Chapter4TimeValueofMoney71

Principles of Managerial Finance

Arab World Edition
Gitman, Zutter, Elali, Al-Roubaie

Part

Important Financial
Concepts
ChaptersinthisPart
Chapter4

TimeValueofMoney

Chapter5

RiskandReturn

Chapter6

InterestRatesandBondValuation

Chapter7

StockValuation

Chapter4TimeValueofMoney

Chapter 4
Time Value of Money
Instructors Resources
Overview
Thischapterintroducesanimportantfinancialconcept:thetimevalueofmoney.ThePVandFVofasum,
aswellasthepresentandfuturevaluesofanannuity,areexplained.Specialapplicationsoftheconcepts
includeintrayearcompounding,mixedcashflowstreams,mixedcashflowswithanembeddedannuity,
perpetuities,depositstoaccumulateafuturesum,andloanamortization.Numerousbusinessandpersonal
financialapplicationsareusedasexamples.Thechapterdriveshometheneedtounderstandtimevalueof
moneyattheprofessionallevelbecausefundingfornewassetsandprogramsmustbejustifiedusingthese
techniques.Decisionsinastudentspersonallifeshouldalsobeacceptableonthebasisofapplyingtime
valueofmoneytechniquestoanticipatedcashflows.

Answers to Review Questions

41

Whatisthedifferencebetweenfuturevalueandpresentvalue?Whichapproachisgenerally
preferredbyfinancialmanagers?Why?
Futurevalue(FV),thevalueofapresentamountatafuturedate,iscalculatedbyapplying
compoundinterestoveraspecifictimeperiod.Presentvalue(PV),representsthedollarvaluetoday
ofafutureamount,ortheamountyouwouldinvesttodayatagiveninterestrateforaspecifiedtime
periodtoequalthefutureamount.Financialmanagerspreferpresentvaluetofuturevaluebecause
theytypicallymakedecisionsattimezero,beforethestartofaproject.

42

Defineanddifferentiateamongthethreebasicpatternsofcashflow:(1)asingleamount,(2)
anannuity,and(3)amixedstream.
Asingleamountcashflowreferstoanindividual,standalone,valueoccurringatonepointintime.
Anannuityconsistsofanunbrokenseriesofcashflowsofequaldollaramountoccurringovermore
thanoneperiod.Amixedstreamisapatternofcashflowsovermorethanonetimeperiodandthe
amountofcashassociatedwitheachperiodwillvary.

43

Howisthecompoundingprocessrelatedtothepaymentofinterestonsavings?Whatisthe
generalequationforfuturevalue?

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Compoundingofinterestoccurswhenanamountisdepositedintoasavingsaccountandtheinterest
paidafterthespecifiedtimeperiodremainsintheaccount,therebybecomingpartoftheprincipalfor
thefollowingperiod.Thegeneralequationforfuturevalueinyearn(FVn)canbeexpressedusingthe
specifiednotationasfollows:
FVnPV(1i)n
44

Whateffectwouldadecreaseintheinterestratehaveonthefuturevalueofadeposit?What
effectwouldanincreaseintheholdingperiodhaveonfuturevalue?
Adecreaseintheinterestratelowersthefutureamountofadepositforagivenholdingperiod,
sincethedepositearnslessatthelowerrate.Anincreaseintheholdingperiodforagiveninterest
ratewouldincreasethefuturevalue.TheincreasedholdingperiodincreasestheFVsincethedeposit
earnsinterestoveralongerperiodoftime.

45

Whatismeantbythepresentvalueofafutureamount?Whatisthegeneralequationfor
presentvalue?
Thepresentvalueofafutureamountindicateshowmuchmoneytodaywouldbeequivalenttothe
futureamountifonecouldinvestthatamountataspecifiedrateofinterest.Usingthegivennotation,
thepresentvalueofafutureamount(FVn)canbedefinedasfollows:

1
n
(1 i )

PV FV
46

Whateffectdoesincreasingtherequiredreturnhaveonthepresentvalueofafutureamount?
Why?
Anincreasingrequiredrateofreturnwouldreducethepresentvalueofafutureamount,sincefuture
dollarswouldbeworthlesstoday.LookingattheformulaforpresentvalueinQuestion5,itshould
beclearthatbyincreasingtheivalue,whichistherequiredreturn,thepresentvalueinterestfactor
woulddecrease,therebyreducingthepresentvalueofthefuturesum.

47

Howarepresentvalueandfuturevaluecalculationsrelated?
Presentvaluecalculationsaretheexactinverseofcompoundinterestcalculations.Usingcompound
interest,oneattemptstofindthefuturevalueofapresentamount;usingpresentvalue,oneattempts
tofindthepresentvalueofanamounttobereceivedinthefuture.

48

Whatisthedifferencebetweenanordinaryannuityandanannuitydue?Whichismore
valuable?Why?
Anordinaryannuityisoneforwhichpaymentsoccurattheendofeachperiod.Anannuitydueis
oneforwhichpaymentsoccuratthebeginningofeachperiod.
Theordinaryannuityisthemorecommon.Forotherwiseidenticalannuitiesandinterestrates,the
annuitydueresultsinahigherFVbecausecashflowsoccurearlierandhavemoretimeto
compound.

49

Whatarethemostefficientwaystocalculatethepresentvalueofanordinaryannuity?

Chapter4TimeValueofMoney

Themostefficientwaystocalculatepresentvalueofanordinaryannuityareusingafinancial
calculator,analgebraicshortcutorExcelspreadsheet.
410 Howcantheformulaforthefuturevalueofanannuitybemodifiedtofindthefuturevalueof
anannuitydue?
Youcancalculatethefuturevalueofanannuityduebymultiplyingthevaluecalculatedforan
ordinaryannuitybyoneplustheinterestrate.
411 Howcantheformulaforthepresentvalueofanordinaryannuitybemodifiedtofindthe
presentvalueofanannuitydue?
Youcancalculatethepresentvalueofanannuityduebymultiplyingthevaluecalculatedforan
ordinaryannuitybyoneplustheinterestrate.
412 Whatisaperpetuity?Whyisthepresentvalueofaperpetuityequaltotheannualcash
paymentdividedbytheinterestrate?
Aperpetuityisaninfinitelivedannuity.IfyoumultiplethePVbytherequiredrateofreturn,i,one
isidentifyingtheannualrequirerequiredonagivenvalue.TheunknownisthePV,sotheknown
cashflowisdividedbytherequiredreturn.
413 Howisthefuturevalueofamixedstreamofcashflowscalculated?Howisthepresentvalue
ofamixedstreamofcashflowscalculated?
Thefuturevalueofamixedstreamofcashflowsiscalculatedbymultiplyingeachyearscashflow
bytheappropriatefuturevalueinterestfactor.Tofindthepresentvalueofamixedstreamofcash
flowsmultiplyeachyearscashflowbytheappropriatepresentvalueinterestfactor.Therewillbe
atleastasmanycalculationsasthenumberofcashflows.
414 Whateffectdoescompoundinginterestmorefrequentlythanannuallyhaveon(a)future
valueand(b)theeffectiveannualrate(EAR)?Why?
Asinterestiscompoundedmorefrequentlythanonceayear,both(a)thefuturevalueforagiven
holdingperiodand(b)theeffectiveannualrateofinterestwillincrease.Thisisduetothefactthat
themorefrequentlyinterestiscompounded,thegreaterthequantityofmoneyaccumulatedand
reinvestedastheprincipalvalue.Insituationsofintrayearcompounding,theactualrateofinterest
isgreaterthanthestatedrateofinterest.
415 Howdoesthefuturevalueofadepositsubjecttocontinuouscompoundingcomparetothe
valueobtainedbyannualcompounding?
Continuouscompoundingassumesinterestwillbecompoundedaninfinitenumberoftimesper
year,atintervalsofmicroseconds.Continuouscompoundingofagivendepositatagivenrateof
interestresultsinthelargestvaluewhencomparedtoanyothercompoundingperiod.
416 Differentiatebetweenanominalannualrateandaneffectiveannualrate(EAR).Define
annualpercentagerate(APR)andannualpercentageyield(APY).

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Thenominalannualrateisthecontractualratethatisquotedtotheborrowerbythelender.The
effectiveannualrate,sometimescalledthetruerate,istheactualratethatispaidbytheborrowerto
thelender.Thedifferencebetweenthetworatesisduetothecompoundingofinterestatafrequency
greaterthanonceperyear.
APRistheannualpercentagerateandisrequiredbytruthinlendinglawstobedisclosedto
consumers.Thisrateiscalculatedbymultiplyingtheperiodicratebythenumberofperiodsin
oneyear.Theperiodicrateisthenominalrateovertheshortesttimeperiodinwhichinterestis
compounded.TheAPY,orannualpercentageyield,istheeffectiverateofinterestthatmustbe
disclosedtoconsumersbybanksontheirsavingsproductsasaresultofthetruthinsavingslaws.
Theselawsresultinbothfavorableandunfavorableinformationtoconsumers.Thegoodnewsisthat
ratequotesonbothloansandsavingsarestandardizedamongfinancialinstitutions.Thenegativeis
thattheAPR,orlendingrate,isanominalrate,whiletheAPY,orsavingrate,isaneffectiverate.
Theseratesarethesamewhencompoundingoccursonlyonceperyear.
417 Howcanyoudeterminethesizeoftheequal,annual,endofperioddepositsnecessaryto
accumulateacertainfuturesumattheendofaspecifiedfutureperiodatagivenannual
interestrate?
Thesizeoftheequalannualendofyeardepositsneededtoaccumulateagivenamountoveracertain
timeperiodataspecifiedratecanbefoundbyinputtingthenumberofyearsintheinvestment
horizon,discountrate,anddesiredfutureamountintothecalculator.Problemslikethisalways
requireacalculatororExcelspreadsheet.
418 Describetheprocedureusedtoamortizealoanintoaseriesofequalperiodicpayments.
Amortizingaloanintoequalannualpaymentsinvolvesfindingthefuturepaymentswhosepresent
valueattheloaninterestratejustequalstheamountoftheinitialprincipalborrowed.
419 Whichpresentvalueinterestfactorswouldbeusedtofind(a)thegrowthrateassociatedwith
aseriesofcashflowsand(b)theinterestrateassociatedwithanequalpaymentloan?
a. Eitherthepresentvalueinterestfactororthefuturevalueinterestfactorcanbeusedtofindthe
growthrateassociatedwithastreamofcashflows.
Thegrowthrateassociatedwithastreamofcashflowsmaybefoundbyusingthefollowing
equation,wherethegrowthrate,g,issubstitutedfork.
PV =

FVn
(1 g )

Tofindtherateatwhichgrowthhasoccurred,theamountreceivedintheearliestyearisdividedby
theamountreceivedinthelatestyear.ThisquotientisthePVIF i%;n.Thegrowthrateassociatedwith
thisfactormaybefoundinthePVIFtable.
b. Tofindtheinterestrateassociatedwithanequalpaymentloan,thepresentvalueinterestfactorsfor
aonedollarannuitytablewouldbeused.
Todeterminetheinterestrateassociatedwithanequalpaymentloan,thefollowingequationmaybe
used:
PVnPMT(PVIFAi%,n)
SolvingtheequationforPVIFAi%,nweget:

Chapter4TimeValueofMoney

PVIFA i %,n

PVn
PMT

ThensubstitutethevaluesforPVnandPMTintotheformula,usingthePVIFAtabletofindthe
interestratemostcloselyassociatedwiththeresultingPVIFA,whichistheinterestrateontheloan.
420 Howcanyoudeterminetheunknownnumberofperiodswhenyouknowthepresentand
futurevaluessingleamountorannuityandtheapplicablerateofinterest?
Thebestwaytodetermineanunknownnumberofperiodsisthoughuseofacalculatoror
spreadsheet.Inbothinstances,youenterthecashflowsandinterestrate,andthencomputethe
numberofperiodsneededtoequatecashinflowsandoutflows.Ifthefuturecashflowisalump
sum,thefuturecashflowisenteredasaFVamount.Ifthefuturecashflowsareanannuity,you
enterthesizeofanysinglepaymentasthePMTamount.Ifthereisbothaseriesofpaymentsand
finalcashflowofadifferentsize,boththeFVandPMTamountsareinput.Itiscriticaltocorrectly
enterthesizeofthecashflows.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Suggested Answer to Focus on Ethics Box:

How Fair Is Check Into Cash?
The391%mentionedisanannualnominalrate[15%(365/14)].Shouldthe2weekrate(15%)be
compoundedtocalculatetheeffectiveannualinterestrate?
No,therolloverfeeisasimple$15per2weekperiod.Inotherwords,the15%2weekrateisonlyapplied
totheoriginalprincipal.Inthiscase,interestisnotcompoundingwitheachadditionalrolloverperiod,and
thereforetheeffectiveannualratewillbeequalto15%365/14.Thatisstillawhopping391%,orover
1%eachday!

Suggested Answer to Focus on Practice Box:

The Impact of the Subprime Crisis on GCC Countries
Asareactiontoproblemsinthesubprimearea,lendersarealreadytighteninglendingstandards.
Whateffectwillthishaveonthehousingmarket?
The tightening of bank regulatory measures, in the aftermath of the subprime crisis in the United States,
has forced banks and other financial institutions to introduce new restrictions on mortgages. New buyers
are faced with high credit costs and tight lending standards. Such restrictive lending practices have
negatively affected the housing market by discouraging prospective home buyers from obtaining
mortgages. Regulatory authorities share blame with lending institutions for the subprime crisis by neither
being vigilant against fraud nor being systematic in monitoring credit activities by financial institutions.
In the GCC countries, the construction sector, in large measure fueled by the residential housing market,
has been among the most important drivers engendering rapid economic growth during the past two
decades. Not surprisingly, therefore, governments in the region provide generous credit packages for their
nationals to fund construction (or purchase) of residential property for their habitation. A good example is
Qatar, where nationals are eligible to take out affordable low interest mortgages up to $330,000 repayable
up to 37 years. Most nationals in United Arab Emirates, however, have been provided houses by the state
and, therefore, they have little need to borrow large amount for building houses. Accordingly, risk of credit
default in the GCC housing market is low. Garnering further information from
http://www.arabianbusiness.com/affordable-housing-in-gcc-national-policies-future-needs-485240.html,
students should debate the merits of alternate policy approaches by governments to secure affordable
housing for its citizenry.

Answers to Warm-Up Exercises

E41.

Futurevalueofalumpsuminvestment

Answer: FV$2,500(10.007)$2,517.50
E42.

Findingthefuturevalue

Answer: Sincetheinterestiscompoundedmonthly,thenumberofperiodsis41248andthe
monthlyinterestrateis1/12thoftheannualrate.

Chapter4TimeValueofMoney

FV48 PV(1I) whereIisthemonthlyinterestrate

48

0.02120.00166667

FV48 ($1,260$975)(10.00166667)48
FV48 ($2,235)1.083215$2,420.99
Ifusingafinancialcalculator,setthecalculatorto12compoundingperiodsperyearandinput
thefollowing:
PV$2,235I/year2
N48(months)
SolveforFVFV$2,420.99
Note:Notallfinancialcalculatorsworkinthesamemanner.Somerequiretheusertousethe
CPT(Compute)button.Othersrequiretheusertocalculatethemonthlyinterestrateandinput
thatamountratherthantheannualrate.Thestepsshowninthesolutionmanualwillbethe
inputsneededtousetheHewlettPackard10Bor10BIImodels.Theyaresimilartothesteps
followedwhenusingtheTexasInstrumentsBAIIcalculators.
Ifusingaspreadsheet,thesolutionis:
ColumnA

ColumnB

Cell1

Futurevalueofasingleamount

Cell2

Presentvalue

Cell3

Interestrate,pctperyearcompoundedmonthly

2/12

Cell4

Numberofmonths

412

Cell5

Futurevalue

FV(B3,B4,0,B2,0)

$2,235

CellB5$2,420.99
E43.

Comparingalumpsumwithanannuity

Answer: Thisproblemcanbesolvedineitheroftwoways.Bothalternativescanbecomparedaslump
sumsinnetpresentvaluetermsorbothalternativescanbecomparedasa25yearannuity.In
eachcase,oneofthealternativesneedstobeconverted.
Method1:Performalumpsumcomparison.Compare$1.3millionnowwiththepresentvalue
ofthetwentyfivepaymentsof$100,000peryear.Inthiscomparison,thepresentvalueofthe
$100,000annuitymustbefoundandcomparedwiththe$1.3million.(Besuretosetthecalculator
to1compoundingperiodperyear.)

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

PMT $100,000
N 25
I 5%
SolveforPV
PV$1,409,394(greaterthan$1.3million)
Choosethe$100,000annuityoverthelumpsum.
Method2:Comparetwoannuities.Sincethe$100,000peryearisalreadyanannuity,allthat
remainsistoconvertthe$1.3millionintoa25yearannuity.
PV $1.3million
N 25years
I 5%
SolveforPMT
PMT$92,238.19(lessthan$100,000)
Choosethe$100,000annuityoverthelumpsum.
Youmayusethetablemethodoraspreadsheettodothesameanalysis.
E44.

Comparingthepresentvalueoftwoalternatives

Answer: Tosolvethisproblemyoumustfirstfindthepresentvalueoftheexpectedsavingsoverthe
5yearlifeofthesoftware.
Year

SavingsEstimate

PresentValue
ofSavings

$35,000

$32,110

50,000

42,084

45,000

34,748

25,000

17,710

15,000

9,749
$136,401

Sincethe$136,401presentvalueofthesavingsexceedsthe$130,000costofthesoftware,the
firmshouldinvestinthenewsoftware.
Youmayuseafinancialcalculator,thetablemethodoraspreadsheettofindthePVofthe
savings.

Chapter4TimeValueofMoney

E45.

Compoundingmorefrequentlythanannually

Answer: NationalBank:
mn

FV1 PV 1
m

FV1 $12,000 (1 0.03/2)2

FV1 $12,000 (1 0.03/2)2 $12,000 1.030225 $12,362.70
Selwyns:
FV1 PV (ei n ) $12,000 (2.71830.02751 )
$12,0000 1.027882 $12,334.58
Josephshouldchoosethe3%ratewithsemiannualcompounding.
E46.

Determiningdepositsneededtoaccumulateafuturesum

Answer: Thefinancialcalculatorinputisasfollows:
FV$150,000
I

N18

6%

SolveforPMT.PMT$4,853.48

Solutions to Problems
P41.

Usingatimeline
a,b,andc

d. Financialmanagersrelymoreonpresentvaluethanfuturevaluebecausetheytypicallymake
decisionsbeforethestartofaproject,attimezero,asdoesthepresentvaluecalculation.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Futurevaluecalculation:FVnPV(1I)n

P42.

Case
A
B
C
D
P43.

N = 2, I = 12%, PV = $1, Solve for FV = 1.2544

N = 3, I = 6%, PV = $1, Solve for FV = 1.1910
N = 2, I = 9%, PV = $1, Solve for FV = 1.1881
N= 4,I= 3%,PV= $1,SolveforFV= 1.1259

Timevalue:
a.

N = 5, PV = $10,200, FV = 15,000

b. N = 5, PV = $8,150, FV =

$15,000
Solve for I = 8.02%
c.

P44.

Solve for I = 12.98%

N = 5, PV = $7150, FV = $15,000
SolveforI= 15.97%

Singlepaymentloanrepayment:
a. N = 1, I = 14%, PV = $200
Solve for FV1 = $228

b. N = 4, I = 14%, PV = $200
Solve for FV4 = $337.79

c. N = 8, I = 14%, PV = $200
SolveforFV8= $570.52

P45.Presentvalues:

P46.

Cashflowinvestmentdecision:PVFVn (PVIFi%,n)
A

N=5,I=10%,FV=$30,000

SolveforPV=$18,627.64
C

N=20,I=10%,FV=$3,000
SolveforPV=$445.93

N=10,I=10%,FV=$10,000

SolveforPV=$3,855.43

SolveforPV=$331.42

Purchase

DoNotPurchase

N=40,I=10%,FV=$15,000

Chapter4TimeValueofMoney

P47.

Timevalueannuities
a.

AnnuityC(Ordinary)
(1)N=10,I=10%,PMT=$2,500
SolveforFV=$39,843.56

AnnuityD(Due)
N=10,I=10%,PMT=$2,200
SolveforFV=$35,062.33
AnnuityDueAdjustment
$35,062.331.1=$38,568.57

(2)N=10,I=20%,PMT=$2,500
SolveforFV=$64,896.71

N=10,I=20%,PMT=$2,200
SolveforFV=$57,109.10
AnnuityDueAdjustment
$57,109.101.2=$68,530.92

b. (1) Attheendofyear10,atarateof10%,AnnuityChasagreatervalue($39,843.56vs.
$38,568.57).
(2) Attheendofyear10,atarateof20%,AnnuityDhasagreatervalue($68,530.92vs.
$64,896.71).
c.

AnnuityC(Ordinary)
(1)N=10,I=10%,PMT=$2,500
SolveforPV=$15,361.14
(2)N=10,I=20%,PMT=$2,500
SolveforPV=$10.481.18

AnnuityD(Due)
N=10,I=10%,PMT=$2,200
SolveforPV=$13,518.05
AnnuityDueAdjustment
$13,518.051.1=$14,869.85
N=10,I=20%,PMT=$2,200
SolveforPV=$9,223.44
AnnuityDueAdjustment
$9,223.441.2=$11,068.13

d. (1)Atthebeginningofthe10years,atarateof10%,AnnuityChasagreatervalue
($15,361.14vs.$14,869.85).
(2) Atthebeginningofthe10years,atarateof20%,AnnuityDhasagreatervalue
($11,068.13vs.$10,481.18).
e.

AnnuityC,withanannualpaymentof$2,500madeattheendoftheyear,hasahigherpresent
valueat10%thanAnnuityDwithanannualpaymentof$2,200madeatthebeginningofthe
year.Whentherateisincreasedto20%,theshorterperiodoftimetodiscountatthehigher
rateresultsinalargervalueforAnnuityD,despitethelowerpayment.

P48.Valueofanannuityversusasingleamount
a.

N= 25,I= 5%,PMT= $40,000

Solve for PV = $563,757.78
At 5%, taking the award as an annuity is better; the present value is $563,760, compared to
receiving $500,000 as a lump sum. However, one has to live at least 23.5 years [25
(63,757.78 excess/ $40,000)] to benefit more from the annuity stream of payments.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

b. N=25,I=7%,PMT=$40,000
SolveforNPV=$466,143.33
At7%,takingtheawardasalumpsumisbetter;thepresentvalueoftheannuityisonly
$466,160,comparedtothe$500,000lumpsumpayment.
c.

Viewthisproblemasaninvestmentof$500,000togeta25yearannuityof$40,000.The
discount rate that equates the two sums is 6.24%, calculated at follows:
N= 25,PV= $500,000,PMT= $40,000
SolveforI= 6.24

P49.Valueofamixedstream
a.

b. CF1=$30,000,CF2=$25,000,CF3=$15,000,F3=7,CF4=$10,000
SetI=12
SolveforNPV=$104,508.28
c. Harteshouldaccepttheseriesofpaymentsoffer.Thepresentvalueofthatmixedstreamof
paymentsisgreaterthanthe$100,000immediatepayment.

P410. Fundingbudgetshortfalls
a.

CF1= $5,000,CF2= $4,000,CF3= $6,000,CF4= $10,000,CF5= $3,000

Set I = 8
SolveforNPV= $22,214.03

Adepositof$22,215wouldbeneededtofundtheshortfall.
b. Anincreaseintheearningsratewouldreducetheamountcalculatedinpart(a).Thehigher
ratewouldleadtoalargerinterestbeingearnedeachyearontheinvestment.Thelargerinterest
amountswillpermitadecreaseintheinitialinvestmenttoobtainthesamefuturevalue
availableforcoveringtheshortfall.
P411. Compoundingfrequency,timevalue,andeffectiveannualrates
a.

Compoundingfrequency:

Chapter4TimeValueofMoney

A
C

N=10,I=3%,PV=$2,500
olveforFV5=$3,359.79
N=10,I=5%,PV=$1,000
SolveforFV10=$1,628.89

b. Effectiveinterestrate:ieff(1i%/m)m1
A
ieff(10.06/2)21

B
D

iefff(10.03)21
ieff(1.061)1
ieff0.06106.1%
C

ieff(10.05/1)11
ieff(10.05)11
ieff(1.05)1
ieff0.055%

N=18,I=2%,PV=$50,000
SolveforFV3=$71,412.31
N=24,I=4%,PV=$20,000
SolveforFV6=$51,226.08
ieff(10.12/6)61
ieff(10.02)61
ieff(1.126)1
ieff0.12612.6%

ieff(10.16/4)41
ieff(10.04)41
ieff(1.170)1
ieff0.1717%

c. Theeffectiveratesofinterestriserelativetothestatednominalratewithincreasing
compoundingfrequency.
P412. Compoundingfrequencyandtimevalue
a.

(1)N= 10;I= 8%,PV= $2,000

Solve for FV = $4,317.85
(3) N = 3650; I = 8 365 = 0.022, PV = $2,000
SolveforFV= $4,450.69

b. (1) ieff(10.08/1)11
ieff(10.08)11
ieff(1.08)1
ieff0.088%
(3) ieff(10.08/365)3651
ieff(10.00022)3651
ieff(1.0833)1
ieff0.08338.33%
c.

(2)N= 20,I= 4%,PV= $2,000

Solve for FV $4,382.25
(4) FV10 = $2,000 (e0.8)
SolveforFV$4,451.08

(2) ieff(10.08/2)21
ieff(10.04)21
ieff(1.082)1
ieff0.0828.2%
(4) ieff(ek1)
ieff(e0.081)
ieff(1.08331)
ieff0.08338.33%

Compoundingcontinuouslywillresultin$134moredollarsattheendofthe10yearperiod
thancompoundingannually.
d. Themorefrequentthecompoundingthelargerthefuturevalue.Thisresultisshowninparta
bythefactthatthefuturevaluebecomeslargerasthecompoundingperiodmovesfrom
annuallytocontinuously.Sincethefuturevalueislargerforagivenfixedamountinvested,
theeffectivereturnalsoincreasesdirectlywiththefrequencyofcompounding.Inpartbwe
seethisfactastheeffectiveratemovedfrom8%to8.33%ascompoundingfrequencymoved
fromannuallytocontinuously.
P413. Accumulatingagrowingfuturesum
Step 1:Determining the cost of a home in 20 years.
N = 20, I = 6%, PV = $185,000

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

Solve for FV20 = $593,320.06

Step 2: Determining how much has to be saved annual to afford home.
Step 2: Determining how much has to be saved annually to afford home.
N = 20, I = 10%, FV = $593,295
SolveforPMT= $10,359.15
P414.Inflation,timevalue,andannualdeposits
a. N = 25, I = 5%, PV $200,000
SolveforFV= $677,270.99
b. N=25,I=9%,FV=$677,270.99
SolveforPMT=$7,996.03
c.

SinceMohammadwillhaveanadditionalyearonwhichtoearninterestattheendofthe25
yearshisannuitydepositwillbesmallereachyear.Todeterminetheannuityamount
Mohammadwillfirstdiscountbackthe$677,200oneperiod.
N = 1, I = 9%, FV25 = $677,270.99
Solve for PV = $621,349.53
ThisistheamountMohammadmustaccumulateoverthe25years.Mohammadcansolvefor
hisannuityamountusingthesamecalculationasinpartb.
N=25,I=9,FV=$621,349.53
SolveforPMT=7,335.80
Tocheckthisvalue,multiplytheannualpaymentby1plusthe9%discountrate.
$7,335.81(1.09)=$7996.03

P415. Loanamortizationschedule
a.

N= 3,I= 14%,PV= $15,000

SolveforPMT= $6,460.97

b.
Payments

Endof
Year

Loan
Payment

Beginningof
YearPrincipal

Interest

Principal

EndofYear
Principal

$6,459.95

$15,000.00

$2,100.00

$4,359.95

$10,640.05

6,459.95

10,640.05

1,489.61

4,970.34

5,669.71

6,459.95

5,669.71

793.76

5,666.19

(Thedifferenceinthelastyearsbeginningandendingprincipalisduetorounding.)
c.

Throughannualendoftheyearpayments,theprincipalbalanceoftheloanisdeclining,
causinglessinteresttobeaccruedonthebalance.

P416. Growthrates
a.

Chapter4TimeValueofMoney

Case
A N=4,PV=$500,FV=$800.
SolveforI=12.47%
C N=6,PV=$2,500,FV=$2,900
SolveforI=2.50%

N=9,PV=$1,500,FV=$2,280
SolveforI=4.76%.

b.
Case
A Sameasina
B Sameasina
C Sameasina
c.

Thegrowthrateandtheinterestrateshouldbeequal,sincetheyrepresentthesamething.

P417. Rateofreturnandinvestmentchoice
a.
A
C

N = 6, PV = 5,000, FV = $8,400
Solve for I = 9.03%
N = 4, PV = $5,000, FV = $7,600
SolveforI= 11.04%

B
D

N = 15, PV = $5,000, FV = $15,900

Solve for I = 8.02%
N = 10, PV = $5,000, FV = $13,000
SolveforI= 10.03%

b. InvestmentCprovidesthehighestreturnofthefouralternatives.Assumingequalriskforthe
alternatives,KuloodshouldchooseC.
P418. Interestrateforanannuity
Defendantsinterestrateassumption
N = 25, PV = $2,000,000, PMT = $156,000
SolveforI= 5.97%
b. Prosecutioninterestrateassumption
N = 25, PV = $2,000,000, PMT = $255,000
SolveforI= 12.0%
c. N= 25,I= 9%,PV= $2,000,000
SolveforPMT= $203,612.50
a.

P419. Loanratesofinterest:PVAnPMT(PVIFAi%,n)
a.
Loan A
Loan B
N = 5, PV = $5,000, PMT = $1,352.81
= 4, PV = $5,000 PMT = $1,543.21
Solve for I = 11.0%
Solve for I = 9.0%
Loan C
N = 3, PV = $5,000, PMT = $2,010.45
SolveforI= 10.0%
b. Mr.FarookshouldchooseLoanB,whichhasthelowestinterestrate.
P420. Timetoaccumulateagivensum

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

a.I=10%,PV=$10,000,FV=$20,000
SolveforN=7.27years
b.I=7%,PV=$10,000,FV=$20,000
SolveforN=10.24years
c.I=12%,PV=$10,000,FV=$20,000
SolveforN=6.12years
d.Thehighertherateofinterest,thelesstimeisrequiredtoaccumulateagivenfuturesum.
P421. Ethicsproblem
Thisisatoughissue.EvenbackintheMiddleAges,scholarsdebatedtheideaofajustprice.
Theethicaldebatehingeson(1)thebasisforusurylaws,(2)whetherfulldisclosureismadeof
thetruecostoftheadvance,and(3)whethercustomersunderstandthedisclosures.Usurylawsare
premisedonthenotionthatthereissuchathingasaninterestrate(priceofcredit)thatistoo
high.Acenturiesoldfairnessnotionguidesusintonottakingadvantageofsomeoneinduressor
facinganemergencysituation.Onemustask,too,whytherearenotmarketsuppliedcredit
sourcesforborrowers,whichwouldchargelowerinterestratesandreceiveanacceptablerisk
adjustedreturn.Onissues#2and#3,thereisnoassurancethatborrowerscomprehendorare
givenadequatedisclosures.Seetheboxforthekeyethicsissuesonwhichtorefocusattention
(somewouldviewtheobjectioncitedasasmokescreentotakeourattentionoffthetrueethical
issuesinthiscreditoffer).
As with regard to Islamic finance, compliance with Islamic law requires financial transactions be
conducted free of interest charges. Interest or Riba is considered ethically and morally
unacceptable because of its unjust distributional effects and exploitative nature. A guaranteed
revenue stream implies that the lender only shares profit but not losses. Islamic finance provides
alternative vehicles for interest payment by obtaining profit from investment activities designed to
create new assets and generate additional wealth. The prohibition of interest arguably renders
Islamic financial activities more stable by curbing speculative transactions designed to extract
wealth from borrowers while shirking business risks incurred by borrowers in the real economy in
a way that amplifies moral hazards. Yet, the controversy over interest-free transactions continues
unabated, and therefore, students in finance ought to partake in the debate by comparing the merits
of Islamic instruments with conventional financial means of debt finance.

MyFinanceLab
Furtherchapterrelevantproblemsandassignmentscanbefoundatthebooksaccompanyingresource:
MyFinanceLab.Gotowww.myfinancelab.com.

Chapter4TimeValueofMoney

Case
Funding Nadia Sarhans Retirement Annuity
Chapter4scasechallengesthestudenttoapplypresentvalueandfuturevaluetechniquestoarealworld
situation.ThefirststepinsolvingthiscaseistodeterminethetotalamountSunriseIndustriesneedsto
accumulateuntilMs.Sarhanretires,rememberingtotakeintoaccounttheinterestthatwillbeearned
duringthe20yearpayoutperiod.Oncethatiscalculated,theannualamounttobedepositedcanbe
determined.
1.

2.

Totalamounttoaccumulatebyendofyear12
N = 20, I = 12%, PMT = $42,000
SolveforPV= $313,716.63

3.

Endofyeardeposits,9%interest:
N = 12, I = 9%, FV = $313,716.63
SolveforPMT= $15,576.24

SunriseIndustriesmustmakea$15,576.24annualendofyeardepositinyears112inorderto
provideMs.Sarhanaretirementannuityof$42,000peryearinyears13to32.
4.

Endofyeardeposits,10%interest
N = 12, I = 10%, FV = $313,716.63
SolveforPMT= $14,670.43

Thecorporationmustmakea$14,670.43annualendofyeardepositinyears112inorderto
provideMs.Sarhanaretirementannuityof$42,000peryearinyears13to32.

GitmanPrinciplesofManagerialFinance,ArabWorld Edition

5.

Initialdepositifannuityisaperpetuityandinitialdepositearns9%:
PVperp = PMT r
PVperp = $42,000 0.12
PVperp = $350,000
End-of-year deposit:
N = 12, I = 9%, FV = $350,000
SolveforPMT= $17,377.73

Spreadsheet Exercise
TheanswertoChapter4sHudaCorporationspreadsheetproblemislocatedinMyFinanceLab:
www.myfinancelab.com.