Chapter 5: The Time Value of Money

ultiple Choices

If an investment earns compound interest, the dollar amount of interest earned every period will increase because: The interest rate increases every year. The investor has to increase the value of original investment every year. Increase in interest rate and increase in original value of investment. Interest is earned on original investment plus accumulated interest to date.

Naomi deposited $15,000 in an investment fund that pays annual interest of 8%, paid quarterly. How much will she have at the end of 20 years? $69,914.36 $73,131.59 $22,289.21 $7,079,322.51

What is the present value of $5,000 to be received 10 years from today if the discount rate is 7%? $9,835.75 $2,541.75 $4,672.90 $24.81

The following will increase the FV of Annuity: Increasing average annual return. Increasing periodic deposits. Increasing time. All of the above.

Chapter 5: The Time Value of Money

If your friend requires you to repay $6,500 after two years on a loan amount of $5,000, what is the implied rate of interest being charged by your friend? 1.41% 14.01% .14% 30%

You wish to accumulate $25,000 in 5 years to put towards your down payment on a home. How much should you save every year if you are able to earn an average annual return of 7%? $1,247.73 $4,347.27 $6,210.82 $6,097.26

How much should you pay for an investment that requires an original investment of $10,000 and promises to pay 9% in perpetuity (that is, for ever). Assume the discount rate is 12%. $10,000 $83,333 Cannot be determined as the cash flows will occur for an infinite period $7,500

You are planning to obtain a 15-year mortgage on your house and are expecting to get an approval for the loan at an annual interest rate of 6%. If you can afford a monthly payment of $1,200 how much loan should you apply for? $142,204 $19,999.40 $139,856.39 $23,996.75

Chapter 5: The Time Value of Money

If you deposit $2,000 every year for 40 years in your retirement savings account, how much will you have accumulated at the end of 40 years if you are able to earn an average annual return of 7%? $29,948 $399,270 $427,841 $377,668

The following is true about amortized loans: The total payment reduces every year. The total payment remains constant every period but the amount allocated towards interest payment declines with each payment. The total payment remains constant every period but the amount allocated towards principal payment declines with each payment. The total payment remains constant each period and so does the allocation of total payment towards interest and principal.

Interest is earned on original investment plus accumulated interest to date. The correct answer is #4. The interest rate remains constant every year. The amount of interest increases because interest is earned on the original investment plus any interest earned in the past.

1. Answer:

2.Answer: $73,131.59
This is the correct answer. FV = PV (1 + i)n = $15000(1 + .02)80 = $73,131.59. Note since the interest is paid quarterly, i = .08/4 = .02 and t = 20*4 = 80.

3. Answer: $2,541.75
PV = FV/(1 + i)n = 5000/(1.07)10 = $2,541.75

4.Answer: All of the above.

FV will increase if the average annual return, time and periodic deposits are increased.

5.Answer: 14.01%
Rate = (FV/PV)1/n - 1 = (6500/5000)1/2 - 1 = .1401 or 14.01%

Chapter 5: The Time Value of Money

6. answer is #2.
Here you will use the FV for annuity formula and then solve for PMT. You can use the following formula: FV = PMT*((1 + i)n - 1)/I ; Thus $25,000 = PMT *((1.07)5 - 1)/.07 = PMT*199.63. Thus, PMT = 25000/199.63 = $4,347.27. You did not subtract 1.

7.
Answer: $7,500 Appropriate price = PV of perpetuity = Periodic cash flows/discount rate = $900/.12 = $7,500. Periodic cash flows = .09*1000 = $900. You have used $10,000 instead of the periodic cash flow of $900. 8. Answer: $142,204 You will solve for PV of Annuity. PV of Annuity = PMT*(1- 1/(1 + i)n)/R = 1200*(1 1/(1.005)180)/.005 = 1200*118.50 = $18,103.95. Note you have to adjust i = .06/12 = .005 and t = 15*12 = 180 months, to reflect monthly payments. You have annualized the monthly payments and not adjusted time and interest rate to reflect monthly payments.

9. Answer: $399,270
here you will use the FV for annuity formula. You can use the following formula: FV = PMT*((1 + i)n - 1)/I ; Thus FV = 2000 *((1.07)40 - 1)/.07 = 2000*199.63 = $399,270

10.Answer: The total payment remains constant every period but the amount allocated towards
interest payment declines with each payment.

Chapter 5: The Time Value of Money

True or False

A rational investor will be indifferent between receiving $500 today versus receiving $500 next year.

True False

If Boaz deposits $1,000 in his savings account that earns 3% annual interest rate, the annual interest will be $30 every year.

True False

There is an inverse relationship between interest rate and FV.

True False

Present Value shows the value in today's dollars of a sum of money to be received in the future.

True False

Chapter 5: The Time Value of Money

The present value of an investment that yields $1,000 in 4 years and $3,000 in 6 years, based on a discount rate of 5%, will be equal to $5,235.

True False

An annuity is a series of cash flows that continue for a fixed period.

True False

In time value of money problems, n refers to number of years.

True False

There is no difference between annuity and perpetuity.

True False

Chapter 5: The Time Value of Money

If your original investment of $10,000 grows to $15,000 in 10 years, the implied rate of return is less than 5 percent.

True False

One of the variables to be forecasted while determining the appropriate discount rate is the expected rate of inflation.

True False

Chapter 5: The Time Value of Money

Answers 1. False Answer is false. A rational investor will prefer $500 today. Receiving $500 today has two benefits: first, $500 can be invested for a year and thus accumulate to a bigger sum at the end of the year; second, if $500 is received today there is no uncertainty or risk of default. 2. False The amount of interest will increase every year. This is because each year interest is received on the original deposit of $1,000 plus any interest accumulated to date. Thus in the second year, interest will be equal to 3% of ($1,000 + 1st year interest of $30) = $30.90.

3. False
There is a direct relationship between interest rates and FV i.e. as interest rate rises, FV also increases.

4.True
PV computation is done to determine the value in today's dollars of money to be received in the future.

5.False
The PV will be equal to $3061.35. It is found as follows: $1,000 divided by (1.05)4 + $3,000 divided by (1.05)6 = $822.70 + $2,238.65 = $3,061.35. You have used some variation of FV formula.

6.False
An annuity also requires that the cash flows be of equal dollar value.

7.False
n refers to number of periods. Thus if the loan payment is made monthly over a 30-year period, n will be equal to 360 and not 30.

8. False
In annuity, the cash flows occur over a fixed period whereas in perpetuity, the cash flows occur over an infinite period.

9. True
The implied rate of return is = (FV/PV)1/n - 1 = (15000/10000)1/10 - 1 = 4.138%

10.True

Chapter 5: The Time Value of Money

Discount rate reflects the overall risk or expected return on the investment. Thus inflation is an important variable in determining the appropriate discount rate.

Essay
1. Your friend has recently applied for a 30-year mortgage to buy a $200,000 home. Your friend is able to get a loan for $200,000 at an annual rate of 7%. (a) What is the total interest cost over the life of the loan? (b) What advice can you give your friend to reduce the total interest payments? (c) Is all of the money paid towards interest payments a loss for the homeowner? Discuss. 2. Your friend is 20-years old and wishes to accumulate $500,000 by the time he is 65-years old. What advice can you give him based on your knowledge of time value of money? What are some dangers about the plan that you would warn him about? 3. How would you explain the concept of discounting and compounding? What is the

relationship between the two? Give some examples of application for each
4. Review the ten principles listed in chapter 1. Identify and relate one of the principles to

chapter

Solutions
a. In order to compute the total interest payments, compute the monthly payment using PV of annuity formula: PV of Annuity = PMT*(1 - 1/(1 + i)n)/I 200,000 = PMT*(1 - 1/(1 + .0058)360)/.0058 Monthly Payment = $1330.60 Total Payments = $1330.60*360 = $479,016 Total Interest = Total Payments - Loan = 479,016 - 200,000 = $279,016 b. In order to reduce the total interest payments, your friend can do the following: put a down payment towards the loan, take a loan for a shorter period, shop around for a lower interest rate or refinance if the interest rates drop, and use any unexpected income towards paying off the mortgage. For example, the total interest payments will drop to $93,409 if your friend puts a down payment of $20,000 and is able to reduce the interest rate to 6% and time period to 15-years. c. If we consider home ownership as an investment, the interest payment can be regarded as cost that we hope to recover (and indeed, surpass) through the following avenues: tax benefit on interest payment, possible rent on part of the house, and capital gain on sale of the house.

2.This chapter clearly illustrates that the secret to accumulating wealth is to have a systematic savings plan from an early age.
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Chapter 5: The Time Value of Money

Since your friend is young, you will advise him to have a good savings plan and be fully committed to it. For example, if your friend is able to save $100 every month for the next 45 years and is able to get an average annual return of 8%, he would have accumulated nearly $535,000. You would obtain $535,000 when you use the FV of Annuity formula (using payment = $100; Time = 540 months; and I = .0067) There are several dangers or limitations to the plan: First, if your friend is not disciplined and is not able to save $100 every month, the goal will not be reached; Second, the average annual of return of 8% is an estimate, which may or may not be achieved. Third, $535,000 does not include any deduction for taxes and transaction costs (such as brokerage fees for investing and taxes on capital gain). Fourth, $535,000 does not guarantee a decent retirement as the cost of living might be much higher in 45 years. Nonetheless, having a good plan and sticking to it is fundamental to accumulating reasonable wealth at the time of retirement.

3. Discounting refers to estimating how much a sum of money to be paid or to be received in the future (as a lump sum or as a series of periodic cash flows) is worth today. For example, the PV of $20,000 to be received 5 years later is $18,000 at a discount rate of 2.12%. It implies that receiving $18,000 today is equivalent to receiving $20,000 5 years later or we can say if a car costs $18,000 today, it will cost $20,000 5 years later if the price of car increases annually, on average, by 2.12% or we can say that we need to deposit $18,000 today if we wish to accumulate $20,000 in 5 years if we are expecting an annual average return of 2.12%. Compounding refers to estimating how much a sum of money to be paid or deposited today (as a lump sum or as a series of periodic cash flows into the future) will accumulate to in the future. Thus discounting and compounding are really two sides of the same coin. Mathematically, they are inverse of each other. The concepts of compounding and discounting are extremely useful and have wide ranging applications in finance. Some examples are listed below: Discounting: 1. You win a lottery and are given a choice between taking a lump sum today and a series of cash payments into the future. How would you decide? We can compare the lump sum to the PV of the series of cash payments to make a decision (given the discount rate and time period) 2. You wish to accumulate a fixed sum in a few years. How will you decide how much to deposit today? We can compute the PV of the future fixed sum (given the discount rate and time period).
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Chapter 5: The Time Value of Money

3. You feel that you can afford a certain amount towards your car or house payment. How will you decide how much to borrow towards your house or car? We can compute the PV of Annuity based on our budget (given the discount rate and time). 4. How would we determine the price of stocks and bonds? We can use PV formulas to estimate the price if we know the expected future cash flows and discount rate.

Compounding 1. If you wish to accumulate a fixed amount towards your retirement how will you decide how much to contribute every month? You can use the FV of Annuity formula to determine the required monthly savings (given the time horizon and interest rate) 2. If your budget allows you to contribute a certain amount of dollars every month, how will you find the total amount that you will have after several years? You can compute the FV of annuity to determine how much you will have (given the time horizon and interest rate). 4. the most appropriate principle that can be applied to chapter 5 is Principle 1. Principle 1 explains the risk-return trade-off i.e. rational investors will not take risk unless they are adequately compensated for it. The discount rate that we use for moving cash flows over time adjusts for various risk factors that the cash flow might be exposed to (such as inflation, potential default etc.). Higher the risk factor, higher would be the discount rate. For example, if an investor is expecting $5,000 each in 10-years from a domestic corporate bond and a U.S. treasury bond, the investor will use a higher discount rate for the corporate bonds. If the corporate bond is traded in a foreign market, the investor may use an even higher interest to compensate for additional risk factors such as exchange rate risk and political risk.

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