Introduction to Corporate Finance, Second Edition Booth, Cleary

Solutions Manual 1 Chapter 5

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Chapter 5: Time Value of Money

Multiple Choice Questions
1. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning Objective: 5.2 and 5.3
Level of difficulty: Easy
Solution: B.
Simple interest rate: $1,000 + ($1,000)(8%)(5) = $1,400
Compound interest rate: ( )
5
$1, 000 1 .08 $1, 469.33 + =

2. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning Objective: 5.2 and 5.3
Difficulty: Medium
Solution: B
Simple interest: Total interest paid over three years: $6,100 - $5,000 = $1,100
Annual interest = $1,100/3 = $366.67
$366.67/$5,000 = 7.33%
Compound interest:
1
3
6100
1 6.85%
5000
| |
=
|
\ .


3. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning Objective: 5.2 and 5.3
Difficulty: Medium
Solution: B

4. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning Objective: 5.2 and 5.3
Level of difficulty: Easy
Solution: C.
A) $1,000 + ($1,000)(10%)(5) = $1,500
B) $1,000 + ($1,000)(8%)(10) = $1,800
C) $1,000(1.08)
8
= $1,851
D) $1,000(1.07)
8
= $1,718
Therefore, C is the largest.

Interest rates in the following questions are compound rates unless otherwise stated

5. Section: 5.3 Compound Interest
Learning Objective: 5.3
Introduction to Corporate Finance, Second Edition Booth, Cleary
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Level of difficulty: Medium
Solution: B.
PV=$15,000,000/(1.05)
25
=$4,429,541.58
Or using a financial calculator (TI BAII Plus),
N=25, I/Y=5, PMT=0, FV=15,000,000, CPT PV= 4,429,541.58

6. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning Objective: 5.2 and 5.3
Level of difficulty: Medium
Solution: B. The greater the interest rate, the smaller the present value, given a $100 future value
and holding the time period constant.

7. Section: 5.3 Compound Interest
Learning Objective: 5.3
Level of difficulty: Medium
Solution: A.
FV=PV(1+k)
n

17,000=10,000(1+ k)
8

8ln(1+k)=ln(1.7), therefore k=6.86%
Or using a financial calculator (TI BAII Plus),
N=8, PV= 10,000, PMT=0, FV=17,000, CPT I/Y=6.86%

8. Section: 5.3 Compound Interest
Learning Objective: 5.3
Level of difficulty: Medium
Solution: C.
FV=PV(1+k)
n
Assume that the initial investment is $1.
(3)(1)=1 (1.09)
n

ln(3)=(n)ln(1.09)
n=12.7 years
Or using a financial calculator (TI BAII Plus),
I/Y=9, PV= 1, PMT=0, FV=3, CPT N=12.7

9. Section: 5.4 Annuities and Perpetuities
Learning objective: 5.4
Level of difficulty: Medium
Solution: D. The annuity due has a greater PV because it pays one year earlier than an ordinary
annuity.

10. Section: 5.4 Annuities and Perpetuities
Introduction to Corporate Finance, Second Edition Booth, Cleary
Solutions Manual 3 Chapter 5
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Learning Objective: 5.4
Level of difficulty: Difficult
Solution: C.
(

+
=
k
k
PMT FV
1 ) 1 (
20
20
=$ 887 , 204 $ ) 4436 . 102 ( 000 , 2
15 .
1 ) 15 . 1 (
000 , 2
20
= =
(

+

Or using a financial calculator (TI BAII Plus),
N=20, I/Y=15, PV=0, PMT= -2,000, CPT FV=204,887

11. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Medium
Solution: B.
(
(
(
(

=
k
k
PMT PV
n
) 1 (
1
1
0
519 , 12 $ ) 25933 . 6 ( 000 , 2
15 .
) 15 . 1 (
1
1
000 , 2 $
20
= =
(
(
(
(

=
Or using a financial calculator (TI BAII Plus),
N=20, I/Y=15, FV=0, PMT= 2,000, CPT PV=12,519

12. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Easy
Solution: D.
PV
0
=PMT/k=$1,500/.12=$12,500

13. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Easy
Solution: A.
PV
0
=PMT/k=$1,500/.12 + $1,500 =$14,000

14. Section: 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.6
Level of difficulty: Medium
Solution: B
PV of annuity of 120 remaining payments at 1% per month.
Using a financial calculator (TI BAII Plus),
N = 120, I/Y = 1, FV = 0, PMT = -2,752.72, CPT PV = 191,866

Introduction to Corporate Finance, Second Edition Booth, Cleary
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15. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Difficult
Solution: A.
The future value of a perpetuity cannot be computed as it is infinite.

Practice Problems
16. Section: 5.1 Opportunity Cost
Learning Objective: 5.1
Difficulty: Medium
Solution:
Cost = tuition + textbook + loss of income = $500+$200+$500 = $1,200
The rent and food are expenses that he will be facing regardless of taking the course.
We are, of course, assuming that the extra time he spends studying for the philosophy course will
not have any impact on his grades in his other courses and are not placing any value on his
enjoyment of the subject.

17. Section: 5.2 Simple Interest
Learning Objective: 5.2
Difficulty: Easy
Solution:
As this is simple interest, Dmitri will earn the same amount of interest each year. The annual
amount of interest is 8% * initial investment = .08 * $25,000 = $2,000.
a. $2,000
b. $2,000

18. Section: 5.2 Simple Interest
Learning Objective: 5.2
Level of difficulty: Easy
Solution:
a. In one year he will owe P x k = $1,500 x 6% = $90 of interest.
b. After three years, the total (principal and interest) owing will be: P + (n x P x k) = $1,500 + (3
x $1,500 x 6%) = $1,770.

19. Section: 5.2 Simple Interest
Learning Objective: 5.2
Level of difficulty: Easy
Solution:
As the exact amount of interest owing each year will be paid, there is no compounding. The
amount of each annual payment will be P x k = $2,500 x 6% = $150. Unfortunately, these
payments never reduce the principal owing, so the loan will never be paid off!
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20. Section: 5.2 Simple Interest
Learning Objective: 5.2
Level of difficulty: Easy
Solution:
Khalil will be paid interest each month for 12 months, but without compounding. The total
interest earned is (n x P x k) = (12 x $1,200 x 0.5%) = $72.

21. Section: 5.3 Compound Interest
Learning Objective: 5.3
Level of difficulty: Easy
Solution:
The payment of compound interest means that we must compound (or find the future value of)
the amount invested (the present value):
01 . 274 , 1 $ ) 005 . 0 1 ( 200 , 1 $
12
12
= + =
months
FV
Of this amount, $1,200 was the original amount invested, so $74.01 of interest will be earned.

22. Section: 5.2 Simple Interest and 5.3 Compound Interest
Learning outcome: 5.2 and 5.3
Level of difficulty: Easy
Solution:
A. Value = P + (n x P x k) = $24 + (380 x $24 x 5%) = $480

B.
7 . 6 , 8 6 , 7 0 4 , 2 $ ) 0 5 . 0 1 ( 2 4 $
3 8 0
3 8 0
= + =
y e a r s
F V


23. Section: 5.3 Compound Interest
Learning outcome: 5.3
Level of difficulty: Easy
Solution:
The future value of the loan (the amount to be repaid) is $2,500. The amount that can be
borrowed is the present value amount, calculated as:
81 . 314 , 2 $
) 08 . 1 (
1
500 , 2 $
) 1 (
1
1 1
1 0
=
+
=
+
=
k
FV PV
Or using a financial calculator (TI BAII Plus),
N=1, I/Y=8, PMT=0, FV= -2,500, CPT PV=2,314.81

24. Section: 5.4 Annuities and Perpetuities
Learning outcome: 5.4
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Level of difficulty: Easy
Solution:
Present value of the perpetual scholarship payment:
0
1 1
$5000 $166, 667
0.03
PV PMT
k
( (
= = =
( (



25. Section: 5.4 Annuities and Perpetuities
Learning outcome: 5.4
Level of difficulty: Medium
Solution:
Present value of the perpetual scholarship payment at the end of 4 years:
4
1 1
$5000 $166, 667
0.03
PV PMT
k
( (
= = =
( (


So present value today is
4
$166, 667 / (1.03) $148, 081 = .Grace will need to endow $148,081
today for the scholarship to start in 5 years.

26. Section: 5.4 Annuities and Perpetuities
Learning outcome: 5.4
Level of difficulty: Easy
Solution:
Find the present value of the four-year annuity at year 3:
85 . 548 , 13 $
07 . 0
) 07 . 0 1 (
1
1
000 , 4 $
) 1 (
1
1
4
3
=
(
(
(
(

=
(
(
(
(

=
k
k
PMT PV
n

Now, find the present value of this amount today:
90 . 059 , 11 $
) 07 . 1 (
1
85 . 548 , 13 $
) 1 (
1
3 3
0
=
(

=
(

+
=
k
FV PV

27. Section: 5.4 Annuities and Perpetuities
Learning outcome: 5.4
Level of difficulty: Medium
Solution:

To be indifferent between the two options means that the present value of the annuity must equal
$40 million (the immediate payout).
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( )
10
1
1
1
40 5
k
k
| |

|
+
|
=
|
|
\ .
. Solving this using the calculator is the easiest way. N=10, PMT = -5, PV =
40, CPT I/Y. We find an interest rate of 4.28%. If the interest rate is greater than 4.28%, I prefer
the immediate payout of $40 million. The present value of the 10-year annuity is less than $40
million. If the interest rate is less than 4.28%, I prefer the annuity because the present value will
be greater than $40 million.

28. Section: 5.4 Annuities and Perpetuities
Learning outcome: 5.4
Level of difficulty: Hard
Solution:

Step 1: determine Betty`s annual deposits = $15,051.435. Betty will have to make annual
deposits of $15,051.435 per year for 30 years at 5% in order to have $1 million.

Step 2: Abe will be making deposits of 2*15,051 = $30,102.87. How many annual deposits will
he need to make in order for the future value to be $1 million? (solve for N) The number of
deposits is 20.06

Therefore, Abe can afford to wait 10 years before he has to start making his large deposits.

29. Section: 5.1 Opportunity Cost, 5.2 Simple Interest, 5.3 Compound Interest, and 5.4 Annuities
and Perpetuities
Learning outcome: 5.1, 5.2, 5.3, 5.4
Level of difficulty: Hard
Solution:

The manager is confused. To make the choice between the two options you should consider the
present value of each set of payments, not the sum of the payments. Summing the payments
assumes that the opportunity cost is zero.

For example, if your opportunity cost is 10%, then the PV of Long is $161,009. The value of the
house if $250,000 but the cost of the loan (to you) is only $161,009 a net benefit of $88,991.
The PV of the Short option is $216,289 in this case, with an opportunity cost of 10%, the short
option costs me $55,280 more.

If instead, your opportunity cost is 1%, then the PV of the Long option is $390,647 while the PV
Introduction to Corporate Finance, Second Edition Booth, Cleary
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of the Short option is only $333,390. By taking the Short option, you will save $57,257.

30. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Easy
Solution:
For Bank A,
% 3 8 . 7 1
2
0 7 2 5 . 0
1
2
=
|
.
|

\
|
+ = k

For Bank B,
% 4 0 . 7 1
4
0 7 2 0 . 0
1
4
=
|
.
|

\
|
+ = k

For Bank C,
% 3 9 . 7 1
1 2
0 7 1 5 . 0
1
1 2
=
|
.
|

\
|
+ = k

Bank B pays the highest effective annual rate.

31. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Easy
Solution:
a. For annual compounding, the effective annual rate will be the same as the quoted rate. To
check this:
% 5 . 9 1
1
% 5 . 9
1 1 1
1
= |
.
|

\
|
+ = |
.
|

\
|
+ =
m
m
QR
k
b. With quarterly compounding, set m=4,
% 84 . 9 1
4
% 5 . 9
1
4
= |
.
|

\
|
+ = k
c. With monthly compounding, set m=12,
% 92 . 9 1
12
% 5 . 9
1
12
= |
.
|

\
|
+ = k

32. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Easy
Solution:
a. 000 , 53 $ ) 06 . 1 ( 000 , 50 $ ) 1 ( % 6
0 1
= = + = = = k PV FV Rate Quoted k
year

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b. 89 . 083 , 53 $ ) 0616778 . 1 ( 000 , 50 $ % 16778 . 6 1
12
1
1
12
= = = |
.
|

\
|
+ =
year
FV
QR
k
c. 57 . 091 , 53 $ ) 0618313 . 1 ( 000 , 50 $ % 18313 . 6 1
365
1
1
365
= = = |
.
|

\
|
+ =
year
FV
QR
k

33. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Difficult
Solution:
Step 1: determine monthly effective rate

= 0.66227

Step 2: given the monthly effective rate, determine the quoted rate compounded monthly.
QR
monthly
= 12 x 0.66227
= 7.94724

Therefore, 8% compounded quarterly is equivalent to 7.94724% compounded monthly.

34. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Easy
Solution:
The value of any perpetual stream of payments can be valued as a perpetuity:
67 . 16 $
12 . 0
2 $
0
= = =
k
PMT
PV
Each share is worth $16.67.

35. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Easy
Solution:
Because the fees are paid at the start of the year, this is not an ordinary annuity, but rather, an
annuity due.
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47 . 303 , 21 $ ) 06 . 0 1 (
06 . 0
) 06 . 0 1 (
1
1
800 , 5 $
4
0
= +
(
(
(
(

= PV

36. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Medium.
Solution:
a. m = 365:
%. 11 . 27 1 )
365
24 .
1 (
365
= + = k

b. m = 4:
%. 25 . 26 1 )
4
24 .
1 (
4
= + = k

c. m = 3:
%. 97 . 25 1 )
3
24 .
1 (
3
= + = k

d. m = 2:
%. 44 . 25 1 )
2
24 .
1 (
2
= + = k

e. Continuous compounding: %. 12 . 27 1
24 .
= = e k
f. The effectively monthly rate for a to d is:
a. m=365, f=12 1 ) 1 ( + =
f
m
m
QR
k = 1 )
365
24 .
1 (
12
365
+ =2.02%
b. m=4, f=12. 1 ) 1 ( + =
f
m
m
QR
k = 1 )
4
24 .
1 (
12
4
+ =1.96%
c. m=3, f=12. 1 ) 1 ( + =
f
m
m
QR
k = 1 )
3
24 .
1 (
12
3
+ =1.94%
d. m=2, f=12. 1 ) 1 ( + =
f
m
m
QR
k = 1 )
2
24 .
1 (
12
2
+ =1.91%

37. Section: 5.4 Annuities and Perpetuities and 5.5 Nominal versus Effective Rates
Learning Objective: 5.4, 5.5
Level of difficulty: Difficult
Solution:

Step 1: make the payment frequency match the compounding frequency. We need to convert the
6 percent compounded monthly to a quarterly effective rate.

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( )
12
1
4
1
12 4
12 4
.06
1 1
12
1 1
.06
1
12
.06
1
12
1.5075%
annual
quarterly annual
quarterly
k
k k
k
| |
+ = +
|
\ .
+ = +
(
| |
= +
(
|
\ .
(

| |
= +
|
\ .
=

Step 2: Now we have an annuity of 5*4 = 20 quarterly payments, a present value of $50,000, and
an effective quarterly rate of 1.5075%. Solving for the payments we get: $2,914.44

38. Section: 5.4 Annuities and Perpetuities and 5.5 Nominal versus Effective Rates
Learning Objective: 5.4, 5.5
Level of difficulty: Difficult
Solution:

Step 1: make the payment frequency match the compounding frequency. We need to convert the
6% compounded quarterly to a monthly effective rate.

( )
4
1
12
1
4 12
4 12
.06
1 1
4
1 1
.06
1
4
.06
1
4
0.4975%
annual
monthly annual
monthly
k
k k
k
| |
+ = +
|
\ .
+ = +
(
| |
= +
(
|
\ .
(

| |
= +
|
\ .
=

Step 2: Now we have an annuity of 5*12 = 60 monthly payments, a present value of $150,000
and an effective monthly rate of 0.4975%. Solving for the payments we get: $2,897.85

39. Section: 5.3 Compound Interest
Learning Objective: 5.3
Level of difficulty: Medium
Solution:
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a. 00 . 000 , 22 $ ) 10 . 0 1 ( 000 , 20 $
1
1
= + =
year
FV
b. 20 . 210 , 32 $ ) 10 . 0 1 ( 000 , 20 $
5
5
= + =
years
FV
c. 85 . 874 , 51 $ ) 10 . 0 1 ( 000 , 20 $
10
10
= + =
years
FV

40. Section: 5.3 Compound Interest
Learning Objectives: 5.3
Level of difficulty: Medium
Solution:
Jon needs $800 in three years; that is the future value amount. The present value equivalent is:
07 . 691 $
) 05 . 1 (
1
800 $
) 1 (
1
3 3 3 0
=
+
=
+
=
k
FV PV
Or using a financial calculator (TI BAII Plus),
N=3, I/Y=5, PMT=0, FV= -800, CPT PV=691.07

41. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Medium
Solution:
The future value amount is $40,000. The amount to be saved each year is really the payment on
an ordinary annuity:
71 . 898 , 3 $
07 . 0
1 ) 07 . 0 1 (
000 , 40 $
8
=
(

+
= PMT PMT
Or using a financial calculator (TI BAII Plus),
N=8, I/Y=7, PV=0, FV= -40,000, CPT PMT= 3898.71


42. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Medium
Solution:
A. The future value of Janes account will be:
88 . 212 , 28 $
06 . 0
1 ) 06 . 0 1 (
000 , 1 $
17
17
=
(

+
= FV
B. The grant has the effect of increasing the amount saved from $1,000 to $1,200. The future
value of the account will now be:
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46 . 855 , 33 $
06 . 0
1 ) 06 . 0 1 (
200 , 1 $
17
17
=
(

+
= FV

43. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Medium
Solution:
Find the present value of the four-year annuity due:
26 . 497 , 14 $ ) 07 . 0 1 (
07 . 0
) 07 . 0 1 (
1
1
000 , 4 $ ) 1 (
) 1 (
1
1
4
0
= +
(
(
(
(

= +
(
(
(
(

= k
k
k
PMT PV
n

Now, discount this amount back three years:
08 . 834 , 11 $
) 07 . 1 (
1
26 . 497 , 14 $
) 1 (
1
3 3
0
=
(

=
(

+
=
k
FV PV

44. Section: 5.5 Nominal versus Effective Rates and 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.5, 5.6
Level of difficulty: Medium
Solution:
a. First, find the effective interest corresponding to the frequency of Jimmies car payments (f
=12); with monthly compounding, set m=12,
% 7083 . 0 1
12
% 5 . 8
1 1 1
12
12
=
|
.
|

\
|
+ =
|
.
|

\
|
+ =
f
m
monthly
m
QR
k
The 60 car payments form an annuity whose present value is the amount of the loan (the price
of the car):
98 . 594 $
007083 . 0
) 007083 . 0 1 (
1
1
000 , 29 $
60
=
(
(
(
(

= PMT PMT
b. Use the effective monthly interest rate from part A, k=0.7083%

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Period
(1)
Principal
Outstanding
(2)
Payment
(3)
Interest
=k*(1)
(4)
Principal
Repayment
= (2)-(3)
Ending
Principal
= (1)-(4)
1 29,000.00 594.98 205.42 389.56 28,610.44
2 28,610.44 594.98 202.66 392.32 28,218.12
3 28,218.12 594.98 199.88 395.10 27,823.01
4 27,823.01 594.98 197.08 397.90 27,425.11
5 27,425.11 594.98 194.26 400.72 27,024.40
6 27,024.40 594.98 191.42 403.56 26,620.84
7 26,620.84 594.98 188.56 406.42 26,214.42
8 26,214.42 594.98 185.69 409.29 25,805.13
9 25,805.13 594.98 182.79 412.19 25,392.94
10 25,392.94 594.98 179.87 415.11 24,977.82
11 24,977.82 594.98 176.93 418.05 24,559.77
12 24,559.77 594.98 173.97 421.01 24,138.76
13 24,138.76 594.98 170.98 424.00 23,714.76
...
35 14,083.18 594.98 99.76 495.22 13,587.95
36 13,587.95 594.98 96.25 498.73 13,089.22
37 13,089.22 594.98 92.72 502.26 12,586.96
...
59 1,177.43 594.98 8.34 586.64 590.79
60 590.79 594.98 4.18 590.79 0.00

The first monthly payment repays $389.56 of the principal amount of the loan and the last
payment repays $590.79.

c. After three years, or 36 monthly payments, the principal outstanding is $13,089.22 (from the
amortization table). The present value of this amount is:

30 . 152 , 10 $
) 007083 . 0 1 (
1
22 . 089 , 13 $
36 0
=
|
|
.
|

\
|
+
= PV

45. Section: 5.5 Nominal versus Effective Rates and 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.5 and 5.6
Level of difficulty: Medium
Solution:
The 60 monthly payments form an annuity whose present value is $29,000. Finding the interest
rate is most easily done with a financial calculator (TI BAII Plus):
N=60, PMT=588.02, PV= -29,000, CPT I/Y = 0.6667%
Note that we used N=60 months, so the solution is a monthly interest rate, however, the problem
asks for the effective annual rate.
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% 30 . 8 1 ) 006667 . 0 1 ( 1 ) 1 (
12 12
= + = + =
monthly
k k
The quoted rate would be:
% 00 . 8 ] 1 ) 0830 . 0 1 [( 12 ] 1 ) 1 [(
12
1
12
1
= + = + = k m QR
Or simply: % 00 . 8 006667 . 0 12 = = =
monthly
k m QR

46. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Medium
Solution:
Solve the annuity equation to find k, the interest rate:
?
) 1 (
1
1
24 . 935 , 6 $ 00 . 000 , 25 $
5
=
(
(
(
(

= k
k
k

The calculations are most easily done with a financial calculator (TI BAII Plus),
PV = -25,000, PMT=6,935.24, N= 5, FV=0, CPT I/Y = 12%
The effective annual interest rate is 12 percent. With annual compounding, the nominal rate (or
quoted rate) will also be 12 percent per year.

47. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5
Level of difficulty: Medium
Solution:
a. There will be 5 x 12 = 60 monthly payments. The calculations are most easily done with a
financial calculator (TI BAII Plus),

PV = 25,000, PMT=556.11, N= 60, CPT I/Y = 1.0%
Because we used monthly payments, and months as the time period, 1.0% is the effective
monthly rate.

b. The compounding period matches the payment frequency, so the nominal rate, or quoted rate,
is:
% 0 . 12 % 0 . 1 12 = = =
monthly
k m QR per year.

48. Section: 5.5 Nominal versus Effective Rates
Learning Objective: 5.5

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Level of difficulty: Medium
Solution:
a. You will pay interest of (800750) = $50 after one week. This implies a nominal interest rate
of 50/750 = 6.67% per week. With 52 weeks in the year, the nominal rate per year is then 52 x
6.67% = 346.84%.
b. The effective annual interest rate is % 10 . 772 , 2 7210 . 27 1 ) 0667 . 0 1 (
52
= = + = k

49. Section: 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.6
Level of difficulty: Medium
Solution:
a. In Canada, fixed-rate mortgages use semi-annual compounding of interest, so m=2. The
effective annual rate is therefore:
% 5024 . 6 1
2
064 . 0
1 1 1
2
=
|
.
|

\
|
+ =
|
.
|

\
|
+ =
m
m
QR
k
b. With monthly payments, f=12. We can find the effective monthly interest rate from the
effective annual rate, k:
( ) ( ) % 5264 . 0 1 % 5024 . 6 1 1 1
12
1 1
= + = + =
f
monthly
k k
c. The amortization period is 20 years, or 20 x12 = 240 months. Josephines monthly payments
can be computed as:
69 . 322 , 1 $
005264 . 0
) 005264 . 0 1 (
1
1
000 , 180 $
240
=
(
(
(
(

= PMT PMT
d. With monthly compounding and payments, the effective monthly interest rate is:
% 530 . 0 1
12
0636 . 0
1 1 1
12
12
=
|
.
|

\
|
+ =
|
.
|

\
|
+ =
f
m
monthly
m
QR
k
Even though the quoted rate is lower at the Credit Union than at the Bank, the effective rate is
higher. Josephine should take the mortgage loan from Providence Bank in this case. The monthly
payment for the credit union mortgage would be $1,327.24, which, as expected, is higher than
that at Providence Bank.

50. Section: 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.6
Level of difficulty: Medium
Solution:
Introduction to Corporate Finance, Second Edition Booth, Cleary
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With semi-annual compounding (the norm in Canada) and monthly payments, m=2 and f=12.
The effective monthly rate is:
% 3224 . 0 1
2
039 . 0
1 1 1
12
2
=
|
.
|

\
|
+ =
|
.
|

\
|
+ =
f
m
monthly
m
QR
k
The present value of the mortgage payments over the amortization period (25 years x 12 = 300
months) is:
72 . 553 , 374 $
003224 . 0
) 003224 . 0 1 (
1
1
00 . 950 , 1 $
300
0
=
(
(
(
(

= PV
In addition, Charlie has $130,000 available as a down payment; the most he can pay for the
house is, therefore, $374,553.72 + $130,000 = $504,553.72.

51. Section: 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.6
Level of Difficulty: Difficult
Solution:

Part 1: determine the principal outstanding after the 60
th
payment (i.e., How much will the next
mortgage be for?)
Step 1: determine effective monthly rate:
1
2 12
.06
1 1 0.00493862
2
monthly
k
(
| |
= + =
(
|
\ .
(


Step 2: determine the monthly payments:
300
1
1
(1 0.00493862)
$300, 000
0.00493862
$1, 919.4194
PMT
PMT
(

(
+
= (
(
(

=

Step 3: determine Present Value of remaining (300 60) payments of $1,919.4194
300 60
1
1
(1 0.00493862)
$1, 919.4194
0.00493862
$269, 510.0994
PV
PV

(
+
= (
(
(

=

Part 2: determine new payments
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Step 1: determine new effective monthly rate
1
2 12
.08
1 1 0.00655820
2
monthly
k
(
| |
= + =
(
|
\ .
(


Step 2: determine the new monthly payment

300 60
1
1
(1 0.00655820)
$269, 510.0994
0.00655820
$2, 232.507688
PMT
PV

(
+
= (
(
(

=

Franklins new payment is $2,232.51, an increase of $313.09.

52. Section: 5.7 Comprehensive Examples
Learning Objective: 5.7
Level of difficulty: Medium
Solution:
a. Timmys savings extend right to age 61 (end of each year), so this is an ordinary annuity.
67 . 777 , 327 , 1 $
10 . 0
1 ) 10 . 0 1 (
000 , 3 $
40
40
=
(

+
= FV
Yes, Timmy will achieve his goal by a comfortable margin.

b. In the equation for part A set FV=$1,000,000, and solve for the number of years, n. This is
easiest done with a financial calculator (TI BAII Plus),
FV = 1,000,000, I/Y = 10, PMT = 3,000, CPT N = 37.1.

Timmy will hit the $1 million dollar mark in just over 37 years, or shortly after his 58
th
birthday.

53. Section: 5.7 Comprehensive Examples
Learning Objective: 5.7
Level of difficulty: Medium
Solution:
This is an ordinary annuity.
45 . 174 , 953 $
10 . 0
1 ) 10 . 0 1 (
000 , 30 $
15
15
=
(

+
= FV
No, Tommy will not quite achieve his goal by age 61.

54. Section: 5.7 Comprehensive Examples
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Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
Learning Objective: 5.7
Level of difficulty: Difficult.
Solution:
Annual investment = Annual income Annual expenditure = $45,000 $36,000 = $9,000.
This is an annuity due.
) 1 (
1 ) 1 (
k
k
k
PMT FV
n
n
+
(

+
=
384 , 039 , 5 $ ) 126 . 1 )( 2749 . 497 )( 000 , 9 ( ) 126 . 1 (
126 .
1 ) 126 . 1 (
000 , 9
35
= =
(

+
=
Or using a financial calculator (TI BAII Plus),
Hit [2
nd
] [BGN] [2
nd
] [Set]
N=35, I/Y=12.6, PV=0, PMT= -9,000, CPT FV=5,039,384

55. Section: 5.7 Comprehensive Examples
Learning Objective: 5.7
Level of Difficulty: Difficult
Solution:

a. PV=200,000, monthly rate=12%/12=1%, N = (10)(12)=120 months
(
(
(
(

=
01 .
) 01 . 1 (
1
1
000 , 200
120
PMT
(
(
(
(

=
01 .
) 01 . 1 (
1
1
/ 000 , 200
120
PMT
So, PMT=$2,869
Or using a financial calculator (TI BAII Plus),
N=120, I/Y=1, PV=-200,000, FV=0, CPT PMT=2,869

b. Remaining months to pay=120 18=102 months
(
(
(
(

=
01 .
) 01 . 1 (
1
1
869 , 2
102
0
PV =$182,920
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Or using a financial calculator (TI BAII Plus),
N=102, I/Y=1, PMT=- 2,869, FV=0, CPT PV=182,920

c. k
monthly
= 1 )
2
12 .
1 (
12
2
+ =.9759%
(
(
(
(

=
009759 .
) 009759 . 1 (
1
1
000 , 200
120
PMT
(
(
(
(

=
009759 .
) 009759 . 1 (
1
1
/ 000 , 200
120
PMT

So, PMT=$2,836
Or using a financial calculator (TI BAII Plus),
N=120, I/Y=.9759, PV=-200,000, FV=0, CPT PMT=2,836

56. Section: 5.7 Comprehensive Examples
Learning Objective: 5.7
Level of difficulty: Difficult
Solution:
Investor A:
k=e
.15
1=16.183424%.
1
st
, consider an ordinary annuity and the present value of the investment when A turns 25 years
old is:
(
(
(
(

=
16183424 .
) 16183424 . 1 (
1
1
500 , 5
8
25
PV =$23,749.19
Or using a financial calculator (TI BAII Plus),
N=8, I/Y=16.183424, PMT=5,500, FV=0, CPT PV=- 23,749.19

2
nd
, discount this amount for five years back to today when she is 20.
PV=FV/(1+k)
5
=23,749.19/(1.16183424)
5
=$11,218.3231
Or, N=5, I/Y=16.183424, PMT=0, FV=- 23,749.19, CPT PV=11,218.3231

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Investor B:
k= 1 )
4
16 .
1 (
4
+ =16.985856%
) 16985856 . 1 (
16985856 .
) 16985856 . 1 (
1
1
3231 . 218 , 11
10
(
(
(
(

= PMT
PMT=$2,057.38
Or using a financial calculator (TI BAII Plus),
Hit [2
nd
] [BGN] [2
nd
] [Set]
N=10, I/Y=16.985856, PV=11,218.3231, FV=0, CPT PMT= - 2,057.38
Therefore, Investor B has to make an equal payment of $2,057.38 so that the present value of the
two investments is the same.

57. Section: 5.7 Comprehensive Examples
Learning Objective: 5.7
Level of difficulty
Solution:
a. 1
st
Calculate their yearly income available for investment
Monthly income available=$9,000 $3,000 $850 $1,450=$3,700
Yearly available=$(3,700)(12)=$44,400
2
nd
Calculate the FV of their investment when they retire:
(

+
=
1 .
1 ) 1 . 1 (
400 , 44
30
30
FV =$7,303,535
Or using a financial calculator (TI BAII Plus),
N=30, I/Y=10, PV=0, PMT=- 44,400, CPT FV=7,303,535
3
rd
Calculate the amount they will have when they retire:
$7,303,535 + $50,000 = $7,353,535

b. This is an annuity due problem.
PV=7,353,535, k=10%, n=30
) 1 . 1 (
1 .
) 1 . 1 (
1
1
535 , 353 , 7
30
+
(
(
(
(

= PMT
So, PMT=709,143
Or using a financial calculator (TI BAII Plus),
Hit [2
nd
] [BGN] [2
nd
] [Set]
Introduction to Corporate Finance, Second Edition Booth, Cleary
Solutions Manual 22 Chapter 5
Copyright 2010 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.
N=30, I/Y=10, PV=- 7,353,535, FV=0, CPT PMT=709,143

58. Section: 5.1 Opportunity Cost and 5.3 Compound Interest
Learning Objective: 5.1, 5.3
Level of difficulty: Difficult
Solution:
Find the present value of the money paid back to Veda by each investment, using the interest rate
on the alternative (the bank account) as the discount rate.
For Investment A: 58 . 1144 $ 07 . 691 $ 51 . 453 $
) 05 . 0 1 (
800 $
) 05 . 0 1 (
500 $
3 2 0
= + =
+
+
+
= PV
For Investment B:
98 . 1157 $ 69 . 604 81 . 362 48 . 190
) 05 . 0 1 (
700
) 05 . 0 1 (
400
) 05 . 0 1 (
200
3 2 1 0
= + + =
+
+
+
+
+
= PV
Veda would prefer Investment B, because it has the higher present value.

59. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Difficult
Solution:
We have two separate annuities to consider: the tuition payments, and the savings amounts. First,
find the present value of the four annual tuition payments (at time 8, when Felix is due to begin
university studies):
11 . 872 , 33 $
07 . 0
) 07 . 0 1 (
1
1
000 , 10
4
8
=
|
|
|
|
.
|

\
|
+

= PV
This is the amount of savings required at time 8. From the perspective of time 0, this is a future
value amount (replaces the $40,000 in Problem 41.) Next, find the annual savings amount:
44 . 301 , 3 $
07 . 0
1 ) 07 . 0 1 (
11 . 872 , 33 $
8
=
(

+
= PMT PMT

60. Section: 5.3 Compound Interest
Learning Objective: 5.3
Level of difficulty: Difficult
Solution:
a. We know the future value and present value amounts, as well as the monthly interest rate.
Finding the number of time periods (months) is most easily done with a financial calculator (TI
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BAII Plus),
PV = 15,000, FV = -20,000, I/Y = 0.5, CPT N = 57.68
It will take nearly 58 months, or close to 5 years before Roger can afford to buy the car!
b. Solving the following equation for n we get:
(

+ =
005 .
1 ) 005 . 1 (
250
) 005 . 1 (
000 , 15
000 , 20
n
n
n= 14.86.
Or using a financial calculator (TI BAII Plus),
I/Y=0.5, PV=15,000, FV= -20,000, PMT = 250, CPT N = 14.86

61. Section: 5.3 Compound Interest and 5.5 Nominal versus Effective Rates
Learning Objective: 5.3, 5.5
Level of difficulty: Difficult
Solution:
Lets assume the present value of the investment is $1. The future value, after doubling, is then
$2.
a. Annually: With annual compounding, the effective rate is the same as the quoted rate, 9%.
Using a financial calculator (TI BAII Plus),
PV = 1, FV = 2, I/Y = 9, CPT N = 8.04
So the investment will double in just over 8 years.
b. Quarterly: With quarterly compounding, the effective annual rate is,
% 308 . 9 1 )
4
09 . 0
1 (
4
= + = k , and a financial calculator allows us to find:

PV = -1, FV = 2, I/Y = 9.308, CPT N = 7.79
The higher effective rate means that only 7.79 years are needed to double the value of the
investment.

62. Section: 5.4 Annuities and Perpetuities
Learning Objectives: 5.4
Level of difficulty: Difficult
Solution:
a. The present value of the annual payments can be found with a financial calculator, (TI BAII
Plus), N=9, PMT = -6,000, I/Y = 5.0, FV=0, CPT PV = 42,646.93
As this is less than $50,000, the immediate payment alternative is better.

b. This problem can be solved by trial and error, but the task is much easier with a financial
calculator, (TI BAII Plus), N=9, PMT = 6,000, PV = 50,000, FV=0, CPT I/Y = 1.5675%. At an
interest rate below 1.5675% per year, the nine-year annuity would be preferable; above the rate
the immediate payment is better.

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63. Section: 5.6 Loan or Mortgage Arrangements
Learning Objective: 5.6
Level of difficulty: Difficult
Solution:
a. The effective monthly interest rate is,
% 4206 . 0 1
2
051 . 0
1
12
2
=
|
.
|

\
|
+ =
monthly
k
The amount of the mortgage loan will be ($280,000 $50,000) = $230,000, and there will be 12
x 25 = 300 monthly payments, the value of which can be found with a financial calculator, (TI
BAII Plus), N=300, PV = 230,000, I/Y = 0.4206, CPT PMT = 1,350.89. Alyshas two friends
will be paying 2 x $475 = $950 in rent, so she will need an additional $1,350.89 $950 =
$400.81 to make the mortgage payments.

b. In two years, Alysha will have made 24 payments, leaving 276. The present value of these
payments is the outstanding value of the mortgage loan. Use the calculator again: N=276, I/Y =
0.4206, PMT = 1350.89, CPT PV = 220,336.58. To pay off the loan, and recoup her down
payment, Alysha would have to sell the house for at least $220,336.58 + $50,000 = $270,336.58.

64. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Difficult
Solution:
The dividends for the first five years form an ordinary annuity. Starting in year 6, the reduced
dividend stream can be thought of as a perpetuity. However, the value of this perpetuity, as
determined by our formula, occurs at year 5 (one year before the first $2 dividend), and must be
discounted to the present:
| | | | 27 . 20 $ 5674 . 0 67 . 16 81 . 10
) 12 . 0 1 (
1
12 . 0
00 . 2 $
12 . 0
) 12 . 0 1 (
1
1
00 . 3 $
5
5
0
= + =
(

+
|
.
|

\
|
+
(
(
(
(

|
|
|
|
.
|

\
|
+

= PV
65. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Difficult
Solution:
% 3125 . 0
12
0375 . 0
= =
monthly
k
Rent payments are typically made at the start of each month (so this is an annuity due). Over
three years, we would expect 36 monthly rent payments. However, the last months rent must be
paid up front, so the annuity includes only 35 payments; the present value of the last months rent
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is $450 because it will be paid today.
77 . 393 , 15 $ 450 $ ) 003125 . 0 1 (
003125 . 0
) 003125 . 0 1 (
1
1
450 $
35
0
= + +
(
(
(
(

= PV

66. Section: 5.4 Annuities and Perpetuities
Learning Objective: 5.4
Level of difficulty: Difficult
Solution:
It is tempting to view the first option as a perpetuity, but this would be incorrect as the man will
die at some time, and the payment will then cease. Thus, option one is an ordinary annuity, with
an uncertain number of payments. Option two is much easier to value; it includes exactly 240
monthly payments.

% 5 . 0
12
06 . 0
= =
monthly
k

Using a financial calculator (TI BAII Plus),
N = 240, PMT = 3,500, I/Y = 0.5, FV=0, CPT PV = 488,532.70

For the first option to be a better deal, it must include enough payments so that its present value
is at least as great as for option two. Again using the calculator,
PV = 488,532.70, PMT = 2,785, I/Y = 0.5, CPT N = 420.3
So option one must continue for 420.3 monthly payments to equal the value of option two, or
421 payments to surpass it. This is just over 35 years. Hence, the man must live to be at least 100
years old for option one to be a better deal!

67. Section: Appendix 5A: Growing Annuities and Perpetuities
Level of difficulty: Easy
Solution:

100
$1, 666.67
.09 .03
PV = =

. The most I would be willing to pay for the investment is the present
value, therefore, $1,666.67.

68. Section: Appendix 5A: Growing Annuities and Perpetuities
Learning Objective: Appendix
Level of difficulty: Medium
Solution:
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.
= $1,816.67

The most Id pay is the present value of the investment. In this case the cash flows start
immediately ($100) and then grow by 3% per year. The present value, or the maximum Id be
willing to pay, is $1,816.67

69. Section: Appendix 5A: Growing Annuities and Perpetuities
Learning Objective: Appendix
Level of difficulty: Difficult
Solution:

To solve this we need to realize that the present value of a perpetuity (growing or otherwise)
occurs one period prior to the first cash flow. Hence, using the growing perpetuity formula will
give us the value of the cash flows in year 4. We need to discount those back to time 0.

= $1,180.7087
The most Id be willing to pay for this investment is $1,180.71.

70. Section: Appendix 5A: Growing Annuities and Perpetuities
Learning Objective: Appendix
Level of difficulty: Difficult
Solution:

Present value of Grow:
100
$10, 000
.05 .04
GROW
PV = =

Present value of Shrink:
1000
$14, 285.71
.05 ( .02)
SHRINK
PV = =


Grow exceeds the cost by $9,000 while Shrink exceeds the investment cost by $13,285.71 Shrink
is preferred, as it exceeds the investment cost by the most.
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71. Section: Appendix 5A: Growing Annuities and Perpetuities
Learning Objective: Appendix
Level of difficulty: Difficult
Solution:


=
PMT
1

(1.8946799
.02

The initial deposit is $10,555.87

If Xiang made constant deposits (i.e., no growth), he would have to deposit $15,051.44 per year for
the next 30 years.