Strictly for course AB1201 internal circulation only.

Nanyang Business School

AB1201 Financial Management
Tutorial 2: Time Value of Money
(Common Questions)
Note to students: All students should learn to write down the numerical working for TVM and
TVM-related questions instead of just writing down the calculator steps. In the exams,
students are required to write down the numerical working. For example, when calculating
FV, students should write FV = 1000(1+0.05)10. Students will be penalized in the exams if
they write "N = 10, I/YR = 5, PMT = 0, PV = 1000. Find FV".

Questions 1 to 4 will be presented by students while Question 5 will be presented by

instructors.

1) Evaluating lump sums and annuities. Crissie just won the lottery, and she must choose
between three award options. She can elect to receive a lump sum today of $61 million, to
receive 10 end-of-year payments of $9.5 million, or 30 end-of-year payments of $5.5
million.
a) If she thinks she can earn 7 percent annually, which should she choose?
b) If she expects to earn 8 percent annually, which is the best choice?
c) If she expects to earn 9 percent annually, which would you recommend?
d) Explain how interest rates influence the optimal choice.

2) Power of compounding. 20-year-old Leia wants to save $3 a day for her retirement.
Every day she places $3 in a drawer. At the end of one year, she invests the accumulated
savings ($1,095) in a brokerage account with an expected annual return of 12%.
a) If the last deposit was made when she turns 65, how much money will Leia have when
she is 65 years old?
b) If Leia doesnt start saving until she is 40 years old, how much will she have at 65?
c) If Leia start saving only when she is 40 years old, how much must Leia deposit annually
so that she would have the same retirement amount as she has if she had started saving at
20 years old?

3) Effective versus nominal interest rates. Bank A pays 4% interest compounded annually
on deposits, Bank B pays 3.75% compounded semiannually, and Bank C pays 3.5%
compounded daily.
a) Which bank would you use? Why?
b) If you deposited $5,000 in each bank today, how much would you have at the end of 2
years?
c) What nominal rate would cause Banks B and C to provide the same effective annual rate
as Bank A?
d) Suppose you do not have $5000 now but need it at the end of 1 year. You plan to make a
series of deposits, annually for Bank A, semiannually for Bank B, and daily for Bank C,
with payments beginning today. How large must the payments be to each bank?

4) Interest portions and remaining balance. The Jackson family is interested in buying a
home. The family is applying for a $125,000, 30-year mortgage. Under the terms of the
mortgage, they will receive $125,000 today to help purchase their home. The loan will be

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fully amortized over the next 30 years. Current mortgage rates are 8 percent. Interest is
compounded monthly and all payments are due at the end of the month.
a) What is the monthly mortgage payment?
b) What will be the remaining balance on the mortgage after the first year?
c) What portion of the mortgage payments made during the first year will go toward
interest?
d) What portion of the 25th mortgage payment will go toward interest?

5) Required annuity payments. A father is now planning a savings program to put his
daughter through college. She just celebrated her 13th birthday, she plans to enroll at the
university in 5 years when she turns 18 years old, and she should graduate in 4 years.
Currently, the annual cost (for everything food, clothing, tuition, books, transportation,
and so forth) is $15,000, but these costs are expected to increase by 5% annually. The
college requires that this amount be paid at the start of the school year. She now has $7,500
in a college savings account that pays 6% annually.

a) How large must each payment be if the father makes five equal annual deposits into her
account; the first deposit today and the fifth deposit on the daughters 17th birthday? [Hint:
Calculate the cost (inflated at 5%) for each year of college and find the PV of these costs,
discounted at 6%, as of the day she enters college. Then find the compounded value of her
initial $7,500 on that same day. The difference between the PV costs and the amount that
would be in the savings account must be made up by the fathers deposits].

b) If instead, her father makes six equal annual deposits into her account; the first deposit
today and the sixth on the day she starts college. How large must each of the six payments
be?

Self-practice questions

Question 1

Terry started a savings plan some years ago when he was 30 years old, and the savings plan
would allow him to accumulate $1,000,000 in his bank account to meet his early retirement
expenses by the time he reaches 50 years old. The savings are made at the end of every
month, and the bank pays a nominal annual interest rate of 6%, compounded monthly.

(a) What is Terrys monthly contribution to his savings account under this plan, assuming
the last payment was made when he turns 50 years old?

(b) Terry has just turned 40 today and he just made his 120th contribution. An unfortunate
economic crisis has caused him to lose his job, and he is temporarily unable to
continue the monthly contributions. In fact, he would need to make monthly
withdrawal of $1,500 from the savings account to meet living expenses, starting the
end of the month. Assuming Terry is out of job for 3 years till he turns 43 years old
(i.e. he would have to make 36 monthly withdrawals), how much money will he have
in his savings account by the time he reaches 43 years old?

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(c) At age 43, Terry finds a new job with higher salary than before, he intends to resume
his savings plan but with higher monthly contributions so as to reach the same
$1,000,000 that he set out to achieve by time he turns 50. The new monthly
contributions are also made at the end of every month. What should the new higher
monthly contribution be?

Question 2

David bought a unique 20-year insurance-cum-savings plan which allows him to choose one
of the following two options:

Option 1: Contribute a fixed sum at the end of every month.

Option 2: Contribute a fixed sum at the end of each of the first ten months (January to
October) of every year, with no contributions required for the months of November and
December. This special option is structured to meet the needs of individuals who may have
high year-end expenses.

Annual nominal interest rate earned in the plan is 6%, with interest compounded monthly.

(a) What amount of monthly contribution must David make in order to have $500,000 at
the end of 20 years if he chooses Option 1?

(b) If David chooses Option 2, and still wants to have $500,000 at the end of 20 years,
what amount of monthly contribution must he make in the first ten months of each
year?

Question 3

James turns 20 today, and makes plans to start saving for his retirement now. He wishes to
retire at the age of 65, and believes he cannot live past age 85. At retirement, James hopes to
withdraw a constant monthly income, starting from his 65th birthday. He intends that his last
withdrawal will take place a month before his 85th birthday. James assumes he will be able to
earn an annual effective interest rate of 5% per annum on his savings. Compounding is
monthly.

(a) James can set aside a monthly income of $200, starting at his 20th birthday, for 10
years. For the next 10 years, starting at his 30th birthday, he estimates that he will be
able to set aside $500 monthly. Thereafter starting at his 40th birthday till just a
month before his 65th birthday, a monthly amount of $750. Based on his plans, how
much can he expect to withdraw each month upon retirement?

(b) If he hopes to withdraw a constant monthly amount of $5,000 during his retirement,
what lump sum can he contribute or withdraw at age 30 assuming that his plans as
laid out in (a) is unchanged?

Question 4
It is Jan 1 2010. Celeste Cheung and her husband are considering buying their first home. The
cost of the house now is $320,000. They have two options.

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Option A: Buy the house now and apply for a $320,000, 30-year mortgage. Under the terms
of the mortgage, they will receive $320,000 today to help purchase their home. The loan will
be fully amortized over the next 30 years. Current mortgage rates are 9%. Interest is
compounded monthly and all payments are due at the end of the month.

Option B: Delay buying the house for ten years and live with Celestes parents. During these
ten years, Celeste and her husband hope to save enough money to pay off the full amount of
the house in cash without taking out a loan. They plan to save a fixed amount of money every
month in a brokerage account that yields a nominal annual interest rate of 12% with monthly
compounding. The deposits will be made at the beginning of each month, with the first
deposit being made today and the last deposit will be made on 1 December 2019. They will
use their savings to pay for the house on 31 December 2019. They estimate that house prices
will increase at the overall inflation rate. Inflation is expected to average 4% for the next 10
years.

(a) If Celeste chooses Option A, what will be the monthly mortgage payment?

(b) What will be the remaining balance on the mortgage after the 24th payment?

(c) If Celeste chooses Option B, how much will she have to deposit in the brokerage
account every month?

Answers to self-practice questions

Note: There are many ways to solve the questions. The below presentation is only one of the
many ways.

Question 1
(a)
1,000,000 = PMT*(1+6%/12)239 +. + PMT*(1+6%/12)1 +PMT

PMT (monthly installment) = $2,164.31

Alternatively,
0.06 240
(1+ ) 1
12
1,000,000 = [ ]
0.06/12
PMT = $2,164.31

(b)
Step 1 - Compute the amount he has when he reaches 40 years old (t=120)

FV120 = 2,164.31(1+6%/12)119 + 2,164.31(1+6%/12)118 + + 2,164.31

= $354,685.80

Step 2 Compound this amount to age 43 (t=156)

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FV156(s) = 354,685.80(1+6%/12)36
= $424,445.60

Step 3 Find the FV (t=156) of the 36 monthly withdrawal of $1,500

FV156(w) = 1,500(1+6%/12)35 + 1,500(1+6%/12)34 + + 1,500

= $59,004.16

Step 4 Find the balanced amount he has when he reaches 43 years old (t=156)

Amount = 424,445.60 59,004.16 = $365,441.44

(c)
Step 1 Find the FV of $365,441.44 at age 50 (t=240)

FV240 = 365,441.44(1+6%/12)240-156
= $555,606.07

Step 2 Compute the extra amount in order to reach $1,000,000 at age 50 (t=240)

Extra amount = 1,000,000 555,606.07 = $444,393.93

Step 3 Compute the monthly installment required between age 43 and age 50

444,393.93 = PMT(1+6%/12)83 + PMT(1+6%/12)82 + + PMT(1+6%/12) + PMT

PMT (new monthly contribution) = $4,269.98

Question 2

(a)
i = 6%/12 = 0.5%
500,000 = P(1+0.5%)239 + P(1+0.5%)238 + + P(1+0.5%) + P
P = $1,082.16

(b)

r = EAR = (1 + 6%/12)12 1 = 6.1678%

500,000 = Q(1+6.1678%)19 + Q(1+6.1678%)18 + + Q(1+6.1678%) + Q

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Q = $13,348.99

i = 6%/12 = 0.5%

PV = 13,348.99/(1 + 0.5%)12 = $12,573.49

12,573.49 = R/(1+0.5%) + R/(1+0.5%)2 + + R/(1+0.5%)9 + R/(1+0.5%)10

R = $1,292.18

Question 3

a) The periodic interest rate is i p 1 0.05 1 0.407412378% .

1 12

The time line is:

0 1 120 121 240 241 540 779 780
ip 1
$200 $200 $500 $500 $750 $750 -$PMT -$PMT -$0

The present value of all the deposits at t = 0 is

200 200 500 500 750 750
PV 200
1 i p 1 i p 1 i p
119 120
1 i p 1 i p
239 240
1 i p 539
$97,329.62

TI BA II Plus calculator:
Method 1) Go to CF mode. Set CF0 = 200, CF1 = 200, F01 = 119, CF2 = 500, F02 = 120, CF3 =
750, F03 = 300. Go to NPV mode. Set I = (1.05)^(1/12) 1. Compute NPV.

Now find the FV at t = 540.

FV $97,329.621 i p $874,507.43 .
540

Finally use this as the new PV and find the PMT.

PMT 1
1 i
$874,507.43 1
i p 1 i p
240 p

PMT $5,694.65 (Ans)

b) Given that the PMT = $5000 (outflow). Hence the PV at t=0 excluding the withdrawal at age
30 is

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200 200 500 500 750 750

PV 200
1 i p 1 i p 1 i p
119 120
1 i p 1 i p
239 240
1 i p 539
5000 5000
$11,872.52
1 i
p
540
1 i
p
779

TI BA II Plus calculator:
Method 1) Go to CF mode. Set CF0 = 200, CF1 = 200, F01 = 119, CF2 = 500, F02 = 120, CF3 =
750, F03 = 300, CF4 = -5000, F04 = 240. Go to NPV mode. Set I = (1.05)^(1/12) 1. Compute
NPV.

Now find the FV at t = 120.

FV $11,872.521 i p $19,339.08 . (Ans)

120

Question 4
(a) The monthly mortgage payment is
PMT 1
320000 1
0.09 12 1 0.09 123012

PMT 2574.79

(b) After the first 24 months, there are 360-24 = 336 payments left. Hence the remaining
balance is
2574.79 1
PV 1 315, 422.46
0.09 12 1 0.09 12 336

(c) Step 1: Find price of house at the end of 10 years
Price at the end of 10 years = 320000 X (1+0.04)10 = 473,678.17

Step 2: This is an annuity due

(1 0.12 / 12)10 X 12 1
473678.17 PMT 1 0.12 / 12
(0.12 / 12)
PMT 2,038.74

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