BASFIN1 TUTORIAL 3

Conducted by Dr. Dulani Jayasuriya, January 2016

Time Value of Money

 A dollar paid today is worth more than a dollar paid

tomorrow.
 FV = PV × (1 + r)t
 PV = FV / (1 + r)t
 PVA = C × {1 – [1 / (1 + r)t]} / r
 FVA = C × [(1 + r)t – 1] / r
 EAR = (1 + APR / m)m-1
Method

 Manually:
 Five factors: PV; FV; r; t; PMT
 Step 1: Draw Time Line
 Step 2: Distinguish known factors and unknown factors
 Financial Calculator:
 Generally: 4 known, 1 unknown.
 Important: PMT,N,1/Y. All three inputs must have the
same frequency.
 If FV is given as positive enter PV & PMT as negative
values.
Annuities
Discount rates

 Annual Percentage Rate (APR)

 (Nominal Annual Rate or Quoted Rate or Stated Rate)
 This is the annual rate that is quoted by law
 By definition APR = period rate * the number of periods
per year
 Consequently, to get the period rate we rearrange the
APR equation: Period rate = APR / number of periods per
year
 Note that you should NEVER divide the effective rate by
the number of periods per year – it will NOT give you the
period rate .
Loans

 Loan with Fixed Principal Payment

 Each payment covers the interest expense plus a
fixed principal portion.
 Amortized Loan

 Each payment covers the interest expense plus reduces

principal.
Question 1


First City Bank pays 8 percent simple interest on its
savings account balances, whereas Second City
Bank pays 8 percent interest compounded annually.
If you made a $5,000 deposit in each bank, how
much more money would you earn from your
Second City Bank account at the end of 10 years?
 Calculator: Compounded interest calculation:-5000 PV, 10 N, 8 1/Y, 0 PMT, CPT FY
Question1-Solution
The simple interest per year is:
$5,000 × .08 = $400
So after 10 years you will have:
$400 × 10 = $4,000 in interest.

The total balance will be $5,000 + 4,000 = $9,000

With compound interest we use the future value formula:

FV = PV(1 +r)t
FV = $5,000(1.08)10 = $10,794.62

The difference is:

$10,794.62 – 9,000 = $1,794.62

Question 2

 Although appealing to more refined tastes, art as a

collectible has not always performed so profitably.
During 2003, Sotheby's sold the Edgar Degas bronze
sculpture Petite Danseuse de Quartorze Ans at
auction for a price of $10,311,500. Unfortunately for
the previous owner, he had purchased it in 1999 at a
price of $12,377,500. What was his annual rate of
return on this sculpture?
 Calculator: 4 N , 10311500 FV, -12377500 PV, 0 PMT, CPT 1/Y
Question2-Solution
To answer this question, we can use either the FV or the PV formula. Both
will give the same answer since they are the inverse of each other. We will
use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:

r = (FV / PV)1 / t – 1
r = ($10,311,500 / $12,377,500)1/4 – 1 = – 4.46%

Notice that the interest rate is negative. This occurs when the FV is less
than the PV.
Question 3

 You are to make monthly deposits of $300 into a

retirement account that pays 10 percent interest
compounded monthly. If your first deposit will be
made one month from now, how large will your
retirement account be in 30 years?
 Calculator: 30*12 N , 10/12 1/Y, 0 PV, -300 PMT, CPT FV
Question3-Solution
This problem requires us to find the FVA. The equation to find
the FVA is:

FVA = C{[(1 + r)t – 1] / r}

FVA = $300[{[1 + (.10/12) ]360 – 1} / (.10/12)] = $678,146.38
Question 4

 You've just joined the investment banking firm of Dewey,

Cheatum, and Howe. They've offered you two different salary
arrangements. You can have $95,000 per year for the next two
years, or you can have $70,000 per year for the next two years,
along with a $45,000 signing bonus today. The bonus is paid
immediately, and the salary is paid at the end of each year. If the
interest rate is 10 percent compounded monthly, which do you
prefer?
 Calculator: SET C/Y to 12 & P/Y to 1
 First compensation package: 2 N , 0 FV,10 1/Y, -95000 PMT, CPT PV
 Second compensation package: 2 N , 0 FV,10 1/Y, -70000 PMT, CPT PV+45000
Question4-Solution
Since we have an APR compounded monthly and an annual payment, we
must first convert the interest rate to an EAR so that the compounding
period is the same as the cash flows.

EAR = [1 + (.10 / 12)]12 – 1 = .104713 or 10.4713%

PVA1 = $95,000 {[1 – (1 / 1.104713)2] / .104713} = $163,839.09

PVA2 = $45,000 + $70,000{[1 – (1/1.104713)2] / .104713} = $165,723.54

You would choose the second option since it has a higher PV.
Question 5

 You're prepared to make monthly payments of $340,

beginning at the end of this month, into an account that pays 6
percent interest compounded monthly. How many payments
will you have made when your account balance reaches
$20,000?
 Calculator: 0 PV , 20000 FV,6/12 1/Y, -340 PMT, CPT N
Question5-Solution
Here we are given the FVA, the interest rate, and the amount of
the annuity. We need to solve for the number of payments.
Using the FVA equation:

FVA = $20,000 = $340[{[1 + (.06/12)]t – 1 } / (.06/12)]

Solving for t, we get:

1.005t = 1 + [($20,000)/($340)](.06/12)
t = ln 1.294118 / ln 1.005 = 51.69 payments
Question 6
 You need a 30-year, fixed-rate mortgage to buy a
new home for $240,000. Your mortgage bank will
lend you the money at a 6.35 percent APR for this
360-month loan. However, you can afford monthly
payments of only $1,150, so you offer to pay off any
remaining loan balance at the end of the loan in the
form of a single balloon payment. How large will
this balloon payment have to be for you to keep your
monthly payments at $1,150?
 Calculator: Step 1: 6.35/12 1/Y, -1150 PMT, 30*12 N, 0FV, CPT PV
 Step 2: (Home price –Answer step 1) PV, 30*12 N, 6.35/12 1/Y, 0 PMT, CPT FV
Question6-Solution
The amount of principal paid on the loan is the PV of the monthly payments you
make. So, the present value of the $1,150 monthly payments is:
PVA = $1,150[(1 – {1 / [1 + (.0635/12)]}360) / (.0635/12)] = $184,817.42

The monthly payments of $1,150 will amount to a principal payment of

$184,817.42. The amount of principal you will still owe is:
$240,000 – 184,817.42 = $55,182.58

This remaining principal amount will increase at the interest rate on the loan until
the end of the loan period. So the balloon payment in 30 years, which is the FV of
the remaining principal will be:

Balloon payment = $55,182.58[1 + (.0635/12)]360 = $368,936.54

Question 7
 The present value of the following cash flow
stream is $6,550 when discounted at 10 percent
annually. What is the value of the missing cash
flow?
Year Cash flow
1 $1,700
2 ?
3 $2,100
4 $2,800
Question7-Solution
We are given the total PV of all four cash flows. If we find the PV of
the three cash flows we know, and subtract them from the total PV, the
amount left over must be the PV of the missing cash flow. So, the PV of
the cash flows we know are:

PV of Year 1 CF: $1,700 / 1.10 = $1,545.45

PV of Year 3 CF: $2,100 / 1.103 = $1,577.76
PV of Year 4 CF: $2,800 / 1.104 = $1,912.44

So, the PV of the missing CF is:

$6,550 – 1,545.45 – 1,577.76 – 1,912.44 = $1,514.35
The question asks for the value of the cash flow in Year 2, so we must
find the future value of this amount. The value of the missing CF is:

$1,514.35(1.10)2 = $1,832.36
Question 8
 Suppose you are going to receive $10,000 per year for five years. The
appropriate interest rate is 11 percent.

a. What is the present value of the payments if they are in the form of an
ordinary annuity? What is the present value if the payments are an
annuity due?
Calculator: Ordinary annuity:-10000 PMT, 0 FV, 5 N, 11 1/Y, CPT PV
Annuity Due: Reset mode to BGN and do the same steps or get the above answer and multiply by (1+r)

b. Suppose you plan to invest the payments for five years. What is the
future value if the payments are an ordinary annuity? What if the
payments are an annuity due?
c. Which has the highest present value, the ordinary annuity or annuity
due? Which has the highest future value? Will this always be true?
Question8-Solution
a. If the payments are in the form of an ordinary annuity, the present value
will be:

PVA = C({1 – [1/(1 + r)t]} / r )

PVA = $10,000[{1 – [1 / (1 + .11)]5}/ .11]
PVA = $36,958.97

If the payments are an annuity due, the present value will be:

PVAdue = (1 + r) PVA
PVAdue = (1 + .11)$36,958.97
PVAdue = $41,024.46
Question8-Solution
b. We can find the future value of the ordinary annuity as:

FVA = C{[(1 + r)t – 1] / r}

FVA = $10,000{[(1 + .11)5 – 1] / .11}
FVA = $62,278.01

If the payments are an annuity due, the future value will be:

FVAdue = (1 + r) FVA
FVAdue = (1 + .11)$62,278.01
FVAdue = $69,128.60
Question8-Solution

c. Assuming a positive interest rate, the present value of an

annuity due will always be larger than the present value of an
ordinary annuity. Each cash flow in an annuity due is received
one period earlier, which means there is one period less to
discount each cash flow. Assuming a positive interest rate, the
future value of an annuity due will always be higher than the
future value of an ordinary annuity. Since each cash flow is
made one period sooner, each cash flow receives one extra
period of compounding.
Question 9

 Explain the difference between the effective annual

rate (EAR) and the annual percentage rate (APR).
Of the two, which one has the greater importance
and why?
Q9-Solution
 1. The APR is a stated rate and is computed as (r  n),
where r is the rate per period and n is the number of
periods per year. The EAR considers compounding and
is computed as (1 + r)n - 1, where r is the rate per period
and n is the number of periods per year. The effective
annual rate will always be higher than the annual
percentage rate as long as the account is compounded
more than once a year and the interest rate is greater
than zero. The EAR is the equivalent rate based on
annual compounding. The EAR has greater importance
because it is the actual cost of a loan.
Question 10

 You just won the grand prize in a DLSU writing

contest! As your prize, you will receive $2,000 a
month for ten years. If you can earn 7 percent on
your money, what is this prize worth to you today?
Q10-Solution
Question 11

 Your employer contributes $75 a week to your

retirement plan. Assume that you work for your
employer for another 20 years and that the
applicable discount rate is 7.5 percent. Given these
assumptions, what is this employee benefit worth
to you today?
Q11-Solution
Question 12

 Your car dealer is willing to lease you a new car for

$245 a month for 48 months. Payments are due on
the first day of each month starting with the day
you sign the lease contract. If your cost of money is
6.5 percent, what is the current value of the lease?
Q12-Solution
Question 13

 You are considering two loans offered by DBS. The

terms of the two loans are equivalent with the
exception of the interest rates. Loan A offers a rate
of 7.75 percent, compounded daily. Loan B offers a
rate of 8 percent, compounded semi-annually.
Which loan should you select and why?
Q13-Solution
Question 14

 You have your choice of two investment accounts.

Investment A is a 5-year annuity that features end-of-
month $2,500 payments and has an interest rate of 11.5
percent compounded monthly. Investment B is a 10.5
percent continuously compounded lump sum
investment, also good for five years. How much would
you need to invest in B today for it to be worth as much
as investment A five years from now?
Q14-Solution
 FVA = $2,500  [{[1 + (0.115/12)]5  12
-1}/(0.115/12)] = $201,462.23


PV = $201,462.23 e-1  0.105 5 = $119,176.06

Question 15

 You are looking at a one-year loan of $10,000. The interest rate is

quoted as 10 percent plus 5 points. A point on a loan is simply 1
percent (one percentage point) of the loan amount. Quotes similar
to this one are very common with home mortgages. The interest
rate quotation in this example requires the borrower to pay 5
points to the lender up front and repay the loan later with 10
percent interest. What is the actual rate you are paying on this
loan?

 Extension: What if this loan lasts for 10 years, what’s the actual
loan rate you pay?
Q15-Solution
 Loan amount received = $10,000  (1 - .05) =
$9,500
Loan repayment amount = $10,000  1.101 =
$11,000
$11,000 = $9,500  (1 + r)1; r = 15.79 percent