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Questions

LG1

5-1 How can you add a cash flow in year two and a cash flow in year four in year seven?

To add cash flows, they need to be moved to the same time period. The cash flows in years

two and four should be moved forward with interest to year seven, then they can be added

together.

LG2

5-2 People can become millionaires in their retirement years quite easily if they start saving

early in employer 401(k) or 403(b) programs (or even if their employers dont offer such

programs). Demonstrate the growth of a $250 monthly contribution for 40 years earning 9

percent APR.

Using equation 5-2, we have:

FVA 40 250

LG3

0.09/12

5-3 When you discount multiple cash flows, how does the future period that a cash flow is

paid affect its present value and its contribution to the value of all the cash flows?

Discounting reduces a future cash flow to a smaller present value. Cash flows far into the

future become very small when discounted to the present. Thus, cash flows in distant future

periods have small impacts on present values.

LG4

5-4 How can you use the present value of an annuity concept to determine the price of a

house you can afford?

Mortgages are typically for a large enough amount of money that borrowing is required to

purchase a home. The amount that one can afford for a home is a function of their current

state of wealth. Mortgages allow consumers to spread the expense of a home over a longer

period, typically 15 or 30 years. This allows consumers to put a smaller portion of wealth

into the home (for example, a 20% down payment) and borrow the balance over the life of

the loan. Due to the effect of annuity compounding, the payments for such a long lived debt

make the monthly payments of a manageable nature so that they can be paid from current

income.

LG5

5-5 Since perpetuity payments continue for ever, how can a present value be computed?

Why isnt the present value infinite?

5-1

Chapter 5, Solutions

Equation 5-5 is used to calculate the present value of a perpetuity. It is a limiting version of

equation 5-4 in which the period N grows infinitely large. As this occurs the expression

following the 1 in equation 5-4 drives to the value 0 and the numerator simply become

1. The present value is not infinite since the terms following the PMT in equation 5-4

converge to a finite limit of 1/i. This also demonstrates how payments far into the future

have infinitesimal value today.

LG6

5-6 Explain why you use the same adjustment factor, (1 + i), when you adjust annuity due

payments for both future value and present value.

Adjusting an annuity due calculation involves shifting the entire series of payments forward

one period. This is accomplished by multiplying by (1 + i) irrespective of whether it is a

future value or present value calculation.

LG7

5-7 Use the idea of compound interest to explain why EAR is larger than APR.

The annual percentage rate does not take into account the frequency of interest

compounding. Equation 5-8 illustrates the conversion from APR to EAR. The effective

annual rate converts the annual percentage rate to a rate that can be compared to other

annual rates.

LG8

5-8 Would you rather pay $10,000 for a five year $2,500 annuity or a ten-year $1,250

annuity? Why?

The effective annual rates for these two payment streams are 7.93% and 4.28% respectively.

I would rather pay $10,000 for a five year $2,500 annuity as it earns a higher effective

annual rate of interest.

LG9

5-9 The interest on your home mortgage is tax deductible. Why are the early years of the

mortgage more helpful in reducing taxes than in the later years?

Mortgage payments at the beginning of the amortization schedule are predominantly interest

with little principal. In later years, interest payments decline and principal payments make

up an ever increasing part of the payments. Thus, the tax deductible part (the interest

payment) is larger in the beginning years.

LG10 5-10 How can you use the concepts illustrated in computing the number of payments in an

annuity to figure how to pay off a credit card balance? How does the magnitude of the

payment impact the number of months?

Utilizing equation 5-2, you can declare the present balance for the credit card and set that

equal to the PVA. The interest can be obtained as an APR and converted to and EAR using

equation 5-8. This is the value to put into i in equation 5-2. You then decide when you

want to have the credit card paid off and convert this to a monthly value of N in equation 5-

5-2

Chapter 5, Solutions

2. Solving for PMT will yield the amount needed to pay the credit card off in the time

frame you desire, assuming that no additional charges are made to the credit card and that

the interest rate remains level.

Problems

Basic

Problems

LG1

5-1 Future Value Compute the future value in year 8 of a $1,000 deposit in year 1 and

another $1,500 deposit at the end of year 3 using a 10% interest rate.

Use equation 5-1:

FV = $1,000 (1 + 0.10)7 + $1,500 (1 + 0.10)5 = $1,948.72 + $2,415.77 = $4,364.48

LG1

5-2 Future Value Compute the future value in year 7 of a $2,000 deposit in year 1 and

another $2,500 deposit at the end of year 4 using a 8% interest rate..

Use equation 5-1:

FV = $2,000 (1 + 0.08)6 + $2,500 (1 + 0.08)3 = $3,173.75 + $3,149.28 = $6,323.03

LG2

5-3 Future Value of an Annuity What is the future value of a $500 annuity payment over 5

years if interest rates are 9 percent?

Use equation 5-2:

FVA 5 $500

LG2

0.09

5-4 Future Value of an Annuity What is the future value of a $700 annuity payment over 4

years if interest rates are 10 percent?

Use equation 5-2:

FVA 4 $500

LG3

0.10

5-5 Present Value Compute the present value of a $1,000 deposit in year 1 and another

$1,500 deposit at the end of year 3 if interest rates are 10 percent.

Use equation 5-3:

PV = $1,000 (1 + 0.10)1 + $1,500 (1 + 0.10)3 = $909.09 + $1,126.97 = $2,036.06

LG3

5-6 Present Value Compute the present value of a $2,000 deposit in year 1 and another

$2,500 deposit at the end of year 4 using an 8% interest rate.

5-3

Chapter 5, Solutions

PV = $2,000 (1 + 0.08)1 + $2,500 (1 + 0.08)4 = $1,851.85 + $1,837.57 = $3,689.43

LG4

5-7 Present Value of an Annuity Whats the present value of a $500 annuity payment over

5 years if interest rates are 9 percent?

Use equation 5-4:

PVA 5

LG4

1

1 1 0.09 5

$500

0.09

5-8 Present Value of an Annuity Whats the present value of a $700 annuity payment over

4 years if interest rates are 10 percent?

Use equation 5-4:

PVA 4

LG5

1

1 1 0.10 4

$700

0.10

5-9 Present Value of a Perpetuity Whats the present value, when interest rates are 7.5

percent, of a $50 payment made every year forever?

Use equation 5-5:

PV of a perpetuity

LG5

$50

$666.67

0.075

5-10 Present Value of a Perpetuity Whats the present value, when interest rates are 8.5

percent, of a $75 payment made every year forever?

Use equation 5-5:

PV of a perpetuity

LG6

$75

$882.35

0.085

5-11 Present Value of an Annuity Due If the present value of an ordinary, 7-year annuity is

$6,500 and interest rates are 8.5 percent, whats the present value of the same annuity due?

Use equation 5-7:

PVA7 due = 6,500 (1 +0.085) = $7,052.50

LG6

5-12 Present Value of an Annuity Due If the present value of an ordinary, 6-year annuity is

$8,500 and interest rates are 9.5 percent, whats the present value of the same annuity due?

Use equation 5-7:

5-4

Chapter 5, Solutions

LG6

5-13 Future Value of an Annuity Due If the future value of an ordinary, 7-year annuity is

$6,500 and interest rates are 8.5 percent, what is the future value of the same annuity due?

Use equation 5-6:

FVA7 due = 6,500 (1 + 0.085) = $7,052.50

(Note this is the same answer as problem 5-11, as expected)

LG6

5-14 Future Value of an Annuity Due If the future value of an ordinary, 6-year annuity is

$8,500 and interest

rates are 9.5 percent, whats the future value of the same annuity due?

Use equation 5-6:

FVA6 due = 8,500 (1 + 0.095) = $9,307.50

(Note this is the same answer as problem 5-12, as expected)

LG7

5-15 Effective Annual Rate A loan is offered with monthly payments and an 11 percent

APR. Whats the loans effective annual rate (EAR)?

Use equation 5-8:

0.11

EAR 1

12

LG7

12

1 0.115718841 11.57%

5-16 Effective Annual Rate A loan is offered with monthly payments and a 12 percent

APR. Whats the loans effective annual rate (EAR)?

Use equation 5-8:

0.12

EAR 1

12

12

1 0.12682503 12.68%

Intermediate

Problems 5-17 Future Value Given a 6 percent interest rate, compute the year 6 future value of

deposits made in years 1, 2, 3, and 4 of $1,000, $1,200, $1,200, and $1,500.

LG1

Use equation 5-1:

FV = $1,000 (1 + 0.06)5 + $1,200 (1 + 0.06)4 + $1,200 (1 + 0.06)3 + $1,500 (1 + 0.06)2

5-5

Chapter 5, Solutions

LG1

5-18 Future Value Given a 7 percent interest rate, compute the year 6 future value of

deposits made in years 1, 2, 3, and 4 of $1,000, $1,300, $1,300, and $1,400.

Use equation 5-1:

FV = $1,000 (1 + 0.07)5 + $1,300 (1 + 0.07)4 + $1,300 (1 + 0.07)3 + $1,400 (1 + 0.07)2

FV = $1,402.55 + $1,704.03 + $1,592.56 + $1,602.86 = $6,302

LG2

5-19 Future Value of Multiple Annuities Assume that you contribute $200 per month to a

retirement plan for 20 years. Then you are able to increase the contribution to $400 per

month for another 20 years. Given a 7 percent interest rate, what is the value of your

retirement plan after the 40 years?

Break the annuity streams into a level stream of payments of $200 for 40 years and another

level stream of payments of $200 for the last 20 years. Use equation 5-2 for each payment

stream and add the results:

LG2

0.07/12

0.07/12

5-20 Future Value of Multiple Annuities Assume that you contribute $150 per month to a

retirement plan for 15 years. Then you are able to increase the contribution to $350 per

month for the next 25 years. Given an 8 percent interest rate, what is the value of your

retirement plan after the 40 years?

Break the annuity streams into a level stream of payments of $150 for 40 years and another

level stream of payments of $200 for the last 25 years. Use equation 5-2 for each payment

stream and add the results

LG3

0.08/12

0.08/12

5-21 Present Value Given a 6 percent interest rate, compute the present value of payments

made in years 1, 2, 3, and 4 of $1,000, $1,200, $1,200, and $1,500.

Use equation 5-3:

PV = $1,000 (1 + 0.06)1 + $1,200 (1 + 0.06)2 + $1,200 (1 + 0.06)3 + $1,500 (1 + 0.06)4

PV = $943.40 + $1,068 + $1,007.54 + $1,188.14 = $4,207.08

LG3

5-22 Present Value Given a 7 percent interest rate, compute the present value of payments

made in years 1, 2, 3, and 4 of $1,000, $1,300, $1,300, and $1,400.

Use equation 5-3:

5-6

Chapter 5, Solutions

PV = $934.58 + $1,135.47 + $1,061.19 + $1,068.05 = $4,199.29

LG2

5-23 Present Value of Multiple Annuities A small business owner visits his bank to ask for

a loan. The owner states that he can repay a loan at $1,000 per month for the next three

years and then $2,000 per month for two years after that. If the bank is charging customers

7.5 percent APR, how much would it be willing to lend the business owner?

Break the annuity streams into a level stream of payments of $2,000 for 5 years and another

level stream of payments of $1,000 for the first 3 years. Use equation 5-4 for each payment

stream and subtract the results.

PVA 5 PVA 3

LG2

1

1 1 0.075 / 12 60

$2,000

0.075/12

1

1 1 0.075 / 12 36

$1,000

0.075/12

$99,810.62 $32,147.

5-24 Present Value of Multiple Annuities A small business owner visits his bank to ask for

a loan. The owner states that she can repay a loan at $1,500 per month for the next three

years and then $500 per month for two years after that. If the bank is charging customers

8.5 percent APR, how much would it be willing to lend the business owner?

Break the annuity into two streams of payments: $500 monthly for five years and $1,000

for three years. Use equation 5-4 for each annuity and add the results.

PVA 5 PVA 3

LG5

1

1 1 0.085 / 12 60

$500

0.085/12

1

1 1 0.085 / 12 36

$1,000

0.085/12

$24,370.59 $31,678

5-25 Present Value of a Perpetuity A perpetuity pays $100 per year and interest rates are

7.5 percent. How much would its value change if interest rates increased to 8.5 percent?

Did the value increase or decrease?

Use equation 5-5:

PV of a perpetuity

$100

$1,333.33

0.075

PV of a perpetuity

$100

$1,176.47

0.085

The difference between these perpetuities is $156.86. The value of the perpetuity decreased with an

increase in the interest rate.

5-7

Chapter 5, Solutions

LG5

5-26 Present Value of a Perpetuity A perpetuity pays $50 per year and interest rates are 9

percent. How much would its value change if interest rates decreased to 8 percent? Did the

value increase or decrease?

Use equation 5-5:

PV of a perpetuity

$50

$555.55

0.09

PV of a perpetuity

$50

$625.00

0.08

The difference between these perpetuities is $69.45. The value of the perpetuity increased

with a decrease in the interest rate.

LG6

5-27 Future and Present Value of an Annuity Due If you start making $50 monthly

contributions today and continue them for 5 years, whats their future value if the

compounding rate is 10 percent APR? What is the present value of this annuity?

Compute the future value using equation 5-2:

FVA 60 $50

0.10/12

PVA 60

LG6

1

1 1 0.10 / 12 60

$50

0.10/12

5-28 Future and Present Value of an Annuity Due If you start making $75 monthly

contributions today and continue them for 4 years, what is their future value if the

compounding rate is 12 percent APR? What is the present value of this annuity?

First calculate the future values and present values, using equations 5-2 and 5-4,

respectively. Using these results, the annuity due values can be computed using equations

5-6 and 5-7, respectively.

FVA 48 $75

0.12/12

5-8

Chapter 5, Solutions

PVA 48

1

1 1 0.12 / 12 48

$75

0.12/12

LG7

5-29 Compound Frequency Payday loans are very short-term loans that charge very high

interest rates. You can borrow $250 today and repay $300 in two weeks. What is the

compounded annual rate implied by this 20 percent rate charged for only two weeks?

20% for two weeks needs to be compounded 26 times to form a year.

(1 + i)26 1 = (1 + 0.20)26 1 = 113.475 = 11,347.5%

LG7

5-30 Compound Frequency Payday loans are very short-term loans that charge very high

interest rates. You can borrow $500 today and repay $575 in two weeks. What is the

compounded annual rate implied by this 15 percent rate charged for only two weeks?

15% for two weeks needs to be compounded 26 times to form a year.

(1 + i)26 1 = (1 + 0.15)26 1 = 36.857 = 3,685.7%

LG8

5-31 Annuity Interest Rate Whats the interest rate of a 5-year, annual $5,000 annuity

with present value of $20,000?

Use equation 5-2 and solve for i:

20,000 $5,000

1 i 5 1 i 7.93%

i

LG8

5-32 Annuity Interest Rate Whats the interest rate of a 7-year, annual $4,000 annuity with

present value of $20,000?

Use equation 5-2 and solve for i:

20,000 $4,000

1 i 7 1 i 9.20%

i

LG8

5-33 Annuity Interest Rate What annual interest rate would you need to earn if you wanted

a $1,000 per month contribution to grow to $75,000 in 5 years?

5-9

Chapter 5, Solutions

$75,000 $1,000

1 i / 12 60 1 i .732%

i/12

Now convert the monthly interest rate to an annual rate by multiplying by 12 which yields

8.78%.

or TVM calculator: N=60, PV=0, PMT=-1,000, FV=75,000, CPT I = 0.732%

LG8

5-34 Annuity Interest Rate What annual interest rate would you need to earn if you wanted

a $500 per month contribution to grow to $45,000 in 6 years?

Use equation 5-2 and solve for i:

$45,000 $500

1 i / 12 72 1 i .60809%

i/12

Now convert the monthly interest rate to an annual rate by multiplying by 12 which yields

7.30%.

or TVM calculator: N=72, PV=0, PMT=-500, FV=45,000, CPT I = 0.608%

LG9

5-35 Loan Payments You wish to buy a $25,000 car. The dealer offers you a 4-year loan

with a 10 percent APR. What are the monthly payments? How would the payment differ if

you paid interest only? What would the consequences of such a decision be?

Use equation 5-9:

PMT48 $25,000

.10 / 12

1

1

1 .10 / 12 48

If you only paid interest over the length of the loan and your principal balance was repaid at

the end of the 48 months, your payment would be $208.33 per month (= $25,0000.1012)

for interest only and you would owe $25,000 at the end of the 48 months, too.

LG9

5-36 Loan Payments You wish to buy a $10,000 dining room set. The furniture store offers

you a 3-year loan with a 11 percent APR. What are the monthly payments? How would the

payment differ if you paid interest only? What would the consequences of such a decision

be?

Use equation 5-9:

5-10

Chapter 5, Solutions

PMT36 $10,000

.11 / 12

1

1

1 .11 / 12 36

If you only paid interest over the length of the loan and your principal balance was repaid at

the end of the 36 months, your payment would be $91.67 per month (= $10,0000.1112)

for interest only and you would owe $10,000 at the end of the 36 months, too.

LG10 5-37 Number of Annuity Payments Joey realizes that he has charged too much on his

credit card and has racked up $5,000 in debt. If he can pay $150 each month and the card

charges 17 percent APR (compounded monthly), how long will it take him to pay off the

debt?

Rewrite equation 5-9 in terms of N:

ln 150

150 5,000 0.17 / 12

N

45.4 months

ln 1 0.17 / 12

LG10 5-38 Number of Annuity Payments Phoebe realizes that she has charged too much on her

credit card and has racked up $6,000 in debt. If she can pay $200 each month and the card

charges 18 percent APR (compounded monthly), how long will it take her to pay off the

debt?

Rewrite equation 5-9 in terms of N:

ln 200

200 6,000 0.18 / 12

N

40.15 months

ln 1 0.18 / 12

Advanced

Problems

LG1

5-39 Future Value Given a 8 percent interest rate, compute the year 7 future value if

deposits of $1,000 and

$2,000 are made in years 1, and 3, respectively, and a withdrawal of $500 is made in year 4.

Use equation 5-1:

$629.86 = $3,677.99

LG1

5-40 Future Value Given a 9 percent interest rate, compute the year 6 future value if

deposits of $1,500 and $2,500 are made in years 2, and 3, respectively, and a withdrawal of

$700 is made in year 5.

5-11

Chapter 5, Solutions

FV = $1,500 (1 + 0.09) 4 + $2,500 (1 + 0.09)3 - $700 (1 + 0.09)1 = $2,117.37 + $3,237.57

$763 = $4,591.94

LG4

LG9

5-41 Low Financing or Cash Back? A car company is offering a choice of deals. You

can receive $500 cash back on the purchase, or a 3 percent APR, 4-year loan. The price of

the car is $15,000 and you could obtain a 4-year loan from your credit union, at 7 percent

APR. Which deal is cheaper?

Compare two cases. The first case is to elect the 3% APR and fully finance $15,000 over 48

months. Using equation 5-9, the payment under this scenario would be:

PMT48 15,000

0.03 / 12

1

1

1 0.03/12 48

$332.01

The second case is to take the $500 cash back, apply it to the purchase and finance only

$14,500 through your credit union at 7%. The payment under this scenario would be:

PMT48 14,500

0.07 / 12

1

1

1 0.07/12 48

$347.22

The lower payment represents the more advantageous scenario that you should choose,

electing the 3% financing through the car dealer.

LG4

LG9

5-42 Low Financing or Cash Back? A car company is offering a choice of deals. You

can receive $1,000 cash back on the purchase, or a 2 percent APR, 5-year loan. The price of

the car is $20,000 and you could obtain a 5-year loan from your credit union, at 7 percent

APR. Which deal is cheaper?

Compare two cases. The first case is to elect the 2% APR and fully finance $20,000 over 60

months. Using equation 5-9, the payment under this scenario would be:

PMT60 20,000

0.03 / 12

1

1

1 0.02/12 60

$350.56

The second case is to take the $1,000 cash back, apply it to the purchase and finance only

$19,000 through your credit union at 7%. The payment under this scenario would be:

5-12

Chapter 5, Solutions

PMT60 19,000

0.07 / 12

1

1

1 0.07/12 60

$376.22

The lower payment represents the more advantageous scenario that you should choose,

electing the 2% financing through the car dealer.

LG9

5-43 Amortization Schedule Create the amortization schedule for a loan of $15,000, paid

monthly over 3 years using a 9 percent APR.

Month

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

Beginning

Balance

$15,000.00

14,635.50

14,268.27

13,898.29

13,525.53

13,149.98

12,771.61

12,390.40

12,006.33

11,619.38

11,229.53

10,836.76

10,441.03

10,042.35

9,640.67

9,235.98

8,828.25

8,417.47

8,003.60

7,586.63

7,166.54

6,743.29

6,316.87

5,887.25

5,454.41

5,018.32

4,578.96

4,136.31

3,690.33

3,241.02

2,788.33

2,332.24

1,872.74

1,409.79

Total

Payment

$477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

477.00

Interest

Paid

$112.50

109.77

107.01

104.24

101.44

98.62

95.79

92.93

90.05

87.15

84.22

81.28

78.31

75.32

72.31

69.27

66.21

63.13

60.03

56.90

53.75

50.57

47.38

44.15

40.91

37.64

34.34

31.02

27.68

24.31

20.91

17.49

14.05

10.57

Principal

Paid

$364.50

367.23

369.98

372.76

375.55

378.37

381.21

384.07

386.95

389.85

392.77

395.72

398.69

401.68

404.69

407.73

410.78

413.86

416.97

420.10

423.25

426.42

429.62

432.84

436.09

439.36

442.65

445.97

449.32

452.69

456.08

459.50

462.95

466.42

5-13

Ending

Balance

$14,635.50

14,268.27

13,898.29

13,525.53

13,149.98

12,771.61

12,390.40

12,006.33

11,619.38

11,229.53

10,836.76

10,441.03

10,042.35

9,640.67

9,235.98

8,828.25

8,417.47

8,003.60

7,586.63

7,166.54

6,743.29

6,316.87

5,887.25

5,454.41

5,018.32

4,578.96

4,136.31

3,690.33

3,241.02

2,788.33

2,332.24

1,872.74

1,409.79

943.37

Chapter 5, Solutions

35

36

LG9

477.00

477.00

7.08

3.55

469.92

473.45

473.45

0.00

5-44 Amortization Schedule Create the amortization schedule for a loan of $5,000, paid

monthly over 2 years using a 8 percent APR.

Month

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

LG4

LG9

943.37

473.45

Beginning

Balance

$5,000.00

4,807.20

4,613.11

4,417.73

4,221.04

4,023.04

3,823.73

3,623.08

3,421.10

3,217.77

3,013.09

2,807.04

2,599.62

2,390.81

2,180.61

1,969.01

1,756.00

1,541.57

1,325.71

1,108.42

889.67

669.46

447.79

224.64

Total

Payment

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

$226.14

Interest

Paid

$33.33

$32.05

$30.75

$29.45

$28.14

$26.82

$25.49

$24.15

$22.81

$21.45

$20.09

$18.71

$17.33

$15.94

$14.54

$13.13

$11.71

$10.28

$8.84

$7.39

$5.93

$4.46

$2.99

$1.50

Principal

Paid

$192.80

194.09

195.38

196.68

198.00

199.32

200.64

201.98

203.33

204.68

206.05

207.42

208.81

210.20

211.60

213.01

214.43

215.86

217.30

218.75

220.21

221.67

223.15

224.64

Ending

Balance

$4,807.20

4,613.11

4,417.73

4,221.04

4,023.04

3,823.73

3,623.08

3,421.10

3,217.77

3,013.09

2,807.04

2,599.62

2,390.81

2,180.61

1,969.01

1,756.00

1,541.57

1,325.71

1,108.42

889.67

669.46

447.79

224.64

0.00

5-45 Investing for Retirement Monica has decided that she wants to build enough

retirement wealth that, if invested at 8 percent per year, will provide her with $3,500 of

monthly income for 30 years. To date, she has saved nothing, but she still has 25 years until

she retires. How much money does she need to contribute per month to reach her goal?

First, calculate the amount you would need to have in 25 years time to yield the $3,500

monthly payments for an additional 30 years. Use equation 5-4 to calculate this present

value:

5-14

Chapter 5, Solutions

1

1 1 0.08 / 12 360

PVA $3,500

0.08/12

$476,992.23

This amount will become the future value in the next calculation, assuming 8% interest and

300 level monthly payments. Use equation 5-2 and solve for the monthly payment:

$476,992.23 PMT

LG4

LG9

0.08/12

$501.56

5-46 Investing for Retirement Ross has decided that he wants to build enough retirement

wealth that, if invested at 7 percent per year, will provide him with $4,000 of monthly

income for 30 years. To date, he has saved nothing, but he still has 20 years until he retires.

How much money does he need to contribute per month to reach his goal?

First, calculate the amount you would need to have in 20 years time to yield the $4,000

monthly payments for an additional 30 years. Use equation 5-4 to calculate this present

value:

1

1 1 0.07 / 12 360

PVA $4,000

0.07/12

$601,230.27

This amount will become the future value in the next calculation, assuming 7% interest and

240 level monthly payments. Use equation 5-2 and solve for the monthly payment:

240

1 0.07 / 12 1

$601,230.27 PMT

PMT

0.07/12

LG9

$1,154.16

5-47 Loan Balance Rachel purchased a $15,000 car two years ago using an 8 percent, 4year loan. He has decided that he would sell the car now, if he could get a price that would

pay off the balance of his loan. What is the minimum price Rachel would need to receive for

his car?

First calculate the monthly payment that she has been paying using equation 5-9:

PMT48 15,000

0.08 / 12

1

1

1 0.08/12 48

$366.19

The loan balance is the principal amount outstanding. The duration of remaining payments

is 24, the interest rate is 8% annual and the monthly payment is $366.19 from the previous

calculation. Use these values to calculate the present value of the loan using equation 5-4:

5-15

Chapter 5, Solutions

PVA

1

1 1 0.08 / 12 24

$366.19

0.08/12

$8,096.66

This is the minimum price the car needs to be sold for and it represents her break even price.

LG9

5-48 Loan Balance Hank purchased a $20,000 car two years ago using an 9 percent, 5-year

loan. He has decided that he would sell the car now, if he could get a price that would pay

off the balance of his loan. Whats the minimum price Hank would need to receive for his

car?

First calculate the monthly payment that he has been paying using equation 5-9:

PMT60 20,000

0.09 / 12

1

1

1 0.09/12 60

$415.17

The loan balance is the principal amount outstanding. The duration of remaining payments

is 36, the interest rate is 9% annual and the monthly payment is $415.17 from the previous

calculation. Use these values to calculate the present value of the loan using equation 5-4:

PVA

1

1 1 0.09 / 12 36

$415.17

0.09/12

$13,055.77

This is the minimum price the car needs to be sold for and it represents his break even price.

LG9

5-49 Teaser Rate Mortgage A mortgage broker is offering a $183,900 30-year mortgage

with a teaser rate. In the first two years of the mortgage, the borrower makes monthly

payments on only a 4 percent APR interest rate. After the second year, the mortgage interest

rate charged increases to 7 percent APR. What are the monthly payments in the first two

years? What are the monthly payments after the second year?

Use equation 5-9 to calculate the payment using the teaser rate:

PMT360 $183,900

0.04 / 12

1

1

1 0.04 / 12 360

$877.97

Now calculate the outstanding loan balance after the first 24 payments using equation 5-4:

5-16

Chapter 5, Solutions

PVA 336

1

1 1 0.04 / 12 336

$877.97

0.04/12

$177,291.62

Now use this amount for the present value, the new interest rate of 7% over the remaining

336 payments in equation to calculate the new payment amount after expiration of the teaser

rate, using equation 5-9:

PMT336 $177,291.62

0.07 / 12

1

1

1 0.07 / 12 336

LG9

$1,204.89

5-50 Teaser Rate Mortgage A mortgage broker is offering a $279,000 30-year mortgage

with a teaser rate. In the first two years of the mortgage, the borrower makes monthly

payments on only a 4.5 percent APR interest rate. After the second year, the mortgage

interest rate charged increases to 7.5 percent APR. What are the monthly payments in the

first two years? What are the monthly payments after the second year?

Use equation 5-9 to calculate the payment using the teaser rate:

PMT360 $279,000

0.045 / 12

1

1

1 0.045 / 12 360

$1,413.65

Now calculate the outstanding loan balance after the first 24 payments using equation 5-4:

PVA 336

1

1 1 0.045 / 12 336

$1,413.65

0.045/12

$269,791.04

Now use this amount for the present value, the new interest rate of 7.5% over the remaining

336 payments in equation to calculate the new payment amount after expiration of the teaser

rate, using equation 5-9:

PMT336 $269,791.04

0.075 / 12

1

1

1 0.075 / 12 336

$1,923.25

5-51 Excel Problem Consider a person who begins contributing to a retirement plan at age

25 and contributes for 40 years until retirement at age 65. For the first ten years, she

5-17

Chapter 5, Solutions

contributes $3,000 per year. She increases the contribution rate to $5,000 per year in years

11 through 20. This is followed by increases to $10,000 per year in years 21 through 31 and

to $15,000 per year for the last ten years. This money earns a 9 percent return, first

compute the value of the retirement plan when she turns age 65. Then compute the annual

payment she would receive over the next 40 years if the wealth was converted to an annuity

payment at 8 percent.

End of

Age

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

Contribution

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$3,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$5,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$10,000.00

$15,000.00

$15,000.00

$15,000.00

$15,000.00

$15,000.00

$15,000.00

$15,000.00

$15,000.00

Total Wealth

$3,000.00

$6,270.00

$9,834.30

$13,719.39

$17,954.13

$22,570.00

$27,601.30

$33,085.42

$39,063.11

$45,578.79

$54,680.88

$64,602.16

$75,416.35

$87,203.83

$100,052.17

$114,056.87

$129,321.98

$145,960.96

$164,097.45

$183,866.22

$210,414.18

$239,351.45

$270,893.08

$305,273.46

$342,748.07

$383,595.40

$428,118.99

$476,649.70

$529,548.17

$587,207.50

$655,056.18

$729,011.23

$809,622.25

$897,488.25

$993,262.19

$1,097,655.79

$1,211,444.81

$1,335,474.84

5-18

Chapter 5, Solutions

63

64

$15,000.00

$15,000.00

PMT =

$1,470,667.58

$1,618,027.66

($135,688.06)

Research It!

Retirement Income Calculators

The Internet provides some excellent retirement income calculators. You can find one by

Googling retirement income calculator. Many of the calculators allow you to determine

your predicted annual income from a retirement nest egg under different assumptions. For

example, you can spend only the investment income generated from the nest egg. Most

retirees try not to touch the principal. Or, you can spend both the income and the nest egg

itself. These calculators let you input the size of the retirement wealth and the investment

return to be earned. They then make time value computations to determine the annual

income the nest egg will provide.

Go to a retirement income calculator like the one at MSN Money. Use the calculator to

create a retirement scenario. Use the TVM equations or a financial calculator to check the

Internet results.

(http://moneycentral.msn.com/investor/calcs/n_retire/main.asp)

SOLUTION: Assuming the principal amount is exhausted and the amount of savings at my

retirement at age 65, here is what the calculator gives.

Summary

Given a certain amount of savings, how much can I spend annually during

retirement?

Your annual income is estimated to be $70,000.

Information entered

1. Savings

Amount saved

Rate of return

Inflation rate

Average effective tax rate

$1,000,000

7%

3.8%

22.6%

2. Retirement years

Retirement age

Life expectancy

Estate amount

65 years

85 years

$0

5-19

Chapter 5, Solutions

Using a financial calculator, the following inputs are needed to determine the projected

annual payment:

n = 20 years

i = 1.07/1.038 -1 = 3.083%

PV = $1,000,000

CPT PMT = $67,732.56 (The calculator rounds this amount to the nearest $10,000 for an

estimate of $70,000 gross annually.)

Consider Gunther, a new freshman who has just received a Stafford student loan and started

college. He plans to obtain the maximum loan from Stafford at the beginning of each year.

Although Gavin does not have to make any payments while he is in school, the 6.8 percent

interest owed (compounded monthly) accrues and is added to the balance of the loan.

Stafford loan limits:

Freshman

$2,625

Sophomore $3,500

Junior

$5,500

Senior

$5,500

After graduation, Gavin gets a six month grace period. This means that monthly payments

are still not required, but interest is still accruing. After the grace period, the standard

repayment plan is to amortize the debt using monthly payments for 10 years.

a. Show a time line of when the loans will be taken.

b. What will be the loan balance when Gavin graduates after his fourth year of school?

c. What is the loan balance six months after graduation?

d. Using the standard repayment plan and a 6.8 percent APR interest rate, compute the

monthly payments Gavin owes after the grace period.

SOLUTION:

a. Show a time line of when the loans will be taken.

Cash Flows $2,625

Period 0

6.8%

$3,500

1

$5,500

6.8% 2

5-20

$5,500

6.8% 3

6.8% 4 6.8%

5 years

Chapter 5, Solutions

b. What will be the loan balance when Gavin graduates after his fourth year of school?

Each payment needs to be moved forward with 6.8% interest to the middle of years 4 and 5

to calculate the outstanding accrued loan balance as of the date payments are set to begin:

FV4 = $2,625 (1.068)4 + $3,500 (1.068)3 + $5,500 (1.068)2 + $5,500 (1.068)1

FV4 = $3,415.19 + $4,263.65 + $6,273.43 + $5,874.00 = $19,826.27

c. What is the loan balance six months after graduation?

Each payment needs to be moved forward with 6.8% interest to the middle of years 4 and 5

to calculate the outstanding accrued loan balance as of the date payments are set to begin:

FV4.5= $2,625 (1.068)4.5 + $3,500 (1.068)3.5 + $5,500 (1.068)2.5 + $5,500 (1.068)1.5

FV4.5= $3,529.39 + $4,406.23 + $6,483.22 + $6,070.43 = $20,489.27

Note, this can be checked by multiplying $19,826.27 by 1.0680.5.

d. Using the standard repayment plan and a 6.8 percent APR interest rate, compute the

monthly payments Gavin owes after the grace period.

Using equation 5-9, the monthly payments will be:

PMT120 $20,489.27

0.068 / 12

1

1

1 0.068 / 12 120

$235.79

4&5-1 Future Value Consider that you are 35 years old and have just changed to a new job.

You have $80,000 in the retirement plan from your former employer. You can roll that

money into the retirement plan of the new employer. You will also contribute $5,000 each

year into your new employers plan. If the rolled-over money and the new contributions

both earn a 7 percent return, how much should you expect to have when you retire in 30

years?

The future value can be calculated by adding the accumulated value of $80,000 brought

forward with interest 30 years to a 30 year annuity of $5,000 per year, both using the 7%

interest assumption. Use equations 5-1 and 5-2 and add the results:

FVA Abe 65 $80,000 1 0.07

30

$5,000

5-21

0.07

Chapter 5, Solutions

4&5-2 Future Value Consider that you are 45 years old and have just changed to a new job.

You have $150,000 in the retirement plan from your former employer. You can roll that

money into the retirement plan of the new employer. You will also contribute $8,000 each

year into your new employers plan. If the rolled-over money and the new contributions

both earn an 8 percent return, how much should you expect to have when you retire in 20

years?

The future value can be calculated by adding the accumulated value of $150,000 brought

forward with interest 20 years to a 20 year annuity of $8,000 per year, both using the 8%

interest assumption. Use equations 5-1 and 5-2 and add the results:

20

1 0.08 1

FVA Abe 65 $150,000 1 0.08 $8,000

$699,143.57 $366,095.71 $1,065,239.

20

0.08

4&5-3 Future Value and Number of Annuity Payments Your client has been given a

trust fund valued at $1 million. He cannot access the money until he turns 65 years old,

which is in 25 years. At that time, he can withdrawal $25,000 per month. If the trust fund is

invested at a 5.5 percent rate, how many months will it last your client once he starts to

withdraw the money?

Using equation 5-1, $1 million will accumulate for 25 more years at 5.5% interest for a

future value:

FVA Abe 65 $1,000,000 1 0.055

25

$3,813,392.35

ln 25,000

25

,

000

3

,

813

,

392

.

35

0

.

055

/

12

263 months

N

ln1 0.055 / 12

4&5-4 Future Value and Number of Annuity Payments Your client has been given a trust

fund valued at $1.5 million. She cannot access the money until she turns 65 years old,

which is in 15 years. At that time, she can withdraw $20,000 per month. If the trust fund is

invested at a 5 percent rate, how many months will it last your client once she starts to

withdraw the money?

Using equation 5-1, $1.5 million will accumulate for 15 more years at 5% interest for a

future value:

Now, rewrite equation 5-9 in terms of N:

5-22

Chapter 5, Solutions

ln 20,000

20,000 3,118,392.27 0.05 / 12

N

253 months

ln 1 0.05 / 12

4&5-5 Present Value and Annuity Payments A local furniture store is advertising a deal

in which you buy a $3,000 dining room set and do not need to pay for two years (no interest

cost is incurred). How much money would you have to deposit now in a savings account

earning 5 percent APR, compounded monthly, to pay the $3,000 bill in two years?

Alternatively, how much would you have to deposit in the savings account each month to be

able to pay the bill?

Use equation 5-1 and solve for the lump sum payment:

PV $3,000 1 0.05 / 12

24

$2,715.08

$3,000 PMT

1 0.05/12 24 1 PMT

0.05/12

4&5-6 Present Value and Annuity Payments A local furniture store is advertising a deal in

which you buy a $5,000 living room set with 3 years before you need to make any payments

(no interest cost is incurred). How much money would you have to deposit now in a

savings account earning 4 percent APR, compounded monthly, to pay the $5,000 bill in

three years? Alternatively, how much would you have to deposit in the savings account each

month to be able to pay the bill?

Use equation 5-1 and solve for the lump sum payment:

PV $5,000 1 0.04 / 12

36

$4,435.49

$5,000 PMT

1 0.04/12 36 1 PMT

0.04/12

$130.95

4&5-7 House Appreciation and Mortgage Payments Say that you purchase a house for

$200,000 by getting a mortgage for $180,000 and paying a $20,000 down payment. If you

get a 30-year mortgage with a 7 percent interest rate, what are the monthly payments? What

would the loan balance be in 10 years? If the house appreciates at 3 percent per year, what

will be the value of the house in 10 years? How much of this value is your equity?

Use equation 5-9 to calculate your monthly payment:

5-23

Chapter 5, Solutions

PMT $180,000

0.07 / 12

1

1

1 0.07 / 12 360

$1,197.54

In ten years, you will have 240 payments of $1,197.54 left to pay. The present value can be

calculated using equation 5-4:

PVA 240

1

1 1 0.07 / 12 240

$1,197.54

0.07/12

$154,461.71

An appreciation of 3% per year will result in a forecast future value of the home using the

original purchase price in equation 5-1:

FV10 years $200,000 1 .03

10

$268,783.28

The amount of equity is the difference between the homes value and the outstanding

balance on the mortgage:

Equity = $268,783.28 - $154,461.17 = $114,321.57

4&5-8 House Appreciation and Mortgage Payments Say that you purchase a house for

$150,000 by getting a mortgage for $135,000 and paying a $15,000 down payment. If you

get a 15-year mortgage with a 7 percent interest rate, what are the monthly payments? What

would the loan balance be in 5 years? If the house appreciates at 4 percent per year, what

will be the value of the house in 5 years? How much of this value is your equity?

Use equation 5-9 to calculate your monthly payment:

PMT $135,000

0.07 / 12

1

1

1 0.07 / 12 180

$1,213.42

In ten years, you will have 120 payments of $1,213.42 left to pay. The present value can be

calculated using equation 5-4:

PVA 120

1

1 1 0.07 / 12 120

$1,213.42

0.07/12

$104,507.44

An appreciation of 4% per year will result in a forecast future value of the home using the

original purchase price in equation 5-1:

5-24

Chapter 5, Solutions

5

The amount of equity is the difference between the homes value and the outstanding

balance on the mortgage:

Equity = $182,497.94-$104,507.44=$77,990.50

4&5-9 Construction Loan You have secured a loan from your bank for 2 years to build

your home. The terms of the loan are that you will borrow $100,000 now and an additional

$100,000 in one year. Interest of 10 percent APR will be charged on the balance monthly.

Since no payments will be made during the two-year loan, the balance will grow at the 10%

compounded rate. At the end of the two years, the balance will be converted to a traditional

30-year mortgage at a 6 percent interest rate. What will you paying monthly mortgage

payments (Principal and Interest only)?

Use equation 5-1 to calculate the capitalized value of your mortgage at the end of year 2:

FV2 $100,000 1 0.10 / 12

24

$100,000 1 0.10/12

12

$232,510.41

This is the amount that you will need to finance over 30 years at 6%. Use equation 5-9 to

compute the monthly payment:

PMT $232,510.41

0.06 / 12

1

1

1 0.06 / 12 360

$1,394.02

4&5-10 Construction Loan You have secured a loan from your bank for 2 years to build

your home. The terms of the loan are that you will borrow $100,000 now and an additional

$50,000 in one year. Interest of 9 percent APR will be charged on the balance monthly.

Since no payments will be made during the two-year loan, the balance will grow. At the end

of the two years, the balance will be converted to a traditional 30-year mortgage at a 7

percent interest rate. What will you pay as monthly mortgage payments (Principal and

Interest only)?

Use equation 5-1 to calculate the capitalized value of your mortgage at the end of year 2:

FV2 $100,000 1 0.09 / 12

24

$50,000 1 0.09/12

12

$174,331.69

This is the amount that you will need to finance over 30 years at 7%. Use equation 5-9 to

compute the monthly payment:

5-25

Chapter 5, Solutions

PMT $174,331.69

0.07 / 12

1

1

1 0.07 / 12 360

5-26

$1,159.83

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