CHAPTER 6

THE TIME VALUE OF MONEY

FOCUS This chapter develops and applies time value formulas for amounts and annuities. The focus is on using time value concepts to solve business problems. PEDAGOGY Students learn and retain discounted cash flow concepts best when they become comfortable with formulas and tables before relying on financial calculators. For that pedagogical reason the formula approach is presented in the text even though calculators are used almost universally in practice. Switching to a calculator after one understands what's going on is a trivial matter. A large number of illustrative problems are included and instructors can supplement solution techniques with calculators if they're so inclined. Calculator solutions are included in the margins next to all illustrative examples. The chapter's illustrative examples serve two purposes. n addition to demonstrating technique! several are designed to teach practice in specific areas. For example! by the time readers finish with annuity problems! they're familiar with some of the intricacies of mortgage loans. That means they're relatively "nowledgeable about real estate finance. TEACHING OBJECTIVES Students should develop an understanding of discounted cash flow concepts and a facility for solving problems. Their problem solving ability should extend to relatively complex applications. OUTLINE . #$T% &' #F A(()#AC* A brief explanation of the fact that money promised in the future is worth less than money in hand today. Four "inds of problems and using time lines. . A+#$&T ()#,%'+S A. The Future -alue of an Amount The expression relating future and present values of a single amount is developed in terms of the future value factor and the associated table. (roblem solving technique is introduced. Applications include deferred payment terms as the equivalent of cash discounts and the opportunity cost rate. Financial calculators are introduced and instruction is provided on their use in solving time value problems. ,. The 'xpression for The (resent -alue of an Amount An alternate formulation emphasi.ing the present value in terms of the future value. +ore on technique. . A&&$ T/ ()#,%'+S A. Annuities 012

01>

Chapter 3 The concept of an annuity and its present and future values. ,. The Future -alue of an Annuity 4 5eveloping a Formula The F-A expression! factor and tables are developed. C. The Future -alue of an Annuity 4 Solving (roblems (roblem solving technique! the sin"ing fund concept! using a financial calculator for annuity problems. 5. Compound nterest and &on4Annual Compounding Compound interest concepts and how to handle non4annual compounding in problems. The 'A) and A(). '. The (resent -alue of an Annuity The formula! factor! and table are developed. Computer spreadsheet techniques for solving time value problems are introduced and explained. F. The (resent -alue of an Annuity 4 Solving (roblems Applications include discounting a stream of payments! amorti.ed loans and amorti.ation schedules! and wor"ing with mortgages. 6. The Annuity 5ue The concept and formula are developed and applied. *. (erpetuities The idea of a never4ending stream with a finite present value is developed intuitively. Applications include the capitali.ation of earnings and preferred stoc". . +ulti4(art (roblems 5ealing with situations in which the solutions to problems become inputs to other problems. -isuali.ing and time lining complex problems. 7. $neven Streams and mbedded Annuities )ecogni.ing and dealing with annuities imbedded in uneven payment streams.

QUESTIONS 0. 8hy are time value concepts important in ordinary business dealings! especially those involving contracts9 ANSWER: ,usiness contracts and agreements generally specify payments that are due at future times. f such payments are more than a few months into the future! the correct analysis of the value of the agreement depends on a recognition of the time value of money. 1. 8hy are time value concepts crucial in determining what a bond or a share of stoc" should be worth9 ANSWER: All securities derive their value solely from the future cash flows that come from owning them. The only way to value a future cash flow today is through the present value concept. Therefore! the value of a security depends entirely on time value ideas. :. n a retail store a discount is a price reduction. 8hat's a discount in finance9 Are the two ideas related9 ANSWER: 5iscounting in finance means ta"ing the present value of a sum promised in the future. The present value process always results in an figure that's less than the future amount! so in a sense! present valuing reduces the price of the future payment. ;. Calculate the present value of one dollar :< years in the future at 0<= interest. 8hat does the result tell you about very long4term contracts9

The Time -alue of +oney

0:<

ANSWER:

(- ? F-:<@(-F0<!:<A ? B0 @.<CD:A ? B<.<CD: ? A little less than six cents.

+oney promised in a very long4term contract isn't worth much today! even if its receipt is certain. Therefore! we should be careful about what we give up today for a commitment in the distant future. C. 8rite a brief! verbal description of the logic behind the development of the time value formulas for annuities. ANSWER: To develop a time value formula for an annuity we ta"e an annuity with a finite number of payments and develop its present or future value by treating each payment as an amount. 8e then examine the resulting expression loo"ing for a pattern that can be extended to longer streams of payments. )ecogni.ing such a pattern allows us to generali.e the expression to an arbitrary number of annuity payments! n. 3. 5eferred payment terms are equivalent to a cash discount. 5iscuss and explain this idea. ANSWER: 5eferred payment means the seller will accept the promise of a future payment instead of the full price today Ewith no interest charged on the amount deferredF. Since the present value of the deferred amount is less than its nominal value! the transaction is actually being conducted at a price Ein present value termsF that's less than the stated price of the article. n essence this is a sale at a discount. %oo"ing at it another way! the buyer could put the deferred amount in the ban" until it was due. At that time she could withdraw the amount deposited! pay the bill! and "eep the interest that would be approximately the amount of the discount. D. 8hat's an opportunity cost interest rate9 ANSWER: An opportunity rate is the rate that would be earned on money given up for some purpose. For example! in the previous question! if the seller finances his business at 01=! his cost of deferring payment is 01=! because he could have paid off some 01= debt if he'd have received the money at the time of the sale. 2. 5iscuss the idea of a sin"ing fund. *ow is it related to time value9 ANSWER: %enders are often concerned that borrowers won't be able to raise the cash to pay off loan principals even though they're able ma"e interest payments during the lives of loans. A sin"ing fund is an arrangement in which a borrower is required to put aside money periodically during the life of a loan! so that at maturity funds are available to pay off the principal. n one such arrangement! funds are deposited at interest to accumulate into the principal amount by the loan's maturity. Time value is involved because it ta"es a future value of an annuity problem to calculate the periodic payment that will Gust pay off the loan at maturity. >. The amount formulas share a closer relationship than the annuity formulas. 'xplain and interpret this statement. ANSWER: The two amount formulas are really the same expression written differently for convenience. ,oth expressions involve the present value and the future value of the same money! and either can be used to solve any amount problem.

0:0

Chapter 3

The annuity formulas are two distinct! separately derived expressions. They deal with two different things! the present and future value of the annuity in question. Annuity problems must be classified as either present or future value! and the correct expression has to be used to solve either. 0<. 5escribe the underlying meaning of compounding and compounding periods. *ow does it relate to time value9 nclude the idea of an effective annual rate E'A)F. 8hat is the annual percentage rate EA()F9 s the A() related to the 'A)9 ANSWER: Compounding relates to earning interest on previously earned interest. +oney initially deposited at interest earns interest on that amount until the end of a compounding period. At that time the interest is HcreditedH to the account! and future interest is earned on the sum of the original deposit plus the interest earned in the first period. nterest earned in the second period is credited at its end! so interest earned in the third period is based on the original deposit plus the first and second period's interest. And so on. The more frequently Eshorter compounding periodsF interest is compounded! the more interest is earned. nterest rates are generally stated in annual terms Ethe nominal rateF and must be adGusted to reflect the compounding periods in use. Time value assumes compound interest. n problems! compounding periods and rates must be consistently specified. The 'ffective Annual )ate E'A)F is the rate of annually compounded interest that is Gust equivalent to a nominal rate compounded more frequently. The A() is the nominal rate. The A() and the 'A) are not directly related. 00. 8hat information are we li"ely to be interested in thatIs contained in a loan amorti.ation schedule9 ANSWER: A loan amorti.ation schedule details the interest and principal components of every loan payment as well as the beginning and ending loan balance for every payment period. 01. 5iscuss mortgage loans in terms of the time value of money and loan amorti.ation. 8hat important points should every homeowner "now about how mortgages wor"9 EHint: Thin" about taxes and getting the mortgage paid off.F ANSWER: A mortgage is an amorti.ed loan! generally of fairly long term. :< years is common. (ayments are made monthly so there are :3< payments in a :<4year mortgage. Amorti.ed loan payments are generally constant in amount! but the split between interest and principal within the payments varies during the life of the loan. 'arly payments contain relatively more interest and later payments relatively more principal repayment. This phenomenon is extreme in long term loans li"e mortgages. 'arly payments are nearly all interest while later payments are nearly all principal repayment. This leads to two important facts for homeowners. First! because interest is tax deductible! early mortgage payments save a lot on taxes while later payments save only a little. Second! a loan is not reduced by much during the early years of its life. That is! half way through the loanIs life! a great deal more than half of the original loan balance is still unpaid. 0:. 5iscuss the idea of capitali.ing a stream of earnings in perpetuity. 8here is this idea useful9 there a financial asset that ma"es use of this idea9 s

ANSWER: A constant stream of earnings that can be expected to go on forever has a finite present value! which is "nown as the capitali.ed value of the stream. The idea is useful in valuing businesses. 'ssentially! any firm is worth the capitali.ed value of its expected future earnings. 8here the best estimate of future earnings is simply a continuation of current earnings! capitali.ing a stream of that magnitude gives an estimate of value.

The Time -alue of +oney (referred stoc" is a security that pays a constant dividend indefinitely. ts value is the capitali.ation of the stream of its dividends.

0:1

0;. 8hen an annuity begins several time periods into the future! how do we calculate its present value today9 5escribe the procedure in a few words. ANSWER: The formula for the present value of an annuity gives a value at the beginning of the annuity. f that time is in the future! the Hpresent valueH of the annuity has to be brought bac" in time to the true present as an amount. *ence two consecutive calculations are required. First ta"e the present value of the annuity! then treat that figure as an amount and ta"e its present value. BUSINESS ANALYSIS 0. A business can be valued by capitali.ing itIs earnings stream Esee example 3.0CF. *ow might you use the same idea to value securities! especially the stoc" of large publicly held companies9 s there a way to calculate a value that could be compared to the stoc"Is mar"et price that would tell an investor whether itIs a good buy9 E f the mar"et price is lower than the calculated value! the stoc" is a bargain.F 8hat financial figures associated with shares of stoc" might be used in the calculation. Consider the per share figures and ratios discussed in chapter : including '(S! dividends! boo" value per share etc. 5oes one measure ma"e more sense than the others9 8hat factors would ma"e a stoc" worth more or less than your calculated value. Answer: A privately or closely held company is valued by capitali.ing a stream of earnings Enet incomeF because all of a firmIs earnings are available to its owners. The analogous figure for the stoc"s of publicly held companies is dividends! because they represent cash received by stoc"holders. Although all earnings technically belong to owners! the stoc"holders of larger companies generally canIt influence how much of those earnings they receive. *ence dividends! which stoc"holders do receive! are the best measure for mathematically calculating value. E*owever! practitioners do use '(S regularly for less precise estimates.F The starting point should be the capitali.ed value of the current dividend! essentially assuming it will go on forever. The rate used for capitali.ation should be consistent with the ris"iness of the company involved. This starting estimated value should be factored up or down based on expectations about future dividends. f the stream is expected to grow or shrin"! value will be higher or lower respectively. Further! a stable stream should be worth more than one that varies substantially from year to year. 'xpectations about future performance usually come from performance in the recent past so a stoc" with a record of consistent dividend Eor '(SF growth should be worth more than one whose dividends have been constant for some time or erratic.

PROBLEMS NOTE: FOR ALL PROBLEMS INVOLVING NON ANNUAL COMPOUNDING! SEE CONCEPT CONNECTION E"AMPLES 6#$ AND 6#%! PAGES &6' ( &6) AS WELL AS THE PROBLEM REFERENCED#

A*+,n- Pr+./e*s
Presen- V0/,e +1 0n A*+,n- ( E20*3/e 6#& 4305e &)66
0. The %exington (roperty 5evelopment Company has a B0<!<<< note receivable from a customer due in three years. *ow much is the note worth today if the interest rate is

0:: a. >=9 b. 01= compounded monthly9 c. 2= compounded quarterly9 d. 02= compounded monthly9 e. D= compounded continuously9 SOLUTION: a. (- ? F- @(-F"!nA (- ? B0<!<<< @(-F>!:A ? B0<!<<< E.DD11F ? BD!D11 (- ? B0<!<<< @(-F0!:3A ? B0<!<<< E.3>2>F ? B3!>2> (- ? B0<!<<< @(-F1!01A ? B0<!<<< E.D22CF ? BD!22C (- ? B0<!<<< @(-F0.C!:3A ? B0<!<<< E.C2C0F ? BC!2C0 F- ? (- Ee"nF B0<!<<< ? (- @e.<DE:FA B0<!<<< ? (- @0.1::DA (- ? B2!0<C.D<

Chapter 3

b.

c.

d.

e.

F,-,re V0/,e +1 0n A*+,n- ( E20*3/e 6#7 4305e &)66

1. 8hat will a deposit of B;!C<< left in the ban" be worth under the following conditionsJ a. %eft for nine years at D= interest9 b. %eft for six years at 0<= compounded semiannually9 c. %eft for five years at 2= compounded quarterly9 d. %eft for 0< years at 01= compounded monthly9 SOLUTION: a. b. c. d. F- ? (- @F-F"!nF F- ? B;!C<< @F-FD!>A ? B;!C<< E0.2:2CF ? B2!1D:.1C F- ? B;!C<< @F-FC!01A ? B;!C<< E0.D>C>F ? B2!<20.CC F- ? B;!C<< @F-F1!1<A ? B;!C<< E0.;2C>F ? B3!323.CC F- ? B;!C<< @F-F0!01<A ? B;!C<< E:.:<<;F ? B0;!2C0.2<

F8n98n5 -:e In-eres- R0-e ( E20*3/e 6#'! 4305e &;<6

:. 8hat interest rates are implied by the following lending arrangements9 a. /ou borrow BC<< and repay BCCC in one year. b. /ou lend B0!2C< and are repaid B1!<D2.33 in two years. c. /ou lend BDC< and are repaid B0!00;.;3 in five years with quarterly compounding. d. /ou borrow B01!C<< and repay B10!:3;.1; in three years under monthly compounding. E&oteJ n c and d! be sure to give your answer as the annual nominal rate.F

The Time -alue of +oney SOLUTION: a. F- ? (- @F-F"!nA BCCC ? BC<< @F-F"!0A F-F"!0 ? 0.00<< " ? 00= B1!<D2.33 ? B0!2C<.<< @F-F"!1A F-F"!1 ? 0.01:3 " ? 3= B0!00;.;3 ? BDC<.<< @F-F"!1<A F-F"!1< ? 0.;2C> " ? 1= "nom ? 2= B10!:3;.1; ? B01!C<<.<< @F-F"!:3A F-F"!:3 ? 0.D<>0 " ? 0.C= "nom ? 02=

0:;

b.

c.

d.

S+/=8n5 1+r -:e N,*.er +1 Per8+9s ( E20*3/e 6#) 4305e &;76

;. *ow long does it ta"e for the following to happen9 a. B2C3 grows into B0!011 at D=. b. B;C< grows into BD1C.C< at 01= compounded monthly. c. BC!<<< grows into B3D1;.;; at 0<= compounded quarterly. SOLUTION: (- ? F- @(-F"!nA a. B2C3 ? B0!011 @(-FD!nA (-FD!n ? .D31> n ? ; years B;C<.<< ? BD1C.C< @(-F0!nA (-F0!n ? .31<: n ? ;2 months ? ; years BC!<<< ? B3!D1;.;; @(-F1.C!nA (-F1.C!n ? <.D;:3 n ? 01 quarters ? : years

b.

c.

C. Sally 6uthrie is loo"ing for an investment vehicle that will double her money in five years. a. 8hat interest rate! to the nearest whole percentage! does she have to receive9 b. At that rate! how long will it ta"e the money to triple9 c. f she can't find anything that pays more than 00=! approximately how long will it ta"e to double her investment9 d. 8hat "ind of financial instruments do you thin" Sally is loo"ing at9 Are they ris"y9 8hat could happen to Sally's investment9

0:C SOLUTION: F- ? (- @F-F"!nA a. 1 ? 0 @F-F"!CA F-F"!C ? 1 "? 0C=

Chapter 3

b. c.

F-F0C!n ? : n ? D.> years Eapproximate with 2 yearsF F-F00!n ? 1 n ? 3.3 years Eapproximate with D yearsF

d. nvestments with anticipated returns li"e these are probably growth4oriented stoc"s with considerable ris". She could lose money.

De1erre9 P0>*en- 8s E?,8=0/en- -+ 0 C0s: D8s@+,n- ( E20*3/e 6#& 4305e &)66

3. ,ranson nc. has sold product to the ,randywine Company! a maGor customer! for B1<!<<<. As a courtesy to ,randywine! ,ranson has agreed to ta"e a note due in two years for half of the amount due! and half in cash. a. 8hat is the effective price of the transaction to ,ranson if the interest rate isJ E0F 3=! E1F 2=! E:F 0<=! E;F 01=9 b. $nder what conditions might the effective price be even less as viewed by ,randywine9 SOLUTION: a. 0F (- ? F- @(-F3!1A ? B0<!<<< E.2><<F ? B2!><< B2!><< K B0<!<<< ? B02!><< 'ffective 5iscount ? C.C= 1F (- ? F- @(-F2!1A ? B0<!<<< E.2CD:F ? B2!CD: B2!CD: K B0<!<<< ? B02!CD: 'ffective 5iscount ? D.0= :F (- ? F- @(-F0<!1A ? B0<!<<< E.213;F ? B2!13; B2!13; K B0<!<<< ? B02!13; 'ffective 5iscount ? 2.D= ;F (- ? F- @(-F01!1A ? B0<!<<< E.D>D1F ? BD!>D1 BD!>D1 K B0<!<<< ? B0D!>D1 'ffective 5iscount ? 0<.0= b. The discount from ,randywine's perspective is calculated as in part aF! but using the interest rate at which that firm borrows. f ,randywine's rate is higher than ,ranson's! it will perceive a greater discount. D. 7ohn Cleaver's grandfather died in 1<<D and left him a trun" that had been loc"ed in his attic for years. At the bottom of the trun" 7ohn found a pac"et of C< 8orld 8ar Hliberty bondsH that had never been cashed in. The bonds were purchased for B00.C< each in 0>02! and pay := interest as long as they're held. E6overnment savings bonds li"e these accumulate and compound their interest unli"e corporate bonds! which regularly pay out interest to bondholders.F a. *ow much are the bonds worth in 1<<D9 (Hint: [FVFk,a+b] = [FVFk,a][FVFk,b] b. *ow much would they have been worth if they paid interest at a rate more li"e that paid during the 0>D<s and 2<s! say D=9 c. Comment on the difference between the answers to parts a and b.

The Time -alue of +oney SOLUTION: First notice that @F-F"!aKbA ? @F-F"!aA @F-F"!bA because E0K"FaKb ? E0K"Fa E0K"Fb! and F-F"!n ? E0K"Fn Therefore! @F-F"!>1A ? @F-F"!3<A @F-F"!:<A @F-F"!1A *ence! @F-F:!>1A ? @F-F:!3<A @F-F:!:<A @F-F:!>A ? EC.2>03FE1.;1D:FE0.<3<>F ? 0C.0D03 and @F-FD!>1A ? @F-FD!3<A @F-FD!:<A @F-FD!1A ? ECD.>;3;FED.301:FE0.0;;>F ? C<C.<11 a. F- ? (- @F-F:!>1A ? B00.C< E0C.0D03F ? B0D;.;D per bond F- ? (- @F-FD!>1A ? B00.C< EC<C.11F ? BC!20<.<: per bond

0:3

b.

c. #ver a long period the interest rate ma"es an enormous difference in investment resultsL

De1erre9 P0>*en- 8s E?,8=0/en- -+ 0 C0s: D8s@+,n- ( E20*3/e 6#& 4305e &)66

2. (aladin 'nterprises manufactures printing presses for small4town newspapers that are often short of cash. To accommodate these customers! (aladin offers the following payment termsJ 0M: on delivery 0M: after six months 0M: after 02 months The %ittleton Sentinel is a typically cash4poor newspaper considering one of (aladin's presses a. 8hat discount is implied by the terms from (aladin's point of view if it can invest excess funds at 2= compounded quarterly9 b. The Sentinel can borrow limited amounts of money at 01= compounded monthly. 8hat discount do the payment terms imply to the Sentinel9 c. )econcile these different views of the same thing in terms of opportunity cost. SOLUTION: Assume a price of B:<<. a. (- ? B0<< K B0<< @(-F1!1A K B0<< @(-F1!3A ? B0<< K B0<< E.>301FK B0<< E.222<F ? B12;.>1 5iscount ? B0C.<2MB:<< ? C= b. (- ? B0<< K B0<< @(-F0!3A K B0<< @(-F0!02A ? B0<< K B0<< E.>;1<FK B0<< E.2:3<F ? B1DD.2< 5iscount ? B11.1<MB:<< ? D.;=

0:D

Chapter 3

c. The buyer is avoiding more financing cost than the seller is giving up because funds are available to both of them at different opportunity rates. >. Charlie owes 7oe B2!<<< on a note which is due in five years with accumulated interest at 3=. 7oe has an investment opportunity now that he thin"s will earn 02=. ThereIs a chance! however! that it will earn as little as ;=. A ban" has offered to discount the note at 0;= and give 7oe cash that he can invest today. a. *ow much ahead will 7oe be if he ta"es the ban"Is offer and the investment does turn out to yield 02=9 b. *ow much behind will he be if the investment turns out to yield only ;=9 S+/,-8+n: a. First calculate the amount CharlieIs note will pay in five years. F- ? (-@F-F3!CA ? B2!<<<E0.::21F ? B0<!D<C.3< f the ban" discounts that at 0;=! 7oe will receive (- ? F-@(-F0;!CA ? B0<!D<C.3<E.C0>;F ? BC!C3<.;> This amount invested at 02= for five years will grow into F- ? (-@F-F02!CA ? BC!C3<.;>E1.12D2F ? B01!D10.1>. And 7oe will be ahead by the difference B01!D10.1> 4 B0<!D<C.3< ? B1!<0C.3> b. f the investment yields only ;=! the last time value calculation will be F- ? (-@F-F;!CA ? BC!C3<.;>E0.103DF ? B3!D3C.;C! And 7oe will be behind by B0<!D<C.3< 4 B3!D3C.;C ? B:!>;<.0C

Ann,8-> Pr+./e*s
F,-,re V0/,e +1 0n Ann,8-> ( E20*3/e 6#; 4305e &;66
0<. *ow much will B3C< per year be worth in eight years at interest rates of a. 01= b. 2= c. 3= SOLUTION: a. b. c. F-A ? (+T @F-FA"!nA F-A ? B3C< @F-FA01!2A ? B3C< E01.1>>DF ? BD!>>;.20 F-A ? B3C< @F-FA2!2A ? B3C< E0<.3:33F ? B3!>0:.D> F-A ? B3C< @F-FA3!2A ? B3C< E>.2>DCF ? B3!;::.:2

00. The 8intergreens are planning ahead for their son's education. *e's eight now and will start college in 0< years. *ow much will they have to set aside each year to have B3C!<<< when he starts if the interest rate is D=9 SOLUTION: F-A ? (+T @F-FA"!nA B3C!<<< ? (+T @F-FAD!0<A ? (+T E0:.203;F (+T ? B;!D<;.CC 01. 8hat interest rate would you need to get to have an annuity of BD!C<< per year accumulate to B1D>!3<< in 0C years9

The Time -alue of +oney SOLUTION: F-A ? (+T @F-FA"!nA B1D>!3<< ? BD!C<< @F-FA"!0CA F-FA"!0C ? :D.12 " ? 01= 0:. *ow many years will it ta"e for B2C< per year to amount to B1<!<<< if the interest rate is 2=9 nterpolate and give an answer to the nearest month. SOLUTION: F-A ? (+T @F-FA"!nA B1<!<<< ? B2C< @F-FA2!nA F-FA2!n ? 1:.C1> n ? 0:.DC yrs ? 0: yrs > mos

0:2

Presen- V0/,e +1 0n Ann,8-> ( E20*3/e 6#A 4305e &666

0;. 8hat would you pay for an annuity of B1!<<< paid every six months for 01 years if you could invest your money elsewhere at 0<= compounded semiannually9 SOLUTION: (-A ? (+T @(-FA"!nA (-A ? B1!<<< @(-FAC!1;A ? B1!<<< E0:.D>23F (-A ? B1D!C>D.1<

A*+r-8Be9 L+0n F8n98n5 P0>*en- ( E20*3/e 6#77 4305e &$76

0C. Sam )othstein wants borrow B0C!C<< to be repaid in quarterly installments over five years at 03= compounded quarterly. *ow much will his payment be9 SOLUTION: For quarterly compounding we have " ? "nomM01 ? 03=M; ? ;= n ? C years x 01 monthsMyear ? 3< months. 8rite equation 3.0> and substitute. (-A ? (+T@(-FA"!nA B0C!C<< ? (+T@(-FA;!3<A $sing Appendix A4; B0C!C<< ? (+T@11.31:CA (+T ? B32C

A*+r-8Be9 L+0n F8n98n5 A*+,n- B+rr+we9 ( E20*3/e 6#7& 4305e &$76

03. *arry Clements would li"e to buy a new car. *e can afford payments of B3C< a month. The ban" ma"es four4year car loans at 01= compounded monthly. *ow much can *arry borrow toward a new car9 SOLUTION: First calculate " and n for monthly compounding! " ? "nomM01 ? 01=M01 ? 0= n ? ; years x 01 monthsMyear ? ;2 months. 8rite equation 3.0> and substitute.

0:>

Chapter 3 (-A ? (+T@(-FA"!nA (-A ? B3C<@(-FA0!;2A

$sing Appendix A4; (-A ? B3C<@:D.>D;<A (-A ? B1;!32: 0D. Construct an amorti.ation schedule for a four4year! B0<!<<< loan at 3= interest compounded annually. SOLUTION: (-A ? (+T @(-FA"!nA B0<!<<< ? (+T @(-FA3!;A (+T ? B1!22C.>1 /ear 0 1 : ; ,eg ,al B0<!<<<.<< D!D0;.<2 C!1>0.<< 1!D11.C; (+T &T (rin )ed B1!12C.>1 1!;1:.<2 1!C32.;3 1!D11.C; 'nd ,al BD!D0;.<2 C!1>0.<< 1!D11.C; <.<<

B1!22C.>1 B3<<.<< 1!22C.>1 ;31.2; 1!22C.>1 :0D.;3 1!22C.>1 03:.:C

02. A B0<!<<< car loan has payments of B:30.C1 per month for three years. 8hat is the interest rate9 Assume monthly compounding and give the answer in terms of an annual rate. SOLUTION: (-A ? (+T @(-FA"!nA B0<!<<< ? B:30.C1 @(-FA"!:3A (-FA"!:3 ? 1D.330 " ? 0.C= "nom ? 02=

EAR 4305e &676

0>. )alph )enner Gust borrowed B:<!<<< to pay for a new sports car. *e too" out a 3< month loan and his car payments are BD30.2< per month. 8hat is the effective annual interest rate E'A)F on )alphIs loan9

SOLUTION: First! calculate the periodic interest rate n ? 3<N (- ? :<!<<<N (+T ? ED30.2<FN F- ? < C(T M/ ? 0.C= 'A) ? E0 K .<0CF01 O 0 ? .0>C3 or 0>.C3=

Ann,8-> D,e ( E20*3/e 6#7$ 4305e &$$6

1<. 7oe Ferro's uncle is going to give him B1C< a month for the next two years starting today. f 7oe ban"s every payment in an account paying 3= compounded monthly! how much will he have at the end of -:ree years9 SOLUTION: F-Ad ? (+T @F-FA"!nAE0K"F ? B1C< @F-FA.C!1;AE0.<<CF ? B1C< E1C.;:1<F E0.<<CF ? B3!:2>.D>

The Time -alue of +oney which stays in the ban" for another yearJ F- ? B3!:2>.D> @F-F.C!01A ? B3!:2>.D> E0.<30DF ? B3!D2;.<;

0;<

10. *ow long will it ta"e a payment of BC<< per quarter to amorti.e a loan of B2!<<< at 03= compounded quarterly9 Approximate your answer in terms of years and months. *ow much less time will it ta"e if loan payments are made at the beginning of each month rather than at the end9 SOLUTION: (-A ? (+T @(-FA"!nA B2!<<< ? BC<< @(-FA;!nA (-FA;!n ? 03 n ? 13 quarters ? 3.C years ? 3 years 3 months (-Ad ? (+T @(-FA"!nAE0K"F B2!<<< ? BC<< @(-FA;!nAE0.<;F (-FA;!n ? 0C.:2;3 n ? 1; 0M: quarters ? 3 years 0 month So it will ta"e about C months less time.

M+r-505e L+0ns ( E20*3/es 6#7' 6#7; 4305es &$& &$)6

11. )yan and %aurie +iddleton Gust purchased their first home with a traditional Emonthly compounding and paymentsF 3= :<4year mortgage loan of B0D2!<<<. a. *ow much is their monthly payment9 b. *ow much interest will they pay the first month9 c. f they ma"e all their payments on time over the :<4year period! how much interest will they have paid9 d. f )yan and %aurie decide to move after D years what will the balance of their loan be at that time9 e. f they finance their home over 0C rather than :< years at the same interest rate! how much less interest will they pay over the life of the loan9 SOLUTION Eusing a financial calculatorFJ a. (- ? B0D2!<<<N n ? :3<! M/ ? .CN C(T (+T ? B0!<3D.1< b. nterest in the first payment is the opening loan balance times the monthly rate B0D2!<<< x .<<C ? B2>< c. Total interest is total payments minus the amount borrowed Total payments are B0<3D.1< x :3< ? B:2;!0>1 And total interest is B:2;!0>1 4 B0D2!<<< ? B1<3!0>1 d. The loan balance at any time is the (- of the remaining payments. After D years! the +iddletons will have made D x 01 ? 2; monthly payments which leaves :3<42; ? 1D3 remaining. n ? 1D3! M/ ? .C! (+T ? B0!<3D.1<N C(T (- ? B0C>!CC2.00 e. The payment on a 0C year loan is n ? 02<! M/ ? .C! (- ? B0D2!<<<N C(T (+T ? B0!C<1.<D Total interest is total payments minus the amount borrowed Total payments are B0!C<1.<D x 02< ? B1D<!:D1.3<. And total interest is B1D<!:D1.3< 4 B0D2!<<< ? B>1!:D1.3< The difference is B00:!20>.;<

0;0

Chapter 3

1:. 8hat are the monthly mortgage payments on a :<4year loan for B0C<!<<< at 01=9 Construct an amorti.ation table for the first six months of the loan. SOLUTION: (-A ? (+T @(-FA"!nA B0C<!<<< ? (+T @(-FA0!:3<A ? (+TE>D.102:F (+T ? B0!C;1.>1 +onth 0 1 : ; C 3 ,eg ,al B0C<!<<<.<< 0;>!>CD.<2 0;>!>0:.D: 0;>!23>.>; 0;>!21C.D1 0;>!D20.<3 (+T B0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 &T (rin )ed 'nd ,al B0!C<<.<< B;1.>1 B0;>!>CD.<2 0!;>>.CD ;:.:C 0;>!>0:.D: 0!;>>.0: ;:.D> 0;>!23>.>; 0!;>2.D< ;;.11 0;>!21C.D1 0!;>2.13 ;;.33 0;>!D20.<3 0!;>D.20 ;C.00 0;>!D:C.>C

1;. Construct an amorti.ation schedule for the last six months of the loan in (roblem 10. E*intJ 8hat is the unpaid balance at the end of 1> P years9F SOLUTION: (-A ? (+T @(-FA0!3A ? B0!C;1.>1 EC.D>CCF ? B2!>;0.>> +onth ,eg ,al :CC :C3 :CD :C2 :C> :3< B2!>;0.>> D!;22.;> 3!<1<.;C ;!C:D.D: :!<;<.0> 0!C1D.3D (+T B0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 0!C;1.>1 &T B2>.;1 D;.22 3<.1< ;C.:2 :<.;< 0C.1C (rin )ed 'nd ,al

B0!;C:.C< BD!;22.;> 0!;32.<; 3!<1<.;C 0!;21.D1 ;!C:D.D: 0!;>D.C; :!<;<.0> 0!C01.C1 0!C1D.3D 0!C1D.3D <.<<

1C. *ow soon would the loan in (roblem 10 pay off if the borrower made a single additional payment of B0D!>:3.1> to reduce principal at the end of the fifth year9 :3< 3< ? :<< (-A ? (+T @(-FA0!:<<A (-A ? B0!C;1.>1 E>;.>;33F ? B0;3!;>C.<0 %ess additional payment 0D!>:3.1> &ew ,alance ? B012!CC2.D1 (-A ? (+T @(-FA0!nA B012!CC2.D1 ? B0!C;1.>1 @(-FA0!nA (-FA0!n ? 2:.:10D n ? 02< months ? 0C years So the loan would pay off in a total of 1< years. SOLUTION: 13. 8hat are the payments to interest and principal during the twenty4fifth year of the loan in problem 109 SOLUTION: Calculate the loan balance after 1C and 13 years Efive and four years remainingF. The difference is the amount paid into principal during the twenty4fifth year.

The Time -alue of +oney

0;1

(-A ? (+T @(-FA0!3<A ? B0!C;1.>1 E;;.>CC<F ? B3>!:30.>D (-A ? (+T @(-FA0!;2A ? B0!C;1.>1 E:D.>D;<F ? BC2!C><.2; (ayments to principalJ B3>!:30.>D C2!C><.2; B0<!DD0.0:

Total paymentsJ B0!C;1.>1 01 ? B02!C0C.<; nterest paymentsJ B02!C0C.<; 0<!DD0.0: B D!D;:.>0

1D. a. b. c. d.

Adam 8ilson Gust purchased a home and too" out a B1C<!<<< mortgage for :< years at 2=! compounded monthly. *ow much is AdamIs monthly mortgage payment9 *ow much sooner would Adam pay off his mortgage if he made an additional B0<< payment each month9 Assume Adam ma"es his normal mortgage payments and at the end of five years! he refinances the balance of his loan at 3=. f he continues to ma"e the same mortgage payments! how soon after the first five years will he pay off his mortgage9 *ow much interest will Adam pay in the tenth year of the loan i. if he does not refinance9 ii. if he does refinance9

SOLUTION: a. n ? :3<N M/ ? 2M01 ? .33333DN (- ? 1C<!<<<N F- ? < C(T (+T ? B0!2:;.;0 b. Add B0<<.<< to the (+T calculated above and recompute nJ M/ ? .33333DN (- ? 1C<!<<<N (+T ? E0!>:;.;0FN F- ? < C(T n ? 1>D.31 Adam would eliminate the last 31 months of payments by paying an additional B0<<Mmonth First calculate the mortgage balance at the end of C years n ? 3<N M/ ? .33333DN (- ? 1C<!<<<N (+T ? E0!2:;.;0>:F C(T F- ? B1:D!3D;.DC Then solve for n using the original (+T! the new M/! and the mortgage balance as the new (M/ ? 3.<M01 ? .C<N (- ? 1:D!3D;.3;N (+T ? E0!2:;.;0FN F- ? < C(T n ? 1<>.1C The mortgage would pay off about >< months earlier. F- after the 0<2th payment n ? 0<2N M/ ? 2M01 ? .33333DN (- ? 1C<!<<< (+T ? EB02:;.;0FN C(T F- ? B11:!C>1.<1 F- after the 01<th payment ? B10>!:00.D3 (rincipal payments ? B11:!C>1.<1 4 B10>!:00.D3 ? B;!12<.13 nterest payments ? 01 x B02:;.;0 ? B11!<01.>1 4 B;!12<.13 ? B0D!D:1.33 F- after the 3<th payment Ewhen the refinancing would occurF

c.

d. i.

ii.

0;:

Chapter 3 n ? 3<N M/ ? 2M01 ? .33333DN (- ? B1C<!<<<N (+T ? EB02:;.;0FN C(T F- ? B1:D!3D;.DCN Then find the balance after ;2 payments of the refinanced loan n ? ;2N M/ ? 3M01 ? .C<N (- ? B1:D!3D;.3;N (+T ? EB02:;.;0FN C(T F- ? B1<1!D1C.:;. F- after the 3<th payment ? B0>1!3<<.3: (rincipal payments ? B1<1!D1C.:; 4 B0>1!3<<.3: ? B0<!01;.D0 nterest payments ? 01 x B02:;.;0 ? B11!<01.>1 4 B0<!01;.D0 ? B00!222.10

Es-8*0-8n5 0n ARM Rese- ( E20*3/e 76#6 4305e &$;6

12. *arrison Conway is choosing between a fix rate and an adGustable rate mortgage EA)+F for B:<<!<<<. ,oth are :< year mortgages with monthly payments and compounding. The fixed rate is offered at 2= while the initial rate on the A)+ is 3=. *arrison is concerned that inflation may be a problem within ten years and that rates may return to levels not seen since the mid 0>2<s! i.e.! in the neighborhood of 01=. Compare the payment on the fixed rate loan to what *arrison would have to pay on the A)+ if it reset to 01= after ten years. For simplicity assume Gust that one resetting occurs. )ound all calculations to the nearest dollar. S+/,-8+n: First calculate the initial A)+ payment. " ? 3 M 01 ? .C n ? :< x 01 ? :3< (-A ? (+T @(-FA"!nA B:<<!<<< ? (+T @(-FA.C!:3<A B:<<!<<< ? (+T @033.D>1A (+T ? B0!D>> &ext calculate the proGected unpaid A)+ balance after ten years E1< years or 1;< months remainingF. (-A ? (+T @(-FA"!nA ? B0!D>> @(-FA.C!1;<A ? B0!D>> @0:>.C20A ? B1C0!0<3 &ext calculate the payment required to amorti.e B1C0!0<3 over the remaining 1< years at 01=. " ? 01 M 01 ? 0 n ? 1< x 01 ? 1;< (-A ? (+T @(-FA"!nA B1C0!0<3 ? (+T @(-FA0!1;<A B1C0!0<3 ? (+T @><.20>;A (+T ? B1!D3C The fixed rate payment at 2= is " ? 2 M 01 ? .3D n ? :< x 01 ? :3< (-A ? (+T @(-FA"!nA B:<<!<<< ? (+T @(-FA.3D!:3<A B:<<!<<< ? (+T @0:3.12:A (+T ? B1!1<0 *ence the A)+ would be BC3; per month higher

The Time -alue of +oney

0;;

1>. %ee Childs is negotiating a contract to do some wor" for *aas Corp. over the next five years. *aas proposes to pay %ee B0<!<<< at the end of each of the third! fourth and fifth years. &o payments will be received prior to that time. f %ee discounts these payments at 2=! what is the contract worth to him today9 SOLUTION: This is an annuity problem! but the annuity doesnIt begin today. Since the payments occur at the end of the :rd through Cth years! we can solve for the value of the annuity at the end of the second year using the following valuesJ n ? :N M/ ? 2N (+T ? 0<!<<<N F- ? < C(T (- ? B1C!DD<.>D This amount needs to be discounted bac" two periods to find the value today n ? 1N M/ ? 2N (+T ? <N F- ? 1C!DD<.>D C(T (- ? B11!<>;.;C :<. )eferring to the previous problem! %ee wants to receive the payments for his wor" sooner than *aas proposes to ma"e them. *e has counter proposed that the payments be made at the beginning of the third! fourth and fifth years rather than at the end. 8hat will the contract be worth to %ee if *aas accepts his counter proposal9 SOLUTION: 8e want to retain the (- of the contract from the previous problem at B11!<>;.;C. Since payments will occur at the beginning of the :rd through Cth years under this proposal! we first need to determine the future value of the contract at the beginning of the 1 nd period. Then we can treat the payments as an ordinary annuity starting at that time. n ? 0N M/ ? 2N (- ? 11.<>;.;CN (+T ? < C(T F- ? B1:!231.<0 This amount becomes the (- of an ordinary annuity three years long n ? :N M/ ? 2N (- ? 1:!231.<0N F- ? < C(T (+T ? B>!1C>.13 :0. The #rion Corp. is evaluating a proposal for a new proGect. t will cost BC<!<<< to get the underta"ing started. The proGect will then generate cash inflows of B1<!<<< in its first year and B03!<<< per year in the next five years after which it will end. #rion uses an interest rate of 0C= compounded annually for such evaluations. a. Calculate the Q&et (resent -alueR E&(-F of the proGect by treating the initial cost as a cash outflow Ea negativeF in the present! and adding the present value of the subsequent cash inflows as positives. b. 8hat is the implication of a positive &(-9 E8ords only.F c. Suppose the inflows were somewhat lower! and the &(- turned out to be negative. 8hat would be the implication of that result9 E8ords only.F EThis problem is a preview of a technique called capital budgeting! which weIll study in detail in Chapters 0<! 00! and 01.F S+/,-8+n: a. First ta"e the present value of the first inflow (- ? F-@(-F0C!0A ? B1<!<<<E.23>3F ? B0D!:>1 &ext ta"e the present value of the annuity in two steps (-A ? (+T@(-FA0C!CA ? B03!<<<E:.:C11F ? BC:!3:C.1< &ext bring that figure bac"ward one year into the present as an amount. (- ? F-@(-F0C!0A ? BC:!3:C.1<E.23>3F ? B;3!3;0.0D *ence the &(- of the proGect is &(- ? BC<!<<< K B0D!:>1 K B;3!3;0.0D ? B0;!<::.0D

0;C

Chapter 3

b. A positive &(- means that on a present value basis the proGectIs cash inflows exceed its outflows. That implies itIs a good deal for the company. n essence it is expected to increase the firmIs wealth and value to stoc"holders. Since thatIs what management is supposed to do! they should accept the proGect. c. A negative means Gust the opposite. t implies that! on balance! the proGect will cost the firm money. *ence it should be reGected.

Per3e-,8-8es ( C038-0/8B0-8+n +1 E0rn8n5s ( E20*3/e 6#7A 4305e &%<6

:1. )oper +etals nc. is in negotiations to acquire the *anson Sheet +etal Company. *ansonIs after tax earnings have averaged B0> million per year for the last four years without much variation around that average figure. So far discussions have been about the business fit of the two firms and pricing has been conspicuously ignored. )operIs C'# feels the venture is ris"y and needs to pay a price that would yield his firm a return of about 1<= if no operating improvements came out of the merger. a. 8hat offering price should he put on the table to open negotiations9 b. *ansonIs management is sure to want a higher price. 8ould that imply capitali.ing earnings at a higher or lower rate. 8hy. c. 8hat arguments is *anson li"ely to use. SOLUTION: a. )operIs C'# should start by capitali.ing earnings as a perpetuity at the rate he feels he needs to see as a return. This yields
PHanson = Earnings B0>M = = B>CM Rateof )e turn .1<

b. (aying a higher price would imply a lower percentage return because )oper would be paying more for the same earnings stream. +athematically! a lower denominator in the equation above implies a higher price. c. *anson is li"ely to argue that the acquisition is not very ris"y because the firm is stable and has a solid ongoing business. *e also may argue that thereIs a good deal of growth potential which would increase the earnings stream into the future above the value of a perpetuity.

M,/-8 P0r- Pr+./e*s

S8*3/e M,/-830r- ( E20*3/e 6#&7 4305e &%&6
::. The Tower family wants to ma"e a home improvement that is expected to cost B3<!<<<. They want to fund as much of the cost as possible with a home equity loan! but can afford payments of only B3<< per month. Their ban" offers equity loans at 01= compounded monthly for a maximum term of 0< years. a. *ow much cash do they need as a down payment9 b. Their ban" account pays 2= compounded quarterly. f they delay starting the proGect for two years! how much would they have to save each quarter to ma"e the required down payment if the loan rate and estimated cost remains the same9 SOLUTION: %oanJ (-A ? (+T @(-FA"!nA ? B3<< @(-FA0!01<A ? B3<< E3>.D<<CF ? B;0!21<.:< a. Savings reqJ B3<!<<< B;0!21<.:< ? B02!0D>.D<

The Time -alue of +oney

0;3

b. Save4upJ F-A ? (+T @F-FA"!nA ? (+T @(-FA1!2A B02!0D>.D< ? (+T E2.C2:<F (+T ? B1!002.0<

C+*3/e2 M,/-830r- ( E20*3/e 6#&& 4305e &%)6

:;. The Stein family wants to buy a small vacation house in a year and a half. They expect it to cost BDC!<<< at that time. They have the following sources of money 0. They currently have B0<!<<< in a ban" account that pays 3= compounded monthly. 1. $ncle +urray has promised to give them B0!<<< a month for 02 months starting today. :. At the time of purchase! they'll ta"e out a mortgage. They anticipate being able to ma"e payments of about B:<< a month on a 0C4year! 01= loan. n addition! they plan to ma"e quarterly deposits to an investment account to save up any shortfall in the amount required. *ow much must those additions be if the investment account pays 2= compounded quarterly9 SOLUTION: Current ban" accountJ F- ? (- @F-F"!nA ? B0<!<<< @F-F.C!02A ? B0<!<<< E0.<>:>F ? B0<!>:> $ncle +urrayJ F-Ad ? (+T @F-FA"!nAE0K"F ? B0!<<< @F-FA.C!02AE0K"F ? B0!<<< E02.D2C2F E0.<<CF ? B02!2D>.D: %oanJ SourcesJ (-A ? (+T @(-FA"!nA ? B:<< @(-FA0!02<A ? B:<< E2:.:10DF ? B1;!>>3.C0 B0<!>:>.<< 02!2D>.D: 1;!>>3.C0 BC;!20C.1; ShortfallJ BDC!<<<.<< C;!20C.1; B1<!02;.D3

Save4upJ F-A ? (+T @F-FA"!nA ? (+T @F-FA1!3A B1<!02;.D3 ? (+T E3.:<20F (+T ? B:!0>>.21 :C. Clyde Atherton wants to buy a car when he graduates college in two years. *e has the following sources of moneyJ 0. *e has BC!<<< now in the ban" in an account paying 2= compounded quarterly. 1. *e will receive B1!<<< in one year from a trust. :. *e'll ta"e out a car loan at the time of purchase on which he'll ma"e BC<< monthly payments at 02= compounded monthly over four years. ;. Clyde's uncle is going to give him B0!C<< a quarter starting today for one year. n addition Clyde will save up money in a credit union through monthly payroll deductions at his part4time Gob. The credit union pays 01= compounded monthly. f the car is expected to cost B;<!<<< EClyde has expensive tasteLF! how much must he save each month9

SOLUTION:

0;D

Chapter 3

Current ban" accountJ F- ? (- @F-F"!nA ? BC!<<< @F-F1!2A ? BC!<<< E0.0D0DF ? BC!2C2.C< TrustJ %oanJ $ncleJ F-Ad ? (+T @F-FA"!nAE0K"F ? B0!C<< @F-FA1!;AE0.<1F ? B0!C<< E;.0103F E0.<1F ? B3!:<3.<C ,ring this forward as an amount F- ? (- @F-F"!nA ? B3!:<3.<C @F-F1!;A ? B3!:<3.<C E0.<21;F ? B3!21C.3D SourcesJ B C!2C2.C< 1!03;.2< 0D!<10.:< 3!21C.3D B:0!2D<.1D ShortfallJ B;<!<<<.<< :0!2D<.1D B 2!01>.D: F- ? (- @F-F"!nA ? B1!<<< @F-F1!;A ? B1!<<< E0.<21;F ? B1!03;.2< (-A ? (+T @(-FA"!nA ? BC<< @(-FA0.C!;2A ? BC<< E:;.<;13F ? B0D!<10.:<

Save4upJ

F-A ? (+T @F-FA"!nA ? (+T @F-FA0!1;A B2!01>.D: ? (+T E13.>D:CF (+T ? B:<0.;<

:3. 7oe Trenton expects to retire in 0C years and has suddenly reali.ed that he hasnIt saved anything toward that goal. After giving the matter some thought! he has decided that he would li"e to retire with enough money in savings to withdraw B2C!<<< per year for 1C years after he retires. Assume a 3= return on investment before and after retirement and that all payments into and withdrawals from savings are at year end. a. *ow much does 7oe have to save in each year for the next 0C years to reach this goal9 b. *ow much would 7oe have needed to save each year if he had started when retirement was 1C years away9 c. Comment on the difference between the results of parts a and b. SOLUTION: 0# This is a 14step solution. First! calculate the amount needed at retirement to fund 1C annual withdrawals of B2C!<<<. This is the amount that will be needed in savings at retirement. Then calculate how much 7oe will need to save each year until retirement to have that much. (-A ? (+T@(-FA"!nA ? B2C!<<<@F-A3!1CA ? B2C!<<< E01.D2:;F ? B0!<23!C2> This (-A becomes the F-A of the required savings over the next 0C years. F-A ? (+T@F-FA3!0CA B0!<23!C2> ? (+T@1:.1D3<A (+T ? B;3!32: .# The first calculation is the same! B0!<23!C2> is required at retirement. The only change in the second calculation is n becomes 1C rather than 0C.

The Time -alue of +oney

0;2

F-A ? (+T@F-FA3!1CA B0!<23!C2> ? (+T@C;.23;CA (+T ? B0>!2<C @# For most people saving more than B;3!<<< a year is impossible! while about putting aside B1<!<<< or less than half of that amount would be very difficult but might be possible. There is no substitute for starting retirement planning early. :D. 7anet 'lliott Gust turned 1<! and received a gift of B1<!<<< from her rich uncle. 7anet plans ahead and would li"e to retire on her CCth birthday. She thin"s sheIll need to have about B1 million saved by that time in order to maintain her lavish lifestyle. She wants to ma"e a payment at the end of each year until sheIs C< into an account sheIll open with her uncleIs gift. After that sheId li"e to stop ma"ing payments and let the money grow at interest until it reaches B1 million when she turns CC. Assume she can invest at D= compounded annually. gnore the effect of taxes. a. *ow much will she have to invest each year in order to achieve her obGective9 b. 8hat percent of the B1 million will have been contributed by 7anet Eincluding the B1<!<<< she got from her uncleF9 SOLUTION: a. First we need to "now how much she will need to accumulate by the time she reaches C< so that amount can grow to B1 million by the time she reaches CC. n ? CN M/ ? DN (+T ? <N F- ? 1!<<<!<<< C(T (- ? B0!;1C!>D1.:3 That number becomes the F- in an ordinary annuity with a B1<!<<< (n ? :<N M/ ? DN (- ? 1<!<<<N F- ? E0!;1C!>D1.:3F C(T (+T ? B0:!;2;.0> b. 7anet will have contributed B1<!<<< K :< x B0:!;2;.0> ? B;1;!C1C.D<! and ;1;!C1C.D<M1!<<<!<<< ? 10.1:=

:2. +erritt +anufacturing needs to accumulate B1< million to retire a bond issue that matures in 0: years. The firmIs manufacturing division can contribute B0<<!<<< per quarter to an account that will pay 2=! compounded quarterly. *ow much will the remaining divisions have to contribute every month to a second account that pays 3= compounded monthly in order to reach the B1< million goal9 SOLUTION: First calculate how much the "nown source of funding EB0<<!<<< per quarterF will grow to by the end of 0: years n ? 0: x ; ? C1N M/ ? 2M; ? 1N (- ? <N (+T ? 0<<!<<< C(T F- ? B>!<<0!3;<.>: The remainder B0<!>>2!:C>.<D will have to be raised from the other divisions and becomes the F- of the second annuity problem n ? 0C3N M/ ? .CN (- ? <N F- ? 0<!>>2!:C>.<D C(T (+T ? B;3!D01.30 :>. Carol (asca Gust had her fifth birthday. As a birthday present! her uncle promised to contribute B:<< per month to her education fund until she turns 02 and starts college. CarolIs parents estimate college will cost B1!C<< per month for four years! but donIt thin" theyIll be able to save anything toward it for five years. *ow much will CarolIs parents need to contribute to the fund each month starting on her tenth birthday to pay for her college education9 Assume the fund earns 3= compounded monthly9

0;>

Chapter 3

SOLUTION: First! we need to calculate how much money Carol will need when she starts college. ThatIs the present value of B1!C<< per month for four years. n ? ;2N M/ ? .CN (+T ? 1!C<<N F- ? < C(T (- ? B0<3!;C<.D> The money from her uncle will contribute the future value of an annuity of B:<< per month for 0: yearsJ n ? 0C3N M/ ? .CN (- ? <N (+T ? :<< C(T F- ? BD<!3:;.1< The shortfall is the difference of B:C!203.C> which must be made up by her parents contributions over five years n ? 3<N M/ ? .CN F- ? :CN203.C>N (-?<N C(T (+T ? BC0:.:C ;<# 7oan Colby is approaching retirement and plans to purchase a condominium in Florida in three years. She now has B;<!<<< saved toward the purchase in a ban" account that pays 2= compounded quarterly. She also has five B0!<<< face value corporate bonds that mature in two years. She plans to deposit the bondsI principal repayments in the same account when theyIre paid. 7oan also receives B0!1<< per month alimony from her ex4husband which will continue for two more years until he retires E1; chec"s including one that arrived todayF. SheIs decided to put her remaining alimony money toward her condo depositing it as received in a credit union account that pays 2= compounded monthly. SheIll ma"e the first deposit today with the chec" she already has. 7oan anticipates buying a B1<<!<<< property. 8hat will her monthly payment be on a 0C year mortgage at 3=9 8hat would the payment be on a :< year loan at the same interest rate9 SOLUTION: Calculate the value of money 7oan will have in the ban" and credit union in three years B;<!<<< already on deposit F- ? (-@F-F"!nA ? B;<!<<<@F-F1!01A ? B;<!<<<E0.1321F ? BC<!D12.<< ,ond principal repayment F- ? (-@F-F"!nA ? BC!<<<@F-F1!;A ? BC!<<<E0.<21;F ? BC!;01.<< AlimonyJ First calculate the future value of the stream at its end in two years recogni.ing that the deposits will be an annuity due. Then proGect at sum forward one year to the date of purchase. F-A ? (+T@F-FA"!nAE0K"F ? B0!1<<@F-FA.3D!1;AE0.<<3DF ? B0!1<<E1C.>::1FE0.<<3DF ? B:0!00>.2;E0.<<3DF ? B:0!:12.:; F- ? (-@F-F"!nA ? B:0!:12.:;@F-F.3D!01A ? B:0!:12.:; E0.<2:<F ? B::!>12.C> Funds saved BC<!D12.<< K BC!;01 K B::!>12.C> ? B><!<32.C> &ext calculate the mortgage required B1<<!<<< 4 B><!<32.C> ? B0<>!>:0.;0 Finally calculate the mortgage payment (-A ? (+T@(-FA"!nA ? (+T@(-FA.C!02<A

The Time -alue of +oney B0<>!>:0.;0 ? (+TE002.C<;F (+T ? B>1D.33 f 7oan chooses a :< year mortgage at the same rate! her payments will be as followsJ (-A ? (+T@(-FA"!nA ? (+T@(-FA.C!:3<A B0<>!>:0.;0 ? (+TE033.D>1F (+T ? B3C>.<>

0C<

I*.e99e9 Ann,8-> ( E20*3/e 6#&) 4305e &%'6

;0. AmyIs uncle died recently and left her some money in a trust that will pay her BC<< per month for five years starting on her twenty fifth birthday. Amy is getting married soon! and would li"e to use this money as a down payment on a house now. f the trust allows her to assign its future payments to a ban"! and her ban" is willing to discount them at >= compounded monthly! how much will she have toward her down payment on home ownership9 Amy Gust turned 1:. SOLUTION: This problem requires a two4step calculation. The payments are an annuity! so we need to ta"e its present value. That will give us a result at the beginning of the annuity! which is two years in the future. That (-A then has to be brought to the present as an amount. First calculate the QpresentR value of the annuity at its beginning. " ? >M01 ? .DC n ? C 01 ? 3< (-A ? (+T@(-FA.DC!3<A ? BC<<E;2.0D:;F ? B1;!<23.D< &ext bring that figure bac"ward two years into the present as an amount. " ? >M01 ? .DC n ? 1 01 ? 1; (- ? F-@(-F.DC!1;A ? B1;!<23.D<E.2:C2F ? B1<!0:0.33 COMPUTER PROBLEMS ;1. At any particular time! home mortgage rates are determined by mar"et forces and individual borrowers can't do much about them. The length of time required to pay off a mortgage loan! however! varies a great deal with the si.e of the monthly payment made! which is under the borrower's control. /ou're a Gunior loan officer for a large metropolitan ban". The head of the mortgage department is concerned that customers don't fully appreciate that a relatively small increase in the si.e of mortgage payments can ma"e a big difference in how long the payments have to be made. She feels homeowners may be passing up an opportunity to ma"e their lives better in the long run by not choosing shorter4term mortgages that they can readily afford. To explain the phenomenon to customers she's as"ed you to put together a chart that displays the variation in term with payment si.e at typical interest rates. The starting point for the charts should be the term for a typical thirty4year E:3<4monthF loan. $se the TIMEVAL program to construct the following chart.

M+r-505e P0>*en-s 3er C7<<!<<< B+rr+we9 0s Ter* De@re0ses

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Chapter 3 MORTGAGE TERM IN YEARS '< 6D RATES %D 7<D 7&D &; &< 7;

8rite a paragraph using the chart to explain the point. 8hat happens to the effect as interest rates rise9 8hy9 SOLUTION: M+r-505e P0>*en-s 3er C7<<!<<< B+rr+we9 0s Ter* De@re0ses MORTGAGE TERM IN YEARS RATES 6D %D 7<D 7&D '< B3<< B2D2 B0!<1> B0!02C &; B3;; B><> B0!<C: B0!1<; &< B2:3 B>3C B0!0<0 B0!1;; 7; B0!<DC B0!1<< B0!::1

&otice how much faster the homeowner's mortgage is paid off if a little extra money is devoted to house payment each month. At 2= an extra B:2 a month pays off the typical mortgage loan a full five years sooner! while the term is cut in half by paying B111 a month extra. That means a :<= increase Eor 111MD:;F in payment brings a C<= reduction in the time mortgage payments have to be made. At higher interest rates the effect more significant. At 01=! five years of payments can be avoided by paying only an additional B1; dollars a month! and the term can be cut in half with a 0D= increase in the monthly payment. The term shortening effect of an extra dollar paid increases with the interest rate! because the additional payment reduces principal ahead of schedule! and early pay4down avoids more interest at higher rates. ;:. Amitron nc. is considering an engineering proGect that requires an investment of B1C<!<<< and is expected to generate the following stream of payments EincomeF in the future. $se the TIMEVAL program to determine if the proGect is a good idea in a present value sense. That is! does the present value of expected cash inflows exceed the value of the investment that has to be made today9 /ear (ayment 0 B3:!<<< 1 B3>!C<< : B:1!D<< ; BD>!DC< C B31!;<< 3 B:2!1C< a. Answer the question if the relevant interest rate for ta"ing present values is >=! 0<=! 00= and 01=. n the program! notice that period .ero represents a cash flow made at the present time! which

The Time -alue of +oney

0C1

isn't discounted. The program will do the entire calculation for if you input the initial investment as a negative number in this cell. b. $se trial and error in the program to find the interest rate Eto the nearest hundredth of a percentF at which Amitron would be Gust indifferent to the proGect. This problem is a preview of an important method of evaluating proGects "nown as apita! bu"geting# 8e'll study the topic in detail in chapters 0<! 00! and 01. n part a of this problem! we found the net present $a!ue (%PV& of the proGect's cash flows at various interest rates! and reasoned intuitively that the proGect was a good idea if that figure was positive. n part b we found the return inherent in the proGect itself! which is called the interna! rate of return ('RR&# 8e'll learn how to use that in Chapter 0<. SOLUTION: a. " &(>= B00!;<C good idea 0<= ;!<23 good idea 00= E1!>0<F bad idea 01= E>!3<0F bad idea b. ndifference implies &(- ? < which occurs at " ? 0<.C2= ;;. The Centurion Corp. is putting together a financial plan for the company covering the next three years! and needs to forecast its interest expense and the related tax savings. The firm's most significant liability is a fully amorti.ed mortgage loan on its real estate. The loan was made exactly ten and one half years ago for B:.1 million at 00= compounded monthly for a term of thirty years. $se the AMORTIE program to predict the interest expense associated with the real estate mortgage over the next three years. EHintJ )un AMORTIE from the loan's beginning and add up the months in each of the next three years.F SOLUTION: n the A+#)T S output! the next three years are months 01D40:2! 0:>40C<! and 0C04 031. nterest each year isJ 0 B:1<!10:.00 1 B:0;!>C<.:C : B:<>!<D2.C> DEVELOPING SOFTWARE 0. 8rite your own program to amorti.e a ten4year! B1<!<<< loan at 0<= compounded annually. nput the loan amount! the payment! and the interest rate. Set up your spreadsheet Gust li"e Table 34;! and write your program to duplicate the calculation procedure described. SOLUTION: A sample solution is in the nstructor's +aterial on the text website.