CHAPTER 2

TIME VALUE OF MONEY

(Difficulty: E = Easy, M = Medium, and T = Tough)

Note: Most problems assume students have a calculator with a yx feature

(i.e., an exponential feature). Annuity problems for finding the interest
rate or the number of periods are in the financial calculator section at the
end of this chapter.

Multiple Choice: Conceptual

Easy:
PV and discount rate Answer: a Diff: E
1
. You have determined the profitability of a planned project by finding
the present value of all the cash flows from that project. Which of
the following would cause the project to look more appealing in terms
of the present value of those cash flows?

a. The discount rate decreases.

b. The cash flows are extended over a longer period of time, but the
total amount of the cash flows remains the same.
c. The discount rate increases.
d. Answers b and c above.
e. Answers a and b above.

PV versus FV Answer: e Diff: E

2
. Which of the following statements is most correct?

a. If the discount (or interest) rate is positive, the future value of

an expected series of payments will always exceed the present value
of the same series.
b. To increase present consumption beyond present income normally
requires either the payment of interest or else an opportunity cost
of interest foregone.
c. Disregarding risk, if money has time value, it is impossible for the
present value of a given sum to be greater than its future value.
d. Disregarding risk, if the present value of a sum is equal to its
future value, either k = 0 or t = 0.
e. Each of the statements above is true.

Time value concepts Answer: e Diff: E

3
. Which of the following statements is most correct?

a. A 5-year $100 annuity due will have a higher present value than a 5-
year $100 ordinary annuity.
b. A 15-year mortgage will have larger monthly payments than a 30-year
mortgage of the same amount and same interest rate.
c. If an investment pays 10 percent interest compounded annually, its
effective rate will also be 10 percent.

Chapter 2 - Page 1
 d. Statements a and c are correct.
e. All of the statements above are correct.

Time value concepts Answer: d Diff: E

4
. The future value of a lump sum at the end of five years is $1,000. The
nominal interest rate is 10 percent and interest is compounded
semiannually. Which of the following statements is most correct?

a. The present value of the $1,000 is greater if interest is compounded

monthly rather than semiannually.
b. The effective annual rate is greater than 10 percent.
c. The periodic interest rate is 5 percent.
d. Both statements b and c are correct.
e. All of the statements above are correct.

Time value concepts Answer: d Diff: E

5
. Which of the following statements is most correct?

a. The present value of an annuity due will exceed the present value of
an ordinary annuity (assuming all else equal).
b. The future value of an annuity due will exceed the future value of
an ordinary annuity (assuming all else equal).
c. The nominal interest rate will always be greater than or equal to
the effective annual interest rate.
d. Statements a and b are correct.
e. All of the statements above are correct.

Effective annual rate Answer: d Diff: E

6
. Which of the following statements is most correct?

a. If annual compounding is used, the effective annual rate equals the

nominal rate.
b. If annual compounding is used, the effective annual rate equals the
periodic rate.
c. If a loan has a 12 percent nominal rate with semiannual compounding,
its effective annual rate is equal to 11.66 percent.
d. Answers a and b are correct.
e. Answers a and c are correct.

Chapter 2 - Page 2
Effective annual rate Answer: b Diff: E
7
. Which of the following bank accounts has the highest effective annual
return?

a. An account which pays 10 percent nominal interest with monthly com-

pounding.
b. An account which pays 10 percent nominal interest with daily com-
pounding.
c. An account which pays 10 percent nominal interest with annual com-
pounding.
d. An account which pays 9 percent nominal interest with daily com-
pounding.
e. All of the investments above have the same effective annual return.

Effective annual rate Answer: d Diff: E

8
. You are interested in investing your money in a bank account. Which of
the following banks provides you with the highest effective rate of
interest?

a. Bank 1; 8 percent with monthly compounding.

b. Bank 2; 8 percent with annual compounding.
c. Bank 3; 8 percent with quarterly compounding.
d. Bank 4; 8 percent with daily (365-day) compounding.
e. Bank 5; 7.8 percent with annual compounding.

Amortization Answer: b Diff: E

9
. Your family recently obtained a 30-year (360-month) $100,000 fixed-rate
mortgage. Which of the following statements is most correct? (Ignore
all taxes and transactions costs.)

a. The remaining balance after three years will be $100,000 less the
total amount of interest paid during the first 36 months.
b. The proportion of the monthly payment that goes towards repayment of
principal will be higher ten years from now than it will be this
year.
c. The monthly payment on the mortgage will steadily decline over time.
d. All of the statements above are correct.
e. None of the statements above is correct.

Chapter 2 - Page 3
Amortization Answer: e Diff: E
10
. Frank Lewis has a 30-year, $100,000 mortgage with a nominal interest
rate of 10 percent and monthly compounding. Which of the following
statements regarding his mortgage is most correct?

a. The monthly payments will decline over time.

b. The proportion of the monthly payment which represents interest will
be lower for the last payment than for the first payment on the loan.
c. The total dollar amount of principal being paid off each month gets
larger as the loan approaches maturity.
d. Statements a and c are correct.
e. Statements b and c are correct.

Medium:
Annuities Answer: c Diff: M
11
. Suppose someone offered you the choice of two equally risky annuities,
each paying $10,000 per year for five years. One is an ordinary (or
deferred) annuity, the other is an annuity due. Which of the following
statements is most correct?

a. The present value of the ordinary annuity must exceed the present
value of the annuity due, but the future value of an ordinary
annuity may be less than the future value of the annuity due.
b. The present value of the annuity due exceeds the present value of
the ordinary annuity, while the future value of the annuity due is
less than the future value of the ordinary annuity.
c. The present value of the annuity due exceeds the present value of
the ordinary annuity, and the future value of the annuity due also
exceeds the future value of the ordinary annuity.
d. If interest rates increase, the difference between the present value
of the ordinary annuity and the present value of the annuity due
remains the same.
e. Answers a and d are correct.

Chapter 2 - Page 4
Time value concepts Answer: e Diff: M
12
. A $10,000 loan is to be amortized over 5 years, with annual end-of-year
payments. Given the following facts, which of these statements is most
correct?

a. The annual payments would be larger if the interest rate were lower.
b. If the loan were amortized over 10 years rather than 5 years, and if
the interest rate were the same in either case, the first payment
would include more dollars of interest under the 5-year amortization
plan.
c. The last payment would have a higher proportion of interest than the
first payment.
d. The proportion of interest versus principal repayment would be the
same for each of the 5 payments.
e. The proportion of each payment that represents interest as opposed
to repayment of principal would be higher if the interest rate were
higher.

Time value concepts Answer: e Diff: M

13
. Which of the following is most correct?

a. The present value of a 5-year annuity due will exceed the present
value of a 5-year ordinary annuity. (Assume that both annuities pay
$100 per period and there is no chance of default.)
b. If a loan has a nominal rate of 10 percent, then the effective rate
can never be less than 10 percent.
c. If there is annual compounding, then the effective, periodic, and
nominal rates of interest are all the same.
d. Answers a and c are correct.
e. All of the answers above are correct.

Time value concepts Answer: c Diff: M

14
. Which of the following statements is most correct?

a. An investment which compounds interest semiannually, and has a

nominal rate of 10 percent, will have an effective rate less than 10
percent.
b. The present value of a three-year $100 annuity due is less than the
present value of a three-year $100 ordinary annuity.
c. The proportion of the payment of a fully amortized loan which goes
toward interest declines over time.
d. Statements a and c are correct.
e. None of the answers above is correct.

Chapter 2 - Page 5
Tough:
Time value concepts Answer: d Diff: T
15
. Which of the following statements is most correct?

a. The first payment under a 3-year, annual payment, amortized loan for
$1,000 will include a smaller percentage (or fraction) of interest
if the interest rate is 5 percent than if it is 10 percent.
b. If you are lending money, then, based on effective interest rates,
you should prefer to lend at a 10 percent nominal, or quoted, rate
but with semiannual payments, rather than at a 10.1 percent nominal
rate with annual payments. However, as a borrower you should prefer
the annual payment loan.
c. The value of a perpetuity (say for $100 per year) will approach
infinity as the interest rate used to evaluate the perpetuity
approaches zero.
d. Statements a, b, and c are all true.
e. Statements b and c are true.

Multiple Choice: Problems

Easy:

Solving for N for an annuity Answer: b Diff: E

16
. You are currently investing your money in a bank account which has a
nominal annual rate of 9 percent, compounded monthly. If you invest
$900 at the end of each month, how many months will it take for your
account to grow to $301,066.27 (rounded to the nearest month)?

a. 40 months
b. 168 months
c. 175 months
d. 221 months
e. 335 months

Nominal and effective rates Answer: b Diff: E

17
. An investment pays you 9 percent interest compounded semiannually. A
second investment of equal risk, pays interest compounded quarterly.
What nominal rate of interest would you have to receive on the second
investment in order to make you indifferent between the two investments?

a. 8.71%
b. 8.90%
c. 9.00%
d. 9.20%
e. 9.31%

Effective annual rate Answer: c Diff: E

18
. You want to borrow $1,000 from a friend for one year, and you propose
to pay her $1,120 at the end of the year. She agrees to lend you the

Chapter 2 - Page 6
 $1,000, but she wants you to pay her $10 of interest at the end of each
of the first 11 months plus $1,010 at the end of the 12th month. How
much higher is the effective annual rate under your friend's proposal
than under your proposal?

a. 0.00%
b. 0.45%
c. 0.68%
d. 0.89%
e. 1.00%

Time for a sum to double Answer: d Diff: E

19
. You are currently investing your money in a bank account which has a
nominal annual rate of 7 percent, compounded monthly. How many years
will it take for you to double your money?

a. 8.67 years
b. 9.15 years
c. 9.50 years
d. 9.93 years
e. 10.25 years

Monthly payments on loan Answer: c Diff: E

20
. You are considering buying a new car. The sticker price is $15,000 and
you have $2,000 to put toward a down payment. If you can negotiate a
nominal annual interest rate of 10 percent and you wish to pay for the
car over a 5-year period, what are your monthly car payments?

a. $216.67
b. $252.34
c. $276.21
d. $285.78
e. $318.71

Interest rate of an annuity Answer: b Diff: E

21
. South Penn Trucking is financing a new truck with a loan of $10,000 to
be repaid in 5 annual end-of-year installments of $2,504.56. What
annual interest rate is the company paying?

a. 7%
b. 8%
c. 9%
d. 10%
e. 11%

Medium:

Chapter 2 - Page 7
Effective annual rate Answer: b Diff: M
22
. If it were evaluated with an interest rate of 0 percent, a 10-year
regular annuity would have a present value of $3,755.50. If the future
(compounded) value of this annuity, evaluated at Year 10, is $5,440.22,
what effective annual interest rate must the analyst be using to find
the future value?

a. 7%
b. 8%
c. 9%
d. 10%
e. 11%

FV of a sum Answer: d Diff: M

23
. Suppose you put $100 into a savings account today, the account pays a
nominal annual interest rate of 6 percent, but compounded semiannually,
and you withdraw $100 after 6 months. What would your ending balance
be 20 years after the initial $100 deposit was made?

a. $226.20
b. $115.35
c. $ 62.91
d. $ 9.50
e. $ 3.00

FV of annuity due Answer: d Diff: M

24
. You are contributing money to an investment account so that you can
purchase a house in five years. You plan to contribute six payments of
$3,000 a year--the first payment will be made today (t = 0), and the
final payment will be made five years from now (t = 5). If you earn 11
percent in your investment account, how much money will you have in the
account five years from now (at t = 5)?

a. $19,412
b. $20,856
c. $21,683
d. $23,739
e. $26,350

Chapter 2 - Page 8
Effective annual rate Answer: a Diff: M
25
. You have just borrowed $20,000 to buy a new car. The loan agreement
calls for 60 monthly payments of $444.89 each to begin one month from
today. If the interest is compounded monthly, then what is the
effective annual rate on this loan?

a. 12.68%
b. 14.12%
c. 12.00%
d. 13.25%
e. 15.08%

Effective annual rate Answer: e Diff: M

26
. You have just taken out a 10-year, $12,000 loan to purchase a new car.
This loan is to be repaid in 120 equal end-of-month installments. If
each of the monthly installments is $150, what is the effective annual
interest rate on this car loan?

a. 6.5431%
b. 7.8942%
c. 8.6892%
d. 8.8869%
e. 9.0438%

NPV and non-annual discounting Answer: b Diff: M

27
. Your lease calls for payments of $500 at the end of each month for the
next 12 months. Now your landlord offers you a new 1-year lease which
calls for zero rent for 3 months, then rental payments of $700 at the
end of each month for the next 9 months. You keep your money in a bank
time deposit that pays a nominal annual rate of 5 percent. By what
amount would your net worth change if you accept the new lease? (Hint:
Your return per month is 5%/12 = 0.4166667%.)

a. -$509.81
b. -$253.62
c. +$125.30
d. +$253.62
e. +$509.81

Chapter 2 - Page 9
FV under monthly compounding Answer: d Diff: M
28
. Steven just deposited $10,000 in a bank account which has a 12 percent
nominal interest rate, and the interest is compounded monthly. Steven
also plans to contribute another $10,000 to the account one year (12
months) from now and another $20,000 to the account two years from now.
How much will be in the account three years (36 months) from now?

a. $57,231
b. $48,993
c. $50,971
d. $49,542
e. $49,130

FV under daily compounding Answer: a Diff: M

29
. You have $2,000 invested in a bank account that pays a 4 percent
nominal annual interest with daily compounding. How much money will
you have in the account at the end of July (i.e., in 132 days)?
(Assume there are 365 days in each year.)

a. $2,029.14
b. $2,028.93
c. $2,040.00
d. $2,023.44
e. $2,023.99

PV under monthly compounding Answer: b Diff: M

30
. You have just bought a security which pays $500 every six months. The
security lasts for ten years. Another security of equal risk also has
a maturity of ten years, and pays 10 percent compounded monthly (that
is, the nominal rate is 10 percent). What should be the price of the
security that you just purchased?

a. $6,108.46
b. $6,175.82
c. $6,231.11
d. $6,566.21
e. $7,314.86

PV under non-annual compounding Answer: c Diff: M

31
. You have been offered an investment that pays $500 at the end of every
6 months for the next 3 years. The nominal interest rate is 12
percent; however, interest is compounded quarterly. What is the
present value of the investment?

a. $2,458.66
b. $2,444.67
c. $2,451.73
d. $2,463.33
e. $2,437.56

Value of missing payments Answer: d Diff: M

32
. You recently purchased a 20-year investment which pays you $100 at
t = 1, $500 at t = 2, $750 at t = 3, and some fixed cash flow, X, at
the end of each of the remaining 17 years. The investment cost you

Chapter 2 - Page 10
 $5,544.87. Alternative investments of equal risk have a required return
of 9 percent. What is the annual cash flow received at the end of each
of the final 17 years, that is, what is X?

a. $600
b. $625
c. $650
d. $675
e. $700

Value of missing payments Answer: c Diff: M

33
. A ten-year security generates cash flows of $2,000 a year at the end of
each of the next three years (t = 1, 2, 3). After three years, the
security pays some constant cash flow at the end of each of the next
six years. (t = 4, 5, 6, 7, 8, 9). Ten years from now (t = 10) the
security will mature and pay $10,000. The security sells for
$24,307.85, and has a yield to maturity of 7.3 percent. What annual
cash flow does the security pay for years 4 through 9?

a. $2,995
b. $3,568
c. $3,700
d. $3,970
e. $4,296

Value of missing payments Answer: d Diff: M

34
. An investment costs $3,000 today and provides cash flows at the end of
each year for 20 years. The investments expected return is 10
percent. The projected cash flows for years 1, 2, and 3 are $100, $200,
and $300 respectively. What is the annual cash flow received for each
of the years 4 through 20 (17 years)? (Assume the same payment for
each of these years.)

a. $285.41
b. $313.96
c. $379.89
d. $417.87
e. $459.66

Amortization Answer: d Diff: M

35
. You have just bought a house and have a $125,000, 25-year mortgage with
a fixed interest rate of 8.5 percent with monthly payments. Over the
next five years, what percentage of your mortgage payments will go
toward the repayment of principal?

a. 8.50%
b. 10.67%
c. 12.88%
d. 14.93%
e. 17.55%

Amortization Answer: a Diff: M

36
. You have just taken out an installment loan for $100,000. Assume that
the loan will be repaid in 12 equal monthly installments of $9,456 and
that the first payment will be due one month from today. How much of

Chapter 2 - Page 11
 your third monthly payment will go toward the repayment of principal?

a. $7,757.16
b. $6,359.12
c. $7,212.50
d. $7,925.88
e. $8,333.33

Amortization Answer: c Diff: M

37
. A homeowner just obtained a $90,000 mortgage. The mortgage is for 30
years (360 months) and has a fixed nominal annual rate of 9 percent,
with monthly payments. What percentage of the total payments made the
first two years will go toward repayment of interest?

a. 89.30%
b. 91.70%
c. 92.59%
d. 93.65%
e. 94.76%

Remaining balance on mortgage Answer: d Diff: M

38
. Your family purchased a house three years ago. When you bought the
house you financed it with a $160,000 mortgage with an 8.5 percent
nominal interest rate (compounded monthly). The mortgage was for 15
years (180 months). What is the remaining balance on your mortgage
today?

a. $ 95,649
b. $103,300
c. $125,745
d. $141,937
e. $159,998

Tough:
Required annuity payments Answer: d Diff: T
39
. Your father, who is 60, plans to retire in 2 years, and he expects to
live independently for 3 years. Suppose your father wants to have a
real income of $40,000 in today's dollars in each year after he
retires. His retirement income will start the day he retires, 2 years
from today, and he will receive a total of 3 retirement payments.

Inflation is expected to be constant at 5 percent. Your father has

$100,000 in savings now, and he can earn 8 percent on savings now and
in the future. How much must he save each year, starting today, to meet
his retirement goals?

a. $1,863
b. $2,034
c. $2,716
d. $5,350
e. $6,102

Chapter 2 - Page 12
Required annuity payments Answer: a Diff: T
40
. Your client just turned 75 years old and plans on retiring in 10 years
on her 85th birthday. She is saving money today for her retirement and
is establishing a retirement account with your office. She would like
to withdraw money from her retirement account on her birthday each year
until she dies. She would ideally like to withdraw $50,000 on her 85th
birthday, and increase her withdrawals 10 percent a year through her
89th birthday (i.e., she would like to withdraw $73,205 on her 89th
birthday). She plans to die on her 90th birthday, at which time she
would like to leave $200,000 to her descendants. Your client currently
has $100,000. You estimate that the money in the retirement account
will earn 8 percent a year over the next 15 years.

Your client plans to contribute an equal amount of money each year

until her retirement. Her first contribution will come in 1 year; her
10th and final contribution will come in 10 years (on her 85th
birthday). How much should she contribute each year to meet her
objectives?

a. $12,401.59
b. $12,998.63
c. $13,243.18
d. $13,759.44
e. $14,021.53

Chapter 2 - Page 13
Required annuity payments Answer: c Diff: T
41
. You are considering an investment in a 40-year security. The security
will pay $25 a year at the end of each of the first three years. The
security will then pay $30 a year at the end of each of the next 20
years. The nominal interest rate is assumed to be 8 percent, and the
current price (present value) of the security is $360.39. Given this
information, what is the equal annual payment to be received from Year
24 through Year 40 (i.e., for 17 years)?

a. $35
b. $38
c. $40
d. $45
e. $50

Required annuity payments Answer: a Diff: T

42
. Joe and Jane are interested in saving money to put their two children,
John and Susy through college. John is currently 12 years old and will
enter college in six years. Susy is 10 years old and will enter
college in 8 years. Both children plan to finish college in four years.

College costs are currently $15,000 a year (per child), and are
expected to increase at 5 percent a year for the foreseeable future.
All college costs are paid at the beginning of the school year. Up
until now, Joe and Jane have saved nothing but they expect to receive
$25,000 from a favorite uncle in three years.

To provide for the additional funds that are needed, they expect to
make 12 equal payments at the beginning of each of the next twelve
years--the first payment will be made today and the final payment will
be made on Susys 21st birthday (which is also the day that the last
payment must be made to the college). If all funds are invested in a
stock fund which is expected to earn 12 percent, how large should each
of the annual contributions be?

a. $ 7,475.60
b. $ 7,798.76
c. $ 8,372.67
d. $ 9,675.98
e. $14,731.90

Chapter 2 - Page 14
 Required annuity payments Answer: b
Diff: T
43
. Jim and Nancy are interested in saving money for their son's education.
Today is their son's 8th birthday. Their son will enter college ten
years from now on his 18th birthday, and will attend for four years.
All college costs are due at the beginning of the year, so Jim and
Nancy will have to make payments on their son's 18th, 19th, 20th and
21st birthdays (t = 10, 11, 12, 13). They estimate that the college
their son wants to attend will cost $35,000 the first year (t = 10) and
that the costs will increase 7 percent each year (the final college
payment will be made 13 years from now).

Currently, Jim and Nancy have $20,000 in an investment account. They

also plan to contribute a fixed amount at the end of each of the next
ten years (t = 1, 2, 3, ... 10). Their invested money will be in an
account which pays 9 percent interest compounded annually. How much
money do Jim and Nancy need to contribute to the account in each of the
next ten years?

a. $5,638
b. $5,848
c. $6,052
d. $6,854
e. $7,285

FV of annuity due Answer: a Diff: T

44
. To save money for a new house, you want to begin contributing money to
a brokerage account. Your plan is to make ten contributions to the
brokerage account. Each contribution will be for $1,500. The con-
tributions will come at the beginning of each of the next 10 years,
i.e., the first contribution will be made at t = 0 and the final
contribution will be made at t = 9. Assume that the brokerage account
pays a 9 percent return with quarterly compounding. How much money do
you expect to have in the brokerage account nine years from now (t = 9)?

a. $23,127.49
b. $25,140.65
c. $25,280.27
d. $21,627.49
e. $19,785.76

FV of investment account Answer: b Diff: T

45
. Kelly and Brian Johnson are a recently married couple whose parents
have counseled them to start saving immediately in order to have enough
money down the road to pay for their retirement and their childrens
college expenses. Today (t = 0) is their 25th birthday (the couple
shares the same birthday).

The couple plans to have two children (Dick and Jane). Dick is
expected to enter college 20 years from now (t = 20); Jane is expected
to enter college 22 years from now (t = 22). So in years t = 22 and t
= 23 there will be two children in college. Each child will take 4
years to complete college, and college costs are paid at the beginning

Chapter 2 - Page 15
 of each year of college.

College costs per child will be as follows:

Year Cost per child Children in college

20 $ 58,045 Dick
21 $ 62,108 Dick
22 $ 66,456 Dick and Jane
23 $ 71,108 Dick and Jane
24 $ 76,086 Jane
25 $ 81,411 Jane

Kelly and Brian plan to retire forty years from now at age 65 (at
t = 40). They plan to contribute $12,000 per year at the end of each
year for the next 40 years into an investment account that earns 10
percent per year. This account will be used to pay for the college
costs, and also to provide a nest egg for Kelly and Brians retirement
at age 65. How big will Kelly and Brians nest egg (the balance of the
investment account) be when they retire at age 65 (t = 40)?

a. $1,854,642
b. $2,393,273
c. $2,658,531
d. $3,564,751
e. $4,758,333

Effective annual rate Answer: c Diff: T

46
. You have some money on deposit in a bank account which pays a nominal
(or quoted) rate of 8.0944 percent, but with interest compounded daily
(using a 365-day year). Your friend owns a security which calls for
the payment of $10,000 after 27 months. The security is just as safe
as your bank deposit, and your friend offers to sell it to you for
$8,000. If you buy the security, by how much will the effective annual
rate of return on your investment change?

a. 1.87%
b. 1.53%
c. 2.00%
d. 0.96%
e. 0.44%

Non-annual compounding Answer: a Diff: T

47
. A financial planner has offered you three possible options for
receiving cash flows. You must choose the option that has the highest
present value.

(1) $1,000 now and another $1,000 at the beginning of each of the 11
subsequent months during the remainder of the year, to be
deposited in an account paying a 12 percent nominal annual rate,
but compounded monthly (to be left on deposit for the year).
(2) $12,750 at the end of the year (assume a 12 percent nominal
interest rate with semiannual compounding).
(3) A payment scheme of 8 quarterly payments made over the next two
years. The first payment of $800 is to be made at the end of the
current quarter. Payments will increase by 20 percent each

Chapter 2 - Page 16
 quarter. The money is to be deposited in an account paying a 12
percent nominal annual rate, but compounded quarterly (to be left
on deposit for the entire 2-year period).

Which one would you choose?

a. Choice 1.
b. Choice 2.
c. Choice 3.
d. Any one, since they all have the same present value.
e. Choice 1, if the payments were made at the end of each month.

PMT and quarterly compounding Answer: b Diff: T

48
. Your employer has agreed to make 80 quarterly payments of $400 each
into a trust account to fund your early retirement. The first payment
will be made 3 months from now. At the end of 20 years (80 payments),
you will be paid 10 equal annual payments, with the first payment to be
made at the beginning of Year 21 (or the end of Year 20). The funds
will be invested at a nominal rate of 8 percent, quarterly compounding,
during both the accumulation and the distribution periods. How large
will each of your 10 receipts be? (Hint: You must find the EAR and use
it in one of your calculations.)

a. $ 7,561
b. $10,789
c. $11,678
d. $12,342
e. $13,119

PV of an uneven CF stream Answer: d Diff: T

49
. Hillary is trying to determine the cost of health care to college
students, and parents' ability to cover those costs. She assumes that
the cost of one year of health care for a college student is $1,000
today, that the average student is 18 when he or she enters college,
that inflation in health care cost is rising at the rate of 10 percent
per year, and that parents can save $100 per year to help cover their
children's costs. All payments occur at the end of the relevant
period, and the $100/year savings will stop the day the child enters
college (hence 18 payments will be made). Savings can be invested at a
nominal rate of 6 percent, annual compounding. Hillary wants a health
care plan which covers the fully inflated cost of health care for a
student for 4 years, during Years 19 through 22 (with payments made at
the end of years 19 through 22). How much would the government have to
set aside now (when a child is born), to supplement the average
parent's share of a child's college health care cost? The lump sum the
government sets aside will also be invested at 6 percent, annual
compounding.

a. $1,082.76
b. $3,997.81
c. $5,674.23
d. $7,472.08
e. $8,554.84

Chapter 2 - Page 17
 CHAPTER 2
ANSWERS AND SOLUTIONS

Chapter 2 - Page 18
1. PV and discount rate Answer: a Diff: E

2. PV versus FV Answer: e Diff: E

3. Time value concepts Answer: e Diff: E

4. Time value concepts Answer: d Diff: E

Statements b and c are correct; therefore, statement d is the correct choice.

The present value is smaller if interest is compounded monthly rather than
semiannually.

5. Time value concepts Answer: d Diff: E

Statements a and b are correct; therefore, statement d is the correct choice.

The nominal interest rate will be less than the effective rate when the
number of periods per year is greater than one.
6

. Effective annual rate Answer: d Diff: E

Statement d is correct. The equation for EAR is as follows:

m
r
EAR = 1 + Nom 1
m

If annual compounding is used, m = 1 and the equation above reduces to EAR =

rNom. The equation for the periodic rate is:
rNom .
rPER =
m

If annual compounding is used then m = 1 and rPER = rNom, and since EAR = rNom
then rPER = EAR.

7. Effective annual rate Answer: b Diff: E

The bank account which pays the highest nominal rate with the most frequent
rate of compounding will have the highest EAR. Consequently, statement b is
the correct choice.

8. Effective annual rate Answer: d Diff: E

Statement d is correct; the other statements are incorrect. Looking at

responses a through d, you should realize the choice with the greatest
frequency of compounding will give you the highest EAR. This is statement d.
Now, compare choices d and e. We know EARd > 7.8%; therefore, statement d is
the correct choice. The EAR of each of the statements is shown below.

EARa = 8.30%; EARb = 8%; EARc = 8.24%; EARd = 8.328%; EARe = 7.8%.

9. Amortization Answer: b Diff: E

Statement b is true; the others are false. The remaining balance after three
years will be $100,000 less the total amount of repaid principal during the
first 36 months. On a fixed-rate mortgage the monthly payment remains the
same.

10. Amortization Answer: e Diff: E

 Statements b and c are correct; therefore, statement e is the correct choice.
Monthly payments will remain the same over the life of the loan.

11. Annuities Answer: c Diff: M

By definition, an annuity due is received at the beginning of the year while

an ordinary annuity is received at the end of the year. Because the payments
are received earlier, both the present and future values of the annuity due
are greater than those of the ordinary annuity.

12. Time value concepts Answer: e Diff: M

If the interest rate were higher, the payments would all be higher, and all
of the increase would be attributable to interest. So, the proportion of
each payment that represents interest would be higher. Note that statement b
is false because interest during Year 1 would be the interest rate times the
beginning balance, which is $10,000. With the same interest rate and the
same beginning balance, the Year 1 interest charge will be the same,
regardless of whether the loan is amortized over 5 or 10 years.

13. Time value concepts Answer: e Diff: M

14. Time value concepts Answer: c Diff: M

Statement c is correct; the other statements are false. The effective rate
of the investment in statement a is 10.25%. The present value of the annuity
due is greater than the present value of the ordinary annuity.
15
1
. Time value concepts Answer: d Diff: T

16. Solving for N for a single payment Answer: b Diff: E

Financial calculator solution:

PV = 0
FV = 301,066.27
PMT = -900
I = 9/12 = 0.75
N = ? = 168 months.

17

. Nominal and effective rates Answer: b Diff: E

1st investment Enter the following:

NOM% = 9
P/YR = 2
Solve for EFF% = 9.2025%.

2nd investment Enter the following:

EFF% = 9.2025
P/YR = 4
Solve for NOM% = 8.90%.
18
. Effective annual rate Answer: c Diff: E

Your proposal:
EAR1 = $120/$1,000
EAR1 = 12%.

Your friend's proposal:

Interest is being paid each month ($10/$1,000 = 1% per month), so it
compounds, and the EAR is higher than rNom = 12%:
12

EAR2 = 1 +
0.12
- 1 = 12.68%.
12
Difference = 12.68% - 12.00% = 0.68%.

You could also visualize your friend's proposal in a time line format:
0 i=? 1 2 11 12
_____________ ____________ ____ . . . ___ ____________

1,000 -10 -10 -10 -1,010

Insert those cash flows in the cash flow register of a calculator and solve
for IRR. The answer is 1%, but this is a monthly rate. The nominal rate is
12(1%) = 12%, which converts to an EAR of 12.68% as follows:
Input into a financial calculator the following:
P/YR = 12, NOM% = 12, and solve for EFF% = 12.68%.

19. Time for a sum to double Answer: d Diff: E

PV = -1
FV = 2
PMT = 0
I = 7/12
N = ? = 119.17 months = 9.93 years.
20
2
. Monthly payments on loan Answer: c Diff: E

First, find the monthly interest rate = 0.10/12 = 0.8333%/month. Now, enter
in your calculator N = 60, I/YR = 0.8333, PV = -13,000, FV = 0, and solve for
PMT = $276.21.
21
2
. Interest rate of an annuity Answer: b Diff: E

Time Line:
0 i = ? 1 2 3 4 5 Years
___________ ____________ ____________ ____________ ____________

10,000 -2,504.56 -2,504.56 -2,504.56 -2,504.56 -2,504.56

Tabular solution:
$10,000 = $2,504.56(PVIFAi,5)
PVIFAi,5 = $10,000/$2,504.56 = 3.9927
i = 8%.

Financial calculator solution:

Inputs: N = 5; PV = 10,000; PMT = -2,504.56; FV = 0. Output: I = 8%.
22
2
. Effective annual rate Answer: b Diff: M
 Time Line:
iB = ?

0 iA = 0% 1 2 3 4 10 Years
| | | | | . . . |
PV = 3,755.50 PMT PMT PMT PMT PMT
PMTB = PMTA = 375.55 FV = 5,440.22

Financial calculator solution:

Calculate the PMT of the annuity
Inputs: N = 10; I = 0; PV = -3,755.50; FV = 0. Output: PMT = $375.55.
Calculate the effective annual interest rate
Inputs: N = 10; PV = 0; PMT = -375.55; FV = 5,440.22.
Output: I = 7.999 8.0%.
2
23

. FV of a sum Answer: d Diff: M

Time Line:
0 3% 1 2 3 4 40 6-months
| | | | | ... | Periods
100 -100 FV = ?

Tabular/Numerical solution:
Solve for amount on deposit at the end of 6 months.
Step 1 FV = $100(FVIF3%,1) - $100 = $3.00.
FV = $100(1 + 0.06/2) - $100 = $3.00.
Step 2 Compound the $3.00 for 39 periods at 3%
FV = $3.00(FVIF3%,39) = $9.50.
Since table does not show 39 periods, use numerical/calculator
exponent method.
FV = $3.00(1.03)39 = $9.50.

Financial calculator solution: (Step 2 only)

Inputs: N = 39; I = 3; PV = -3.00; PMT = 0. Output: FV = $9.50.

24. FV of annuity due Answer: d Diff: M

There are a few ways to do this. One way is shown below.

To get the value at t = 5 of the first 5 payments:
BEGIN mode
N = 5
I = 11
PV = 0
PMT = -3,000
FV = $20,738.58

Now add on to this the last payment that occurs at t = 5.

$20,738.58 + $3,000 = $23,738.58 $23,739.

25
. Effective annual rate Answer: a Diff: M

Time Line:
EAR = ?
0 i = ? 1 2 60 Months
| | | ... |
PV = -20,000 444.89 444.89 444.89

Tabular solution:
$20,000 = $444.89(PVIFAi,60)
PVIFAi,60 = 44.9549
i = 1%.
EAR = (1.01)12 - 1.0 = 1.12681 - 1.0 = 0.1268 = 12.68%.

Financial calculator solution:

Calculate periodic rate and nominal rate
Inputs: N = 60; PV = -20,000; PMT = 444.89; FV = 0.
Output: I = 1.0. NOM% = 1.0% 12 = 12.00%.
Use interest rate conversion feature
Inputs: P/YR = 12; NOM% = 12.0. Output: EFF% = EAR = 12.68%.

26. Effective annual rate Answer: e Diff: M

Given: Loan Value = $12,000; Loan Term = 10 years (120 months);

Monthly Payment = $150.

N = 120
PV = -12,000
PMT = 150
FV = 0
Solve for I/YR = 0.7241 12 = 8.6892%. However, this is a nominal rate.
To find the effective rate, enter the following:
NOM% = 8.6892
P/YR = 12
Solve for EFF% = 9.0438%.
2
27

. NPV and non-annual discounting Answer: b Diff: M

Current 0 5%/12 = 0.4167% 1 2 3 12

lease | | | | . . . |
0 -500 -500 -500 -500
5/12 =
12 0.4167 500 0
2
N I PV PMT FV

-5,840.61
 New 0 5%/12 = 0.4167% 1 2 3 4 12
lease | | | | | |
0 0 0 0 -700 -700
CF0 = 0
CF1-3 = 0
CF4-12 = -700
I = 0.4167
Solve for NPV = -$6,094.23.
Therefore, the PV of payments under the proposed lease would be greater than
the PV of payments under the old lease by $6,094.23 - $5,840.61 = $253.62.
Thus, your net worth would decrease by $253.62.

28. FV under monthly compounding Answer: d Diff: M

Step 1 Calculate the FV at t = 3 of the first deposit.

Enter N = 36, I/YR = 12/12 = 1, PV = -10000, and PMT = 0.
Solve for FV = $14,308.

Step 2 Calculate the FV at t = 3 of the second deposit.

Enter N = 24, I/YR = 12/12 = 1, PV = -10000, and PMT = 0.
Solve for FV = $12,697.

Step 3 Calculate the FV at t = 3 of the third deposit.

Enter N = 12, I/YR = 12/12 = 1, PV = -20000, and PMT = 0.
Solve for FV = $22,537.

Step 4 The sum of the future values gives you the answer, $49,542.
29
2
. FV under daily compounding Answer: a Diff: M

The answer is a. Solve for FV as N = 132, I = 4/365 = 0.0110,

PV = -2,000, PMT = 0, and solve for FV = ? = $2,029.14.

30. PV under monthly compounding Answer: b Diff: M

Start by calculating the effective rate on the second security:

P/YR = 12
NOM% = 10
Solve for EFF% = 10.4713%.
Then, convert this effective rate to a semiannual rate:
EFF% = 10.4713
P/YR = 2
NOM% = 10.2107%.
Now, calculate the value of the first security as follows:
N = 10 2 = 20, I = 10.2107/2 = 5.1054, PMT = 500, FV = 0, thus, PV = -
$6,175.82.
31
. PV under non-annual compounding Answer: c Diff: M

First, find the effective annual rate for a nominal rate of 12% with
quarterly compounding: P/YR = 4, NOM% = 12, and EFF% = ? = 12.55%. In order
to discount the cash flows properly, it is necessary to find the nominal rate
with semiannual compounding that corresponds to the effective rate calculated
above. Convert the effective rate to a semiannual nominal rate as P/YR = 2,
EFF% = 12.55, and NOM% = ? = 12.18%. Finally, find the PV as N = 2 3 = 6,
I = 12.18/2 = 6.09, PMT = 500, FV = 0, and PV = ? = -$2,451.73.
32
3
. Value of missing payments Answer: d Diff: M

Find the FV of the price and the first three cash flows at t = 3.
To do this first find the present value of them.
CF0 = -5,544.87
CF1 = 100
CF2 = 500
CF3 = 750
I = 9; solve for NPV = -$4,453.15.

N = 3
I = 9
PV = -4,453.15
PMT = 0
FV = $5,766.96.

Now solve for X.

N = 17
I = 9
PV = -5,766.96
FV = 0
Solve for PMT = $675.

33. Value of missing payments Answer: c Diff: M

There are several different ways of doing this. One way is:
Find the future value of the first three years of the investment at
Year 3.
N = 3
I = 7.3
PV = -24,307.85
PMT = 2,000
FV = $23,580.68.

Find the value of the final $10,000 at Year 3.

N = 7
I = 7.3
PMT = 0
FV = 10,000
PV = -$6,106.63.

Add the two Year 3 values (remember to keep the signs right).
$23,580.68 + -$6,106.63 = $17,474.05.

Now solve for the PMTs over years 4 through 9 (6 years) that have a PV of
$17,474.05.
N = 6
 I = 7.3
PV = -17,474.05
FV = 0
PMT = $3,700.00.
34
3
. Value of missing payments Answer: d Diff: M

The projects cost should be the PV of the future cash flows. Use the cash
flow key to find the PV of the first 3 years of cash flows.

CF0 = 0, CF1 = 100, CF2 = 200, CF3 = 300, I/YR = 10, NPV = $481.59.

The PV of the cash flows for Years 4 - 20 must be:

$3,000 - $481.59 = $2,518.41.

Take this amount forward in time 3 years:

N = 3, I/YR = 10, PV = -2,518.41, PMT = 0, solve for FV = $3,352.00.
This amount is also the present value of the 17-year annuity.
N = 17, I/YR = 10, PV = -3,352, FV = 0, solve for PMT = $417.87.
35
3
. Amortization Answer: d Diff: M

N = 25 12
I = 8.5/12
PV = -125,000
FV = 0
PMT = $1,006.53

Do amortization:
Enter: 1 INPUT 60 AMORT
Interest = $51,375.85
Principal = $9,015.95
Balance = $115,984.05

Total Payments = 5 12 $1,006.53

= $60,391.80.

% Repayment $9,015.95
of principal = $60,391.80 = 0.1493 = 14.93%.
3
36

. Amortization Answer: a Diff: M

Given: Loan Value = $100,000; Repayment Period = 12 months;

Monthly Payment = $9,456.

N = 12
PV = -100,000
PMT = 9,456
FV = 0
Solve for I/YR = 2.00% 12 = 24.00%.

To find the amount of principal paid in the third month (or period), use the
calculators amortization feature. Enter: 3 INPUT 3 AMORT (to activate
 the calculator's amortization feature).
Interest = $1,698.84
Principal = $7,757.16
Balance = $77,181.86

37. Amortization Answer: c Diff: M

We will use the amortization feature of the HP-10B.

Enter the loan details:
N = 30 12 = 360
I = 9/12 = 0.75
PV = -90,000
FV = 0
PMT = $724.16.

Total payments in the first 2 years are $724.16 24 = $17,379.85.

Now get the interest:

1 INPUT 24 AMORT
Interest = $16,092.44
Percentage of first two years that is interest is:
$16,092.44/$17,379.85 = 0.9259 = 92.59%.

38
3
. Remaining balance on mortgage Answer: d Diff: M

Solve for the monthly payment as follows:

N = 12 15 = 180
I = 8.5/12 = 0.7083
PV = -160,000
FV = 0
PMT = $1,575.58.

Use the calculators amortization feature to find the remaining principal

balance:
1 INPUT 36 AMORT
Interest = $ 38,658.34
Principal = $ 18,062.54
Balance = $141,937.46
3
39

. Required annuity payments Answer: d Diff: T

Goes on
 Infl. = 5% Retires Welfare
0 i = 8% 1 2 3 4 5
__________________ _______________ _________________ ________________ _______________

40,000 44,100 46,305 48,620
_________________________________
___________
128,659
100,000 ____________________ (116,640)
PMT PMT 12,019

Step 1 The retirement payments, which begin at t = 2, must be:

t = 2: $40,000(1.05)2 = $44,100.
t = 3: $44,100(1.05) = $46,305.
t = 4: $46,305(1.05) = $48,620.

Step 2 Now we need enough at t = 2 to make the 3 retirement payments as

calculated in Step 1. We cannot use the annuity method, but we can
enter, in the cash flow register, the following:
CF0 = 44,100.
CF1 = 46,305.
CF2 = 48,620.
Then enter I = 8, and press NPV to find NPV = PV = $128,659.

Step 3 The $100,000 now on hand will compound at 8% for 2 years:

$100,000(1.08)2 = $116,640.

Step 4 The net funds needed is:

Need at t = 2 $ 128,659
Will have ( 116,640)
Net needed $ 12,019

Step 5 Find the payments needed to accumulate $12,019. Set the

calculator to "Begin" and then enter:
N = 2; I = 8; PV = 0; FV = 12,019. Solve for PMT = $5,350.
4
40

. Required annuity payments Answer: a Diff: T

75 i=8% 76 84 85 86 87 88 89 90
__ . . . __ _________ __________ __________ ___________ __________ __________

+100,000 __________________ +215,892.50
PMT PMT PMT
 (50,000) (55,000) (60,500) (66,550) (73,205) (200,000)
_____________________________________________________
______________
(395,548.96)
(179,656.46) Amount needed

Value of cash outflows:

Age 85 CF0 = ($ 50,000)
CF1 = ( 55,000) = (-50,000)1.1
CF2 = ( 60,500) = (-50,000)(1.1)2
CF3 = ( 66,550) = (-50,000)(1.1)3
CF4 = ( 73,205) = (-50,000)(1.1)4
CF5 = ( 200,000)
Solve for NPV at 8% = ($395,548.96).
Value of $100,000 at age 85: $100,000(1.08)10 = $215,892.50.
Shortfall at age 85 = $215,892.50 - $395,548.96 = ($179,656.46).
Calculate annual payments to equal this shortfall:
N = 10; I/YR = 8; PV = 0; FV = 179,656.46.
Solve for PMT = $12,401.59.

41. Required annuity payments Answer: c Diff: T

0 i = 8% 1 2 3 4 23 24 40
| | | | | .. . . | | . . . |
(360.39) 25 25 25 30 30 PMT PMT
| |
298.25 |
62.14 364.85

Calculate the NPV of payments in Years 1-23:

CF0 = 0
CF1-3 = 25
CF4-23 = 30
I = 8
Solve for NPV = $298.25.
Difference between the security's price and PV of payments:
$360.39 - $298.25 = $62.14.
Calculate the FV of the difference between the purchase price and PV of
payments, Years 1-23:
N = 23
I = 8
PV = -62.14
PMT = 0
Solve for FV = $364.85.
Calculate the value of the annuity payments in Years 24-40:
N = 17
I = 8
PV = -364.85
FV = 0
Solve for PMT = $40.

42. Required annuity payments Answer: a Diff: T

Step 1 Calculate the cost of tuition in each year:

College Cost Today = $15,000, Inflation = 5%.
$15,000(1.05)6 = $20,101.43(1) = $20,101.43.
$15,000(1.05)7 = $21,106.51(1) = $21,106.51.
$15,000(1.05)8 = $22,161.83(2) = $44,323.66.
$15,000(1.05)9 = $23,269.92(2) = $46,539.85.
$15,000(1.05)10 = $24,433.42(1) = $24,433.42.
$15,000(1.05)11 = $25,655.09(1) = $25,655.09.

Step 2 Find the present value of college costs at t = 0:

 CF0 = 0
CF1-5 = 0
CF6 = 20,101.43
CF7 = 21,106.51
CF8 = 44,323.66
CF9 = 46,539.85
CF10 = 24,433.42
CF11 = 25,655.09
I = 12; solve for NPV = $69,657.98.

Step 3 Find the PV of the $25,000 gift received in Year 3:

N = 3
I = 12
PMT = 0
FV = 25,000
Solve for PV = -$17,794.51.

Step 4 Calculate the PV of the net amount needed to fund college costs:
$69,657.98 - $17,794.51 = $51,863.47.

Step 5 Calculate the annual contributions:

BEGIN Mode
N = 12
I = 12
PV = -51,863.47
FV = 0
Solve for PMT = $7,475.60.

43
4
. Required annuity payments Answer: b Diff: T

Find the present value of the cost of college at t = 10. Use the cash flow
register and remember that college costs increase each year by the rate of
inflation.
t = 10: CF0 = $35,000.
t = 11: CF1 = $35,000 1.07 = $37,450.00.
t = 12: CF2 = $35,000 (1.07)2 = $40,071.50.
t = 13: CF3 = $35,000 (1.07)3 = $42,876.51.
I = 9; solve for NPV = $136,193.71.

Now figure out the amount of payments they should make:

N = 10
I = 9
PV = 20,000
FV = -136,193.71
PMT = $5,847.88 $5,848.
44. FV of annuity due Answer: a Diff: T

First, convert the 9 percent return with quarterly compounding to an

effective rate of 9.308332%. With a financial calculator, NOM% = 9, P/YR =
4, EFF% = 9.308332%. (Dont forget to change P/YR = 4 back to P/YR = 1.)
Then calculate the FV of all but the final payment. BEGIN MODE (1 P/YR) N =
9, I/YR = 9.308332, PV = 0, PMT = 1500, and solve for FV = $21,627.49. You
must then add the $1,500 at t = 9 to find the answer, $23,127.49.

45. FV of investment account Answer: b Diff: T

We need to figure out how much money we would have saved if we didnt pay for
the college costs.
N = 40
I = 10
PV = 0
 PMT = -12,000
Solve for FV = $5,311,110.67.

Now figure out how much we would use for college costs. First get the
college costs at one point in time, t = 20 using the cash flow register.
CF0 = 58,045
CF1 = 62,108
CF2 = 66,456 2 = 132,912 (two kids in school)
CF3 = 71,108 2 = 142,216
CF4 = 76,086
CF5 = 81,411
I = 10; NPV = $433,718.02.

This is the value of the college costs at year t = 20. What we want is to
know how much this is at t = 40
N = 20
I = 10
PV = -433,718.02
PMT = 0
Solve for FV = $2,917,837.96.

The amount in the nest egg at t = 40 is the amount saved less the amount
spent on college;
$5,311,110.67 - $2,917,837.96 = $2,393,272.71 $2,393,273.

46. Effective annual rate Answer: c Diff: T

Time Line:
0 12 24 27 Months
0 i = ?% 1 2 2.25
| | | |
-8,000 10,000
Numerical solution:
Step 1 Find the effective annual rate (EAR) of interest on the bank
deposit
EARDaily = (1 + 0.080944/365)365 - 1 = 8.43%.
Step 2 Find the EAR of the investment
$8,000 = $10,000/(1 + i)2.25
(1 + i)2.25 = 1.25
1 + i = 1.25(1/2.25)
1 + i = 1.10426
i = 0.10426 10.43%
Step 3 Difference = 10.43% - 8.43% = 2.0%

Financial calculator solution:

 Calculate EARDaily using interest rate conversion feature
Inputs: P/YR = 365; NOM% = 8.0944; Output: EFF% = EAR = 8.43%.
Calculate EAR of the equal risk investment
Inputs: N = 2.25; PV = -8,000; PMT = 0; FV = 10,000.
Output: I = 10.4259 10.43%.
Difference: 10.43% - 8.43% = 2.0%.

47. Non-annual compounding Answer: a Diff: T

To compare these alternatives, find the present value of each strategy and
select the option with the highest present value.

Option 1 can be valued as an annuity due. On your financial calculator

enter:
BEGIN mode (to indicate payments will be received at the start of the period)
N = 12
I = 12/12 = 1
PMT = -1,000
FV = 0
Solve for PV = $11,367.63.

Option 2 can be valued as a lump sum payment to be received in the future. On

your financial calculator enter:
END mode (to indicate the lump sum will be received at the end of the year)
N = 2
I = 12/2 = 6
PMT = 0
FV = 12,750
Solve for PV = $11,347.45.

Option 3 can be valued as a series of uneven cash flows. The cash flows at
the end of each period are calculated as follows:
CF0 = $ 0.00.
CF1 = $ 800.00.
CF2 = $ 800.00 x (1.20) = $ 960.00.
CF3 = $ 960.00 x (1.20) = $1,152.00.
CF4 = $1,152.00 x (1.20) = $1,382.40.
CF5 = $1,382.40 x (1.20) = $1,658.88.
CF6 = $1,658.88 x (1.20) = $1,990.66.
CF7 = $1,990.66 x (1.20) = $2,388.79.
 CF8 = $2,388.79 x (1.20) = $2,866.54.

To find the present value of this cash flow stream using your financial
calculator enter:
END mode (to indicate the cash flows will occur at the end of each period)
0 CFj; 800 CFj; 960 CFj; 1,152 CFj; 1,382.40 CFj; 1,658.88 CFj; 1,990.66 CFj;
2,388.79 CFj; 2,866.54 CFj (to enter the cash flows);I/YR = 12/4 = 3; solve
for NPV = $11,267.37.

Choose the alternative with the highest present value, and hence select
Choice 1 (Answer a).

48. PMT and quarterly compounding Answer: b Diff: T

0 i = 2% 1 80 81 82 83 84 116 Qtrs.
| | . . . | | | | | . . . |
+400 +400
PMT 0 0 0 PMT PMT
Find the FV at t = 80 of $400 quarterly payments:
N = 80; I = 2; PV = 0; and PMT = 400.
Solve for FV = $77,508.78.
Find the EAR of 8%, compounded quarterly, so you can determine the value of
each of the receipts:
4

EAR = 1 +
0.08
- 1 = 8.2432%.
4
Now, determine the value of each of the receipts, remembering that this is an
annuity due. With a financial calculator input the following:
N = 10; I = 8.2432; PV = -77,508.78; and FV = 0.
Solve for PMT = $10,788.78 $10,789.

49. PV of an uneven CF stream Answer: d Diff: T

Parent's savings: Health Care Costs, Years 19-22:

N = 18 -$1,000(1.1)19 = -$6,115.91
I = 6 -$1,000(1.1)20 = -$6,727.50
PMT = 100 -$1,000(1.1)21 = -$7,400.25
FV = 0 -$1,000(1.1)22 = -$8,140.27
Solve for PV = $1,082.76.
0 i = 6% 1 2 18 19 20 21 22
| | | . . . | | | | |
+100 +100 +100 -6,115.91 -6,727.50 -7,400.25 -8,140.27
-$8,554.84 PV of Health care costs
1,082.76 PV of parents' savings
-$7,472.08 Lump sum government must set aside

CF0 = 0
CF1-18 = 0
CF19 = -6,115.91
CF20 = -6,727.50
CF21 = -7,400.25
CF22 = -8,140.27
I = 6
Solve for NPV = -8,554.84 = PV of Health care costs.
Consequently, the government must set aside $8,554.84 - $1,082.76 =
$7,472.08.
Alternatively,
CF0 = 0
CF1-18 = 100
CF19 = -6,115.91
CF20 = -6,727.50
CF21 = -7,400.25
CF22 = -8,140.27
I = 6
Solve for NPV = -$7,472.08 = Lump sum government must set aside now.