76

2013 Pearson Education, Inc. Publishing as Prentice Hall

Solutions of Selected Problems
in Chapter 4 - The Time Value of Money (Part 2)
Prepping for Exams
1. b.
2. b.
3. d.
4. a.
5. b.
6. a.
7. d.
8. c.
9. a.
10. b.
Problems
1. Different Cash Flow. Given the following cash inflow at the end of each year, what is
the future value of this cash flow at 6%, 9%, and 15% interest rates at the end of the
seventh year?
Year 1 $15,000
Year 2 $20,000
Year 3 $30,000
Years 4 through 6 $0
Year 7 $150,000
ANSWER
FV at 6% = $15,000 1.06
6
= $15,000 1.4185 = $21,277.79
+ $20,000 1.06
5
= $20,000 1.3382 = $26,764.51
+ $30,000 1.06
4
= $30,000 1.2625 = $37,874.31
+ $150,000 1.06
0
= $15,000 1.0000 = $150,000.00
FV = $21,277.79 + $26,764.51 + $37,874.31 + $150,000.00 = $235,916.61
FV at 9% = $15,000 1.09
6
= $15,000 1.6771 = $25,156.50
+ $20,000 1.09
5
= $20,000 1.5386 = $30,772.48
+ $30,000 1.09
4
= $30,000 1.4116 = $42,347.45
+ $150,000 1.09
0
= $15,000 1.0000 = $150,000.00
FV = $25,156.50 + $30,772.48 + $42,347.45 + $150,000.00 = $248,276.43
FV at 15% = $15,000 1.15
6
= $15,000 2.3131 = $34,695.91
+ $20,000 1.15
5
= $20,000 2.0114 = $40,227.14
+ $30,000 1.15
4
= $30,000 1.7490 = $52,470.19
Chapter 4 The Time Value of Money (Part 2) 77
2013 Pearson Education, Inc. Publishing as Prentice Hall
+ $150,000 1.15
0
= $15,000 1.0000 = $150,000.00
FV = $34,695.91 + $40,227.14 + $52,470.19 + $150,000.00 = $277,393.24

3. Future value. A speculator has purchased land along the southern Oregon coast. He has
taken out a ten-year loan with annual payments of $7,200. The loan rate is 6%. At the
end of ten years, he believes that he can sell the land for $100,000. If he is right on the
future price, did he make a wise investment?
ANSWER
To solve this problem, we must calculate the rate of return earned on an annual investment
of $7,200 over a 10-year period, with a future value of $100,000 and compare it with the
interest rate paid on the loan. If the rate earned is higher, then the investment would be
worth it.
FV = $100,000; PMT = -$7,200; n = 10; PV = 0; CPT I% = 7.11% > 6%; Good Investment
5. Future value: You are a new employee with the Metropolis Daily Planet. The Planet
offers three different retirement plans for you to choose from. Plan 1 starts the first day
of work and puts $1,000 away in your retirement account at the end of every year for
forty years. Plan 2 starts after ten years and puts away $2,000 every year for thirty
years. Plan 3 starts after twenty years and puts away $4,000 every year for the last
twenty years of employment. All three plans guarantee an annual growth rate of 8%.
a. Which plan should you choose if you plan to work at the Planet for forty years?
b. Which plan should you choose if you only plan to work at the Planet for the next
thirty years?
c. Which plan should you choose if you only plan to work at the Planet for the next
twenty years?
d. Which plan should you choose if you only plan to work at the Planet for the next
ten years?
e. What do the answers in parts (a) through (d) imply about savings?
ANSWER
Part a: Plan One FV = $1,000 (1.08
40
-1)/0.08 = $1,000 259.0565 = $259,056.51
Part a: Plan Two FV = $2,000 (1.08
30
-1)/0.08 = $2,000 113.2832 = $226,566.42
Part a: Plan Three FV = $4,000 (1.08
20
-1)/0.08 = $4,000 45.7620 = $183,047.86
Chose Plan One
Part b: Plan One FV = $1,000 (1.08
30
-1)/0.08 = $1,000 113.2832 = $113,283.21
Part b: Plan Two FV = $2,000 (1.08
20
-1)/0.08 = $2,000 45.7620 = $91,523.93
Part b: Plan Three FV = $4,000 (1.08
10
-1)/0.08 = $4,000 14.4866 = $57,946.25
78 Brooks Financial Management: Core Concepts, 2e
2013 Pearson Education, Inc. Publishing as Prentice Hall
Chose Plan One
Part c: Plan One FV = $1,000 (1.08
20
-1)/0.08 = $1,000 45.7620 = $45,761.96
Part c: Plan Two FV = $2,000 (1.08
10
-1)/0.08 = $2,000 14.4866 = $28,973.12
Part c: Plan Three FV = $4,000 (1.08
0
-1)/0.08 = $4,000 0.0000 = $0.00
Chose Plan One
Part d: Plan One FV = $1,000 (1.08
10
-1)/0.08 = $1,000 14.4866 = $14,486.56
Part d: Plan Two FV = $2,000 (1.08
0
-1)/0.08 = $2,000 0.0000 = $0.00
Part d: Plan Three FV = $4,000 (1.08
0
-1)/0.08 = $4,000 0.0000 = $0.00
Chose Plan One
Part e: The sooner you begin to save the better and that increasing the amount of savings in
later years may not be sufficient to catch up to an early savings program.
7. Present value of an ordinary annuity. Fill in the missing present values in the
following table for an ordinary annuity.
Number of
Payments or
Years
Annual
Interest Rate Future Value Annuity Present Value
10 6% 0 $250.00
20 12% 0 $3,387.88
25 4% 0 $600.00
360 1% 0 $2,571.53

ANSWER
Formula Answer (Rounded final answer to two decimal places)
PV = $250.00 [1 -1/(1 + 0.06)
10
] / 0.06 = $250.00 7.3601 = $1,840.02
PV = $3,387.88 [1 -1/(1 + 0.12)
20
] / 0.12 = $3,387.88 7.4694 = $25,305.58
PV = $600.00 [1 -1/(1 + 0.04)
25
] / 0.04 = $600.00 15.6221 = $9,373.25
PV = $2,571.53 [1 -1/(1 + 0.01)
360
] / 0.01 = $2,571.53 97.2183 = $249,999.85
9. Present value. County Ranch Insurance Company wants to offer a guaranteed annuity
in units of $500, payable at the end of each year for twenty-five years. The company
has a strong investment record and can consistently earn 7% on its investments after
taxes. If the company wants to make 1% on this contract, what price should it set on it?
Use 6% as the discount rate. Assume that it is an ordinary annuity and that the price is
the same as present value.
Chapter 4 The Time Value of Money (Part 2) 79
2013 Pearson Education, Inc. Publishing as Prentice Hall
ANSWER
Formula Answer (Rounded final answer to two decimal places)
PV = $500.00 ([1 -1/(1 + 0.06)
25
] / 0.06) = $500.00 12.7834 = $6,391.68
11. Payments. Cooley Landscaping Company needs to borrow $30,000 for a new front-end
dirt loader. The bank is willing to loan the funds at 8.5% interest with annual payments
at the end of the year for the next ten years. What is the annual payment on this loan for
Cooley Landscaping?
ANSWER
Payments = $30,000 / [(1 1/(1.085)
10
) / .085] = $30,000 / 6.5613 = $4,572.23
13. Annuity due. Reginald is about to lease an apartment for the year. The landlord wants
the lease payments paid at the start of the month. The twelve monthly payments are
$1,300 per month. The landlord says he will allow Reginald to prepay the rent for the
entire year with a discount. The one-time annual payment due at the beginning of the
lease is $14,778. What is the implied monthly discount rate for the rent? If Reginald is
earning 1.5% on his savings monthly, should he pay by month or take the one annual
payment?
ANSWER
Using TVM Keys from a Texas Instrument BAII Plus Calculator and rounded to two
decimal places for interest percent. The P/Y and C/Y variables are set to 12. Set the MODE
to BGN as this is an annuity due problem.
INPUT 12 -14,778 1,300 0
TVM KEYS N I/Y PV PMT FV
OUTPUT 12.00
This is an annual rate so with simple interest you get 12% / 12 = 1% per month.
If he can get 1.5% interest per month...then his annual rate is 18% and he can generate
$1,334.82 per month with the $14,778 it would take to pay off the rent. He is ahead $34.82
per month by not taking the one time payment.
INPUT 12 18.0 -14,778 0
TVM KEYS N I/Y PV PMT FV
OUTPUT 1,334.82

15. Perpetuities. The Canadian Government has once again decided to issue a consol (a
bond with a never-ending interest payment and no maturity date). The bond will pay
$50 in interest each year (at the end of the year) but never return the principal. The
current discount rate for Canadian government bonds is 6.5%. What should this bond
sell for in the market? What if the interest rate should fall to 4.5%? Rise to 8.5%? Why
80 Brooks Financial Management: Core Concepts, 2e
2013 Pearson Education, Inc. Publishing as Prentice Hall
does the price go up when interest rates fall? Why does the price go down when interest
rates rise?
ANSWER
at 6.5%, $50 / 0.065 = $769.23
at 4.5%, $50 / 0.045 = $1,111.11
at 8.5%, $50 / 0.085 = $588.24
The price rises when interest rates fall because the present value of each future interest
payment is worth more in present value due to the lower discount rate. The price falls when
interest rates rise because the present value of each future interest payment is worth less in
present value due to the higher discount rate.
17. Annuity due perpetuity. In Problem 16, The Stack agrees to the one-time payment at a
5% discount rate but wants the royalty payments figured from the beginning of the
year, not the end of the year. How much more will the band receive with annuity-due
payments on the royalty checks?
ANSWER
This is the same as before but with an additional payment at time 0 or PV = $200,000 +
$200,000 / 0.05 = $4,200,000
Use the following information for Problems 18 through 21. Chuck Ponzi has talked an
elderly woman into loaning him $25,000 for a new business venture. She has,
however, successfully passed a finance class and requires Chuck to sign a binding
contract on repayment of the $25,000 with an annual interest rate of 10% over the
next ten years. She has left the method of repayment up to him.
18. Discount loan (interest and principal at maturity). Determine the cash flow to the
woman under a discount loan, in which Ponzi will have a lump-sum payment at the end
of the contract.
ANSWER
FV = $25,000 1.10
10
= $25,000 2.593742 = $64,843.56
19. I nterest-only loan (regular interest payments each year and principal at end).
Determine the cash flow to the woman under an interest-only loan, in which Ponzi will
pay the annual interest expense each year and pay the principal back at the end of the
contract.
ANSWER
Ten Annual Interest Payments are $25,000 0.10 = $2,500
Plus the principal of $25,000 for total repayment of $2,500 10 + $25,000
Chapter 4 The Time Value of Money (Part 2) 81
2013 Pearson Education, Inc. Publishing as Prentice Hall
= $50,000.00
20. Fully amortized loan (annual payments for principal and interest with the same
amount each year). Determine the cash flow to the woman under a fully amortized
loan, in which Ponzi will make equal annual payments at the end of each year so that
the final payment will completely retire the original $25,000 loan.
ANSWER
PMT = $25,000 / [(1 1/1.10
10
) / 0.10] = $25,000 / 6.144567
Annual Payment = $4,068.6348 and total payment back is 10 $4,068.6348 = $40,686.35
21. Amortization schedule. Ponzi may choose to pay off the loan early if interest rates
change during the next ten years. Determine the ending balance of the loan each year
under the three different payment plans.
ANSWER
Plan One (discount loan)
Year
(a)
Beginning
Balance
(a) 1.10 = (c)
Annual Increase
(c)
Ending Balance
1 $25,000.00 $25,000.00 1.10 = $27,500.00 $27,500.00
2 $27,500.00 $27,500.00 1.10 = $30,250.00 $30,250.00
3 $30,250.00 $30,250.00 1.10 = $33,275.00 $33,275.00
4 $33,275.00 $33,275.00 1.10 = $36,602.50 $36,602.50
5 $36,602.50 $36,602.50 1.10 = $40,262.75 $40,262.75
6 $40,262.75 $40,262.75 1.10 =
$44,289.025
$44,289.03
7 $44,289.03 $44,289.03 1.10 = $48,717.93 $48,717.93
8 $48,717.93 $48,717.93 1.10 = $53,589.72 $53,589.72
9 $53,589.72 $53,589.72 1.10 = $58,948.69 $58,948.69
10 $58,948.69 $58,948.69 1.10 = $64,843.56 $64,843.56
Plan Two (interest only loan)
Each year the interest is paid so the ending balance is $25,000.00 which reflects the
original principal.
Plan Three (amortized loan)
Amortization Schedule of Payments
82 Brooks Financial Management: Core Concepts, 2e
2013 Pearson Education, Inc. Publishing as Prentice Hall
Annual Interest is Beginning Balance 0.10
And Principal Paid is Payment Interest
Year
(a)
Beginning.
Balance
(b)
Payment
(a) 0.10 = (c)
Interest for Year
(b) (c) = (d)
Principal Paid
(a) (d)
Ending
Balance
1 $25,000.00 $4.068.63 $2,500.00 $1,568.63 $23,431.37
2 $23,431.37 $4.068.63 $2,343.14 $1,725.50 $21,705.87
3 $21,705.87 $4.068.63 $2,170.59 $1,898.05 $19,807.82
4 $19,807.82 $4.068.63 $1,980.82 $2,087.85 $17,719.97
5 $17,719.97 $4.068.63 $1,772.00 $2,296.64 $15,423.33
6 $15,423.33 $4.068.63 $1,542.33 $2,526.30 $12,897.03
7 $12,897.03 $4.068.63 $1,289.70 $2,778.93 $10,118.09
8 $10,118.09 $4.068.63 $1,011.81 $3,056.83 $7,061.27
9 $7,061.27 $4.068.63 $706.13 $3,362.51 $3,698.76
10 $3,698.76 $4.068.63 $369.88 $3,698.76 $0.00

Note that all payments, interest for year, principal paid, and ending balance are rounded to
nearest cent.
23. Waiting period with an ordinary annuity. Fill in the missing waiting periods (years) or
number of payments in the following table for an ordinary annuity stream.
Number of
Payments or
Years
Annual Interest
Rate Future Value Annuity Present Value
6% 0 $250.00 $2,867.48
8% $5,794.62 $400.00 0
10% 0 $636.48 $6,000.00
4% $100,000.00 $80.80 0

ANSWER
Formula Answer (Rounded final answer to whole periods)
n = ln [$250 / ($250-$2,867.48 0.06)] / ln [1+0.06] = 1.1654 / 0.0583 = 20
n = ln [$5,794.62 0.08/$400 +1] / ln [1+0.08] = 0.7696 / 0.0770 = 10
Chapter 4 The Time Value of Money (Part 2) 83
2013 Pearson Education, Inc. Publishing as Prentice Hall
n = ln [$636.48 / ($636.48-$6,000 0.10)] / ln [1+0.10] = 2.8592 / 0.0953 = 30
n = ln [$100,000 0.04/$80.80 +1] / ln [1+0.04] = 3.9221 / 0.0392 = 100
25. Number of payments. Your grandfather will sell you a beach front property for
$72,500. He says the price is firm whenever you can pay him cash. You know that your
finances will only allow you to save $5,000 a year and that you can make 8% on your
investment. If you invest faithfully every year at the end of the year, how long will it
take for you to accumulate the necessary $72,500 future cash for the beach front
property?
ANSWER
Number of Payments = ln [($72,500 0.08 / $5,000) + 1] / ln (1.08)
= ln [($5,800/$5,000) + 1] / ln (1.08)
= 0.7701 / 0.0770 = 100065
10 payments or 10 years
Or on the calculator
INPUT ? 8.0 $0 -$5,000 $72,500
Variables N I/Y PV PMT FV
OUTPUT 10.0065

27. Estimating the annual interest rate with an annuity due. Fill in the missing annual
interest rates in the following table for an annuity-due stream.
Number of
Payments or
Years
Annual
Interest Rate Future Value Annuity Present Value
10 0 $500.00 $3,680.04
20 $25,000.00 $346.97 0
30 0 $1,946.73 $20,000.00
100 $1,044,010.06 $400.00 0

ANSWER
Using TVM Keys from a Texas Instrument BAII Plus Calculator and rounded to two
decimal places for interest percent. The P/Y and C/Y variables are set to 1. The Mode is Srt
to BGN for each of these solutions.
INPUT 10 -3,680.04 500.00 0
TVM KEYS N I/Y PV PMT FV
OUTPUT 7.57
INPUT 20 0 -346.97 25,000
84 Brooks Financial Management: Core Concepts, 2e
2013 Pearson Education, Inc. Publishing as Prentice Hall
TVM KEYS N I/Y PV PMT FV
OUTPUT 11.09
INPUT 30 -20,000 1,946.73 0
TVM KEYS N I/Y PV PMT FV
OUTPUT 10.13
INPUT 100 0 400.00 -1,044,010.06
TVM KEYS N I/Y PV PMT FV
OUTPUT 4.94

29. I nterest rate with annuity. A local government is about to run a lottery but does not
want to be involved in the payoff if a winner picks an annuity payoff. The government
contracts with a trust to pay the lump-sum payout to the trust and have the trust
(probably a local bank) pay the annual payments. The first winner of the lottery chooses
the annuity and will receive $150,000 a year for the next twenty-five years. The local
government will give the trust $2,000,000 to pay for this annuity. What investment rate
must the trust earn to break even on this arrangement?
ANSWER
Using a calculator TVM keys with P/y=1 and C/y = 1 in end mode:
INPUT 25 ? $2,000,000-$150,000 $0
Variables N I/Y PV PMT FV
OUTPUT 5.5619%

31. Lottery. Your dreams of becoming rich have just come true. You have won the State of
Tranquilitys Lottery. The State offers you two payment plans for the $5,000,000
advertised jackpot. You can take annual payments of $250,000 for the next twenty
years or $2,867,480 today.
a. If your investment rate over the next twenty years is 8%, which payoff will you
choose?
b. If your investment rate over the next twenty years is 5%, which payoff will you
choose?
c. At what investment rate will the annuity stream of $250,000 be the same as the
lump sum payment of $2,867,480?
ANSWER
Part a. Find the present value of the annuity stream at an 8% discount rate.
PV = $250,000 (1 1/1.08
20
) / 0.08 = $250,000 9.8181 = $2,454,536.85
Take the lump sum of $2,867,480.
Part b. Find the present value of the annuity stream at a 5% discount rate.
Chapter 4 The Time Value of Money (Part 2) 85
2013 Pearson Education, Inc. Publishing as Prentice Hall
PV = $250,000 (1 1/1.05
20
) / 0.05 = $250,000 12.4622 = $3,115,552.59
Take the annuity stream of $250,000.
Part c. Find the interest rate that sets the PV of $2,867,480 equal to a twenty year annuity
stream of $250,000.
$2,867.480 = $250,000 (1 1/(1+R)
20
) / R and
this implies that the PVIFA is
PVIFA = (1 - 1/(1+R)
20
) / R = $2,867,480 / $250,000 = 11.4699
Looking up this value on Table A-3 for N = 20 we find the value in column 6%.
Or on the calculator
INPUT 20 ? $2,867,480 $250,000 $0
Variables N I/Y PV PMT FV
OUTPUT 6.0
So at 6% investment rate over the next twenty years you would be indifferent between the
two payoff choices.