174 Part 2 Fundamental Concepts in Financial Management

SELF-TEST QUESTIONS AND PRUBLEMS’

(Solutions Appear in Appendix A)

ST-1 KEY TERMS Define each of the following terms:
Time line
FVx; PV; I; INT; N; FVA; PMT; PVAN
e a0 e
mEm Compounding; discounting
Simple interest; compound interest
Opportunity cost
Annuity; ordinary (deferred) annuity; annuity due; perpetuity
Uneven (nonconstant) cash flow; payment (PMT); cash flow (CF,)
Annual compounding; semiannual compounding
Nominal (quoted) interest rate; annual percentage rate (APR); effective (equivalent)
annual rate (EAR or EFF%)
j. Amortized loan; amortization schedule
ST-2 FUTURE VALUE It is now January 1, 2015. Today you will deposit $1,000 into a savings
account that pays 8%.
. If the bank compounds interest annually, how much will you have in your account on
January 1, 20182
b. What will your January 1, 2018, balance be if the bank uses quarterly compounding?
<. Suppose you deposit $1,000 in three payments of $333.333 each on January 1 of 2016,
2017, and 2018. How much will you have in your account on January 1, 2018, based on
8% annual compounding?
How much will be in your account if the three payments begin on January 1, 20152
e Suppose you deposit three equal payments into your account on January 1 of 2016,
2017, and 2018. Assuming an 8% interest rate, how large must your payments be to
have the same ending balance as in part a?
ST-3 TIME VALUE OF MONEY It is now January 1, 2015; and you will need $1,000 on January 1,
2019, in 4 years. Your bank compounds interest at an 8% annual rate.
2. How much must you deposit today to have a balance of $1,000 on January 1, 20197
b. If you want to make four equal payments on each January 1 from 2016 through 2019 to
accumulate the $1,000, how large must each payment be? (Note that the payments
begin a year from today.)
<. If your father offers to make the payments calculated in part b (5221.92) or to give you
$750 on January 1, 2016 (a year from today), which would you choose? Explain.
d. If you have only $750 on January 1, 2016, what interest rate, compounded annually for
3 years, must you eamn to have $1,000 on January 1, 20197
e Suppose you can deposit only $200 each January 1 from 2016 through 2019 (4 years).
What interest rate, with annual compounding, must you earn to end up with $1,000 on
January 1, 2019?
f. Your father offers to give you $400 on January 1, 2016. You will then make six
additional equal payments each 6 months from July 2016 through January 2019. If your
bank pays 8% compounded semiannually, how large must each payment be for you to
end up with $1,000 on January 1, 20197
g What s the EAR, or EFF%, eamed on the bank account in part 2 What is the APR
eamed on the account?
sT-4 EFFECTIVE ANNUAL RATES Bank A offers loans at an 8% nominal rate (its APR)
but requires that interest be paid quarterly; that is, it uses quarterly compounding.
Bank B wants to charge the same effective rate on its loans, but it wants to collect
interest on a monthly basis, that is, to use monthly compounding. What nominal rate
‘must Bank B set?
 Chapter 5 Time Value of Money 175

QuEsTIONS

What is an opportunity cost? How is this concept used in TVM analysis, and where is it
shown on a time line? Is a single number used in all situations? Explain.
52 Explain whether the following statement is true or false: $100 a year for 10 years is an
annuity; but $100 in Year 1, $200 in Year 2, and $400 in Years 3 through 10 does not
constitute an annuity. However, the second series contains an annuity.
53 If a firm's earnings per share grew from $1 to §2 over a 10-year period, the fofal growth
would be 100%, but the annual growth rate would be less than 10%. True or false? Explain.
(Hint: If you aren't sure, plug in some numbers and check it out.)
54 Would you rather have a savings account that pays 5% interest compounded semiannually
or one that pays 5% interest compounded daily? Explain.
55 To find the present value of an uneven series of cash flows, you must find the PVs of the
individual cash flows and then sum them. Annuity procedures can never be of use, even
when some of the cash flows constifute an annuity, because the entire series is not an
annuity. True or false? Explain.
56 ‘The present value of a perpetuity is equal to the payment on the annuity, PMT, divided by
the interest rate, I : PV — PMT/L. What is the future value of a perpetuity of PMT dollars per
year? (Hint: The answer is infinity, but explain why.)
57 Banks and other lenders are required to disclose a rate called the APR. What is this rate?
Why did Congress require that it be disclosed? Is it the same as the effective annual rate? If
you were comparing the costs of loans from different lenders, could you use their APRs to
determine the loan with the lowest effective interest rate? Explain.
58 What is a loan amortization schedule, and what are some ways these schedules are used?

ProBLEMS
Easy 51 FUTURE VALUE If you deposit $10,000 in a bank account that pays 10% interest annually,
Problems how much will be in your account after 5 years?
18 52 PRESENT VALUE What is the present value of a security that will pay $5,000 in 20 years if
securities of equal risk pay 7% annually?
FINDING THE REQUIRED INTEREST RATE Your parents will retire in 18 years. They
currently have $250,000 saved, and they think they will need $1,000,000 af retirement.
What annual interest rate must they earn to reach their goal, assuming they don’t save any
additional funds?
54 TIME FOR A LUMP SUM TO DOUBLE _If you deposit money today in an account that pays
6.5% annual interest, how long will it take to double your money?
55 TIME TO REACH A FINANCIAL GOAL You have $42,180.53 in a brokerage account, and you
plan to deposit an additional $5,000 at the end of every future year until your account totals
$250,000. You expect to eamn 12% annually on the account. How many years will it take to
reach your goal?
56 FUTURE VALUE: ANNUITY VERSUS ANNUITY DUE What's the future value of a 7%, 5-year
ordinary annuity that pays $300 each year? If this was an annuity due, what would its
future value be?
57 PRESENT AND FUTURE VALUES OF A CASH FLOW STREAM An investment will pay $100
at the end of each of the next 3 years, $200 at the end of Year 4, $300 at the end of Year 5,
and $500 at the end of Year 6. If other investments of equal risk eam 8% annually, what is
its present value? Its future value?
58 LOAN AMORTIZATION AND EAR You want to buy a car, and a local bank will lend you
$20,000. The loan will be fully amortized over 5 years (60 months), and the nominal interest
rate will be 12% with interest paid monthly. What will be the monthly loan payment? What
will be the loan’s EAR?
176 Part 2 Fundamental Concepts in Financial Management

Intermediate 59 PRESENT AND FUTURE VALUES FOR DIFFERENT PERIODS Find the following values using
Problems. the equations and then a financial calculator. Compounding/discounting occurs annually.
9-26 a. An initial $500 compounded for 1 year at 6%
b. An initial $500 compounded for 2 years at 6%
¢ The present value of $500 due in 1 year at a discount rate of 6%
d. The present value of $500 due in 2 years at a discount rate of 6%
510 PRESENT AND FUTURE VALUES FOR DIFFERENT INTEREST RATES Find the following
values. Compounding/discounting occurs annually.
a. Aninitial $500 compounded for 10 years at 6%
b. An initial $500 compounded for 10 years at 12%
<. The present value of $500 due in 10 years at 6%
d. The present value of $1,5552.90 due in 10 years at 12% and at 6%
Define present value and illustrate it using a time line with data from part d. How are
present values affected by interest rates?
®

511 GROWTH RATES Shalit Corporation’s 2014 sales were $12 million. Its 2009 sales were
$6 million.
a. At what rate have sales been growing?
b. Suppose someone made this statement: “Sales doubled in 5 years. This represents a
growth of 100% in 5 years; so dividing 100% by 5, we find the growth rate to be 20%
per year.” Is the statement correct?
512 EFFECTIVE RATE OF INTEREST Find the interest rates earned on each of the following:
2. You borrow $700 and promise to pay back $749 at the end of 1 year.
b. You lend $700 and the borrower promises to pay you $749 at the end of 1 year.
<. You borrow $85,000 and promise to pay back $201,229 at the end of 10 years.
d. You borrow $9,000 and promise to make payments of $2,684.80 at the end of each year
for 5 years.
513 TIME FOR A LUMP SUM TO DOUBLE How long will it take $200 to double if it earns the
following rates? Compounding occurs once a year.
a 7%
b 10%
o 18%
d. 100%
514 FUTURE VALUE OF AN ANNUITY Find the future values of these ordinary annuities. Com-
pounding occurs once a year.
2. $400 per year for 10 years at 10%
b, $200 per year for 5 years at 5%
. $400 per year for 5 years at 0%
d. Rework parts a, b, and c assuming they are annuities du.
515 PRESENT VALUE OF AN ANNUITY Find the present values of these ordinary annuities.
Discounting occurs once a year.
2. $400 per year for 10 years at 10%
b, $200 per year for 5 years at 5%
. $400 per year for 5 years at 0%
d. Rework parts a, b, and c assuming they are annuities du.
5-16 PRESENT VALUE OF A PERPETUITY What is the present value of a $100 perpetuity if the
interest rate is 7%? If interest rates doubled to 14%, what would its present value be?
517 EFFECTIVE INTEREST RATE You borrow $85,000; the annual loan payments are $8,273.59
for 30 years. What interest rate are you being charged?
518 UNEVEN CASH FLOW STREAM
a. Find the present values of the following cash flow streams at an 8% discount rate.
 Chapter 5 Time Value of Money 177

0 1 2 3 4 5
———
Stream A $0 $100 $400 $400 $400 $300
Stream B $0 $300 $400 $400 $400 $100

b. What are the PVs of the streams at a 0% discount rate?

519 FUTURE VALUE OF AN ANNUITY Your client is 40 years old. She wants to begin saving for
retirement, with the first payment to come one year from now. She can save $5,000 per
year, and you advise her to invest it in the stock market, which you expect to provide an
average retumn of 9% in the future.
a. If she follows your advice, how much money will she have at 657
b. How much will she have at 707
<. She expects to live for 20 years if she retires at 65 and for 15 years if she retires at 70. If
her investments continue to earn the same rate, how much will she be able to withdraw
at the end of each year after retirement at each retirement age?
520 PV OF A CASH FLOW STREAM A rookie quarterback is negotiating his first NFL contract.
His opportunity cost is 10%. He has been offered three possible 4-year confracts. Payments
are guaranteed, and they would be made at the end of each year. Terms of each contract are
as follows:
1 2 3 4
A
Contract 1 $3,000,000 $3,000,000 $3,000,000 $3,000,000
Contract 2 $2,000,000 $3,000,000 $4,000,000 $5,000,000
Contract 3 $7,000,000 $1,000,000 $1,000,000 $1,000,000
As his adviser, which contract would you recommend that he accept?
521 EVALUATING LUMP SUMS AND ANNUITIES Crissie just won the lottery, and she must
choose among three award options. She can elect to receive a lump sum today of $61
million, to receive 10 end-of-year payments of $9.5 million, or to receive 30 end-of-year
payments of $5.5 million.
a. If she thinks she can earn 7% annually, which should she choose?
b. If she expects to earn 8% annually, which is the best choice?
<. If she expects to earn 9% annually, which option would you recommend?
d. Explain how interest rates influence her choice.
522 LOAN AMORTIZATION Jan sold her house on December 31 and took a $10,000 mortgage
as part of the payment. The 10-year mortgage has a 10% nominal interest rate, but it calls
for semiannual payments beginning next June 30. Next year Jan must report on Schedule B
of her IRS Form 1040 the amount of interest that was included in the two payments she
received during the year.
a. What is the dollar amount of each payment Jan receives?
b. How much interest was included in the first payment? How much repayment of
principal was included? How do these values change for the second payment?
. How much interest must Jan report on Schedule B for the first year? Will her interest
income be the same next year?
d.If the payments are constant, why does the amount of interest income change over
time?

523 FUTURE VALUE FOR VARIOUS COMPOUNDING PERIODS Find the amount to which $500
will grow under each of these conditions:
12% compounded annually for 5 years
12% compounded semiannually for 5 years
e

12% compounded quarterly for 5 years

12% compounded monthly for 5 years
a0

12% compounded daily for 5 years

Why does the observed pattern of FVs occur?
me
178 Part 2 Fundamental Concepts in Financial Management

524 PRESENT VALUE FOR VARIOUS DISCOUNTING PERIODS Find the present value of $500
due in the future under each of these conditions:
. 12% nominal rate, semiannual compounding, discounted back 5 years
b. 12% nominal rate, quarterly compounding, discounted back 5 years
<. 12% nominal rate, monthly compounding, discounted back 1 year
d. Why do the differences in the PVs occur?
525 FUTURE VALUE OF AN ANNUITY Find the future values of the following ordinary annuities:
. FV of $400 paid each 6 months for 5 years at a nominal rate of 12% compounded
semiannually
b. FV0f $200 paid each 3 months for 5 years at a nominal rate of 12% compounded quarterly
. These annuities receive the same amount of cash during the 5-year period and eam interest
at the same nominal rate, yet the annuity in part b ends up larger than the one in part a.
Why does this oceur?
526 PV AND LOAN ELIGIBILITY You have saved $4,000 for a down payment on a new car. The
largest monthly payment you can afford is $350. The loan will have a 12% APR based on
end-of-month payments. What is the most expensive car you can afford if you finance it for
48 months? For 60 months?

Challenging 527 EFFECTIVE VERSUS NOMINAL INTEREST RATES Bank A pays 4% interest compounded
Problems annually on deposits, while Bank B pays 3.5% compounded daily.
27-40 a. Based on the EAR (or EFEY), which bank should you use?
b. Could your choice of banks be influenced by the fact that you might want to withdraw
your funds during the year as opposed to at the end of the year? Assume that your
Funds must be left on deposit during an entire compounding period in order to receive
any interest.
528 NOMINAL INTEREST RATE AND EXTENDING CREDIT As a jewelry store manager, you
want to offer credit, with interest on outstanding balances paid monthly. To carry receiv-
ables, you must borrow funds from your bank at a nominal 6%, monthly compourding. To
offset your overhead, you want to charge your customers an EAR (or EFFY) that is 2%
‘more fhan the bank is charging you. What APR rate should you charge your customers?
529 BUILDING CREDIT COST INTO PRICES Your firm sells for cash only, but it is thinking of
offering credit, allowing customers 90 days to pay. Customers understand the time value of
‘money, so they would all wait and pay on the 90th day. To carry these receivables, you
would have to borrow funds from your bank at a nominal 12%, daily compounding based
on a 360-day year. You want to increase your base prices by exactly enough to offset your
bank interest cost. To the closest whole percentage point, by how much should you raise
your product prices?
5-30 REACHING A FINANCIAL GOAL Erika and Kitty, who are twins, just received $30,000 each for
their 25th birthday. They both have aspirations to become millionaires. Each plans to make a
$5,000 annual contribution to her “early refirement fund” on her birthday, beginning
a year from
today. Erika opened an account with the Safety First Bond Fund, a mutual fund that invests in
high-quality bonds whose investors have eamed 6% per year in the past. Kitty invested in the
New Issue Bio-Tech Fund, which invests in small, newly issued bio-tech stocks and whose
investors have eamed an average of 20% per year in the fund's relatively short history.
a. If the two women’s funds earn the same returs in the future as in the past, how old
will each be when she becomes a millionaire?
b. How large would Erika’s annual contributions have to be for her to become a
millionaire at the same age as Kitty, assuming their expected retums are realized?
<. Isit rational or irrational for Erika to invest in the bond fund rather than in stocks?
531 REQUIRED LUMP SUM PAYMENT Starting next year, you will need $10,000 annually for
4 years to complete your education. (One year from today you will withdraw the first
$10,000.) Your uncle deposits an amount foday in a bank paying 5% annual interest, which
will provide the needed $10,000 payments.
2. How large must the deposit be?
b. How much will be in the account immediately after you make the first withdrawal?
532 REACHING A FINANCIAL GOAL Six years from today you need $10,000. You plan to deposit
$1,500 annually, with the first payment to be made a year from today, in an account that pays.
 Chapter 5 Time Value of Money 179

an 8% effective annual rate. Your last deposit, which will occur at the end of Year 6, will be for
less than $1,500 if less is needed to reach $10,000. How large will your last payment be?
533 FV OF UNEVEN CASH FLOW You want to buy a house within 3 years, and you are currently
saving for the down payment. You plan to save $5,000 at the end of the first year, and you
anticipate that your annual savings will increase by 10% annually thereafter. Your expected
annual return is 7%. How much will you have for a down payment at the end of Year 32
534 AMORTIZATION SCHEDULE
. Set up an amortization schedule for a $25,000 loan to be repaid in equal installments at
the end of each of the next 3 years. The interest rate is 10% compounded annually.
b. What percentage of the payment represents interest and what percentage represents
principal for each of the 3 years? Why do these percentages change over time?
535 AMORTIZATION SCHEDULE WITH A BALLOON PAYMENT You want to buy a house that
costs $100,000. You have $10,000 for a down payment, but your credit is such that mort-
‘gage companies will not lend you the required $90,000. However, the realtor persuades the
Seller to fake a $90,000 morigage (called a seller take-back mortgage) at a rate of 7%,
provided the loan is paid off in full in 3 years. You expect to inherit $100,000 in 3 years;
but right now all you have is $10,000, and you can afford to make payments of no more
than §7,500 per year given your salary. (The loan would call for monthly payments, but
assume end-of-year annual payments to simplify things.)
a. If the loan was amortized over 3 years, how large would each annual payment be?
Could you afford those payments?
b. If the loan was amortized over 30 years, what would each payment be? Could you
afford those payments?
<. Tosatisfy the seller, the 30-year morigage loan would be written as a balloon note,
which means that at the end of the third year, you would have to make the regular
payment plus the remaining balance on the loan. What would the loan balance be at
the end of Year 3, and what would the balloon payment be?
536 NONANNUAL COMPOUNDING
a. You plan to make five deposits of $1,000 each, one every 6 months, with the first payment
being made n 6 months. You will then make no more deposis. I the bank pays 4% nominal
interest, compounded semiannually, how much will be in your account after 3 years?
b. One year from today you must make a payment of $10,000. To prepare for this payment,
you plan to make two equal quarterly deposits (at the end of Quarters 1 and 2) in a bank.
that pays 4% nominal interest compounded quarterly. How large must each of the two.
payments be?
537 PAYING OFF CREDIT CARDS Simon recently received a credit card with an 18% nominal
interest rate. With the card, he purchased an Apple iPhone 5 for $372.71. The minimum
payment on the card is only $10 per month.
a. If Simon makes the minimum monthly payment and makes no other charges, how-
many months will it be before he pays off the card? Round to the nearest month.
b, 1f Simon makes monthly payments of $35, how many months will it be before he pays
off the debt? Round to the nearest month.
<. How much more in total payments will Simon make under the $10-a-month plan than
under the $35-a-month plan? Make sure you use three decimal places for N.
538 PV AND A LAWSUIT SETTLEMENT It is now December 31,2014 (t = 0), and a jury just found
in favor of a woman who sued the city for injuries sustained in a January 2013 accident. She
requested recovery of lost wages plus $100,000 for pain and suffering plus $20,000 for legal
expenses. Her doctor testified that she has been unable to work since the accident and that she
will not be able to work in the future. She is now 62, and the jury decided that she would have
worked for another three years. She was scheduled to have earned $34,000 in 2013. (To
simplify this problem, assume that the entire annual salary amount would have been received
on December 31, 2013.) Her employer testified that she probably would have received raises of
39% per year. The actual payment for the jury award will be made on December 31, 2015. The
judge stipulated that all dollar amounis are to be adjusted to a present value basis on
December 31, 2015, using a 7% annual interest rate and using compound, not simple, interest.
Furthermore, he stipulated that the pain and suffering and legal expenses should be based on a
December 31, 2014, date. How large a check must the city write on December 31, 2015?

539 REQUIRED ANNUITY PAYMENTS Your father is 50 years old and will retire in 10 years. He
expects to live for 25 years after he retires, until he is 85. He wants a fixed retirement income
180 Part 2 Fundamental Concepts in Financial Management

value of his retirement income will decline annually after he retires.) His refirement income
will begin the day he retires, 10 years from today, at which time he will receive 24 additional
annual payments. Annual inflation is expected to be 5%. He currently has $100,000 saved,
and he expects to ear 8% annually on his savings. How much must he save during each of
the next 10 years (end-of-year deposits) to meet his retirement goal?
5-40 REQUIRED ANNUITY PAYMENTS A father is now planning a savings program to put his
daughter through college. She is 13, plans to enroll at the university in 5 years, and should
‘graduate 4 years later. Currently,the annual cost (for every thing—food, clothing, tuition, books,
transportation, and so forth) is $15,000, but these costs are expected to increase by 5% annually.
The college requires total payment at the start of the year. She now has $7,500 in a college
savings account that pays 6% annually. Her father will make six equal annual deposits into her
account; the first deposit today and the sixth on the day shestarts college. How large must each
of the six payments be? [Hint: Calculate the cost (inflated at 5% ) for each year of college and find
the total present value of those costs, discounted at 6%, as of the day she enters college. Then
find the compounded value of her initial $7,500 on that same day. The difference between the
PV of costs and the amount that would be in the savings account must be made up by the
father’s deposits, so find the six equal payments that will compound to the required amount.]

COMPREHENSIVE
/ SPREADSHEET PROBLEM

541 TIME VALUE OF MONEY Answer the following questions:

a. Assuming a rate of 10% annually, find the FV of $1,000 after 5 years.
b. What is the investment’s FV at rates of 0%, 5%, and 20% after 0, 1, 2, 3, 4, and 5 years?
<. Find the PV of $1,000 due in 5 years if the discount rate is 10%.
d. What is the rate of return on a security that costs $1,000 and returns $2,000 after 5
years?
e Suppose California’s population is 36.5 million people and its population is expected to
grow by 2% annually. How long wil it take for the population to double?
f. Find the PV of an ordinary annuity that pays $1,000 each of the next 5 years if the
interest rate is 15%. What is the annuity’s FV?
g How will the PV and FV of the annuity in part f change if it is an annuity due?
h. What will the FV and the PV be for $1,000 due in 5 years if the interest rate is 10%,
semiannual compounding?
i, What will the annual payments be for an ordinary annuity for 10 years with a PV of
$1,000 if the interest rate s 8%? What will the payments be f this is an annuity due?
j. Find the PV and the FV of an investment that pays 8% annually and makes the
following end-of-year payments:
0 3
A
$100 $200 $400
k. Five banks offer nominal rates of 6% on deposits, but A pays interest annually; B pays
semiannually; C pays quarterly; D pays monthly; and E pays daily.
1. What effective annual rate does each bank pay? If you deposit $5,000 in each bank
today, how much will you have in each bank at the end of 1 year? 2 years?
2. If all of the banks are insured by the government (the FDIC) and thus are equally
risky, will they be equally able to attract funds? If not (and the TVM is the only
consideration), what nominal rate will cause all of the banks to provide the same
effective annual rate as Bank A?
3. Suppose you don't have the $5,000 but need it at the end of 1 year. You plan to make
a series of deposits—annually for A, semiannually for B, quarterly for C, monthly
for D, and daily for E—with payments beginning today. How large must the
payments be to each bank?
4. Even if the five banks provided the same effective annual rate, would a rational
investor be indifferent between the banks? Explain.
L. Suppose you borrow $15,000. The loan’s annual interest rate is 8%, and it requires four
equal end-of-year payments. Set up an amortization schedule that shows the annual
payments, interest payments, principal repayments, and beginning and ending loan
balances.
 @) e
FIRST NATIONAL BANK

542 TIME VALUE OF MONEY ANALYSIS You have applied for a job with a local bank. As part of its evaluation process,
you must take an examination on time value of money analysis covering the following questions:
a. Draw time lines for (1) a $100 lump sum cash flow at the end of Year 2; (2) an ordinary annuity of $100 per year for
3 years; and (3) an uneven cash flow stream of ~$50, $100, $75, and $50 at the end of Years 0 through 3.
b. 1. What's the future value of $100 after 3 years if it eams 4%, annual compounding?
2. What's the present value of $100 to be received in 3 years if the interest rate is 4%, annual compounding?
What annual interest rate would cause $100 to grow to $119.10 in 3 years?
If a company’s sales are growing at a rate of 10% annually, how long will it take sales to double?
What's the difference between an ordinary annuity and an annuity due? What type of annuity is shown here?
How would you change it to the other type of annuity?

o 1 2 3
—_—
o $100 $100 $100

1. What s the future value of a 3-year, $100 ordinary annuity if the annual interest rate is 4%2
2. What is its present value?
3. What would the future and present values be if it was an annuity due?
A 5-year $100 ordinary annuity has an annual interest rate of 4%.
1. What is its present value?
2. What would the present value be if it was a 10-year annuity?
3. What would the present value be if it was a 25-year annuity?
4. What would the present value be if this was a perpetuity?
A 20-year-old student wants to save $5a day for her retirement. Every day she places $5 in a drawer. At the end
of each year, she invests the accumulated savings (§1,825) in a brokerage account with an expected annual return
of 8%.
1. If she keeps saving in this manner, how much will she have accumulated at age 657
2. If a 40-year-old investor began saving in this manner, how much would he have at age 657
3. How much would the 40-year-old investor have to save each year to accumulate the same amount at 65 as the
20-year-old investor?
What is the present value of the following uneven cash flow stream? The annual interest rate is 4%.

o 4% 1 2 3 4 Years
Pttt
o $100 $300 $300 —$50

1. Will the future value be larger or smaller if we compound an initial amount more often than annually
(eg., semiannually, holding the stated (nominal) rate constant)? Why?
2. Define (a) the stated (or quoted or nominal) rate, (b) the periodic rate, and (c) the effective annual rate (EAR
or EFFY).
3. What s the EAR corresponding to a nominal rate of 4% compounded semiannually? Compounded quarterly?
Compounded daily?
. What is the future value of $100 after 3 years under 4% semiannual compounding? Quarterly compounding?
182 Part 2 Fundamental Concepts in Financial Management

k. When will the EAR equal the nominal (quoted) rate?

L 1 What is the value at the end of Year 3 of the following cash flow stream if interest is 4% compounded
semiannually? (Hint: You can use the EAR and treat the cash flows as an ordinary annuity or use the
periodic rate and compound the cash flows individually.)

6 Periods
e
0 $100 $100 $100

What is the PV?

What would be wrong with your answer to parts 1(1) and 1(2) if you used the nominal rate, 4%, rather
than the EAR or the periodic rate, Ixom/2 = 4%/2 = 2%, to solve the problems?
. Construct an amortization schedule for a $1,000, 4% annual interest loan with three equal installments.
What s the annual interest expense for the borrower and the annual interest income for the lender
during Year 27