30. Calculating EAR [L04] You are looking at an investment that has an effective annual rate of 12.5 percent.

What is the effe

return?

Here we need to convert an EAR into interest rates for different compounding periods. Using the equation for the EAR, we get

Per six months:

ERA = ( 1 + r )^2 -1 = 0,125
r= per six months
Per quarterly:
ERA = ( 1 + r )^4 -1 = 0,125
r= per quarter
Per Monthly:
ERA = (1+r)^12 - 1 = 0,125
r= per month

The efffective semiannual return is 6,07% per six months, the effective quarterly return is 2,99% per quarter, the effective mon

37. Growing Annuity [ L01 ] You have just won the lottery and will receive $1,500,000 in one year. You will receive payment
appropriate discount rate is 7 percent, what is the pres­ent value of your winnings?

We can use the present value of a growing annuity equation to find the value of your winnings tod

PV = C {[1 / (r – g)] – [1 / (r – g)] × [(1 + g) / (1 + r)]t}

PV = $1,500,000{[1 / (.07 – .025)] – [1 / (.07 – .025)] × [(1 + .025) / (1 + .07)] 30}
24148286.47 $

38. Growing Annuity [ LOI ] Your job pays you only once a year for all the work you did over the previous 12 months. Today
all of it. However, you want to start saving for retirement beginning next year. You have decided that one year from today y
earn 10 per­cent per year. Your salary will increase at 3 percent per year throughout your career.How much money will you

Since your salary grows at 3 percent per year, your salary next year will be:

Next year’s s 51500

This means your deposit next year will be:

Next year's
deposit = 4635

Since your salary grows at 3 percent, your deposit will also grow at 3 percent. We can use the present value of a growing perp
to find the value of your deposits today. Doing so, we find:

PV = C {[1 / (r – g)] – [1 / (r – g)] × [(1 + g) / (1 + r)]t}

PV = $4,635{[1 / (.10 – .03)] – [1 / (.10 – .03)] × [(1 + .03) / (1 + .10)] 40}
PV = 61441.9248
Now, we can find the future value of this lump sum in 40 years. We find:

FV = PV(1 + r)t
FV= 2780815.777
2,780,816 $ is the value of your savings in 40 years.

42. Calculating Loan Payments [L02] You need a 30-year, fixed-rate mortgage to buy a new home for $240,000. Your mortg
an APR of 5.25 percent for this 360-month loan. However, you can afford monthly pay­ments of only $975, so you offer to pa
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

0 1

PV $975 $975

The amount of principal paid on the loan is the PV of the monthly payments you make. So, the present value of the $975 mon

PVA = $975[(1 – {1 / [1 + (0.0525 / 12)] 360}) / (0.0525 / 12)] = 176565.277671656

The monthly payments of $975 will amount to a principal payment of $176,565.28. The amount of principal you will still owe i

$240,000 – 176,565.28 = 63434.72

0 1

$63,434.72

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

Balloon payment = $63,434.72[1 + (0.0525 / 12)] 360 = 305385.846962483

54. Calculating Annuities Due [ LOI ] You want to buy a new sports car from Muscle Motors for $68,000. The contract is in t
annuity due at an APR of 6.4 percent. What will your monthly payment be?
0 1

–$68,000
C C C
We need to use the PVA due equation, that is:
PVAdue = (1 + r) PVA
Using this equation:
 PVAdue = $68,000 = [1 + (0.064/12)] × C[{1 – 1 / [1 + (0.064/12)]60} / (0.064/12)

$68,362.67 = $C{1 – [1 / (1 +0 .064/12)60]} / (0.064/12)

C= 1334.39436783 $

55. Amortization with Equal Payments [L03] Prepare an amortization schedule for a five-year loan of $67,500. The interest
and the loan calls for equal annual payments. How much interest is paid in the third year? How much total interest is paid o

The payment for a loan repaid with equal payments is the annuity payment with the loan value as the PV of the annuity. So, th

PVA = $67,500 = C {[1 – 1 / (1 +0 .07)5] / 0.07}

C= 16462.62187

The interest payment is the beginning balance times the interest rate for the period, and the principal payment is the total pay
interest payment. The ending balance is the beginning balance minus the principal payment. The ending balance for a period i
balance for the next period. The amortization table for an equal payment is:

Beginning
Total Interest Principal
Year Balance
Payment Payment Payment
1 67500 16462.62 4725.00 11737.62
2 55762.38 16462.62 3903.37 12559.25
3 43203.1266 16462.62 3024.22 13438.40
4 29764.72546 16462.62 2083.53 14379.09
5 15385.63624 16462.62 1076.99 15385.63

In the third year, $3,024.22 of interest is paid.

Total interest over life of the loan = $4,725 + 3,903.37 + 3,024.22 + 2,083.53 + 1,076.99 =

56. Amortization with Equal Principal Payments [ L03 ] Rework Problem 55 assum­ing that the loan agreement calls for a pri
of $13,500 every year instead of equal annual payments.

This amortization table calls for equal principal payments of $13,500 per year. The interest payment is the beginning balance ti
and the total payment is the principal payment plus the interest payment. The ending balance for a period is the beginning ba
amortization table for an equal principal reduction is:

Beginning Total Interest Principal

Year
Balance Payment Payment Payment
1 67500 18225 4725 13500
2 54000 17280 3780 13500
 3 40500 16335 2835 13500
4 27000 15390 1890 13500
5 13500 14445 945 13500

In the third year, $2,835 of interest is paid.

Total interest over life of the loan = 14175

60. Discount Interest Loans [ L04] This question illustrates what is known as dis­count interest. Imagine you are discussing
unscrupulous lender. You want to borrow $25,000 for one year. The interest rate is 13.4 percent. You and the lender agree
134 X $25,000 = $3,350. So the lender deducts this interest amount from the loan up front and gives you $21,650. In this c
$3,350. What’s wrong here?
0

$21,650

To find the APR and EAR, we need to use the actual cash flows of the loan. In other words, the interest rate quoted in the prob
relevant to determine the total interest under the terms given. The cash flows of the loan are the $25,000 you must repay in o
$21,650 you borrow today. The interest rate of the loan is:

$25,000 = $21,650(1 + r)
r= 15.47%
of 12.5 percent. What is the effective semiannual return? The effective quarterly return? The effective monthly

he equation for the EAR, we get:

% per quarter, the effective monthly return is 0,99% per month

year. You will receive payments for 30 years, and the payments will increase by 2.5 percent per year. If the

d the value of your winnings today. Doing so, we find:

the previous 12 months. Today, December 31, you just received your salary of $50,000 and you plan to spend
ided that one year from today you will begin depositing 9 percent of your annual salary in an account that will
eer.How much money will you have on the date of your retirement 40 years from today?

present value of a growing perpetuity equation

 home for $240,000. Your mortgage bank will lend you the money at
of only $975, so you offer to pay off any remaining loan balance at
ment have to be for you to keep your monthly payments at $975?

$975 $975 $975 $975 $975 $975

present value of the $975 monthly payments is:

nt of principal you will still owe is:

he loan period. So the balloon payment in 30

for $68,000. The contract is in the form of a 60-month

C C C C C
r loan of $67,500. The interest rate is 7 percent per year,
ow much total interest is paid over the life of the loan?

e as the PV of the annuity. So, the loan payment will be:

rincipal payment is the total payment minus the

he ending balance for a period is the beginning

Ending
Balance
55762.38
43203.13
29764.73
15385.64
0.01

14813.11 $

e loan agreement calls for a principal reduction

yment is the beginning balance times the interest rate for the period,
for a period is the beginning balance for the next period. The

Ending

Balance
54000
40500
 27000
13500
0

est. Imagine you are discussing a loan with a somewhat

cent. You and the lender agree that the interest on the loan will be .
and gives you $21,650. In this case, we say that the discount is

interest rate quoted in the problem is only

the $25,000 you must repay in one year, and the
 360

$975 $975 $975

360

FV

59 60

C C
 1

–$25,000