Chapter 5: Time Value of Money

I. Short answer

Question 1: What is the concept of the time Value of Money?

Question 2: Which annuity has a higher future value: An annuity due or a similar ordinary
annuity? Explain.

Question 3: What is the Difference between Simple Interest and Compound Interest?

III. Multiple Choice Question

2. Which of the following statements is CORRECT?

A. The cash flows of an annuity due occur at the end of each period.

B. If a series of unequal cash flows occurs at regular intervals, such as once a year, then
the series is by definition an annuity.

C. The cash flows for an ordinary annuity remain constant from period to period and they
occur at the end of each period.

D. If a series of equal cash flows occurs at regular intervals, such as once per year, then
the series must not be an annuity.

3. By increasing the number of compounding periods in a year, while holding the stated
annual interest rate constant, you will.....

A. decrease the effective annual rate

B. increase the effective annual rate

C. not change the effective annual rate

D. There is not enough information to answer the question

4. Which of the following statements is TRUE?

Statement I: The future value of a lump sum and the future value of an annuity will both
increase as you increase the interest rate.
Statement II: As you increase the length of time from now until the time of receipt of a
lump sum, the present value of the lump sum increases.

Statement III: The present value of a lump sum to be received at some point in the
futuredecreases as you increase the interest rate, but the present value of an annuity
increases as you increase the interest rate.

A. Statement I only

B. Statement II only

C. Statement III only

D. Statements I and II only

5. Which of the following best describes the structure of an annuity?

A. a series of payments to be received during a period of time.

B. a series of payments to be received at a common interval during a period of time.

C. a series equal payments to be received at a common interval during a period of time.

D. the present value of a set of payments to be received during a future period of time.

6. Your bank account pays a 6% stated annual interest rate (or APR). The interest is
compounded quarterly.Which of the following statements is CORRECT?

A. The quarterly interest rate is 1.5% and the effective annual interest rate is 3%.

B. The quarterly interest rate is 6% and the effective annual interest rate is greater than
6%.

C. The quarterly interest rate is 1.5% and the effective annual interest rate is greater than
6%.

D. The quarterly interest rate is 3% and the effective annual interest rate is 6%.

7. Which of the following investments would have the highest future value at the end of
10 years? Assumethat the effective annual interest rate for all investments is the same
and is greater than zero.
A. Investment A pays $250 at the beginning of every year for the next 10 years (a total of
10 payments).

B. Investment B pays $125 at the end of every 6-month period for the next 10 years (a
total of 20 payments).

C. Investment C pays $125 at the beginning of every 6-month period for the next 10 years
(a total of 20payments).

D. Investment D pays $2,500 at the end of 10 years (just one payment).

8. Which of the following cannot be calculated?

A. The future value of an annuity at the end of its life.

B. The present value of an annuity.

C. The future value of a perpetuity at the end of its life.

D. The present value of a perpetuity.

9. What is the total amount accumulated after three years if someone invests $1,000 today
with a simple annual interest rate of 5 percent? With a compound annual interest rate of
5 percent?

A. $1,150, $1,103

B. $1,110, $1,158

C. $1,150, $1,158

D. $1,110, $1,103

10. Suppose an investor wants to have $10 million to retire 45 years from now. How much
would she have to invest today with an annual rate of return equal to 15 percent?

A. $18,561

B. $17,844

C. $20,003

D. $21,345

11. Which of the following is false?

B. The greater the interest rate, the greater the present value, given a $100 future value
and holding the time period constant.

C. A future dollar is always less valuable than a dollar today if interest rates are positive.

D. The discount factor is the reciprocal of the compound factor.

12. Which of the following concepts is incorrect?

A. An ordinary annuity has payments at the end of each year.

B. An annuity due has payments at the beginning of each year.

C. A perpetuity is considered a perpetual annuity.

D. An ordinary annuity has a greater PV than an annuity due, if they both have the
same periodic payments, discount rate and time period.

13. Jan plans to invest an equal amount of $2,000 in an equity fund every year-end
beginning this year. The expected annual return on the fund is 15 percent. She plans to
invest for 20 years. How much could she expect to have at the end of 20 years?

A. $237,620

B. $176,424

C. $204,887

D. $178,424

14. To triple $1 million, Mika invested today at an annual rate of return of 9 percent. How
long will it take Mika to achieve his goal?

A. 15.5 years

B. 13.9 years

C. 12.7 years

D. 10 years

15. Time value of money indicates that

A. A unit of money obtained today is worth more than a unit of money obtained in future
B. A unit of money obtained today is worth less than a unit of money obtained in future

C. There is no difference in the value of money obtained today and tomorrow

D. None of the above

16. Time value of money supports the comparison of cash flows recorded at different time
period by

A. Discounting all cash flows to a common point of time

B. Compounding all cash flows to a common point of time

C. Using either a or b

D. None of the above.

17. If the nominal rate of interest is 10% per annum and there is quarterly compounding,
the effective rate of interest will be:

A. 10% per annum

B. 10.10 per annum

C. 10.25%per annum

D. 10.38% per annum

18. Relationship between annual nominal rate of interest and annual effective rate of
interest, if frequency of compounding is greater than one:

A. Effective rate > Nominal rate

B. Effective rate < Nominal rate

C. Effective rate = Nominal rate

D. None of the above

A. Rs 19500

B. Rs 19400

C. Rs 19310

D. None of the above

20. If nominal rate of return is 10% per annum and annual effective rate of interest is
10.25% per annum, determine the frequency of compounding:

A. 1

B. 2

C. 3

D. None of the above

22. In a typical loan amortization schedule, the dollar amount of interest paid each
period...

A. increases with each payment

B. decreases with each payment

C. remains constant with each payment

D. A or C

23. In a typical loan amortization schedule, the total dollar amount of money paid each
period...

A. increases with each payment

B. decreases with each payment

C. remains constant with each payment

D. A or C
24. In 3 years you are to receive $5,000. If the interest rate were to suddenly increase, the
present value of that future amount to you would

A. Fall.

B. Rise.

C. Remain unchanged.

D. cannot be determined without more information.

25. With continuous compounding at 10 percent for 30 years, the future value of an initial
investment of 2000 is closest to

A. 34,898

B. 40,141

C. 164,500

D. 111,990

IV. Excersice

1. Your older brother invested $6,000 today at an annual interest rate of 9% for 6 years.
You want to accumulate the same amount at the end of the next 6 years, but you can only
earn an interest rate of 7.5%. How much more money must you invest today than your
brother did to reach the same amount at the end of the 6 years?

2. A local furniture store is advertising a home renovation package for completion two
years from now. The package requires a payment of $20,000 today, $25,000 one year from
today, and a final payment of $40,000 on the day the renovation is completed two years
from today. What is the total cost of this renovation worth today if the discount rate is
8%?

3. Mr. An deposits $2,000 into his savings account at the beginning of each year. Mr. Binh
deposits $2,000 into his savings account at the end of each year. They both earn 7.5%
annual interest. What is the difference in their savings accounts at the end of 4 years?