Financial Economics

Third Year
Economics Department

Sheet 1
"Time Value of Money"
I.

Problems:
1) A firm's earnings were $1.00 a share in 1980 and $3.87 a share 20
years later. What was the compound annual growth rate in earnings
per share during this period?
2) As the production manager for Welbilt Widgets, you have been
asked to project when additional production capacity will be needed.
Last year Welbilt sold 150,000 widgets. If sales are expected to grow at
a compound annual rate of 5 percent, how long will it take to exceed
the current capacity of 200,000 widgets per year?
3) Congratulations! You have just won first prize in a raffle and must
choose between $20,000 in cash today or an annuity of $5,000 a year
for five years. (The annuity payments would come to you at the end of
each year.) Which of these two choices is worth more, assuming a 7
percent discount rate? Show your calculations.
4) Your aunt is bragging about the great investment she made in a
house that she bought 30 years ago for $20,000 and has just sold for
$65,000.
a. Calculate the rate of return on this investment.
b. If the average annual rate of inflation has been 3 percent during this
period, was this "a great investment?" Explain.
5) Bill O'Blarney tells you that he plans to give you $1 million as a
birthday present on your 75th birthday. You are now 25 and a bit
skeptical. You suggest that he deposit the present value of this nice gift
today in an investment account for you. If the investment could earn 8
percent annually for the next 50 years, how much should he deposit
today? (Ignore taxes.)
8) You have decided to endow the insert your name here Chair in
Finance at the State University. How much money must you deposit
into the endowment account today if the Chair pays $125,000 per year
forever (first payment one year from today) and is invested at a rate
that pays out 4.50% per year forever?
9) CyberNow is opening an office in the U.S. CyberNow expects cash flows to be $500,000 for
the first year, $530,000 for the second year, $560,000 in the third year. If CyberNow uses 12
percent as its discount rate, what is the present value of the cash flows? Assume cash flows are
made at the end of the year.

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Financial Economics
Third Year
Economics Department
II. MULTIPLE CHOICE. Choose the one alternative that best
completes the statement or answers the question.
1) The present value of a $100 three-year annuity due discounted at a rate of 10% is equal to ____
A) $135.17
B) $248.69
C) $273.55
D) $300.00
2) A never-ending stream of equal periodic, end-of-the-period cash flows is called a/an ________.
A) annuity due. B) perpetuity.
C) amortization. D) annuity.
3) You dream of endowing a chair in finance at the local university that will provide a salary of
$150,000 per year forever, with the first cash flow to be one year from today. If the university
promises to invest the money at a rate of 5% per year, how much money must you give the university
today to make your dream a reality?
A) $3,000,000 B) This question cannot be answered.
C) $2,857,143 D) $15,000,000
4) Your neighbor owns a perpetuity of $100 per year that has a discount rate of 6% per year. He
offers to sell to you all but the next 20 cash flows for $500. In other words, he keeps the first 20 cash
flows of his perpetuity and you get all of the rest. Is this a good price for you if the appropriate
discount rate is 6%?
A) Yes, because the present value of the remaining cash flows is $519.67 and you are buying them for only
$500.
B) No, because the cash flows you receive are only worth $482.16 and that is less than the $500 your
neighbor is asking for the cash flows.
C) No, because the entire perpetuity is worth only $1,666.67 and your neighbor is taking the best cash
flows worth more than $1,200 in present value terms
D) This question cannot be answered.
5) A hundred dollars deposited in a bank will reach the largest future value if the bank pays
________ interest of ________ percent.
A) simple, 5
B) compound, 6 C) compound, 5 D) simple, 6
6) In order to find out approximately how long (in years) it would take for your money to double at
10 percent, you would ________.
A) divide 78 by the interest rate treated as a whole number (i.e., 10 for 10%)
B) divide 72 by the interest rate treated as a whole number (i.e., 10 for 10%) and add one to that value
C) divide 72 by the interest rate treated as a whole number (i.e., 10 for 10%)
D) divide 78 by the interest rate treated as a whole number (i.e., 10 for 10%) and add one to that value
7) Suppose you wish to set aside $2,000 at the end of each of the next 10 years in an account paying 12
percent compounded annually. You accumulate at the end of 10 years an amount closest to ____
A) $28,324
B) $22,456
C) $20,324
D) $35,098
8) Which of the following statements is correct with respect to a present value interest factor of an
(ordinary) annuity table representing $1 invested annually for periods 1 through 25 (assume positive
interest rates)?
A) The factors will all be larger than one.
B) The factors are the multiples of the future value factors.
C) The factors will be both larger and smaller than one.
D) The factors will all be less than one.
10) What is the present value of a stream of annual end-of-the-year annuity cash flows if the discount

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Financial Economics
Third Year
Economics Department
rate is 0%, and the cash flows of $50 last for 20 years?
A) Less than $1,000.
B) This question cannot be answered because we have an interest rate of 0.0%.
C) More than $1,000.
D) Exactly $1,000.
11) Which is greater, the present value of a $1,000 five-year ordinary annuity discounted at 10%, or
the present value of a $1,000 five-year annuity due discounted at 10%?
A) The annuity due is worth more with a present value of $4,169.87.
B) The annuity due is worth more with a present value of $4,586.85.
C) The ordinary annuity is worth more with a present value of $3,790.79.
D) The ordinary annuity is worth more with a present value of $4,169.87.
12) You are paid to teach classes for the university and wonder how much money the university
makes from your graduate-level classes. Based on historical data, you determine that your summer
classes for the next seven years will generate an average annual revenue of $93,850. If you discount
these cash flows at an annual rate of 8.30%, what is the present value of the expected cash flows?
A) $483,644.36 B) $845,133.52 C) $656,950.00 D) $523,786.85
13) A series of equal periodic finite cash flows that occur at the beginning of the period are known as
a/an ________.
A) perpetuity.
B) annuity due. C) ordinary annuity.
D) amortization.
14) Which of the following actions will INCREASE the present value of an investment?
A) Increase the amount of time.
B) Decrease the future value.
C) Decrease the interest rate.
D) All of the above will increase the present value.

15) Which of the following formulas is correct for finding the present value of an investment?
A) PV = FV r/n
B) PV = FVn (1 + r)
n
C) PV = FV 1/(1 + r)
D) FV = PV/n
16) Your firm has sold a fleet of 100 cars to a local firm at a discounted price of $20,000 each ( a total
of $2,000,000) due in six months. You are willing to discount the purchase price at an annual rate of
4% if the firm pays cash today. What is the least amount of money you will accept if the firm pays
your company today?
A) $1,961,161
B) $2,039,608
C) $1,960,495
D) This problem cannot be answered because we have an annual interest rate but only one-half year in
time.
17) You currently have $2,500 invested at an annual rate of 8%. How long will it take for this
investment to grow to a value of $3,500?
A) 8.03 years
B) 4.37 years
C) 5.60 years
D) 5.00 years
18) Your company just sold a product with the following payment plan: $50,000 today, $25,000 next
year, and $10,000 the following year. If your firm places the payments into an account earning 10%
per year, how much money will be in the account after collecting the last payment?
A) $99,000
B) $98,000
C) $85,000
D) $88,500

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Taghreed Hassouba

Financial Economics
Third Year
Economics Department
19) Your parents plan to spend $20,000 on a car for you upon graduation from college. If you will
graduate in three years and your parents can earn 4.125% annually on their investment, how much
money must they set aside today for your car?
A) $16,387
B) $20,000
C) $17,716
D) $17,704
20)The manufacturing manager of CyberProducts Inc. estimates that she can save the company
$16,000 cash per year over the next 8 years by implementing a recycling plan. What is the value of
the savings today if the appropriate interest rate for the firm is 9%? Assume cash flows occur at the
end of the year.
A) $64,240
B) $88,557
C) $96,527
D) $128,000
23) You just won a lottery - CONGRATULATIONS! Your parents have always told you to plan for
the future, so since you already have a well-paying job you decide to invest rather than spend your
lottery winnings. The payment schedule from the lottery commission is $100,000 after taxes at end of
year and 19 more payments of exactly $100,000 after taxes in equal annual end-of-the-year deposits
(i.e., the first of the next 19 deposits is one year from today) into your account paying 7%
compounded annually. How much money will be in your account after the last deposit is made?
A) $4,099,549.23
B) $4,486,517.68
C) $3,637,896.48
D) $2,000,000.00
24) A/An ________ is a series of equal end-of-the-period cash flows.
A) perpetuity due B) annuity
C) annuity due D) None of the above.

III.TRUE/FALSE. Write 'T' if the statement is true and 'F' if the

statement is false.
1) The formula for the Present Value Interest Factor of an Annuity (PVIFA) is
.
2) Ordinary annuity payments occur at the beginning of the period, whereas annuity due
payments occur at the end of the period.
3) Given a positive interest rate and a positive cash flow, an ordinary annuity always has
a greater present value than an annuity due of the same size and number of cash flows.
4) A British consol bond can be considered a type of perpetuity.
5) Given positive equal annual cash flows and a positive interest rate, the present value of
an annuity will be greater than the sum of the cash flows.
6) The Present Value Interest Factor (PVIF) is the reciprocal of the Future Value Interest
Factor (FVIF).
7) When solving for a present value, the interest rate is commonly referred to as the
compound rate, but when solving for the future value, the interest rate is called the
discount rate.

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Taghreed Hassouba

Financial Economics
Third Year
Economics Department
8) Given an interest rate of 0%, the present value of $1,500 to be received 5 years in the
future is less than $1,500.
9) The "rule of 72" is a formula which gives an approximation of the number of
compounding periods needed to double an initial amount of money.
10) The discounted value of any given future cash flow is known as its present value.
11) Both future value and present value computations involve the use of the term (1 +
interest rate) raised to the power of n where n is the number of compounding periods.
12) An annuity is defined as a series of equal payments or receipts over a specified
number of periods.
13) A perpetuity is an ordinary annuity that continues for more than 15 but less than 50
years.
14) You have $5,000 in an index mutual fund. At an average annual rate of return of 10%
per , this investment should exceed a value of $500,000 by the time you retire in 40 years.
15) You win the $5,000,000 lottery that pays you $250,000 per year over a 20-year
period. Given negative interest rates, the lottery has a present value that is less than
$5,000,000.
16) If interest rates are positive, then discounting increases the future value of an
investment while compounding reduces the present value of an investment.
17)You can invest your money at a rate of 7% per year , At this rate it will take you just
over 12 years to double your money.
18) You could double your money in about 9 years if you could earn an annual rate of
return of 8%.
19) The Rule of 72 can be used to quickly estimate interest rates necessary to double your
money in a given time period without the use of a spreadsheet or calculator. However, the
rule does NOT work for estimating growth rates.
20) Your production manager informs you that currently the firm is producing 1,438
heating units per month but has plans to increase production at a rate of 5% per month
until the firm is producing 3,000 units per month. So you expect this will take 14 months.

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