CHAPTER 5 TUTORIAL

1- Present Value and Multiple Cash Flows.   Rooster Co. has identified an investment project with the
following cash flows. If the discount rate is 10 percent, what is the present value of these cash flows?
What is the present value at 18 percent? At 24 percent?

2- Present Value and Multiple Cash Flows.   Investment X offers to pay you $3,700 per year for nine
years, whereas Investment Y offers to pay you $5,500 per year for five years. Which of these cash flow
streams has the higher present value if the discount rate is 6 percent? If the discount rate is 22 percent?

3- Future Value and Multiple Cash Flows.   Havana, Inc., has identified an investment project with the
following cash flows. If the discount rate is 8 percent, what is the future value of these cash flows in
Year 4? What is the future value at an interest rate of 11 percent? At 24 percent?

4- Calculating Annuity Present Values.   An investment offers $6,700 per year for 15 years, with the
first payment occurring 1 year from now. If the required return is 8 percent, what is the value of the
investment? What would the value be if the payments occurred for 40 years? For 75 years? Forever?

5- Calculating Annuity Cash Flows.   For each of the following annuities, calculate the annual cash
flow.
6- Calculating Annuity Values.   For each of the following annuities, calculate the present value.

7- Calculating Annuity Cash Flows.   For each of the following annuities, calculate the annual cash
flow.

8- Calculating Annuity Values.   For each of the following annuities, calculate the future value.

9- Calculating Annuity Values.   If you deposit $5,000 at the end of each of the next 20 years into an
account paying 10.8 percent interest, how much money will you have in the account in 20 years? How
much will you have if you make deposits for 40 years?

10- Calculating Perpetuity Values.   Curly's Life Insurance Co. is trying to sell you an investment policy
that will pay you and your heirs $25,000 per year forever. If the required return on this investment is 6
percent, how much will you pay for the policy?

11- Calculating Perpetuity Values.   In the previous problem, suppose Curly's told you the policy costs
$450,000. At what interest rate would this be a fair deal?
12- Calculating EAR.   Find the EAR in each of the following cases:

13- Calculating APR.   Find the APR, or stated rate, in each of the following cases:

14- Calculating EAR.   First National Bank charges 10.9 percent compounded monthly on its business
loans. First United Bank charges 11.1 percent compounded semiannually. As a potential borrower,
which bank would you go to for a new loan?

15- APR.   Magnus Credit Corp. wants to earn an effective annual return on its consumer loans of 17
percent per year. The bank uses daily compounding on its loans. What interest rate is the bank required
by law to report to potential borrowers? Explain why this rate is misleading to an uninformed borrower.

16- Calculating Future Values.   What is the future value of $1,270 in 16 years assuming an interest rate
of 9 percent compounded semiannually?

17- Calculating Future Values.   Bucher Credit Bank is offering 4.7 percent compounded daily on its
savings accounts. If you deposit $4,500 today, how much will you have in the account in five years? In
10 years? In 20 years?

18- Calculating Present Values.   An investment will pay you $75,000 in nine years. If the appropriate
discount rate is 6 percent compounded daily, what is the present value?

19- EAR versus APR.   Ricky Ripov's Pawn Shop charges an interest rate of 17 percent per month on
loans to its customers. Like all lenders, Ricky must report an APR to consumers. What rate should the
shop report? What is the effective annual rate?

20- Calculating Loan Payments.   You want to buy a new sports coupe for $68,500, and the finance office
at the dealership has quoted you a loan with an APR of 5.9 for 60 months to buy the car. What will
your monthly payments be? What is the effective annual rate on this loan?
 21- Amortization with Equal Payments.   Prepare an amortization schedule for a three-year loan of
$75,000. The interest rate is 8 percent per year, and the loan calls for equal annual payments. How
much interest is paid in the third year? How much total interest is paid over the life of the loan?

22- Amortization with Equal Principal Payments.   Rework Problem 55 assuming that the loan
agreement calls for a principal reduction of $25,000 every year instead of equal annual payments.

ANSWERS

1. The time line is:

0 1 2 3 4

PV $830 $610 $1,140 $1,390

To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a
lump sum, we use:

PV = FV / (1 + r)t

PV@10% = $830 / 1.10 + $610 / 1.102 + $1,140 / 1.103 + $1,390 / 1.104 = $3,064.57

PV@18% = $830 / 1.18 + $610 / 1.182 + $1,140 / 1.183 + $1,390 / 1.184 = $2,552.27

PV@24% = $830 / 1.24 + $610 / 1.242 + $1,140 / 1.243 + $1,390 / 1.244 = $2,251.93

2. The times lines are:

0 1 2 3 4 5 6 7 8 9

PV $3,700 $3,700 $3,700 $3,700 $3,700 $3,700 $3,700 $3,700 $3,700

0 1 2 3 4 5

PV $5,500 $5,500 $5,500 $5,500 $5,500

To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)t]} / r )

At an interest rate of 6 percent:

X@6%: PVA = $3,700{[1 – (1/1.06)9 ] / .06 } = $25,166.26

Y@6%: PVA = $5,500{[1 – (1/1.06)5 ] / .06 } = $23,168.00

And at an interest rate of 22 percent:

X@22%: PVA = $3,700{[1 – (1/1.22)9 ] / .22 } = $14,009.25

 Y@22%: PVA = $5,500{[1 – (1/1.22)5 ] / .22 } = $15,750.02

Notice that the PV of Investment X has a greater PV at a 6 percent interest rate, but a lower PV
at a 22 percent interest rate. The reason is that X has greater total cash flows. At a lower interest
rate, the total cash flow is more important since the cost of waiting (the interest rate) is not as
great. At a higher interest rate, Y is more valuable since it has larger annual payments. At a
higher interest rate, getting these payments early are more important since the cost of waiting
(the interest rate) is so much greater.

3. The time line is:

0 1 2 3 4

$1,075 $1,235 $1,510 $1,965

To solve this problem, we must find the FV of each cash flow and sum. To find the FV of a lump
sum, we use:

FV = PV(1 + r)t

FV@8% = $1,075(1.08)3 + $1,235(1.08)2 + $1,510(1.08) + $1,965 = $6,390.49

FV@11% = $1,075(1.11)3 + $1,235(1.11)2 + $1,510(1.11) + $1,965 = $6,632.95

FV@24% = $1,075(1.24)3 + $1,235(1.24)2 + $1,510(1.24) + $1,965 = $7,785.96

Notice, since we are finding the value at Year 4, the cash flow at Year 4 is added to the FV of the
other cash flows. In other words, we do not need to compound this cash flow.

4. To find the PVA, we use the equation:

PVA = C({1 – [1/(1 + r)t]} / r )

0 1 … 15

PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@15 yrs: PVA = $6,700{[1 – (1/1.08)15 ] / .08} = $57,348.51

0 1 … 40

PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@40 yrs: PVA = $6,700{[1 – (1/1.08)40 ] / .08} = $79,894.91

0 1 … 75

PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PVA@75 yrs: PVA = $6,700{[1 – (1/1.08)75 ] / .08} = $83,489.26

To find the PV of a perpetuity, we use the equation:

PV = C / r
 0 1 … ∞

PV $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700 $6,700

PV = $6,700 / .08
PV = $83,750.00

Notice that as the length of the annuity payments increases, the present value of the annuity
approaches the present value of the perpetuity. The present value of the 75-year annuity and the
present value of the perpetuity imply that the value today of all perpetuity payments beyond 75
years is only $260.74.

5. Here we have the PVA, the length of the annuity, and the interest rate. We want to calculate the
annuity payment. Using the PVA equation and solving for the payment in each case, we find:

0 1 2 3 4 5 6

$36,800 C C C C C C

6. Here we need to find the present value of an annuity. Using the PVA equation, we find:

0 1 2 3 4 5 6 7

PVA $2,100 $2,100 $2,100 $2,100 $2,100 $2,100 $2,100

PVA = C({1 – [1 / (1 + r)t]} / r )

PVA = $2,100{[1 – (1 / 1.08)7] / .08}
PVA = $10,933.38

0 1 2 3 4 5 6 7 8 9

PVA $1,095 $1,095 $1,095 $1,095 $1,095 $1,095 $1,095 $1,095 $1,095

PVA = C({1 – [1 / (1 + r)t]} / r )

PVA = $1,095{[1 – (1 / 1.07)9 ] / .07}
PVA = $7,134.18

0 1 … 18

PVA $11,000 $11,00 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000 $11,000
0

PVA = C({1 – [1 / (1 + r)t]} / r )

PVA = $11,000{[1 – (1 / 1.09)18 ] / .09}
PVA = $96,311.88

0 1 … 28

PVA $30,000 $30,00 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000 $30,000
0

PVA = C({1 – [1 / (1 + r)t]} / r )

PVA = $30,000{[1 – (1 / 1.11)28] / .11}
PVA = $258,048.65
7. Here we have the FVA, the length of the annuity, and the interest rate. We want to calculate the
annuity payment. Using the FVA equation:

0 1 8

$25,000
C C C C C C C C

FVA = C{[(1 + r)t – 1] / r}

$25,000 = $C[(1.058 – 1) / .05]
C = $25,000 / 9.54911
C = $2,618.05

0 1 … 40

$1,000,000
C C C C C C C C C

FVA = C{[(1 + r)t – 1] / r}

$1,000,000 = $C[(1.0740 – 1) / .07]
C = $1,000,000 / 199.63511
C = $5,009.14

0 1 25
…
$750,000
C C C C C C C C C

FVA = C{[(1 + r)t – 1] / r}

$750,000 = $C[(1.0825 – 1) / .08]
C = $750,000 / 73.10594
C = $10,259.08

0 1 13
…
$135,000
C C C C C C C C C

FVA = C{[(1 + r)t – 1] / r}

$135,000 = $C[(1.0413 – 1) / .04]
C = $135,000 / 16.62684
C = $8,119.40
8. Here, we need to find the future value of an annuity. Using the FVA equation, we find:

0 1 10

FVA
$1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500

FVA = C{[(1 + r)t – 1] / r}

FVA = $1,500[(1.0810 – 1) / .08]
FVA = $21,729.84

0 1 40
…
FVA
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

FVA = C{[(1 + r)t – 1] / r}

FVA = $5,000[(1.0940 – 1) / .09]
FVA = $1,689,412.23

0 1 9

FVA
$3,200 $3,200 $3,200 $3,200 $3,200 $3,200 $3,200 $3,200 $3,200

FVA = C{[(1 + r)t – 1] / r}

FVA = $3,200[(1.069 – 1) / .06]
FVA = $36,772.21

0 1 30
…
FVA
$7,500 $7,500 $7,500 $7,500 $7,500 $7,500 $7,500 $7,500 $7,500

FVA = C{[(1 + r)t – 1] / r}

FVA = $7,500[(1.1030 – 1) / .10]
FVA = $1,233,705.17

9. Here we need to find the FVA. The equation to find the FVA is:

FVA = C{[(1 + r)t – 1] / r}

0 1 20
…
FVA
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

FVA for 20 years = $5,000[(1.10820 – 1) / .108]

FVA for 20 years = $313,736.00

0 1 40
…
FVA
$5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000
 FVA for 40 years = $5,000[(1.10840 – 1) / .108]
FVA for 40 years = $2,753,565.95

Notice that because of exponential growth, doubling the number of periods does not merely
double the FVA.

10. The time line is:

0 1 … ∞

PV $25,000 $25,00 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000

0

This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $25,000 / .06
PV = $416,666.67

11. The time line is:

0 1 ∞
…
–$450,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000 $25,000

Here we need to find the interest rate that equates the perpetuity cash flows with the PV of the
cash flows. Using the PV of a perpetuity equation:

PV = C / r
$450,000 = $25,000 / r

We can now solve for the interest rate as follows:

r = $25,000 / $450,000
r = .0556, or 5.56%

12. For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.10 / 4)]4 – 1 = .1038, or 10.38%

EAR = [1 + (.17 / 12)]12 – 1 = .1839, or 18.39%

EAR = [1 + (.13 / 365)]365 – 1 = .1388, or 13.88%

EAR = [1 + (.09 / 2)]2 – 1 = .0920, or 9.20%

13. Here we are given the EAR and need to find the APR. Using the equation for discrete
compounding:

EAR = [1 + (APR / m)]m – 1

We can now solve for the APR. Doing so, we get:

 APR = m[(1 + EAR)1/m – 1]

EAR = .14 = [1 + (APR / 2)]2 – 1 APR = 2[(1.14)1/2 – 1] = .1354, or

13.54%

EAR = .09 = [1 + (APR / 12)]12 – 1 APR = 12[(1.09)1/12 – 1] = .0865, or

8.65%

EAR = .08 = [1 + (APR / 52)]52 – 1 APR = 52[(1.08)1/52 – 1] = .0770, or

7.70%

EAR = .13 = [1 + (APR / 365)]365 – 1 APR = 365[(1.13)1/365 – 1] = .1222, or

12.22%

14. For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

So, for each bank, the EAR is:

First National: EAR = [1 + (.109 / 12)]12 – 1 = .1146, or 11.46%

First United: EAR = [1 + (.111 / 2)]2 – 1 = .1141, or 11.41%

For a borrower, First United would be preferred since the EAR of the loan is lower. Notice that
the higher APR does not necessarily mean the higher EAR. The number of compounding periods
within a year will also affect the EAR.

15. The reported rate is the APR, so we need to convert the EAR to an APR as follows:

EAR = [1 + (APR / m)]m – 1

APR = m[(1 + EAR)1/m – 1]

APR = 365[(1.17)1/365 – 1] = .1570, or 15.70%

This is deceptive because the borrower is actually paying annualized interest of 17 percent per
year, not the 15.70 percent reported on the loan contract.

16. The time line is:

0 1 32
…
$1,270 FV

For this problem, we need to find the FV of a lump sum using the equation:

FV = PV(1 + r)t

It is important to note that compounding occurs semiannually. To account for this, we will divide
the interest rate by two (the number of compounding periods in a year), and multiply the number
of periods by two. Doing so, we get:

FV = $1,270[1 + (.09 / 2)]32

FV = $5,194.28
17. For this problem, we need to find the FV of a lump sum using the equation:

FV = PV(1 + r)t

It is important to note that compounding occurs daily. To account for this, we will divide the
interest rate by 365 (the number of days in a year, ignoring leap year), and multiply the number
of periods by 365. Doing so, we get:

0 1 5(365)
…
$4,500 FV

FV in 5 years = $4,500[1 + (.047 / 365)]5(365) = $5,692.00

0 1 10(365)
…
$4,500 FV

FV in 10 years = $4,500[1 + (.047 / 365)]10(365) = $7,199.76

0 1 20(365)
…
$4,500 FV

FV in 20 years = $4,500[1 + (.047 / 365)]20(365) = $11,519.22

18. The time line is:

0 1 9(365)
…
PV $75,000

For this problem, we simply need to find the PV of a lump sum using the equation:

PV = FV / (1 + r)t

It is important to note that compounding occurs on a daily basis. To account for this, we will
divide the interest rate by 365 (the number of days in a year, ignoring leap year), and multiply
the number of periods by 365. Doing so, we get:

PV = $75,000 / [(1 + .06 / 365)9(365)]

PV = $43,708.06

19. The APR is simply the interest rate per period times the number of periods in a year. In this case,
the interest rate is 17 percent per month, and there are 12 months in a year, so we get:

APR = 12(17%)
APR = 204%

To find the EAR, we use the EAR formula:

EAR = [1 + (APR / m)]m – 1

EAR = (1 + .17)12 – 1
EAR = 5.5801, or 558.01%
 Notice that we didn’t need to divide the APR by the number of compounding periods per year.
We do this division to get the interest rate per period, but in this problem we are already given
the interest rate per period.

20. The time line is:

0 1 60
…
$65,800 C C C C C C C C C

We first need to find the annuity payment. We have the PVA, the length of the annuity, and the
interest rate. Using the PVA equation:

PVA = C({1 – [1 / (1 + r)t]} / r )

$65,800 = $C[1 – {1 / [1 + (.059/12)]60} / (.059/12)]

Solving for the payment, we get:

C = $65,800 / 51.85018
C = $1,321.11

To find the EAR, we use the EAR equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (.059 / 12)]12 – 1
EAR = .0606, or 6.06%
PVA = C({1 – [1 / (1 + r)t]} / r ))
$36,800 = $C{[1 – (1 / 1.11)6 ] / .11}
C = $36,800 / 4.23054
C = $8,698.66

21- The payment for a loan repaid with equal payments is the annuity payment with the loan
value as the PV of the annuity. So, the loan payment will be:

PVA = C({1 – [1/(1 + r)t]} / r )

$75,000 = C{[1 – 1 / (1 + .08)3] / .08}
C = $29,102.51

The interest payment is the beginning balance times the interest rate for the period, and the
principal payment is the total payment minus the interest payment. The ending balance is the
beginning balance minus the principal payment. The ending balance for a period is the
beginning balance for the next period. The amortization table for an equal payment is:

Beginning Total Interest Principal Ending

Year Balance Payment Payment Payment Balance
1 $75,000.00 $29,102.51 $6,000.00 $23,102.51 $51,897.49
2 51,897.49 29,102.51 4,151.80 24,950.71 26,946.77
3 26,946.77 29,102.51 2,155.74 26,946.77 0

In the third year, $2,155.74 of interest is paid.

Total interest over life of the loan = $6,000 + 4,151.80 + 2,155.74

Total interest over life of the loan = $12,307.54
22- This amortization table calls for equal principal payments of $25,000 per year. The interest
payment is the beginning balance times the interest rate for the period, and the total payment
is the principal payment plus the interest payment. The ending balance for a period is the
beginning balance for the next period. The amortization table for an equal principal reduction
is:

Beginning
Bal Total Interest Principal Ending
Year ance Payment Payment Payment Balance
1 $75,000.00 $31,000.00 $6,000.00 $25,000.00 $50,000.00
2 50,000.00 29,000.00 4,000.00 25,000.00 25,000.00
3 25,000.00 27,000.00 2,000.00 25,000.00 0

In the third year, $2,000 of interest is paid.

Total interest over life of the loan = $6,000 + 4,000 + 2,000

Total interest over life of the loan = $12,000

Notice that the total payments for the equal principal reduction loan are lower. This is
because more principal is repaid early in the loan, which reduces the total interest
expense over the life of the loan.