Tutorial 1 - Time Value of Money 2018 PDF

Principles of Finance
Tutorial n°1: Time Value of Money

Professor: Dr. Ridha Esghaier
(Winter 2018)
Multiple Choices Questions:
Q1. Which of the following is/are NOT CORRECT?

a. In compound rate of interest, the interest earned on the principal during the specified period do not earn interest in the
subsequent periods.
b. In simple rate of interest, the interest earned on the principal during the specified period do not earn interest in the
subsequent periods.
c. If a loan has a nominal rate of 12%, then the effective annual rate can never be less than 12%.
d. If there is annual compounding, then the effective, periodic, and nominal rates of interest are all the same.
e. An investment that compounds interest semiannually, and has a nominal rate of 10%, will have an effective annual
rate less than 10%.
Q2. Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years.
One is an ordinary (or deferred) annuity, while the other is an annuity due. Which of the following statements is/are
CORRECT?
a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an
ordinary annuity may be less than the future value of the annuity due.
b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the
annuity due is less than the future value of the ordinary annuity.
c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the
annuity due also exceeds the future value of the ordinary annuity.
d. The present value of the annuity due equals the present value of the ordinary annuity and the future value of the
annuity due equals the future value of the ordinary annuity.
e. The present value of the ordinary annuity exceeds the present value of the annuity due, and the future value of an
ordinary annuity also exceeds the future value of the annuity due.
Q3. Which of the following is/are TRUE?

a. Investments with the same nominal interest rate but different compounding intervals provide different effective
annual returns.
b. To compare investments with different compounding intervals, you must look at their effective annual returns
c. The effective annual rate of interest can be used in calculations when annuity payments don’t match compounding
periods.
d. The future value of a lump sum is larger if compounded more often, but its present value is smaller. (holding the
stated interest rate constant)
e. When the number of compounding periods per year increases, the effective annual rate of interest increases and the
periodic rate decreases
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EXERCISES:
Exercise n°1: Future Value calculation
A person places the following amounts in a savings account paying 7% interest compounded
annually :
- $5,000 in 1/1/2012
- $8,000 in 1/1/2013
- $10,000 in 1/1/2015
- $12,000 in 31/12/2015
a. Calculate the capital obtained in 1/1/2017.
b. Calculate the amount of Interest.
Exercise n°2: present value and Future Value comparison of uneven cash flow stream
Find the present values (at t=0) and the future values (at t=3) of the following cash flow streams
under compound interest rate of 8%.
Which cash flow stream has the higher present value and the higher future value? Why?
YEAR CASH STREAM A CASH STREAM B
1 $100 $300
2 $200 $200
3 $300 $100
Exercise n°3: future value of an annuity

A person places the two series of annuity at 6% compound interest:
- Four annual equal amount of $9,000 (first capital in 1/1/2010).
- Three annual equal amount of $5,000 (first capital in 1/1/2015).
a- Calculate the capital obtained in 31/12/2018.
b- Calculate the amount of interest.
Exercise n°4: present value of an annuity
You are given three investment alternatives to analyze. The cash flows from these three
investments are as follows:
End of Years 1 2 3 4 5 6 7 8 9
Invest A 10000 10000 10000 10000 10000
Invest B 10000 10000 10000 10000 10000
Invest C 10000 50000 10000
Assuming a 5% interest rate (discount rate), find the present value (at t=0) of each investment.
Exercise n°5: Compound interest

You would like to have $75,000 in 15 years. To accumulate this amount, you plan to deposit each
year an equal sum in the bank, which will earn 8% interest compounded annually. Your first payment
will be made at the end of the year.
a- How much must you deposit annually to accumulate this amount?
b- If you decide to make a lump-sum deposit today instead of the annual deposits, how large should this
lump-sum deposit be? (Assume you can earn 8% on this deposit.)
c- At the end of 5 years you will receive $20,000 and deposit this in the bank toward your goal of
$75,000 at the end of 15 years. In addition to this deposit, how much must you deposit in equal
annual deposits to reach your goal? (Again, assume that you can earn 8% on this deposit.)
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Exercise n°6: Future value of an annuity for various compounding periods
Find the future values of the following ordinary annuities:
a- FV of $400 each 6 months for 5 years at a nominal rate of 12%, compounded semiannually
b- FV of $200 each 3 months for 5 years at a nominal rate of 12%, compounded quarterly
c- The annuities described in parts a and b have the same amount of money paid into them during
the 5-year period, and both earn interest at the same nominal rate, yet the annuity in part b earns
more than the one in part a over the 5 years.
Why does this occur?
Exercise n°7: Future value of an annuity

In 10 years you are planning on retiring and buying a house. The house you are looking at
currently costs $100,000 and is expected to increase in value each year at a rate of 5%.
Assuming you can earn 10% in placing a same amount at the end of each of the next 10 years to
be able to buy your dream home when you retire. Compute this amount.
Exercise n°8 :Value of missing payments

You recently made a 20-year investment that pays you $100 at t = 1, $500 at t = 2, $750 at t = 3, and
some fixed cash flow, X, at the end of each of the remaining 17 years. You purchased this
investment for $5,544.87. Alternative investments of equal risk have a required return of 9% (that is,
the annual interest rate is 9%). What is the annual cash flow received at the end of each of the final
17 years, that is, what is X?
Exercise n°9 : Effective annual rate

You want to borrow $1,000 from a friend for one year, and you propose to pay her $1,120 at the end
of the year. She agrees to lend you the $1,000, but she wants you to pay her $10 of interest at the
end of each of the first 11 months plus $1,010 at the end of the 12th month. How much higher is the
effective annual rate under your friend’s proposal than under your proposal?
Exercise n°10: Nominal and effective rates

An investment pays you 9% interest compounded semiannually. A second investment of equal risk,
pays interest compounded quarterly. What annual nominal rate of interest would you have to receive
on the second investment in order to make you indifferent between the two investments?
Exercise n°11: loan amortization

You just borrowed $45,000 from a bank at an annual interest rate of 6% to be reimbursed over 5
years.
Construct the amortization schedule in each of the following cases:
A/ reimbursement through Fixed Principal
B/ reimbursement through constant Payment
C/ Interest-only loan (reimbursement through constant interest)
Exercise n°12 : constant payments Vs constant principals amortization

A five-year loan of $2,000 is to be repaid with payments at the end of each year. It can be repaid
under the following two options:
(a) Equal annual payments at an annual rate of 8%.
(b) Installments of $400 each year plus interest on the unpaid balance at an annual rate of i.
The sum of the payments under option (a) equals the sum of the payments under option (b)
Determine i.
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Exercise n°13: Loan amortization
A company borrows $100,000 at 8% interest. Equal annual payments are to be made for 6 years.
However at the time of 4th payment, the company decides to pay off the entire loan.
a- Find the equal annual installment (annual payment).
b- Compute the amount of the first principal portion to be repaid at the end of the first year.
b- Calculate the amount of the loan to be paid at the end of the 4th year (the rest).
Exercise n°14: Time to pay off loan

A mortgage of $50,000, with monthly payments $657.07 at 6% annual interest is contemplated.
What amount of time will be required to pay off the mortgage?

Tutorial 1 - Time Value of Money 2018 PDF

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Tutorial 1 - Time Value of Money 2018 PDF

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Principles of Finance

Tutorial n°1: Time Value of Money

Multiple Choices Questions:

Q1. Which of the following is/are NOT CORRECT?

Q3. Which of the following is/are TRUE?

Exercise n°3: future value of an annuity

Exercise n°5: Compound interest

Exercise n°7: Future value of an annuity

Exercise n°8 :Value of missing payments

Exercise n°9 : Effective annual rate

Exercise n°10: Nominal and effective rates

Exercise n°11: loan amortization

Exercise n°12 : constant payments Vs constant principals amortization

Exercise n°14: Time to pay off loan

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