Department of Accounting and Information Systems

University of Rajshahi
Principles of Finance

Chapter- Time Value of Money

1.a) You would like to accumulate Birr 50,000 in five years by making a single investment today.
You believe you can achieve a return from your investment of 8% annually.
b) What is the amount that you need to invest today to achieve your goal?
2. Calculate the present value of Tk. 100,000 received
(a) one year from now;
(b) at the end of five years;
(c) at the end of fifteen years.
Assume 10 percent interest rate is applicable.

 CFt 
PV   
t 
 1  r  
3.

3. Suppose your father has promised to give your youngest brother Afzal Tk. 200,000 in cash on
his 23th birthday. Today is Afzal’s 16th birthday. Your father wants to know two things:
(a) If he decides to make annual payments into a fund after one year. How much will
each year have to be if the fund pays 8 percent interest?
(b) If he decides to invest a lump sum in the account after one year and let it compound
annually, how much will the lump sum be?

4. Your father wants to purchase machinery for tk. 800,000 by making a down payment of tk.
150,000 and reminder in equal installments of tk. 150,000 for six year. What is the rate of
interest of the firm?

5. Your father wants to buy a house for tk. 500,000 by taking loan form a bank at 12% for 10
years with equal installment. (a) How much the annual installment? (b) How much of the each
payment goes towards reducing the principal.

6. If Fred Moreno places $100 in a savings account paying 8% interest compounded annually, at
the end of 1 year he will have $108 in the account, which is the initial principal of $100 plus 8%
($8) in interest. The future value at the end of the first year is
Future value at end of year 1 = $100 * (1 + 0.08) = $108
If Fred were to leave this money in the account for another year, he would be paid interest at the
rate of 8% on the new principal of $108. At the end of this second year, there would be $116.64
in the account. This amount would represent the principal at the beginning of year 2 ($108) plus
8% of the $108 ($8.64) in interest. The future value at the end of the second year is
Future value at end of year 2 = $108 * (1 + 0.08)
= $116.64
Substituting the expression $100 3 (1 1 0.08) from the first-year calculation for the $108 value in
the second-year calculation gives us
Future value at end of year 2 = $100 * (1 + 0.08) * (1 + 0.08)
= $100 * (1 + 0.08)2
= $116.64

7. Pam Valenti wishes to find the present value of $1,700 that she will receive 8 years from now.
Pam’s opportunity cost is
8%. Substituting FV8 = $1,700, n = 8, and r = 0.08 into Equation 5.2 yields
PV = $1,700 (1 + 0.08)8
= $1,700 1.85093
= $918.46

8. Fran Abrams is evaluating two annuities. Both are 5-year,

$1,000 annuities; annuity A is an ordinary annuity, and annuity B is an annuity due. To better
understand the difference between these annuities, she has listed their cash flows in the Table.
The two annuities differ only in the timing of their cash flows: The cash flows occur sooner with
the annuity due than with the ordinary annuity.

Annual cash flows

Year Annuity A (ordinary) Annuity B (annuity due)

0 $ 0 $1,000

1 1,000 1,000

2 1,000 1,000

3 1,000 1,000

4 1,000 1,000

5 1,000 0

Totals $5,000 $5,000

9. Fran Abrams wishes to determine how much money she will have at the end of 5 years if she
chooses annuity A, the ordinary annuity. She will deposit $1,000 annually, at the end of each of
the next 5 years, into a savings account paying 7% annual interest. This situation is depicted on
the following time line.
 $1,000 $1,000 $1,000 $1,000 $1,000

0 1 2 3 4 5
End of Year

$1,310.80
1,225.04
1,144.90
1,070.00
1,000.00
$5,750.74 Future Value

As the figure shows, at the end of year 5, Fran will have $5,750.74 in her ac-count. Note that
because the deposits are made at the end of the year, the first deposit will earn interest for 4
years, the second for 3 years, and so on. Plugging the relevant values we have

3 (1 + 0.07)5 - 1 4
FV5 = $1,000 * e f = $5,750.74
0.07

A B
1 FUTURE VALUE OF AN ORDINARY
ANNUITY
2 Annual annuity payment –$1,000
3 Annual rate of interest 7%
4 Number of years 5
5 Future value $5,750.7
4
Entry in Cell B5 is =FV(B3,B4,B2,0,0).
The minus signseappears before payments
the annuity’s the $1,000

10. Find out the future values (FV) in the following situations :
a) At the end of 3 years, how much is an initial deposit of Taka 1,000 worth, assuming a
quarterly compounded interest rate of (i) 10%; (ii) 20% and (ii) 100%.
b) At the end of 10 years, how much is an initial investment of Taka 1,000 worth, assuming
an interest rate of 10% compounded : (i) annually; (ii) semiannually; (iii) quarterly,
(iv)monthly ?
11. Suppose you’re offered the following two options to pick from:

Option 1 → Receive $225,000 in Year 4

Option 2 → Receive $50,000 from Year 1 to Year 4

The determinant of which option is more profitable is the time value of money (TVM).

If we assume a 10% discount rate, which option should you proceed with?
For both option 1 and option 2, we’ll list out the cash inflow for each year.

While option 1 consists of a one-time payment of $225,000, option 2 consists of four payments
of $50,000.

The formula for discounting each cash flow is the future value (FV) divided by (1 + discount
rate), which is then raised to the power of the period number.

Once completed for each year, the sum of the discounted cash flows equals the present value of
the option, i.e. how much the future cash flows are worth on the present date.

Option 1 = $154,000

Option 2 = $158,000
In our simple example, option 2 is worth more than option 1. But of course, there are far more
considerations in reality that can complicate the decision-making process.

12. Delia Martin has $10,000 that

she can deposit in any of three savings accounts for a 3-year period. Bank A compounds
interest on an annual basis, bank B compounds interest twice each year, and
bank C compounds interest each quarter. All three banks have a stated annual interest
rate of 4%.
a. What amount would Ms. Martin have at the end of the third year, leaving all interest
paid on deposit, in each bank?
b. What effective annual rate (EAR) would she earn in each of the banks?
c. On the basis of your findings in parts a and b, which bank should Ms. Martin
deal with? Why?
d. If a fourth bank (bank D), also with a 4% stated interest rate, compounds interest
continuously, how much would Ms. Martin have at the end of the third year?
Does this alternative change your recommendation in part c? Explain why or
why not.
13. Ramesh Abdul wishes to choose the better of two equally
costly cash flow streams: annuity X and annuity Y. X is an annuity due with a cash
inflow of $9,000 for each of 6 years. Y is an ordinary annuity with a cash inflow of
$10,000 for each of 6 years. Assume that Ramesh can earn 15% on his investments.
a. On a purely subjective basis, which annuity do you think is more attractive? Why?
b. Find the future value at the end of year 6 for both annuities.
c. Use your finding in part b to indicate which annuity is more attractive. Why?
Compare your finding to your subjective response in part a.
14. You have a choice of accepting either
of two 5-year cash flow streams or single amounts. One cash flow stream is an ordinary
annuity, and the other is a mixed stream. You may accept alternative A or B,
either as a cash flow stream or as a single amount. Given the cash flow stream and
single amounts associated with each (see the following table), and assuming a 9%
opportunity cost, which alternative (A or B) and in which form (cash flow stream or
single amount) would you prefer?
Cash flow stream
End of year Alternative A Alternative B
1 $700 $1,100
2 700 900
3 700 700
4 700 500
5 700 300
Single amount
At time zero $2,825 $2,800

15. You have decided to endow your favorite university

with a scholarship. It is expected to cost $6,000 per year to attend the university
into perpetuity. You expect to give the university the endowment in 10 years and
will accumulate it by making equal annual (end-of-year) deposits into an account.
The rate of interest is expected to be 10% for all future time periods.
a. How large must the endowment be?
b. How much must you deposit at the end of each of the next 10 years to accumulate
the required amount?
16. Joan Messineo borrowed $15,000 at a 14% annual rate of interest to be repaid over 3 years.
The loan is amortized into three equal, annual,end-of-year payments.
a. Calculate the annual, end-of-year loan payment.
b. Prepare a loan amortization schedule showing the interest and principal breakdown
of each of the three loan payments.
c. Explain why the interest portion of each payment declines with the passage of
time.
17. Loan interest deductions Liz Rogers just closed a $10,000 business loan that is to be
repaid in three equal, annual, end-of-year payments. The interest rate on the loan is
13%. As part of her firm’s detailed financial planning, Liz wishes to determine the
annual interest deduction attributable to the loan. (Because it is a business loan, the
interest portion of each loan payment is tax-deductible to the business.)
a. Determine the firm’s annual loan payment.
b. Prepare an amortization schedule for the loan.
c. How much interest expense will Liz’s firm have in each of the next 3 years as a
result of this loan?