Divide $10,500 by the present value of an annuity due of 1.
D) Multiply $10,500 by the present value of an ordinary annuity of 1.

Answer: C Learning Objective: 8 Level of Learning: 3

50. To determine the future value factor for an annuity due for period n when given tables only for
an ordinary annuity:
A) Obtain the FVA factor for n+1 and deduct 1.
B) Obtain the FVA factor for n and deduct 1.
C) Obtain the FVA factor for n-1 and add 1.
D) Obtain the FVA factor for n+1 and add 1.

Answer: A Learning Objective: 5 Level of Learning: 3

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Chapter 6 Time Value of Money Concepts

51. A series of equal periodic payments that starts more than one period after the agreement is
called:
A) An annuity due.
B) An ordinary annuity.
C) A future annuity.
D) A deferred annuity.

Answer: D Learning Objective: 5 Level of Learning: 1

52. A series of equal periodic payments in which the first payment is made one compounding
period after the date of the contract is:
A) A deferred annuity.
B) An ordinary annuity.
C) An annuity due.
D) A delayed annuity.

Answer: B Learning Objective: 5 Level of Learning: 1

53. Loan A has the same original principal, interest rate, and payment amount as Loan B.
However, Loan A is structured as an annuity due, while Loan B is structured as an ordinary
annuity. The maturity date of Loan A will be:
A) Earlier than Loan B.
B) Later than Loan B.
C) The same as Loan B.
D) Indeterminate with respect to loan B.

Answer: A Learning Objective: 5 Level of Learning: 2

54. Loan C has the same principal amount, payment amount and maturity date as Loan D.
However, Loan C is structured as an annuity due while Loan D is structured as an ordinary
annuity. Loan C's interest rate is:
A) Higher than Loan D.
B) Less than Loan D.
C) The same as Loan D.
D) Indeterminate compared to Loan D.

Answer: A Learning Objective: 8 Level of Learning: 1

55. Zulu Corporation hires a new chief executive officer and promises to pay her a signing bonus
of $2 million per year for 10 years, starting five years after he joins the company. The liability
for this bonus when the CEO is hired:
A) Is the present value of a deferred annuity.
B) Is the present value of an annuity due.
C) Is $20 million.
D) Is zero because no cash is owed for five years.

Answer: A Learning Objective: 7 Level of Learning: 2

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Chapter 6 Time Value of Money Concepts

56. Yamaha Inc. hires a new chief financial officer and promises to pay him a lump sum bonus
four years after he joins the company. The new CFO insists that the company invest an
amount of money at the beginning of each year in a 7% fixed rate investment fund to insure
the bonus will be available. To determine the amount that must be invested each year, a
computation must be made using the formula for:
A) The future value of a deferred annuity.
B) The future value of an ordinary annuity.
C) The future value of an annuity due.
D) None of the above is correct.

Answer: C Learning Objective: 6 Level of Learning: 2

57. Which of the following must be known to compute the interest rate paid from financing an
asset purchase with an annuity?
A) Fair market value of the asset purchased, number and dollar amount of the annuity
payments
B) Present value of the annuity, dollar amount and timing of the annuity payments
C) Fair market value of the asset and timing of the annuity payments
D) Number of annuity payments and future value of the annuity

Answer: B Learning Objective: 7 Level of Learning: 2

58. Koko Company pays $10 million at the beginning of each year for 10 years to Mocha Inc. for
a building with a fair market value of $75 million. What interest rate is Mocha earning on
financing this land sale?
A) Between 13% and 14%
B) Between 7% and 8%
C) Between 5.5% and 6%
D) Cannot be determined from the given information.

Answer: B Learning Objective: 8 Level of Learning: 3


Rationale: That is, the present value of a 10-year annuity due of $10 million is $75 million,
when the discount factor (from Table 6) equals 7.5000. That point is between 7% and 8% in
the table.

59. Fenland Co. plans to retire $100 million in bonds in five years, so it wishes to create a fund by
making equal investments at the beginning of each year during that period in an account it
expects to earn 8% annually. What amount does Fenland need to invest each year?
A) $15,783,077
B) $17,045,650
C) $23,190,400
D) Cannot be determined from the given information.

Answer: A Learning Objective: 9 Level of Learning: 3


Rationale: This is the amount in the future value of an annuity due formula, where $100
million = investment amount x factor from Table 5 where n=5 and i=8%. Thus, Investment
amount = $100 million/6.3359 = $15,783,077.

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Chapter 6 Time Value of Money Concepts

60. Kunkle Company wishes to earn 20% annually on its investments. If it makes an investment
that equals or exceeds that rate, it considers it a success. Assume that it invests $2 million and
gets $500,000 in return at the end of each year fox X years. What is the minimum value of X
for which it will consider the investment a success? Assume that it cannot invest for fractional
parts of a year.
A) 4 years
B) 6 years
C) 7 years
D) 9 years

Answer: D Learning Objective:8 Level of Learning: 3


Rationale: The investment is successful when the present value of the ordinary annuity = $1
million. This is when the PV factor (from Table 4) is at least 4.0, so that multiplied by
$500,000; it is at least $2 million. In Table 4, at i=20%, the factor passes the 4.0 level in year
9.

61. Davenport Inc. offers a new employee a lump sum signing bonus at the date of employment.
Alternatively, the employee can take $30,000 at the date of employment and another $50,000
two years later. Assuming the employee's time value of money is 8% annually, what lump
sum at employment date would make her indifferent between the two options?
A) $60,000
B) $62,867
C) $72,867
D) $80,000

Answer: C Learning Objective: 7 Level of Learning: 3


Rationale: The lump sum equivalent would be $30,000 + the present value of $50,000 where
n=2 and i=8%. That is, $30,000 + ($50,000 x 0.85734 from Table 2) = $72,867.

62. Quaker State Inc. offers a new employee a lump sum signing bonus at the date of
employment. Alternatively, the employee can take $8,000 at the date of employment plus
$20,000 at the end of each of his first three years of service. Assuming the employee's time
value of money is 10% annually, what lump sum at employment date would make him
indifferent between the two options?
A) $23,026
B) $57,737
C) $62,711
D) None of the above is correct.

Answer: B Learning Objective: 7 Level of Learning: 3


Rationale: The lump sum equivalent would be $8,000 + the present value of a $20,000
ordinary annuity where n=3 and i=10%. That is, $8,000 + ($20,000 x 2.48685 from Table 4)
= $57,737.

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Chapter 6 Time Value of Money Concepts

63. Garland Inc. offers a new employee a lump sum signing bonus at the date of employment,
June 1, 2006. Alternatively, the employee can take $39,000 at the date of employment plus
$10,000 each June 1 for five years, beginning in 2010. Assuming the employee's time value
of money is 9% annually, what lump sum at employment date would make him indifferent
between the two options?
A) $44,035
B) $40,855
C) $69,035
D) $65,855

Answer: C Learning Objective: 7 Level of Learning: 3


Rationale: The lump sum equivalent would be $39,000 + the present value of a $10,000
deferred annuity. The present value of the deferred annuity on June 1, 2010 is an annuity due
with n=5 and i=9%. That is, ($10,000 x 4.23972 from Table 6) = $42,397. To compute the
equivalent of that amount at employment date, we take the present value of $42,397 where
n=4 and i=9% from Table 2, which is $42,397 x 0.70843 = $30,035. Therefore, the lump sum
equivalent would be $39,000 + $30,035 = $69,035.

64. Chancellor Ltd. sells an asset with a $1 million fair market value to Sophie Inc. Sophie agrees
to make 6 equal payments, one year apart, commencing on the date of sale. The payments
include principal and 6% annual interest. Compute the annual payments.
A) $166,651
B) $135,252
C) $203,351
D) $191,852

Answer: D Learning Objective: 8 Level of Learning: 3


Rationale: We compute the annual payments in the present value of an annuity due formula,
where the present value is $1 million, n=6 and i=6%. The discount factor (from table 6) is
5.21236. Dividing $1 million by this factor gives payments of $191,852.

Use the following to answer questions 65-81:

Present and future value tables of $1 at 3% are presented below:

N FV $1 PV $1 FVA $1 PVA $1 FVAD $1 PVAD $1


1 1.03000 0.97087 1.0000 0.97087 1.0300 1.00000
2 1.06090 0.94260 2.0300 1.91347 2.0909 1.97087
3 1.09273 0.91514 3.0909 2.82861 3.1836 2.91347
4 1.12551 0.88849 4.1836 3.71710 4.3091 3.82861
5 1.15927 0.86261 5.3091 4.57971 5.4684 4.71710
6 1.19405 0.83748 6.4684 5.41719 6.6625 5.57971
7 1.22987 0.81309 7.6625 6.23028 7.8923 6.41719
8 1.26677 0.78941 8.8923 7.01969 9.1591 7.23028
9 1.30477 0.76642 10.1591 7.78611 10.4639 8.01969
10 1.34392 0.74409 11.4639 8.53020 11.8078 8.78611
11 1.38423 0.72242 12.8078 9.25262 13.1920 9.53020
12 1.42576 0.70138 14.1920 9.95400 14.6178 10.25262
13 1.46853 0.68095 15.6178 10.63496 16.0863 10.95400
14 1.51259 0.66112 17.0863 11.29607 17.5989 11.63496
15 1.55797 0.64186 18.5989 11.93794 19.1569 12.29607
16 1.60471 0.62317 20.1569 12.56110 20.7616 12.93794

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Chapter 6 Time Value of Money Concepts

65. Today Thomas deposited $100,000 in a three-year 12% CD that compounds quarterly. What is
the maturity value of the CD?
A) $109,270.
B) $119,410.
C) $142,576.
D) $309,090.

Answer: C Learning Objective: 1 Level of Learning: 3


Rationale:
FV = $100,000 x 1.42576* = $142,576
*n = 12; i = 3%

66. Carol wants to invest money in a 6% CD account that compounds semiannually. Carol would
like the account to have a balance of $50,000 five years from now. How much must Carol
deposit to accomplish her goal?
A) $35,069.
B) $43,131.
C) $37,205.
D) $35,000.

Answer: C Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $50,000 x 7.44409* = $37,205
*n = 10; i = 3%

67. Shane wants to invest money in a 6% CD account that compounds semiannually. Shane would
like the account to have a balance of $100,000 four years from now. How much must Shane
deposit to accomplish his goal?
A) $88,848.
B) $78,941.
C) $25,336.
D) $22,510.

Answer: B Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $100,000 x .78941* = $78,941
*n = 8; i = 3%

68. At the end of each quarter, Patti deposits $500 into an account that pays 12% interest
compounded quarterly. How much will Patti have in the account in three years?
A) $7,096.
B) $7,013.
C) $7,129.
D) $8,880.

Answer: A Learning Objective: 6 Level of Learning: 3


Rationale:
FVA = $500 x 14.1920* = $7,096
*n = 12; i = 3%

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Chapter 6 Time Value of Money Concepts

69. Bill wants to give Maria a $500,000 gift in seven years. If money is worth 6% compounded
semiannually, what is Maria's gift worth today?
A) $ 66,110.
B) $ 81,310.
C) $406,550.
D) $330,560.

Answer: D Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $500,000 x .66112* = $330,560
*n = 14; i = 3%

70. Monica wants to sell her share of an investment to Barney for $50,000 in three years. If
money is worth 6% compounded semiannually, what would Monica accept today?
A) $ 8,375.
B) $41,874.
C) $11,941.
D) $41,000.

Answer: B Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $50,000 x .83748* = $41,874
*n = 6; i = 3%

71. Sondra deposits $2,000 in an IRA account on April 15, 2006. Assume the account will earn
only 3% annually. If she repeats this for the next nine years, how much will she have on
deposit on April 14, 2016?
A) $20,600.
B) $20,728.
C) $23,616.
D) $24,715.

Answer: C Learning Objective: 6 Level of Learning: 3


Rationale:
FVAD = $2,000 x 11.8078* = $23,616
*n = 10; i = 3%

72. Shelley wants to cash in her winning lottery ticket. She can either receive ten $100,000
semiannual payments starting today, or she can receive a lump-sum payment now based on a
6% annual interest rate. What would be the lump-sum payment?
A) $853,020.
B) $801,971.
C) $744,090.
D) $878,611.

Answer: D Learning Objective: 7 Level of Learning: 3


Rationale:
PVAD = $100,000 x 8.78611* = $878,611
*n = 10; i = 3%

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Chapter 6 Time Value of Money Concepts

73. Jose wants to cash in his winning lottery ticket. He can either receive five $5,000 semiannual
payments starting today, or he can receive a lump-sum payment now based on a 6% annual
interest rate. What would be the lump-sum payment?
A) $23,586.
B) $22,899.
C) $21,565.
D) $23,000.

Answer: A Learning Objective: 8 Level of Learning: 3


Rationale:
PVAD = $ 5,000 x 4.71710* = $23,586
*n = 5; i = 3%

74. Micro Brewery borrows $300,000 to be paid off in three years. The loan payments are
semiannual with the first payment due in six months, and interest is at 6%. What is the amount
of each payment?
A) $ 55,379.
B) $106,059.
C) $ 30,138.
D) $ 60,276.

Answer: A Learning Objective: 8 Level of Learning: 3


Rationale:
$300,000/5.41719* = $55,379
*PVA: n = 6; i = 3%

75. Rosie's Florist borrows $300,000 to be paid off in six years. The loan payments are
semiannual with the first payment due in six months, and interest is at 6%. What is the amount
of each payment?
A) $25,750.
B) $29,761.
C) $30,139.
D) $25,500.

Answer: C Learning Objective: 8 Level of Learning: 3


Rationale:
$300,000/9.95400* = $30,139
*PVA: n = 12; i = 3%

76. At the end of the next four years, a new machine is expected to generate net cash flows of
$8,000, $12,000, $10,000, and $15,000, respectively. What are the cash flows worth today if a
3% interest rate properly reflects the time value of money in this situation?
A) $41,556.
B) $47,700.
C) $32,400.
D) $38,100.

Answer: A Learning Objective: 3 Level of Learning: 3


Rationale:
($8,000 x .97087) + ($12,000 x .94260) + ($10,000 x .91514) + ($15,000 x .88849) = $7,767
+ 11,311 + 9,151 + 13,327 = $41,556

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Chapter 6 Time Value of Money Concepts

77. A firm leases equipment under a capital lease (analogous to an installment purchase) that calls
for twelve semiannual payments of $39,014.40. The first payment is due at the inception of
the lease. The annual rate on the lease is 6%. What is the value of the leased asset at inception
of the lease?
A) $388,349.
B) $400,000.
C) $454,128.
D) $440,082.

Answer: B Learning Objective: 9 Level of Learning: 3


Rationale:
PVAD = $39,014.40 x 10.25262 * = $400,000
*n = 12 i = 3%

78. Jimmy has $255,906 accumulated in a 401K plan. The fund is earning a low, but safe, 3% a
year. The withdrawals will take place at the end of each year starting a year from now. How
soon will the fund be exhausted if Jimmy withdraws $30,000 each year?
A) 11 years.
B) 10 years.
C) 8.5 years.
D) 8.8 years.

Answer: B Learning Objective: 8 Level of Learning: 3


Rationale:
$255,906/$30,000 = 8.5302
For PVA factor of 8.5302 and i of 3%, n = 10

79. Debbie has $368,882 accumulated in a 401K plan. The fund is earning a low, but safe, 3% a
year. The withdrawals will take place annually starting today. How soon will the fund be
exhausted if Debbie withdraws $30,000 each year?
A) 15 years.
B) 16 years.
C) 14 years.
D) 12.3 years.

Answer: A Learning Objective: 8 Level of Learning: 3


Rationale: $368,882/$30,000 = 12.29607
For PVAD factor of 12.29607 and i of 3%, n = 15

80. On January 1, 2006, you are considering making an investment that will pay three annual
payments of $10,000. The first payment is not expected until December 31, 2008. You are
eager to earn 3%. What is the present value of the investment on January 1, 2006?
A) $26,662.
B) $27,462.
C) $28,286.
D) $29,135.

Answer: A Learning Objective: 7 Level of Learning: 3


Rationale:
PVA = $10,000 x ( 4.57971* - 1.91347**) = $26,662
*n = 5, i = 3% **n = 2; i = 3%

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Chapter 6 Time Value of Money Concepts

81. On January 1, 2006, you are considering making an investment that will pay three annual
payments of $10,000. The first payment is not expected until December 31, 2009. You are
eager to earn 3%. What is the present value of the investment on January 1, 2006?
A) $28,286.
B) $25,886.
C) $26,662.
D) $27,300.

Answer: B Learning Objective: 7 Level of Learning: 3


Rationale:
PVA = $10,000 x (5.41719* 2.82861**) = $25,886
*n = 6, i = 3% **n = 3; i = 3%

Use the following to answer questions 82-86:

Present and future value tables of 1 at 9% are presented below.

Present Future PV of Ord. FV of Ord.


Value Value Annuity Annuity
1 .91743 1.09000 .91743 1.0000
2 .84168 1.18810 1.75911 2.0900
3 .77218 1.29503 2.53129 3.2781
4 .70843 1.41158 3.23972 4.5731
5 .64993 1.53862 3.88965 5.9847
6 .59627 1.67710 4.45892 7.5233

82. How much must be invested now at 9% interest to accumulate to $10,000 in five years?
A) $9,176.
B) $6,499.
C) $5,500.
D) $5,960.

Answer: B Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $10,000 x .64993* = $6,499
*n = 5 i = 9%

83. How much must be deposited at the beginning of each year in order to accumulate to $10,000
in four years if interest is at 9%?
A) $1,671.
B) $2,570.
C) $2,358.
D) $2,006.

Answer: D Learning Objective: 6 Level of Learning: 3


Rationale:
$10,000/(5.9847*= $2,006
FVAD: *n = 5 i = 9%

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 211


Chapter 6 Time Value of Money Concepts

84. Mustard's Inc. sold the rights to use one of their patented processes that will result in cash
receipts of $2,500 at the end of each of the next four years and a lump sum receipt of $4,000 at
the end of the fifth year. The total present value of these payments if interest is at 9% is:
A) $10,699.
B) $11,468.
C) $12,100.
D) $14,000.

Answer: A Learning Objective: 7 Level of Learning: 3


Rationale:
PVA = $2,500 x 3.23972 (n = 4) = $ 8,099
PV = $4,000 x .64993 (n = 5) = 2,600
$10,699

85. Ajax Company purchased a five-year certificate of deposit for their building fund in the
amount of $220,000. How much should the certificate of deposit be worth at the end of five
years if interest is compounded at an annual rate of 9%?
A) $857,230.
B) $142,985.
C) $319,000.
D) $338,496.

Answer: D Learning Objective: 2 Level of Learning: 3


Rationale:
FV = $220,000 x 1.53862 * = $338,496
*n = 5 i = 9%

86. Claudine Corporation will deposit $5,000 into a money market sinking fund at the end of each
year for the next five years. How much will accumulate by the end of the fifth and final
payment if the sinking fund earns 9% interest?
A) $32,617.
B) $29,924.
C) $27,250.
D) $26,800.

Answer: B Learning Objective: 6 Level of Learning: 3


Rationale:
FVA = $5,000 x 5.9847 * = $29,924
*n = 5 i = 9%

Use the following to answer questions 87-90:

Present and future value tables of 1 at 11% are presented below.

Present Future PV of Ord. FV of Ord.


Value Value Annuity Annuity
1 .90090 1.11000 .90090 1.0000
2 .81162 1.23210 1.71252 2.1100
3 .73119 1.36763 2.44371 3.3421
4 .65873 1.51807 3.10245 4.7097
5 .59345 1.68506 3.69590 6.2278
6 .53464 1.87041 4.23054 7.9129

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Chapter 6 Time Value of Money Concepts

87. Spielberg Inc. signed a $200,000 noninterest-bearing note due in five years from a production
company eager to do business. Comparable borrowings have carried an 11% interest rate. At
what amount should this debt be carried at its inception?
A) $200,000.
B) $178,000.
C) $118,690.
D) $222,000.

Answer: C Learning Objective: 3 Level of Learning: 3


Rationale:
PV = $200,000 x .59345 * = $118,690
*n = 5; i = 11%

88. On October 1, 2006, Justine Company purchased equipment from Napa Inc. in exchange for a
noninterest-bearing note payable in five equal annual payments of $500,000, beginning Oct 1,
2007. Similar borrowings have carried an 11% interest rate. The equipment would be recorded
at:
A) $2,500,000.
B) $2,225,000.
C) $1,847,950.
D) $2,115,270.

Answer: C Learning Objective: 9 Level of Learning: 3


Rationale:
PVA = $500,000 x 3.69590 * = $1,847,950
*n = 5; i = 11%

89. Titanic Corporation leased executive limos under terms of $20,000 down and four equal
annual payments of $30,000 on the anniversary date of the lease. The interest rate implicit in
the lease is 11%. The first year's interest expense would be:
A) $13,200.
B) $10,238.
C) $33,200.
D) $15,543.

Answer: B Learning Objective: 9 Level of Learning: 3


Rationale:
PVA = $30,000 x 3.10245 * = $93,074
$93,074 x 11% = $10,238
*n = 4; i = 11%

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 213


Chapter 6 Time Value of Money Concepts

90. Polo Publishers purchased a multi-color offset press with terms of $50,000 down and a
noninterest-bearing note requiring payment of $20,000 at the end of each year for five years.
The interest rate implicit in the purchase contract is 11%. Polo would record the asset at:
A) $109,618.
B) $123,918.
C) $130,000.
D) $169,560.

Answer: B Learning Objective: 9 Level of Learning: 3


Rationale:
$50,000 + ($20,000 x 3.69590) = $123,918
*PVA: n = 5; i = 11%

Problems

91. Compute the future value of the following invested amounts at the specified periods and
interest rates.

Invested Interest Number of


Item Amount Rate Periods
(a.) $20,000 8% 10
(b.) $30,000 4% 8
(c.) $10,000 12% 15

Answer:
(a.) FV = $20,000 x 2.15892 = $43,178
(b.) FV = 30,000 x 1.36857 = 41,057
(c.) FV = 10,000 x 5.47357 = 54,736

Learning Objective: 2 Level of Learning: 3

92. Compute the present value of the following single amounts to be received at the end of the
specified period at the given interest rate.

Invested Interest Number of


Item Amount Rate Periods
(a.) $40,000 7% 20
(b.) $20,000 6% 25
(c.) $50,000 11% 10

Answer:
(a.) PV = $40,000 x .25842 = $10,337
(b.) PV = $20,000 x .23300 = $4,660
(c.) PV = $50,000 x .35218 = $17,609

Learning Objective: 3 Level of Learning: 3

214 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

93. Incognito Company is contemplating the purchase of a machine that provides it with net after-
tax cash savings of $80,000 per year for 5 years. Interest is 8%. Assume the cash savings
occur at the end of each year.
Required: Calculate the present value of the cash savings.

Answer: PVA = $80,000 x 3.99271 = $319,417

Learning Objective: 6 Level of Learning: 3

94. Samson Inc. is contemplating the purchase of a machine that will provide it with net after-tax
cash savings of $100,000 per year for 8 years. Interest is 10%. Assume the cash savings occur
at the end of each year.
Required: Calculate the present value of the cash savings.

Answer: PVA = $100,000 x 5.33493 = $533,493

Learning Objective: 6 Level of Learning: 3

95. DON Corp. is contemplating the purchase of a machine that will produce net after-tax cash
savings of $20,000 per year for 5 years. At the end of five years, the machine can be sold to
realize after-tax cash flows of $5,000. Interest is 12%. Assume the cash flows occur at the end
of each year.
Required: Calculate the total present value of the cash savings.

Answer:
PVA = $20,000 x 3.60478 = $72,096
PV = 5,000 x .56743 = 2,837
PV OF CASH SAVINGS $74,933

Learning Objective: 3 Level of Learning: 3

96. Touche Manufacturing is considering a rearrangement of its manufacturing operations. A


consultant estimates that the rearrangement should result in after-tax cash savings of $6,000
the first year, $10,000 for the next two years, and $12,000 for the next two years. Interest is at
12%. Assume cash flows occur at the end of the year.
Required: Calculate the total present value of the cash flows.

Answer:
PV OF FUTURE VARIABLE CASH FLOWS

Year Cash Flow PV Present Value


1 $ 6,000 .89286 $ 5,357
2 10,000 .79719 7,972
3 10,000 .71178 7,118
4 12,000 .63552 7,626
5 12,000 .56743 6,809
$34,882 TOTAL PV OF CASH SAVINGS

Learning Objective: 3 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 215


Chapter 6 Time Value of Money Concepts

97. Price Mart is considering outsourcing its billing operations. A consultant estimates that
outsourcing should result in after-tax cash savings of $9,000 the first year, $15,000 for the
next two years, and $18,000 for the next two years. Interest is at 12%. Assume cash flows
occur at the end of the year.
Required: Calculate the total present value of the cash flows.

Answer:
PV OF FUTURE VARIABLE CASH FLOWS

Year Cash Flow PV Present Value


1 $ 9,000 .89286 $ 8,036
2 15,000 .79719 11,958
3 15,000 .71178 10,677
4 18,000 .63552 11,439
5 18,000 .56743 10,214
$52,324 TOTAL PV OF CASH SAVINGS

Learning Objective: 3 Level of Learning: 3

98. Baird Bros. Construction is considering the purchase of a machine at a cost of $125,000. The
machine is expected to generate cash flows of $20,000 per year for ten years and can be sold
at the end of ten years for $10,000. Interest is at 10%. Assume the machine would be paid for
on the first day of year one, but that all other cash flows occur at the end of the year. Ignore
income tax considerations.
Required: Determine if Baird should purchase the machine.

Answer:
Present value of cash outflows $125,000
Present value of cash inflows:
Annual cash flows - $20,000 x 6.14457 $122,891
Residual value - $10,000 x .38554 3,855 126,746
Positive present value of net cash flows $ 1,746

Based on present value considerations, Baird Bros. Construction should buy the machine.

Learning Objective: 3 Level of Learning: 3

216 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

99. Dobson Contractors is considering buying equipment at a cost of $75,000. The equipment is
expected to generate cash flows of $15,000 per year for eight years and can be sold at the end
of eight years for $5,000. Interest is at 12%. Assume the equipment would be paid for on the
first day of year one, but that all other cash flows occur at the end of the year. Ignore income
tax considerations.
Required: Determine if Dobson should purchase the machine.

Answer:
Present value of cash outflows $75,000
Present value of cash inflows:
Annual cash flows - $15,000 x 4.96764 $74,515
Residual value - $5,000 x .40388 2,019 76,534
Positive present value of net cash flows $ 1,534

Based on present value considerations, Dobson Construction should buy the machine.

Learning Objective: 3 Level of Learning: 3

100. Hillsdale is considering two options for comparable computer software. Option A will cost
$25,000 plus annual license renewals of $1,000 for three years, which includes technical
support. Option B will cost $20,000 with technical support being an add-on charge. The
estimated cost of technical support is $4,000 the first year, $3,000 the second year, and $2,000
the third year. Assume the software is purchased and paid for at the beginning of year one, but
that technical support is paid for at the end of each year. Interest is at 8%. Ignore income
taxes.
Required: Determine which option should be chosen based on present value considerations.

Answer:
Option A.
Year Cash Flow PV Present Value
0 $25,000 1.00000 $25,000
1 1,000 .92593 926
2 1,000 .85734 857
3 1,000 .79383 794
$27,577

Option B.
Year Cash Flow PV Present Value
0 $20,000 1.00000 $20,000
1 4,000 .92593 3,704
2 3,000 .85734 2,572
3 2,000 .79383 1,588
$27,864

Option A should be chosen because it has the lower cost based on present value
considerations.

Learning Objective: 3 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 217


Chapter 6 Time Value of Money Concepts

101. Bison Mfg. is considering two options for purchasing comparable machinery. Machine 1 will
cost $27,500 plus an annual maintenance fee of $1,500 per year for four years. Machine 2 will
cost $25,000 with maintenance being an add-on charge. The estimated cost of maintenance is
$1,000 the first year, $3,000 the second year, and $4,000 the third year and the fourth year.
Assume the purchase cost is paid up front, but that maintenance is paid for at the end of each
year. Interest is at 10%. Ignore income taxes and residual values.
Required: Determine which machine should be chosen based on present value considerations.

Answer:
Option A.
Year Cash Flow PV Present Value
0 $27,500 1.00000 $27,500
1 1,500 .90909 1,364
2 1,500 .82645 1,240
3 1,500 .75131 1,127
4 1,500 .68301 1,025
$32,256
Option B.
Year Cash Flow PV Present Value
0 $25,000 1.00000 $25,000
1 1,000 .90909 909
2 3,000 .82645 2,479
3 4,000 .75131 3,005
4 4,000 .68301 2,732
$34,125

Option A should be chosen because it has the lower cost based on present value
considerations.

Learning Objective: 3 Level of Learning: 3

102. Under the NBA deferred compensation plan, payments made at the end of each year
accumulate up to retirement and then retirees are given two options. Option 1 allows the
retiree to select the amount of the annual payment to be received and option 2 allows the
retiree to specify over how many years payments are to be received. Assume Rodman has had
$6,000 deposited at the end of each year for 30 years, and that the long-term interest rate has
been 8%.
Required:
(a.) How much has accumulated in Rodman's deferred compensation account?
(b.) How much will Rodman be able to withdraw at the beginning of each year if he elects to
receive payments for fifteen years?
(c.) How many years will Rodman be able to receive payments if he chooses to receive
$65,000 per year at the beginning of each year?

218 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

Answer:
(a.) Balance in fund = FVA = $6,000 x 113.2832 = $679,699
(b.) Option 2: $679,699/9.24424* = $73,527
*PVAD n = 15; i = 8%
(c.) Option 1: $679,699/$65,000 = 10.45691
Interpolation:
PVAD n = 20, i = 8% 10.60360
PVAD n = 19, i = 8% 10.37189
Difference .23171

PVAD n = ?, i = 8% 10.45691
PVAD n = 19, i = 8% 10.37189
Difference .08502

.08502/.23171 = .37
So Rodman will be able to receive $65,000 per year for 19 years, with a partial payment in
year 20 of approximately $65,000 x 37% = $24,050.

Learning Objective: 8 Level of Learning: 3

103. Under the MLB deferred compensation plan, payments made at the end of each year
accumulate up to retirement and then retirees are given two options. Option 1 allows the
retiree to select the amount of the annual payment to be received and option 2 allows the
retiree to specify over how many years payments are to be received. Assume Sosa has had
$5,000 deposited at the end of each year for 40 years, and that the long-term interest rate has
been 7%.
Required:
(a.) How much has accumulated in Sosa's deferred compensation account?
(b.) How much will Sosa be able to withdraw at the beginning of each year if he elects to
receive payments for twenty years?
(c.) For how many years will Sosa be able to receive payments if he chooses to receive
$115,000 per year at the beginning of each year?

Answer:
(a.) Balance in fund = FVA = $5,000 x 199.6351 = $998,176
(b.) Option 2: $998,176/11.33560* = $88,057
*PVAD n = 20; i = 7%
(c.) Option 1: $998,176/$115,000 = 8.67979

Interpolation:
PVAD n = 13, i = 7% 8.94269
PVAD n = 12, i = 7% 8.49867
Difference .44402

PVAD n = ?, I = 7% 8.67979
PVAD n = 12, i = 7% 8.49867
Difference .18112

.18112/.44402 = .41
So Sosa will be able to receive payments of $115,000 for 12 years, with a partial payment in
year 13 of approximately $115,000 x 41% = $47,150.

Learning Objective: 7 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 219


Chapter 6 Time Value of Money Concepts

104. ABC Company will issue $5,000,000 in 6%, 10-year bonds when the market rate of interest is
8%. Interest is paid semiannually.
Required: Determine how much cash ABC Company will realize from the bond issue.

Answer:
$5,000,000 x 6% x 6/12 = $150,000
n= 20; i = 4%

PV:$5,000,000 x .45639 $2,281,950


PVA: $150,000 x 13.59033 2,038,550
BOND ISSUE PRICE $4,320,500

Learning Objective: 9 Level of Learning: 3

105. DEF Company will issue $2,000,000 in 10%, 10-year bonds when the market rate of interest
is 12%. Interest is paid semiannually.
Required: Determine how much cash DEF Company should realize from the bond issue.

Answer:
$2,000,000 x 10% x 6/12 = $100,000
n= 20; i = 6%

PV: $2,000,000 x .31180 $ 623,600


PVA: $100,000 x 11.46992 1,146,992
BOND ISSUE PRICE $1,770,592

Learning Objective: 9 Level of Learning: 3

106. GHI Company will issue $2,000,000 in 8%, 10-year bonds when the market rate of interest is
6%. Interest is paid semiannually.
Required: Determine how much cash GHI Company should realize from the bond issue.

Answer:
$2,000,000 x 8% x 6/12 = $80,000
n= 20; i = 3%

$2,000,000 x .55368 $1,107,360


$80,000 x 14.87747 1,190,198
BOND ISSUE PRICE $2,297,558

Learning Objective: 9 Level of Learning: 3

220 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

107. JKL Company will issue $2,000,000 in 12%, 10 year bonds when the market rate of interest is
10%. Interest is paid semiannually.
Required: Determine how much cash JKL Company should realize from the bond issue.

Answer:
$2,000,000 x 12% x 6/12 = $120,000
n= 20; i = 5%

PV: $2,000,000 x .37689 $ 753,780


PVA: $120,000 x 12.46221 1,495,465
BOND ISSUE PRICE $2,249,245

Learning Objective: 9 Level of Learning: 3

108. MBI Company's largest computer has a cash selling price of $200,000. A customer wishes to
buy the computer on a lease purchase plan over five years, with the first payment to be made
at the inception of the lease. Interest is at 10%.
Required:
(a.) Compute the amount of the annual lease payment and the gross amount due under the
lease.
(b.) Compute the amount of interest income earned by MBI for the first year of the lease.

Answer:
(a.) Annual lease payment = $200,000 / 4.16987* = $47,963
*(PVAD: n = 5; i =10%)
Gross amount due = $47,963 x 5 years = $239,815

(b.) Principal amount $200,000


Payment on signing lease 47,963
Unpaid balance 152,037
Interest rate 10%
Interest income first year of lease $ 15,204

Learning Objective: 9 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 221


Chapter 6 Time Value of Money Concepts

109. Taylor's tractor-trailer rigs sell for $150,000. A customer wishes to buy a rig on a lease
purchase plan over seven years, with the first payment to be made at the inception of the lease.
Interest is at 12%.
Required:
(a.) Compute the amount of the annual lease payment and the gross amount due under the
lease.
(b.) Compute the amount of interest income earned by Taylor's for the first year of the lease.

Answer:
(a.) Annual lease payment = $150,000 / 5.11141* = $29,346
*(PVAD: n = 7; i =12%)
Gross amount due = $29,346 x 7 years = $205,422

(b.) Principal amount $150,000


Payment on signing lease 29,346
Unpaid balance 120,654
Interest rate 12%
Interest income first year of lease $ 14,478

Learning Objective: 9 Level of Learning: 3

110. Triskitt Company borrowed $50,000 on a noninterest-bearing note from a customer to


purchase needed equipment. Triskitt will make five annual end-of-year payments of $10,000
to pay off the note. In addition, Triskitt will sell materials to the customer over the next five
years at less than normal prices to compensate for the unstated interest. The market rate of
interest for such transactions and parties is 12%.
Required:
(a.) What is the present value of the note at its inception?
(b.) What adjustment (if any) should Triskitt make to the sales account over the next five
years?

Answer:
(a.) 10,000 x 3.60478* = $36,048
*(PVA: n = 5; i =12%)
(b.) Amount of note $50,000
Present value of note 36,048
Imputed interest on note $13,952

Triskitt should debit interest expense and credit sales for the imputed interest over the term of
the loan.

Learning Objective: 7 Level of Learning: 3

222 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

111. Oregon Company loaned a supplier $125,000 on a noninterest-bearing note to enable the
supplier to purchase needed equipment. The supplier will make five annual end-of-year
payments of $25,000 to pay off the note. In addition, the supplier will sell materials to Oregon
over the next five years at less than normal prices to compensate for the unstated interest. The
market rate of interest for such transactions and parties is 12%.
Required:
(a.) What is the present value of the note at its inception?
(b.) What adjustment (if any) should Oregon make to the cost of purchases over the next five
years?

Answer:
(a.) 25,000 x 3.60478* = $ 90,120

*(PVA: n = 5; i =12%)
(b.) Amount of note $125,000
Present value of note 90,120
Imputed interest on note $ 34,880

Oregon should debit inventory and credit interest revenue for the imputed interest over the
term of the loan.

Learning Objective: 7 Level of Learning: 3

112. On May 1, 2006, Bo Smith, proud father of newborn son Bobo, purchased a $200,000 zero-
coupon bond which matures on May 1, 2026. The bond pays no interest during the period of
time it is outstanding. The interest rate for such borrowings is at 9%. Interest compounds
annually.
Required: Calculate the price Bo paid for the bond.

Answer:
$200,000 x .17843* = $35,686
*PV: n= 20; i = 9%

Learning Objective: 3 Level of Learning: 3

113. On February 1, 2006, Lynda Brown, proud mother of newborn daughter Goldie, purchased a
$600,000 zero-coupon bond which matures on February 1, 2026. The bond pays no interest
during the period of time it is outstanding. The interest rate for such borrowings is at 12%.
Required: Calculate the price Lynda paid for the bond.

Answer:
$600,000 x .10367* = $62,202
*PV: n= 20; i = 12%

Learning Objective: 3 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 223


Chapter 6 Time Value of Money Concepts

114. Titan Corporation has a defined benefit pension plan. One of its employees has vested benefits
under the plan which will pay her $30,000 annually for life starting with the first $30,000
payment on the day she retires at the age of 65. The employee has just reached the age of 45.
Titan consulted standard mortality tables to come up with a life expectancy of 80 for this
employee. The implicit interest rate under the plan is 9%.
Required:
(a.) What will be the present value of the pension obligation at the time of the employee's
retirement?
(b.) What is the present value of the pension obligation at the current time?

Answer:
30,000 x 8.78615* $263,585

*PVAD: n= 15; i = 9%
263,585 x .17843* $47,031

*PV: n= 20; i = 9%

Learning Objective: 9 Level of Learning: 3

115. King Corporation has a defined benefit pension plan. One of its employees has vested benefits
under the plan which will pay him $40,000 annually for life starting with the first payment of
$40,000 on the day he retires at the age of 65. The employee has just reached the age of 50.
King consulted standard mortality tables to come up with a life expectancy of 80 for this
employee. The implicit interest rate under the plan is 9%.
Required:
(a.) What will be the present value of the pension obligation at the time of the employee's
retirement?
(b.) What is the present value of the pension obligation at the current time?

Answer:
$40,000 x 8.78615* $351,446

*PVAD: n= 15; i = 9%
$351,446 x. .27454* $96,486

*PV: n= 15; i = 9%

Learning Objective: 9 Level of Learning: 3

224 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

Use the following to answer questions 116-119:

The following information was disclosed in the Debt footnote to the financial statements of
Healdsburg Company for the year ended December 31, 2005:

Debt. The following table summarizes the long-term debt of the Company at December 31, 2005:

7.25% notes due 2006 $201,335,000


7.75% notes due 2013 $345,154,000
8% notes due 2023 $225,000,000
7.63% notes due 2031 $200,000,000
6.55% notes due 2007 $ 25,000,000

Required: Assuming that the notes pay interest annually and mature on December 31 of the
respective years, compute the following:

116. The total cash interest payments in 2006 for these notes.

Answer: ($201,335 x .0725) + ($345,154 x .0775) + ($225,000 x .08) + ($200,000 x .0763) +


($25,000 x .0655) = $76,243.72 thousand (i.e., $76, 243,720)

Learning Objective: 1 Level of Learning: 3

117. Suppose that Healdsburg wants to buy back the 7.75% notes on December 31, 2008 (i.e., 5
years early) when the going interest rate is 6%, thereby retiring the $345,154,000 in debt.
How much would Healdsburg have to pay for the notes (principal only)?

Answer: Compute the PV of $345,154,000, where n = 5 and I = 6%. PV = $345,154,000 x .


74726 = $257,919,778

Learning Objective: 3 Level of Learning: 3

118. Suppose that Healdsburg renegotiates the 8% notes on December 31, 2011 when the going
interest rate is 8%. Healdsburg agrees to make 12 equal annual installments, commencing on
December 31, 2012, rather than pay the $225 million in a lump sum at maturity. What would
the annual payments be?

Answer: $225 million would be the PVA; n = 12 and I = 8%. Therefore, the payments would
be $225 million/7.53608 = $29,856,371.

Learning Objective: 8 Level of Learning: 3

119. Suppose that Healdsburg enters into a sales contract with an auto manufacturer on January 1,
2006, to provide tires that cost Healdsburg $18 million to produce. The buyer offers
Healdsburg $6 million in cash and agrees to take over the principal payment only on
Healdsburg 's 6.55% debt notes. Assume that the going market interest is 7% at the time.
What would Healdsburg's gross profit be on the sale?

Answer: The revenue would be $6 million + the PV of the 6.55% note principal, where n = 2
and I = 7%. Revenue = $6 million + ($25 million x .87344) = $27,836,000. Therefore,
Healdsburg's gross profit on the sale would be $27,836,000 18,000,000 = $9,836,000.

Learning Objective: 3 Level of Learning: 3

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 225


Chapter 6 Time Value of Money Concepts

Essay

Instructions:

The following answers point out the key phrases that should appear in students' answers. They are not
intended to be examples of complete student responses. It might be helpful to provide detailed
instructions to students on how brief or in-depth you want their answers to be.

120. Briefly explain how you would arrive at the monthly payment for a 48-month loan where the
first payment is due one month from the loan date. In your explanation, include the use of
present and future value tables.

Answer: The 48-month loan described is an ordinary annuity. Therefore, the appropriate table
would be for the present value of an ordinary annuity (PVA). The annual stated interest rate
would be divided by 12 to arrive at the periodic rate. Thus, an 18% annual rate yields a
periodic rate of 1.5%. You would arrive at the monthly payment by dividing the known loan
amount by the PVA factor at 1.5% for 48 periods.

Learning Objective: 8 Level of Learning: 3

121. Prepare a time diagram for the future value an ordinary annuity with three payments of $300.
Be sure to indicate the periods in which interest is added.

Answer:
TIME DIAGRAM FOR THE FUTURE VALUE OF AN ORDINARY ANNUITY WITH
THREE PAYMENTS OF $300

PERIOD 1 PERIOD 2 PERIOD 3

1st $300 pmt 2nd $300 pmt 3rd $300 pmt FVA

No interest 1st of 2 interest periods 2nd of 2 interest periods

Learning Objective: 6 Level of Learning: 2

122. Prepare a time diagram for the future value an annuity due with three payments of $400. Be
sure to indicate the periods in which interest is added.

Answer:
TIME DIAGRAM FOR THE FUTURE VALUE OF AN ANNUITY DUE WITH THREE
PAYMENTS OF $400

PERIOD 1 PERIOD 2 PERIOD 3


1st $400 pmt 2nd $400 pmt 3rd $400 pmt FVAD

1st of 3 interest periods 2nd of 3 interest periods 3rd of 3 interest periods

Learning Objective: 6 Level of Learning: 2

226 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

123. Explain how you would compute the imputed interest on cash borrowed at zero percent
interest when the market rate of interest is eight percent.

Answer: Imputed interest on a zero percent interest loan is a two-step process. First, compute
the present value of the loan repayments by discounting at the appropriate market rate, 8% in
this situation. Second, compare the loan amount to the lower present value computed in step
one; the difference is the amount of imputed interest to be recognized over the term of the
loan.

Learning Objective: 3 Level of Learning: 3

124. Two banks each have annual CD rates of twelve percent. Bank A compounds quarterly and
Bank B compounds semiannually. Explain which bank offers the better CD.

Answer: The yield on a CD increases with more frequent compounding periods. Therefore,
since both CDs have the same stated rate of 12%, Bank A, that compounds quarterly, offers a
better yield than Bank B with semiannual compounding.

Learning Objective: 4 Level of Learning: 3

125. Provide two examples of the use of present value techniques in accounting.

Answer: This question only asks for two examples of the use of present value techniques in
accounting. The chapter previews the use of PV techniques in accounting for long-term leases
and in computing the pension obligation for defined benefit plans. The major emphasis in the
chapter is accounting for interest-bearing obligations, such as determining the selling price of
bonds, solving for the payment on an installment loan, and determining both future and
present value amounts.

Learning Objective: 9 Level of Learning: 2

126. Briefly describe the differences between an ordinary annuity, an annuity due, and a deferred
annuity.

Answer: An annuity is a series of equal cash flows occurring over equal periods of time. In an
ordinary annuity, cash flows occur at the end of each period; in an annuity due, cash flows
occur at the beginning of each period; and in a deferred annuity, cash flows begin more than
one period beyond the date of the agreement.

Learning Objective: 5 Level of Learning: 2

127. Briefly describe the difference between simple interest and compound interest.

Answer: Simple interest is computed only on the initial principal amount. Compound interest
includes not only interest on the initial principal, but also interest on the accumulated interest
to date.

Learning Objective: 1 Level of Learning: 2

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 227


Chapter 6 Time Value of Money Concepts

Use the following to answer questions 128-130:

The following footnote disclosure is taken from the 2006 Annual Report to Shareholders of Eastern
Oil Company. [Note that capital leases are ones like an installment purchase that require the lessor to
record both a leased asset and a lease liability. By contrast, operating leases are treated purely as a
rental.]

11. Leases (in $millions)


Future minimum commitments for capital leases (including sale-leasebacks accounted for as
financings) and for operating leases having remaining noncancelable lease terms in excess of one year
are as follows:

Capital Operating
(In millions) Leases Leases

2007 $ 12 $ 116
2008 12 90
2009 12 77
2010 12 120
2011 12 34
Later years 78 97
Sublease rentals - (112)
---- ------
Total minimum lease payments $138 $ 422
Less imputed interest costs 47
----
Present value of net minimum
lease payments included in
long-term debt $ 91

Required:

128. Describe how present value methods affect Eastern's long-term lease debt?

Answer: Eastern has long-term obligations on its capital leases. Those lease payments do not
explicitly identify principal and interest, but the substance of these transactions is the same as
other long-term debt. Therefore, the future payments disclosed must be discounted by an
imputed interest rate (the going market rate for such transactions). In this case, the interest
component is $47 million out of the $138 million to be paid. The rest ($91 million) is the
present value of the debt, the amount that should be considered in the long-term liability
section of Eastern's balance sheet.

Learning Objective: 9 Level of Learning: 3

228 Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition


Chapter 6 Time Value of Money Concepts

129. How would the amount of Eastern's long-term lease debt be different if no interest was
imputed?

Answer: All of the lease payments would be considered principal; thus, the debt would be
reported as $138 million, rather than $91 million. This would also eliminate interest expense
from these payments, thereby increasing earnings. This is not reflective of the underlying
economic substance of the capital leases and is not permitted by GAAP.

Learning Objective: 9 Level of Learning:3

130. What would happen if Eastern imputed an interest rate larger than the one used in this
disclosure?

Answer: It would impute an amount of interest greater than the $47 million. Therefore, the
remaining debt component of the payments (the obligation reported on the balance sheet)
would be proportionally less than the $91 million reported.

Learning Objective: 4 Level of Learning: 2

Spiceland/Sepe/Tomassini, Intermediate Accounting, Fourth Edition 229