Question I Solutions

1. The time line for the cash flows is:

0 10

$7,900 FV

The simple interest per year is:

$7,900 × .07 = $553

So, after 10 years, you will have:

$553 × 10 = $5,530 in interest.

The total balance will be $7,900 + 5,530 = $13,430

With compound interest, we use the future value formula:

FV = PV(1 +r)t
FV = $7,900(1.07)10
FV = $15,540.50

The difference is:

$15,540.50 – 13,430 = $2,110.50

2. The time line is:

0 2 8

$10,000 FV
Even though we need to calculate the value in eight years, you will only have the money
for six years, so we need to use six years as the number of periods. To find the FV of a
lump sum, we use:

FV = PV(1 + r)t
FV = $10,000(1.075)6
FV = $15,433.02

3. The time line is:

0 120

PV $85,000

To find the PV of a lump sum, we use:

PV = FV/(1 + r)t
PV = $85,000/(1.0078)120
PV = $33,457.73
4. The time line is:
0 18

–$53,000 $235,000

To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t

Solving for r, we get:

r = (FV/PV)1/t – 1
r = ($235,000/$53,000)1/18 – 1
r = .0863, or 8.63%

5. The time line is:

0 t

–$1,800 $3,100

To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:

FV = PV(1 + r)t
$3,100 = $1,800(1.0031)t
t = ln($3,100/$1,800)/ln 1.0031
t = 175.63 months

6. To find the FV of a lump sum, we use:

FV = PV(1 + r)t

In Regency Bank, you will have:

0 240

$5,800 FV

FV = $5,800(1.01)240
FV = $63,176.81

And in King Bank, you will have:

0 20

$5,800 FV

FV = $5,800(1.12)20
FV = $55,948.50
7. The time line is:
0 1 ∞
…
–$400,000 $2,750 $2,750 $2,750 $2,750 $2,750 $2,750 $2,750 $2,750 $2,750

Here we need to find the interest rate that equates the perpetuity cash flows with the PV
of the cash flows. Using the PV of a perpetuity equation:

PV = C/r
$400,000 = $2,750/r

We can now solve for the interest rate as follows:

r = $2,750/$400,000
r = .0069, or .69% per month

The interest rate is .69 percent per month. To find the APR, we multiply this rate by the
number of months in a year, so:

APR = 12(.69%)
APR = 8.25%

And using the equation to find the EAR, we find:

EAR = [1 + (APR/m)]m – 1
EAR = [1 + .0069]12 – 1
EAR = .0857, or 8.57%

8. The time line is:

0 1 420
…
FVA
$500 $500 $500 $500 $500 $500 $500 $500 $500

This problem requires us to find the FVA. The equation to find the FVA is:

FVA = C{[(1 + r)t – 1]/r}

FVA = $500[{[1 + (.095/12)]420 – 1}/(.095/12)]
FVA = $1,669,731.48
9. The time line is:
0 1 60
…
$68,500
C C C C C C C C C

We need to use the PVA due equation, which is:

PVAdue = (1 + r)PVA

Using this equation:

PVAdue = $68,500 = [1 + (.045/12)] × C[{1 – 1/[1 + (.045/12)]60]}/(.045/12)

$58,347.16 = $C{1 – [1/(1 + .045/12)60]}/(.045/12)
C = $1,272.28

Notice, to find the payment for the PVA due, we find the PV of an ordinary annuity, then
compound this amount forward one period.

10. Here we need to compare two cash flows. The only way to compare cash flows is to find
the value of the cash flows at a common time, so we will find the present value of each
cash flow stream. Since the cash flows are monthly, we need to use the monthly interest
rate, which is:

Monthly rate = .07/12

Monthly rate = .0058 or .58%

The value today of the $6,100 monthly salary is:

0 1 24
…
PVA $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100 $6,100

PVA = C({1 – [1/(1 + r)t]}/r)

PVA = $6,100{[1 – (1/1.0058)24]/.0058}
PVA = $136,244.11

To find the value of the second option, we find the present value of the monthly payments
and add the bonus. We can add the bonus since it is paid today. So:
0 1 24
…
$25,000 $5,100 $5,100 $5,100 $5,100 $5,100 $5,100 $5,100 $5,100 $5,100

PVA = C({1 – [1/(1 + r)t]}/r)

PVA = $5,100{[1 – (1/1.0058)24]/.0058}
PVA = $113,909.01

So, the total value of the second option is:

Value of second option = $113,909.01 + 25,000
Value of second option = $138,909.01

The difference in the value of the two options today is:

Difference in value today = $138,909.01 – 136,244.11

Difference in value today = $2,664.90

What if we found the future value of the two cash flows? For the monthly salary, the future
value will be:

FVA = C{[(1 + r)t – 1]/r}

FVA = $6,100{[(1 + .0058)24 – 1]/.0058}
FVA = $156,654.29

To find the future value of the second option we also need to find the future value of the
bonus. So, the future value of this option is:

FV = C{[(1 + r)t – 1]/r} + PV(1 + r)t

FV = $5,100{[(1 + .0058)24 – 1]/.0058} + $25,000(1 + .0058)24
FV = $159,718.41

So, the Second option is still the better choice. The difference between the future values
of the two options is:

Difference in future value = $159,718.41 – 156,654.29

Difference in future value = $3,064.12

No matter when you compare two cash flows, the cash flow with the greatest value in one
period will always have the greatest value in any other period. Here’s a question for you:
What is the future value of $2,664.90 (the difference in the cash flows at time zero) in 24
months at an interest rate of .58 percent per month? With no calculations, you know the
future value must be $3,064.12, the difference in the cash flows at the same time!