CHAPTER 3

INTEGRATIVE PROBLEM
ANSWER: Discuss basic time value concepts, terminology, and solution methods. A cash flow time
line is a graphical representation that is used to show the timing of cash flows. The tick marks represent
end of periods (often years), so time 0 is today; time 1 is the end of the first year, or 1 year from today;
and so on.
LUMP-SUM AMOUNTa single flow; for example, a $100 inflow in Year 2:
0 1 2 3 Year
100 Cash flow
ANNUITYa series of equal cash flows occurring over equal intervals:
0 1 2 3 Year
100 100 100 Cash flow
UNEVEN CASH FLOW STREAMan irregular series of cash flows that do not constitute an annuity:
0 1 2 3 Year
-50 100 75 50 Cash flow
CF = -50 represents a cash outflow rather than a receipt or inflow.
44
3-33 ASSUME THAT YOU ARE NEARING GRADUATION AND THAT YOU HAVE
APPLIED FOR A JOB WITH A LOCAL BANK. AS PART OF THE BANK'S
EVALUATION PROCESS, YOU HAVE BEEN ASKED TO TAKE AN
EXAMINATION THAT COVERS SEVERAL FINANCIAL ANALYSIS
TECHNIQUES. THE FIRST SECTION OF THE TEST ADDRESSES TIME
VALUE OF MONEY ANALYSIS. SEE HOW YOU WOULD DO BY
ANSWERING THE FOLLOWING QUESTIONS:
A. DRAW CASH FLOW TIME LINES FOR (1) A $100 LUMP SUM CASH FLOW
AT THE END OF YEAR 2, (2) AN ORDINARY ANNUITY OF $100 PER YEAR
FOR THREE YEARS, AND (3) AN UNEVEN CASH FLOW STREAM OF -$50,
$100, $75, AND $50 AT THE END OF YEARS 0 THROUGH 3.
k%
k%
k%
B. (1) WHAT IS THE FUTURE VALUE OF AN INITIAL $100 AFTER THREE YEARS IF
IT IS INVESTED IN AN ACCOUNT PAYING 10 PERCENT ANNUAL INTEREST?
ANSWER: Show dollars corresponding to question mark, calculated as follows:
0 1 2 3
100 FV = ?
After 1 year:
FV1 = PV + INT1 = PV + PV(k) = PV(1 + k) = $100(1.10) = $110.00.
Similarly:
FV2 = FV1 + INT2 = FV1 + FV1(k)
= FV1(1 + k) = $110(1.10) = $121.00
= PV(1 + k)(1 + k) = PV(1 + k)
2
.
FV3 = FV2 + INT3 = FV2 + FV2(k)
= FV2(1 + k) = $121(1.10) = $133.10
= PV(1 + k)
2
(1 + k) = PV(1 + k)
3
In general, we see that:
FVn = PV(1 + i)
n
,
so FV3 = $100(1.10)
3
= $100(1.3310) = $133.10.
Note that this equation has four variables: FVn, PV, k, and n. Here we know all except FVn, so we
solve for FVn. However, often, we will solve for one of the other three variables. By far, the easiest way
to work all time value problems is with a financial calculator. Just plug in any three of the four values
and find the fourth.
Finding future values (moving to the right along the time line) is called compounding. Note we
generally find FV using one of these methods:
(1) Numerical approachuse a regular calculator: FV3 = $100(1.10)
3
= $133.10.
(2) Financial calculator: This is especially efficient for more complex problems, including exam
problems. Input the following values: N = 3, I = 10, PV = -100, and PMT = 0; compute FV =
$133.10.
(3) Spreadsheet: Set up your spreadsheet and use the FV financial function similar to the
following:
45
10%
Step 1: Set up the spreadsheet: Step 2: Select FV in the financial function category:
Step 3: Input the cell locations of the data: Step 4: Press OK to display the solution:

46
B. (2) WHAT IS THE PRESENT VALUE OF $100 TO BE RECEIVED IN 3
YEARS IF THE APPROPRIATE INTEREST RATE IS 10 PERCENT?
ANSWER: Finding present values, or discounting (moving to the left along the time line), is the
reverse of compounding, and the basic present value equation is the reciprocal of the compounding
equation:
0 1 2 3
PV = ? 100
FVn = PV(1 + k)
n
transforms to:

) k + (1
1

FV
=
) k + (1
FV
= PV
n
n
n
n
1
1
]
1

thus:
( ) 13 . 75 $ 75134 . 0 $100 =
(1.10)
1
$100 = PV
3

1
]
1

The same methods (regular calculator, financial calculator, and spreadsheet) used for finding future
values also are used to find present values, which is called discounting.
Numerical (regular calculator) solution: Given above.
Financial calculator solution: Input N = 3, I = 10, PMT = 0, and FV = 100; compute PV =
$75.13.
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet.
ANSWER: We have this situation in time line format:
0 1 2 3 n = ?
-1 3
If we want to find out how long it will take us to triple our money at an interest rate of 20 percent, we
can use any numbers, say, $1 and $3, with this equation:
FVn = $3 = $1(1 + k)
n
= $1(1.20)
n
Numerical (regular calculator) solution: Use a trial-and-error method, substituting values in for
n until the right side of the equation equals 3. Or, using more complex mathematics, we can
solve the above equation as follows:
47
10%
C. WE SOMETIMES NEED TO FIND HOW LONG IT WILL TAKE A SUM OF
MONEY (OR ANYTHING ELSE) TO GROW TO SOME SPECIFIED AMOUNT.
FOR EXAMPLE, IF A COMPANY'S SALES ARE GROWING AT A RATE OF 20
PERCENT PER YEAR, APPROXIMATELY HOW LONG WILL IT TAKE
SALES TO TRIPLE?
20%

1
3
) 20 . 1 (
) 20 . 1 ( 1 3
n
n

years 026 . 6
18232 . 0
09861 . 1
) 20 . 1 ln(
) 3 ln(
n
Financial calculator solution: Input I = 20, PV = -1, PMT = 0, and FV = 3; compute N =
6.026.
Spreadsheet solution: Use the NPER financial function that is available on the spreadsheet.
Thus, it takes approximately 6 periods for an amount to triple at a 20 percent interest rate.
*******************************************************************************
OPTIONAL QUESTION: A FARMER CAN SPEND $60 PER ACRE TO PLANT PINE TREES
ON SOME MARGINAL LAND. THE EXPECTED REAL RATE OF RETURN IS 4 PERCENT,
AND THE EXPECTED INFLATION RATE IS 6 PERCENT. WHAT IS THE EXPECTED
VALUE OF THE TIMBER AFTER 20 YEARS?
FV20 = $60(1 + 0.04 + 0.06)
20
= $60(1.10)
20
= $403.65 per acre.
We could have asked: How long would it take $60 to grow to $403.65, given the real rate of return of 4
percent and an inflation rate of 6 percent. Of course, the answer would be 20 years.
*******************************************************************************
ANSWER: This is an ordinary annuityits payments are at the end of each period; that is, the first
payment is made one period from today. Conversely, an annuity due has its first payment today. In
other words, an ordinary annuity has end-of-period payments, whereas an annuity due has beginning-
of-period payments.
The annuity shown above is an ordinary annuity. To convert it to an annuity due, shift each payment to
the left, so you end up with a payment under the 0 but none under the 3.
ANSWER:
48
D. WHAT IS THE DIFFERENCE BETWEEN AN ORDINARY ANNUITY AND AN
ANNUITY DUE? WHAT TYPE OF ANNUITY IS SHOWN IN THE FOLLOWING
CASH FLOW TIME LINE? HOW WOULD YOU CHANGE IT TO THE OTHER
TYPE OF ANNUITY?
0 10% 1 2 3
100 100 100
E. (1) WHAT IS THE FUTURE VALUE OF A THREE-YEAR ORDINARY
ANNUITY OF $100 IF THE APPROPRIATE INTEREST RATE IS 10
PERCENT?
0 1 2 3
100 100 100
110
121
331
One approach would be to treat each annuity flow as a lump sum as in the time line. Here we have:
FVAn = $100(1.10)
0
+ $100(1.10)
1
+ $100(1.10)
2
= $100[(1.10)
0
+ (1.10)
1
+ (1.10)
2
]
= $100(1.00 + 1.10 + 1.21) = $100(3.3100) = $331.00
Numerical solution:
00 . 331 $ ) 31000 . 3 ( 100 $
10 . 0
1 ) 10 . 1 (
100 $
k
1 ) k 1 (
PMT FVA
3
n
n

1
]
1

1
]
1

Financial calculator solution: Input N = 3, I = 10, PV = 0, and PMT = -100; compute FV =

331
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting 100 for Pmt.
ANSWER:
0 1 2 3
90.91 100 100 100
82.64
75.13
248.68
The present value of the annuity is $248.68. Here we used the lump sum approach, but the same result
could be obtained by using a regular or financial calculator.
Numerical solution:
49
10%
E. (2) WHAT IS THE PRESENT VALUE OF THE ANNUITY?
10%
69 . 248 $ ) 48685 . 2 ( 100 $
10 . 0
1
100 $
k
1
PMT PVA
3
n
) 10 . 1 (
1
) k 1 (
1
n

1
1
]
1

1
1
]
1

+
Financial calculator solution: Input N = 3, I = 10, PMT = 100, and FV = 0; compute PV =
-248.69
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet,
inputting 100 for Pmt.
ANSWER: If the annuity were an annuity due, each payment would be shifted to the left, so each
payment is compounded over an additional period or discounted back over one less period.
Future Value of the Annuity
Numerical solution:
10 . 364 $ ) 64100 . 3 ( 100 $
) 10 . 1 (
10 . 0
1 ) 10 . 1 (
100 $
) k 1 (
k
1 ) k 1 (
PMT ) DUE ( FVA
3
n
n

'

1
]
1

'

+
1
]
1

Financial calculator solution: Switch your calculator to BEB or beginning or DUE mode,
input N = 3, I = 10, PV = 0, and PMT = -100; compute FV = 364.10. Remember to change
back to END mode after working an annuity due problem with your calculator.
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting Pmt = 100 and Type =1.
Present Value of the Annuity
Numerical solution:
50
E. (3) WHAT WOULD THE FUTURE AND PRESENT VALUES BE IF THE
ANNUITY WERE AN ANNUITY DUE?
55 . 273 $ ) 73554 . 2 ( 100 $
) 10 . 1 (
10 . 0
1
100 $
) k 1 (
k
1
PMT ) DUE ( PVA
3
n
) 10 . 1 (
1
) k 1 (
1
n

'

1
1
]
1

'

+
1
1
]
1

+
Financial calculator solution: Switch your calculator to BEB or beginning or DUE mode,
input N = 3, I = 10, PMT = 100, and FV = 0; compute PV = -248.69. Remember to change
back to END mode after working an annuity due problem with your calculator.
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet,
inputting Pmt = 100 and Type =1.
ANSWER: Here we have an uneven cash flow stream. The most straightforward approach is to find the
present value of each cash flow and then sum the PVs as shown below:
0 1 2 3 4
90.91 100 300 300 -50
247.93
225.39
(34 .15 )
530.08
Numerical solution:
09 . 530 ) 1507 . 34 $ ( 3944 . 225 $ 9339 . 247 $ 9091 . 90 $
) 10 . 1 (
1
) 50 $ (
) 10 . 1 (
1
300 $
) 10 . 1 (
1
300 $
) 10 . 1 (
1
100 $
) k 1 (
1
CF
) k 1 (
1
CF
) k 1 (
1
CF PV
4 3 2 1
n
n
2
2
1
1
+ + +
1
]
1

+
1
]
1

+
1
]
1

+
1
]
1

1
]
1

+
+ +
1
]
1

+
+
1
]
1

+

51
F. WHAT IS THE PRESENT VALUE OF THE FOLLOWING UNEVEN CASH
FLOW STREAM? THE APPROPRIATE INTEREST RATE IS 10 PERCENT,
COMPOUNDED ANNUALLY.
0 10% 1 2 3 4 YEARS
100 300 300 -50
10%
Financial calculator solution: Financial calculators have cash flow (CF) functions in which
you would input the cash flows, so they are in the calculators memory, input the interest rate,
I, and then compute the NPV, which is the present value. In this case, CF0 = 0, CF1 = 100, CF2
= 300, CF3 = 300, and CF4 = -50. See the appendix in Chapter 3 for instructions.
Spreadsheet solution: Use the NPV financial function that is available on the spreadsheet. In
Excel, the NPV function computes the PV of CF1, CF2, CF3, and so forth; CF0 is not included
in the computation.

ANSWER:
0 1 2 3
-100 125.97
$100(1 + k)
1
$100(1 + k)
2
$100(1 + k)
3
FV = $100(1 + k)
3
= $125.97
Numerical solution:
% 0 . 8 080 . 0 0 . 1
00 . 100 $
97 . 125 $
k
) k 1 ( 100 $ 97 . 125 $
) k 1 ( PV FV
3
1
3
n

,
_

+
+
Financial calculator solution: Input N = 3, PV = -100, PMT = 0, and FV = 125.97; compute I
= 8.0% = k.
Spreadsheet solution: Use the RATE financial function that is available on the spreadsheet
ANSWER: Investments that pay interest more frequently than once a year, for example, semiannually,
quarterly, or daily, have higher future values because interest is earned on interest more often. Banks
pay interest daily on passbook and most money fund accounts, so they use daily compounding.
52
G. WHAT ANNUAL INTEREST RATE WILL CAUSE $100 TO GROW TO $125.97
IN THREE YEARS?
k = ?
H. (1) WILL THE FUTURE VALUE BE LARGER OR SMALLER IF WE
COMPOUND AN INITIAL AMOUNT MORE OFTEN THAN ANNUALLY,
FOR EXAMPLE, EVERY SIX MONTHS, OR SEMIANNUALLY,
HOLDING THE STATED INTEREST RATE CONSTANT? WHY?
H. (2) DEFINE (I) THE STATED, OR QUOTED, OR SIMPLE, RATE, (II) THE
PERIODIC RATE, AND (III) THE EFFECTIVE ANNUAL RATE (EAR).
H. (3) WHAT IS THE EFFECTIVE ANNUAL RATE FOR A SIMPLE RATE OF
10 PERCENT, COMPOUNDED SEMIANNUALLY? COMPOUNDED
QUARTERLY? COMPOUNDED DAILY?
ANSWER: The quoted, or simple, rate is merely the quoted percentage rate of return, the periodic rate
is the rate charged by a lender or paid by a borrower each period (periodic rate = kSIMPLE/m), and the
effective annual rate (EAR) is that rate of interest that would provide an identical future dollar value
under annual compounding (EAR = {1 + [kSIMPLE/m]}
m
- 1.0).
ANSWER: The effective annual rate for 10 percent semiannual compounding, is 10.25 percent:
% 25 . 10 1025 . 0 0 . 1
2
10 . 0
1
1.0 -
m
i
+ 1 = EAR
2
SIMPLE
m

,
_

,
_

For quarterly compounding, the effective annual rate is 10.38 percent:

EAR = (1.025)
4
- 1.0 = 1.1038 - 1.0 = 0.1038 = 10.38%.
Daily compounding would produce EAR = 10.52%.
ANSWER: With semiannual compounding, the $100 is compounded over six semiannual periods at a
5.0 percent periodic rate:
1 2 3 Years
0 1 2 3 4 5 6 Six-month periods
-100 FV=?
Numerical Solution:

01 . 134 $ ) 34010 . 1 ( 100 $ ) 05 . 1 ( 100 $
2
0.10
+ 1 $100

m
k
1 PV FV
6
3 2
n m
SIMPLE
n

,
_

1
]
1

Quarterly: FVn = $100(1.025)

12
= $134.49
53
H. (4) WHAT IS THE FUTURE VALUE OF $100 AFTER THREE YEARS
UNDER 10 PERCENT SEMIANNUAL COMPOUNDING? QUARTERLY
COMPOUNDING?
5%
Another approach here would be to use the effective annual rate and compound over annual
periods:
Semiannually: $100(1.1025)
3
= $134.01
Quarterly: $100(1.1038)
3
= $134.49
Clearly, the return is higher when using quarterly compounding.
Financial calculator solution: Semiannual compounding: Input N = 6, I = 5, PV = -100, and
PMT = 0; compute FV = 134.01.
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet; adjust
the interest rate so that it represents the interest paid per period and N so that it equals the
number of interest periods.
ANSWER: If annual compounding is used, then the simple rate will be equal to the effective annual
rate. If more frequent compounding is used, the effective annual rate will be greater than the simple
rate.
ANSWER:
0 1 2 3
100 100 100.00
110.25 = $100(1.05)
2
121 .55 = $100(1.05)
4
331.80
Here we have a different situation. The payments occur annually, but compounding occurs each six
months. Thus, we cannot use normal annuity valuation techniques. There are two approaches that can
be applied: (1) Treat the cash flows as lump sums, as was done above, or (2) Treat the cash flows as an
ordinary annuity, but use the effective annual rate:
10.25%. = 1 -
2
0.10
+ 1 = 1 -
m
i
+ 1 = EAR
2
SIMPLE
m

,
_

,
_

Now we have this three-period annuity:

54
I. WILL THE EFFECTIVE ANNUAL RATE EVER BE EQUAL TO THE SIMPLE
(QUOTED) RATE?
J. (1) WHAT IS THE VALUE AT THE END OF YEAR 3 OF THE FOLLOWING
CASH FLOW STREAM IF THE QUOTED INTEREST RATE IS 10
PERCENT, COMPOUNDED SEMIANNUALLY?
0 1 2 3 YEARS
100 100 100
5%
FVA3 = $100(1.1025)
2
+ $100(1.1025)
1
+ $100 = $331.80
Numerical solution:
80 . 331 $ ) 31801 . 3 ( 100 $
1025 . 0
1 ) 1025 . 1 (
100 $
k
1 ) k 1 (
PMT FVA
3
n
n

1
]
1

1
]
1

Financial calculator solution: Input N = 3, I = 10.25, PV = 0, and PMT = -100; compute FV =

331.80
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting 100 for Pmt and 0.1025 for Rate.
ANSWER:
0 1 2 3
90.70 100 100 100
82.27
74 .62
247.59
Numerical solution:
59 . 247 $ ) 47595 . 2 ( 100 $
1025 . 0
1
100 $
k
1
PMT PVA
3
n
) 1025 . 1 (
1
) k 1 (
1
n

1
1
]
1

1
1
]
1

+
Financial calculator solution: Input N = 3, I = 10.25, PMT = 100, and FV = 0; compute PV =
-247.59
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet,
inputting 100 for Pmt and 0.1025 for Rate.
ANSWER: The payment stream is an annuity in the sense of constant amounts at regular intervals, but
the intervals do not correspond with the compounding periods. This kind of situation occurs often. In
this situation the interest is compounded semiannually, so with a quoted rate of 10 percent, the EAR
55
J. (2) WHAT IS THE PV OF THE SAME STREAM?
5%
J. (3) IS THE STREAM AN ANNUITY?
will be 10.25 percent. Here we could find the effective rate and then treat it as an annuity. Enter N = 3,
I = 10.25, PMT = 100, and FV = 0; compute PV = -247.59.
ANSWER: kSIMPLE can only be used in the calculations when annual compounding occurs. If the simple
rate of 10 percent was used to discount the payment stream the present value would be overstated by
$272.32 - $247.59 = $24.73.
ANSWER: To begin, note that the face amount of the loan, $1,000, is the present value of a three-year
annuity at a 10 percent rate:
0 1 2 3
-1,000 PMT PMT PMT
We have an equation with only one unknown, so we can solve it to find PMT.
) PMT(1.10 + ) PMT(1.10 + ) PMT(1.10 =
) k + PMT(1 + ) k + PMT(1 + ) k + PMT(1 = $1,000

) i + (1
1
PMT +
) i + (1
1
PMT +
) i + (1
1
PMT = PVA
3 - 2 - 1 -
3 - 2 - 1 -
3 2 1
3
1
1
]
1

1
1
]
1

1
1
]
1

56
J. (4) AN IMPORTANT RULE IS THAT YOU SHOULD NEVER SHOW A
SIMPLE RATE ON A TIME LINE OR USE IT IN CALCULATIONS
UNLESS WHAT CONDITION HOLDS? (HINT: THINK OF ANNUAL
COMPOUNDING, WHEN kSIMPLE = EAR) WHAT WOULD BE WRONG
WITH YOUR ANSWER TO QUESTIONS J(1) AND J(2) IF YOU USED
THE SIMPLE RATE 10 PERCENT RATHER THAN THE PERIODIC
RATE kSIMPLE 2 = 10%/2 = 5%?
K. (1) CONSTRUCT AN AMORTIZATION SCHEDULE FOR A $1,000, 10
PERCENT ANNUAL RATE LOAN WITH THREE EQUAL
INSTALLMENTS.
(2) WHAT IS THE ANNUAL INTEREST EXPENSE FOR THE BORROWER,
AND THE ANNUAL INTEREST INCOME FOR THE LENDER, DURING
YEAR 2?
10%
Numerical solution:
11 . 402 $
48685 . 2
000 , 1 $
PMT
) 48685 . 2 ( PMT
10 . 0
1
PMT 000 , 1 $
k
1
PMT PVA
3
n
) 10 . 1 (
1
) k 1 (
1
n

1
1
]
1

1
1
]
1

+
Financial calculator solution: Input N = 3, I = 10, PV = 1,000, and FV = 0; compute PMT =
-402.11
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet,
solving for Pmt.
Now make the following points regarding the amortization schedule:
(1) The $402.11 annual payment includes both interest and principal. Interest in the first year is
calculated as follows:
Year 1 interest = k x beginning balance = 0.10 x $1,000 = $100.
(2) The repayment of principal is the difference between the $402.11 annual payment and the
interest payment:
Year principal repayment = $402.11 - $100 = $302.11.
(3) The loan balance at the end of the first year is:
Year 1 ending balance = beginning balance - principal repayment = $1,000 - $302.11 =
$697.89.
(4) We would continue these steps in the following years.
(5) Notice that the interest each year declines because the beginning loan balance is declining.
Because the payment is constant, but the interest component declines, the principal repayment
portion increases each year.
(6) The interest component is an expense that is deductible to a business or a homeowner, and it is
taxable income to the lender. If you buy a house, you will get a schedule constructed like ours,
but longer, with 30 x 12 = 360 monthly payments if you get a 30-year, fixed rate mortgage.
(7) The payment might have to be increased by a few cents in the final year to take care of
rounding errors and make the final payment produce a zero ending balance.
(8) The lender received a 10 percent rate of interest on the average amount of money that was
invested each year, and the $1,000 loan was paid off. This is what amortization schedules are
designed to do.
(9) Most financial calculators have amortization functions built in.
The amortization schedule would be:
Beginning Interest Principal Ending
Year Balance Payment @ 10% Repayment Balance
1 $1,000.00 $402.11 $100.00 $302.11 $697.89
2 697.89 402.11 69.79 332.32 365.57
3 365.57 402.11 36.56 365.55 0.02 (rounding difference)
57
FRACTIONAL TIME PERIODS
To this point, all of our examples have dealt with full years. Now we are going to look at the situation
where we deal with fractional years, such as nine months, or 1 years. In these situations, proceed as
follows:
(1) As always, start by drawing a cash flow time line so you can visualize the situation.
(2) Then think about the interest ratethe simple rate, the compounding periods per year, and the
effective annual rate. If you have been given a simple rate, you might have to convert to the
ear: using this formula:
1
m
k
+ 1 = EAR
SIMPLE
m

,
_

(3) If you know the effective annual rate, then you can find the PV of a lump sum by applying this
equation:
1
1
]
1

) EAR + (1
1

FV
= PV
T
t
Here t can be a fraction of a year, such as 0.75 if you need to find the PV of $1,000 due in nine
months, or 450/365 = 1.2328767 if the payment is due in 450 days.
(4) If you have an annuity with payments different from once a year, say, every month, you can
always work it out as a series of lump sums. You can also use annuity formulas and calculator
functions, but you have to be careful.
ANSWER: First, determine the effective annual rate of interest, with daily compounding:
12.0%. = 0.12 = 1
365
0.1133463
+ 1 = EAR
365

,
_

Thus, if you left your money on deposit for an entire year, you would earn $12 of interest, and you
would end up with $112. The question, however, is: How much will be in your account on October 1,
2005?
Here you will be leaving the money on deposit for 9/12 = 3/4 = 0.75 of a year.

0 0.75 1
-100 FV=? 112
You would use the regular set-up, but with the fraction of the year:
Numerical solution:
FV0.75 = $100(1.12)
0.75
= $100(1.08871) = $108.87
58
L. SUPPOSE ON JANUARY 1, 2005, YOU DEPOSIT $100 IN AN ACCOUNT THAT
PAYS A SIMPLE, OR QUOTED, INTEREST RATE OF 11.33463 PERCENT,
WITH INTEREST ADDED (COMPOUNDED) DAILY. HOW MUCH WILL YOU
HAVE IN YOUR ACCOUNT ON OCTOBER 1, OR AFTER NINE MONTHS?
12%
Financial calculator solution: Input N = 0.75, I = 12, PV = -100, and PMT = 0; compute FV =
108.87
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting 0.75 for Nper.
ANSWER: In this case, the money will be left on deposit for 1 + 9/12 = 1 + 3/4 = 1.75 of a year.
0 1 1.75 2 Years
-100 112 FV=? 125.44
Numerical solution:
FV1.75 = $100(1.12)
1.75
= $100(1.21936) = $121.94
Financial calculator solution: Input N = 1.75, I = 12, PV = -100, and PMT = 0; compute FV =
121.94
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting 1.75 for Nper.
ANSWER: you can solve this problem in three ways: (1) by compounding the $850 now in the bank
for 15 months and comparing that FV with the $1,000 the note will pay; (2) by finding the PV of the
note and then comparing it with the $850 cost; and (3) by finding the effective annual rate of return on
the note and comparing that rate with the 7 percent you are now earning, which is your opportunity cost
of capital. All three procedures lead to the same conclusion. Here is the cash flow time line:
59
M. NOW SUPPOSE YOU LEAVE YOUR MONEY IN THE BANK FOR 21 MONTHS.
THUS, ON JANUARY 1, 2005, YOU DEPOSIT $100 IN AN ACCOUNT THAT
PAYS A 12 PERCENT EFFECTIVE ANNUAL INTEREST RATE. HOW MUCH
WILL BE IN YOUR ACCOUNT ON OCTOBER 1, 2006?
12%
N. SUPPOSE SOMEONE OFFERED TO SELL YOU A NOTE CALLING FOR A
$1,000 PAYMENT 15 MONTHS FROM TODAY. THE PERSON OFFERS TO
SELL THE NOTE FOR $850. YOU HAVE $850 IN A BANK TIME DEPOSIT
(SAVINGS INSTRUMENT) THAT PAYS A 6.76649 PERCENT SIMPLE RATE
WITH DAILY COMPOUNDING, WHICH IS A 7 PERCENT EFFECTIVE
ANNUAL INTEREST RATE; AND YOU PLAN TO LEAVE THE MONEY IN
THE BANK UNLESS YOU BUY THE NOTE. THE NOTE IS NOT RISKYYOU
ARE SURE IT WILL BE PAID ON SCHEDULE. SHOULD YOU BUY THE
NOTE? CHECK THE DECISION IN THREE WAYS: (1) BY COMPARING
YOUR FUTURE VALUE IF YOU BUY THE NOTE VERSUS LEAVING YOUR
MONEY IN THE BANK, (2) BY COMPARING THE PV OF THE NOTE WITH
YOUR CURRENT BANK INVESTMENT, AND (3) BY COMPARING THE EAR
ON THE NOTE WITH THAT OF THE BANK INVESTMENT.
0 1 1.25 2 Years
-850 1,000
(1) Future Value
Numerical solution:
FV1.25 = $850(1.07)
1.25
= $850(1.08825) = $925.01 < $1,000 FV of investment
Financial calculator solution: Input N = 1.25, I = 7, PV = -850, and PMT = 0; compute FV =
925.01
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet,
inputting 1.25 for Nper.
(2) Present Value
Numerical solution:
90 . 918 $ ) 91890 . 0 ( 000 , 1 $
) 07 . 1 (
1
000 , 1 $ PV
25 . 1

1
]
1

> $850 cost of

investment
Financial calculator solution: Input N = 1.25, I = 7, PMT = 0, and FV = 1,000; compute PV =
-918.90
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet,
inputting 1.25 for Nper.
(3) Effective Annual Rate of the Investment
% 88 . 13 1388 . 0 1
850
000 , 1
k
) k 1 ( 850 000 , 1
25 . 1
1
25 . 1

,
_

+
Each computation shows that the investment should be made. If the $850 is invested and grows to
$1,000 in 1 years, the investor will earn 13.9 percent, which is better than the bank rate of 7 percent.
ANSWER: Here is the cash flow time line:
60
7%
O. SUPPOSE THE NOTE DISCUSSED IN PART N HAD A COST OF $850, BUT
CALLED FOR FIVE QUARTERLY PAYMENTS OF $190 EACH, WITH THE
FIRST PAYMENT DUE IN THREE MONTHS RATHER THAN $1,000 AT THE
END OF 15 MONTHS. WOULD IT BE A GOOD INVESTMENT FOR YOU?
1 1 Years
0 1 2 3 4 5 Quarters
850 190 190 190 190 190
Rate per period = (1.07)
0.25
1.0 = 1.70585
(1) Future Value
Numerical solution:
97 . 982 $ ) 17352 . 5 ( 190 $
0170585 . 0
1 ) 0170585 . 1 (
190 $ FVA
5

1
]
1

> $850(1.0170585)
5
= $925.01
Financial calculator solution: Input N = 5, I = 1.70585, PV = 0, and PMT = 190; compute FV
= 982.97.
Spreadsheet solution: Use the FV financial function that is available on the spreadsheet.
(2) Present Value
Numerical solution:
25 . 903 ) 75397 . 4 ( 190 $
0170585 . 0
1
190 $ PVA
) 0170585 . 1 (
1

1
1
]
1

Financial calculator solution: Input N = 5, I = 1.70585, PMT = 190, and FV = 0; compute PV

= -903.25
Spreadsheet solution: Use the PV financial function that is available on the spreadsheet.
(3) Effective Annual Rate of the Investment
1
1
]
1

+
k
1
190 $ 850 $
) k 1 (
1
Numerical solution: Use a trial-and-error method to determine k.
Financial calculator solution: Input N = 5, PV = -850, PMT = 190, and FV = 0; compute I =
3.8259 per quarter. EAR = (1.038259)
4
1 = 0.1620 = 16.20% > 7% on bank deposit.
Each computation shows that the investment should be made.
61
1.706%