Time Value of Money Exercises - Solution

1 It has long been told that the Dutch purchased Manhattan Island in 1626 for the value of 60
guilders ($24). Assuming that the Dutch invested this money into an account earning 5%,
approximately how much would their investment be worth 390 years later in 2016?

Answer:

FV = $24 (1.05)390 = $4.41 billion

2 Joe just inherited the family business, and having no desire to run the family business, he has
decided to sell it to an entrepreneur. In exchange for the family business, Joe has been offered an
immediate payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000
in two years, and $75,000 in three years. The current market rate of interest for Joe is 6%.

a. In terms of present value, how much will Joe receive for selling the family business?
b. Suppose a second entrepreneur approaches Joe and offers him $250,000 today for
the business. Should Joe accept the new entrepreneur's offer or stick with the
original offer of $100,000 and the series of payments over three years? Why?

Answer:

a. PV = $100,000 + $50,000 / (1.06)1 + $50,000 / (1.06)2 + $75,000 / (1.06)3 = $254,641

b. Joe should take the original offer of $100,000 + payments.

PV of the original offer = $100,000 + $50,000 / (1.06)1 + $50,000 / (1.06)2 + $75,000 /
(1.06)3 = $254,641
So, the NPV of taking the second offer is $250,000 - $254,641 = -$4,641
Since the NPV is negative we would not take the second offer.

3 Use the table for the question(s) below.

Year A B
0 -$150 -$225
1 40 175
2 80 125
3 100 -50

a. If the discount rate is 6%, what is the NPV of investment "A"?

b. If the discount rate is 6%, what is the NPV of investment "B"?
c. If the discount rate is 6%, then which investment(s), if any, would you take and why?
d. If the discount rate is 10%, then which investment(s), if any, would you take and why?

Answer: :
a- $42.90
b- $9.36
c- Accept both A & B. Both have positive NPV
d- A = $27.61, B = -$0.17 : Accept A, reject B

© Pearson Education – Edited by Olivier Greusard for CFVG 1

4 The British government has a consol bond outstanding paying £100 per year forever. Assume the
current interest rate is 4% per year.
a. What is the value of the bond immediately after a payment of a coupon is made?
b. What is the value of the bond immediately before a payment of a coupon is made?

Answer :
Timeline:
0 1 2 3

100 100 100

a. The value of the bond is equal to the present value of the cash flows. By the perpetuity formula:

100
PV = = £2, 500.
0.04
b. The value of the bond is equal to the present value of the cash flows. The cash flows are the
perpetuity plus the payment that will be received immediately.
PV = 2,500 + 100 = £ 2,600

5. What is the present value of $1000 paid at the end of each of the next 100 years if the interest
rate is 7% per year?

Answer:
Timeline:
0 1 2 3 100

1,000 1,000 1,000 1,000

The cash flows are a 100 year annuity, so by the annuity formula:

1, 000 æ 1 ö
PV = ç1 - 100 ÷
= 14, 269.25.
0.07 è 1.07 ø

© Pearson Education – Edited by Olivier Greusard for CFVG 2

6. When you purchased your house, you took out a 30-year annual-payment mortgage with an
interest rate of 6% per year. The annual payment on the mortgage is $12,000. You have just
made a payment and have now decided to pay the mortgage off by repaying the outstanding
balance. What is the payoff amount if:
a. You have lived in the house for 12 years (so there are 18 years left on the mortgage)?
b. You have lived in the house for 20 years (so there are 10 years left on the mortgage)?
c. You have lived in the house for 12 years (so there are 18 years left on the mortgage) and you
decide to pay off the mortgage immediately before the twelfth payment is due?
Answer:
a. Timeline:

12 13 14 15 30
0 1 2 3 18

12,000 12,000 12,000 12,000

To pay off the mortgage you must repay the remaining balance. The remaining balance is equal to
the present value of the remaining payments. The remaining payments are an 18-year annuity, so:

12, 000 æ 1 ö
PV = ç1 - 18 ÷
0.06 è 1.06 ø
= 129, 931.24.
b. Timeline:
21 22 23 24 30
0 1 2 3 10

12,000 12,000 12,000 12,000

To pay off the mortgage you must repay the remaining balance. The remaining balance is equal to
the present value of the remaining payments. The remaining payments are a 10 year annuity, so:

12, 000 æ 1 ö
PV = ç1 - 10 ÷
= 88, 321.04.
0.06 è 1.06 ø
c. Timeline:
12 13 14 15 30
0 1 2 3 18

12,000 12,000 12,000 12,000 12,000

If you decide to pay off the mortgage immediately before the 12th payment, you will have to pay
exactly what you paid in part (a) as well as the 12th payment itself:
129, 931.24 + 12, 000 = 141, 931.24.

© Pearson Education – Edited by Olivier Greusard for CFVG 3

7. Your grandmother has been putting $1000 into a savings account on every birthday since your
first (that is, when you turned 1). The account pays an interest rate of 3%. How much money will
be in the account on your 18th birthday immediately after your grandmother makes the deposit
on that birthday?
Answer:

Timeline:
0 1 2 3 18

1,000 1,000 1,000 1,000

We first calculate the present value of the deposits at date 0. The deposits are an 18-year annuity:

1, 000 æ 1 ö
PV = ç1 - 18 ÷
= 13, 753.51
0.03 è 1.03 ø
Now, we calculate the future value of this amount:
18
FV = 13, 753.51(1.03) = 23, 414.43
8. A rich relative has bequeathed you a growing perpetuity. The first payment will occur in a year
and will be $1000. Each year after that, you will receive a payment on the anniversary of the last
payment that is 8% larger than the last payment. This pattern of payments will go on forever. If
the interest rate is 12% per year,
a. What is today’s value of the bequest?
b. What is the value of the bequest immediately after the first payment is made?

Answer:
a. Timeline:
0 1 2 3

1,000 1,000(1.08) 1,000(1.08)2

Using the formula for the PV of a growing perpetuity gives:

æ 1, 000 ö
PV = ç ÷ = 25, 000.
è 0.12 - 0.08 ø
b. Timeline:
1 2 3 4
0 1 2 3

1,000(1.08) 1,000(1.08)2 1,000(1.08)3

Using the formula for the PV of a growing perpetuity gives:

1, 000(1.08)
PV = = 27, 000.
0.12 - 0.08

© Pearson Education – Edited by Olivier Greusard for CFVG 4

9. You work for a pharmaceutical company that has developed a new drug. The patent on the drug
will last 17 years. You expect that the drug’s profits will be $2 million in its first year and that
this amount will grow at a rate of 5% per year for the next 16 years. Once the patent expires,
other pharmaceutical companies will be able to produce the same drug and competition will
likely drive profits to zero. What is the present value of the new drug if the interest rate is 10%
per year?
Answer:
Timeline:

0 1 2 3 17

2 2(1.05) 2(1.05)2 2(1.05)16

This is a 17-year growing annuity. By the growing annuity formula we have

2, 000, 000 æ 1.05 ö ö

17
PV =
æ
ç1 - ç ÷ ÷ = 21, 861, 455.80
0.1 - 0.05 è è 1.1 ø ø

10. You are running a hot Internet company. Analysts predict that its earnings will grow at 30% per
year for the next five years. After that, as competition increases, earnings growth is expected to
slow to 2% per year and continue at that level forever. Your company has just announced
earnings of $1,000,000. What is the present value of all future earnings if the interest rate is 8%?
(Assume all cash flows occur at the end of the year.)
Answer:
Timeline:
0 1 2 3 4 5 6 7

1(1.3) (1.3)2 (1.3)3 (1.3)4 (1.3)5 (1.3)5(1.02) (1.3)5(1.02)2

This problem consists of two parts:
(1) A growing annuity for 5 years;
(2) A growing perpetuity after 5 years.
First we find the PV of (1):

1.3 æ æ 1.3 ö5 ö
PVGA = ç1 - ç ÷ ÷ = $9.02 million.
0.08 - 0.3 è è 1.08 ø ø

Now we calculate the PV of (2). The value at date 5 of the growing perpetuity is

(1.3)5 (1.02 ) 63.12

PV5 = = $63.12 million Þ PV0 = = $42.96 million.
0.08 - 0.02 (1.08 )5
Adding the present value of (1) and (2) together gives the PV value of future earnings:
$9.02 + $42.96 = $51.98 million.

© Pearson Education – Edited by Olivier Greusard for CFVG 5

 11. Suppose that a young couple has just had their first baby and they wish to ensure that enough
money will be available to pay for their child's college education. Currently, college tuition,
books, fees, and other costs, average $12,500 per year. On average, tuition and other costs have
historically increased at a rate of 4% per year.

e. What is the total cost per year (tuition and other costs) for this student in 18 years when
she enters college?

f. Assuming that college costs continue to increase an average of 4% per year and that all
her college savings are invested in an account paying 7% interest, what is the amount of
money she will need to have available at age 18 to pay for all four years of her
undergraduate education (Payments must be made at the beginning of the year)?

Answer:

a. FV18 = $12,500(1+0.04)18 = $25,323

b.
C18=$25,323
C19=$25,323(1+0.04)1 = $26,336
C20=$25,323(1+0.04)2 = $27,389
C21=$25,323(1+0.04)3 = $28,485

PV@18 = $25,323 + (26,336/(1+0.07)1) + (27,389/(1+0.07)2) + (28,485/(1+0.07)3) = $97,110

"#,%%# /0&.&* %
OR PV@18 = $25,323 + +1 − . 1 2 = $97,110
&.&()&.&* /0&.&(

12. You are saving to make a down payment on a house. You have $10,050 saved already, and you
can afford to save an additional $5,000 per year at the end of each year. If you earn 7.25% per
year on your savings, how long will it take you to save $60,000?

Answer:

5000 1
𝐹𝑉5 = (10050 × 1.07255 ) + ? +1 − 2@ × 1.07255 = $60000
0.0725 (1.0725)5

5000
𝐹𝑉5 = (10050 × 1.07255 ) + (1.07255 − 1) = $60000
0.0725
(60000 × 0.0725) + 5000
1.07255 = = 1.63
(10500 × 0.0725) + 5000

ln(1.63)
𝑛= ≈ 7 𝑦𝑒𝑎𝑟𝑠
ln(1.0725)
OR Trial and error, n ≈ 7 𝑦𝑒𝑎𝑟𝑠

© Pearson Education – Edited by Olivier Greusard for CFVG 6