Time Value of Money

Multiple Choice Questions

1. What is the total amount accumulated after three years if someone invests $1,000 today with a
simple annual interest rate of 5 percent? With a compound annual interest rate of 5 percent?
A. $1,150, $1,103
B. $1,110, $1,158
C. $1,150, $1,158
D. $1,110, $1,103
Level of difficulty: Easy
Solution: C.
Simple interest rate: $1,000 + ($1,000)(5%)(3) = $1,150
Compound interest rate: $1,000(1.05)3 = $1,158

2. Which of the following has the largest future value if $1,000 is invested today?
A. Five years with a simple annual interest rate of 10 percent
B. 10 years with a simple annual interest rate of 8 percent
C. Eight years with a compound annual interest rate of 8 percent
D. Eight years with a compound annual interest rate of 7 percent
Level of difficulty: Easy
Solution: C.
A) $1,000 + ($1,000)(10%)(5) = $1,500
B) $1,000 + ($1,000)(8%)(10) = $1,800
C) $1,000(1.08)8 = $1,851
D) $1,000(1.07)8 = $1,718
Therefore, C is the largest.

Interest rates in the following questions are compound rates unless otherwise stated

3. Suppose an investor wants to have $10 million to retire 45 years from now. How much would
she have to invest today with an annual rate of return equal to 15 percent?
A. $18,561
B. $17,844
C. $20,003
D. $21,345
Level of difficulty: Medium
Solution: A.
PV=$10,000,000/(1.15)45=10,000,000/538.7693=$18,561
Or using a financial calculator (TI BAII Plus),
N=45, I/Y=15, PMT=0, FV=10,000,000, CPT PV= –18,561
4. Which of the following is false?
A. The longer the time period, the smaller the present value, given a $100 future value and
holding the interest rate constant.
B. The greater the interest rate, the greater the present value, given a $100 future value and
holding the time period constant.
C. A future dollar is always less valuable than a dollar today if interest rates are positive.
D. The discount factor is the reciprocal of the compound factor.
Level of difficulty: Medium
Solution: B. The greater the interest rate, the smaller the present value, given a $100 future
value and holding time period constant.

5. Maggie deposits $10,000 today and is promised a return of $17,000 in eight years. What is the
implied annual rate of return?
A. 6.86 percent
B. 7.06 percent
C. 5.99 percent
D. 6.07 percent
Level of difficulty: Medium
Solution: A.
FV=PV(1+k)n
17,000=10,000(1+ k)8
8ln(1+k)=ln(1.7), therefore k=6.86%
Or using a financial calculator (TI BAII Plus),
N=8, PV= –10,000, PMT=0, FV=17,000, CPT I/Y=6.86%

6. To triple $1 million, Mika invested today at an annual rate of return of 9 percent. How long
will it take Mika to achieve his goal?
A. 15.5 years
B. 13.9 years
C. 12.7 years
D. 10 years
Level of difficulty: Medium
Solution : C.
FV=PV(1+k)n
(3)(1,000,000)=1,000,000(1.09) n
ln(3)=(n)ln(1.09)
n=12.7 years
Or using a financial calculator (TI BAII Plus),
I/Y=9, PV= –1,000,000, PMT=0, FV=3,000,000, CPT N=12.7
7. Which of the following concepts is incorrect?
A. An ordinary annuity has payments at the end of each year.
B. An annuity due has payments at the beginning of each year.
C. A perpetuity is considered a perpetual annuity.
D. An ordinary annuity has a greater PV than an annuity due, if they both have the same
periodic payments, discount rate and time period.
Level of difficulty: Medium
Solution: D. The annuity due has a greater PV because it pays one year earlier than ordinary
annuity.

8. Jan plans to invest an equal amount of $2,000 in an equity fund every year-end beginning this
year. The expected annual return on the fund is 15 percent. She plans to invest for 20 years. How
much could she expect to have at the end of 20 years?
A. $237,620
B. $176,424
C. $204,887
D. $178,424
Level of difficulty: Difficult
Solution: C.
(1 + k)20 −1 (1 + .15)20 −1
FV20 = PMT   =$ 2,000 .15  = 2,000(102.4436) = $204,887
k
   
Or using a financial calculator (TI BAII Plus),
N=20, I/Y=15, PV=0, PMT= -2,000, CPT FV=204,887

9. In Problem 8, what is the present value of Jan’s investments?

A. $12,625
B. $12,519
C. $14,396
D. $12,396
Level of difficulty: Medium
Solution: B.
1 − 1  1 − 1 
 (1 + k)n   (1.15)20 
PV = PMT = $2,000   = 2,000(6.25933) = $12,519
0   .15
 k   
   
 Or using a financial calculator (TI BAII Plus),
N=20, I/Y=15, FV=0, PMT= –2,000, CPT PV=12,519

10. What is the present value of a perpetuity with an annual year-end payment of $1,500 and
expected annual rate of return equal to 12 percent?
A. $14,000
B. $13,500
C. $11,400
D. $12,500
Level of difficulty: Easy
Solution: D.
PV0=PMT/k=$1,500/.12=$12,500

Practice Problems
11. After a summer of travelling (and not working), a student finds himself $1,500 short for this
year’s tuition fees. His parents have agreed to loan him the money for three years at a simple
interest rate of 6 percent, with interest due at the end of each year.
A. How much interest will he owe his parents after one year?
B. How much will he owe, in total, after three years?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
A. In one year you will own P x k = $1500 x 6% = $90 of interest.
B. After three years, the total (principal and interest) owing will be: P + (n x P x k) = $1500 +
(3 x $1500 x 6%) = $1770.

12. Your sister has been forced to borrow money to pay her tuition this year. If she makes annual
payments on the loan at year end for the next three years, and the loan is for $2,500 at a
simple interest rate of 6 percent, how much will she pay each year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
As the exact amount of interest owing each year will be paid, there is no “compounding.”
The amount of each annual payment will be P x k = $2500 x 6% = $150. Unfortunately, these
payments never reduce the principal owing, so the loan will never be paid off!

13. Khalil’s summer job has given him $1,200 more than he needs for tuition this year. The local
bank pays simple interest at a rate of 0.5 percent per month. How much interest will he earn
in one year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
Khalil will be paid interest each month for 12 months, but without compounding. The total
interest earned is (n x P x k) = (12 x $1200 x 0.5%) = $72.