CHAPTER 5: Time value of money

Future value and Compounding

Future value (FV): the amount an investment is worth after 1 or more periods

Compounding: the process of accumulating interest on an investment over time to earn more interest

Interest on interest: interest earned on the reinvestment of previous interest payments

Interest on interest =FV compoundinginterest −FV simple interest

Compound interest: interest earned on both the initial principal and the interest reinvested from prior
periods
t
FV =C ×(1+r )

Future value interest factor (future value factor) =(1+r )t

Simple interest: interest earned only on the original principal amount invested

FV =C ×(1+r ×t )

Present value and Discounting

Present value (PV): the current value of future cash flows discounted at the appropriate discount rate

1
PV =C ×
(1+r )t

1
Discount factor (present value interest factor, present value factor) = t
(1+r )

Discount rate (r) (rate of return): the rate used to calculate the PV of future cash flows

Discount: calculate the PV of some future amount

Discounted cash flow (DCF) valuation: calculating the present value of future cash flow to determine its
value today

r càng cao PV càng giảm theo thời gian

FV càng tăng theo thời gian

FV t
Basic present value equation: PV =
( 1+ r )t
Quiz
1. Given r and t >0:
I. Present value interest factors are <1
II. FV interest factors are >1
III. PV interest factors are > FV interest factors
IV. PV interest factors grow as t grows, provided r is held constant

I and II only

2. Fresh out of college, you are negotiating with your prospective new employer. They offer you a
signing bonus of $1,000,000 today or a lump sum payment of $1,250,000 3 years from now. If
you can earn 7% on your invested funds, which of the following is true?

Take the lump sum because it has the higher present value

3. You will receive a $250,000 inheritance in 25 years. You can invest that money today at 8%
compounded annually. What is the PV of your inheritance?

$36,504.48

4. An account was opened with an investment of $2,000 10 years ago. The ending balance in the
account is $3,500. If interest was compounded annually, what rate was earned on the account?

5.76%

5. In a growing Midwestern town, the number of eating establishments at the end of each of the last
5 years are as follows:
Year 1=273
Year 2=279
Year 3=302
Year 4=320
Year 5=344
From the end of year 1 to the end of year 5, the number of eating establishments grew at a rate of
___ compounded annually.

5.95%

6. An account paying annual compound interest was opened with $2,000 10 years ago. Today, the
account balance is $3,500. If the same interest rate is offered on an account paying simple
interest, how much income would be earned over the same time period?

$1,152

7. Homer promises Bart that he will give him $8,000 upon his graduation from college at
Springfield U. How much must Homer invest today to make good on his promise, if Bart is
expected to graduate in 13 years and Homer can earn 6% on his money?
$3,750.71

8. You are choosing between investments offered by 2 different banks. 1 promises a return of 10%
for 3 years using simple interest while the other offers a return of 10% for 3 years using
compound interest. You should:

Choose the compound interest option because it provides a higher return

9. In a growing Midwestern town, the number of eating establishments at the end of each of the last
5 years are as follows:
Year 1=273
Year 2=279
Year 3=302
Year 4=320
Year 5=344
If, over the next 5 years, eating establishments are expected to grow at the same rate as they did
during year 5, forecast the number of eating establishments at the end of year 10.

494

10. An insurance company promises to pay Jane $1 mil on her 65 th birthday in return for 1-time
payment of $125,000. (Jane just turned 30). At what rate of interest would Jane be indifferent
between accepting the company’s offer and investing the premium on her own?

6.1%

11. An account was opened with $2,000 10 years ago. Today, the account balance is $3,500. If the
account paid interest compounded annually, how much interest on interest was earned?

$348

12. In a growing Midwestern town, the number of eating establishments at the end of each of the last
5 years are as follows:
Year 1=273
Year 2=279
Year 3=302
Year 4=320
Year 5=344
If the town’s population was 90,000 at the end of year 5, and the population grew at the same
annual rate as the number of eating establishments between the end of year 1 and the end of year
5, what was the town’s population at the end of year 1?

71,423

13. Your parents agree to pay half of the purchase price of a new car when you graduate from
college. You will graduate and buy the car 2 years from now. You have $9,000 to invest today
and can earn 12% on invested funds. If your parents match the amount of money you have in 2
years, what is the maximum you can spend on the new car?
$22,579

14. You have $200 in an account which pays 5% compound interest. How much additional dollars of
interest would you earn over 6 years if you moved the money to an account earning 6%?

$15.68

15. In 1889, Vincent Van Gogh’s painting, “Sunflowers”, sold for $125. 100 years later it sold for
$36 mil. Had the painting ben purchased by your great-grandfather and passed on to you, what
annual return on investment would your family have earned on the painting?

13.40%

16. An account was opened with $1,000 3 years ago. Today, the account balance is $1,157.63. If the
account earns a fixed annual interest rate, how long will it take until the account has earned a total
of $225 in simple interest?

Between 4 and 5 more years

17. What is the FV of $15,000 received today if it is invested at 7.5% compounded annually for 5
years?

$21,534.44

18. Your grandfather placed $5,000 in a trust fund for you. In 12 years the fund will be worth
$10,000. What is the rate of return on the trust fund?

5.95%

19. You need $3,000 to buy a new stereo for your car. If you have $1,200 to invest at 6%
compounded annually, how long will you have to wait to buy the street?

15.73 years

20. Which of the following statements is/are false, all else the same?
I. PV increases as the discount rate increases
II. PV increase the further away in time the FV
III. PV are always smaller than FV when both r and t are positive

I and II only