SOLUTION TO PRACTICE PROBLEMS

1. Consider the following cash flows and interest rates:

Period Interest Rate Cash Flow

1 5% 5,000
2 6% 1,000
3 7% 1,000
4 7% 1,000

a) What is the present value of each of the cash flows if the cash flows occur at the end
of the period?
FVn
PV0 
(1  k ) n

5,000 1,000 1,000 1,000

PV  1
  
(1.05) (1.05)(1.06) (1.05)(1.06)(1.07) (1.05)(1.06)(1.07) 2

PV  4,761.9048  898.4726  839.6940  784.7608

 7,284.8322  7,284.83

b) What is the present value of each of the cash flows if the cash flows occur at the
beginning of the period?
FVn
PV0 
(1  k ) n
5,000 1,000 1,000 1,000
PV  0
  
(1.05) (1.05) (1.05)(1.06) (1.05)(1.06)(1.07)
PV  5,000.00  952.3810  898.4726  839.6940
 7,690.5476  7,690.55

c) What is the future value of each of the cash flows if the cash flows occur at the end
of the period?

FVn  PV0 1  k 
n

FV  5,000(1.06)(1.07) 2  1,000(1.07) 2  1,000(1.07)  1,000

FV  6,067.97  1,144.90  1,070  1,000  9,282.87

d) What is the future value of each of the cash flows if the cash flows occur at the
beginning of the period? (Annuity due)

FVn  PV0 1  k 
n

FV  5,000(1.05)(1.06)(1.07) 2  1,000(1.06)(1.07) 2  1,000(1.07) 2  1,000(1.07)

FV  6,371.3685  1,213.594  1,144.90  1,070.00  9,799.86
2. Mr. G Day has approached his bank about a loan. He expects to receive $30,000 in
three years and $85,000 nine years from now. These funds will be applied against the
loan as they are received. The bank suggests that interest will be 9 percent for the
next five years and 7 percent in subsequent years. Calculate the maximum amount
Mr. G Day can borrow.

FVn
PV0 
(1  k ) n
PV = 30,000 + 85,000 = 23,165.50 + 42,145.51 = $65,311.02
3 5 4
(1.09) (1.09) (1.07)
3) Debbie is looking at an investment fund that will provide cash flows of $2,000 per year
forever.
a) What is the present value of the payments if the interest rate is 8% per year and the
cash flows occur at the end of the year?

PMT 2,000
PV    25,000
k .08
b) What is the present value of the payments if the payments were allowed to grow at a
rate of 5% per year and the payments occur at the end of the year?

PMT 2,000 2,000

PV     66,666.67
k  g .08  .05 .03
c) What is the present value of the payments if the payments were allowed to grow at a
rate of 5% per year and the payments occur at the beginning of the year?

PMT 2,000
PV  (1  k )  (1.08)  72,000
k g .08  .05
4)
The Atlantic Lottery Corporation has a new lottery game that it recently introduced. The
lottery promises $1,000 a week for the next 25 years. There are instant prizes that have a
total value of $125,000. If the current interest rates are 4.5% compounded weekly, how
many tickets at $4.00 each must the Lottery Corporation sell to break even? **assuming the
$1000 is at the beginning of each week

Since payments are weekly, we need to determine an effective weekly rate.

n = 52*25 = 1300 periods
m 52
 k f  0.045 
52

k effective  1    1  1    1  0.000865385
 m  52 
Find the present value of the weekly payments and add to the value of the instant prizes.
 1  1 n 
PV  PM T (1 k )  (1  k )  prizes
 k 
1  1
1300 
 1,000 (1.000865385)  (1.000865385)  125,000  780,894.07  125,000.00  905,894.07
 .000865385 

and they must sell 905,894.07 ÷ 4 = 226,473.5175 = 226,474 tickets to break even.

5)
Congratulations on the birth of your first child. As part of the planning for the future of
your child, you realize that a university education must be in the future. However, as a
student, you also realize that education and living expenses while at university are quite
expensive. You plan to send your child to university by age 17 and tuition and
accommodations are paid at the start of the school year. You estimate that tuition and
accommodation that currently costs $9,500 will grow by 3% per year for the next 17 years.
How much will you need to deposit on a monthly basis into an account to meet your goal?

Assumptions: Tuition and accommodation will grow at a constant rate of 3% during 10

years of post secondary, graduate and post graduate education.
Tuition and accommodation will be paid at beginning of year.
Interest rate is 5.5% compounded monthly.
First deposit will be made at the end of this month.
Once your child starts university, no more deposits are to be made.
0 Savings 17 Spending 27

Expected tuition for year 1 FV  PV(1  k) n  9,500(1.03)17  15,702.05

m/f 12 / 1
 k  0.055 
k annual  1    1  1    1  0.05640786  5.640786%
 m  12 
 interest
factor Present
Year Tuition 5.640786% Value
1 15,702.05 1.0000000 15,702.05
2 16,173.11 1.0564079 15,309.53
3 16,658.30 1.1159976 14,926.83
4 17,158.05 1.1789486 14,553.69
5 17,672.80 1.2454506 14,189.88
6 18,202.98 1.3157038 13,835.17
7 18,749.07 1.3899198 13,489.32
8 19,311.54 1.4683222 13,152.11
9 19,890.89 1.5511471 12,823.34 Total
10 20,487.61 1.6386440 12,502.79 140,484.71

or PV  PMT 1 k
 
1  1g n   1  1.05640786
(1  k )  15,702.05
1.03
10 
(1.05640786)
 k  g   0.05640786  .03 
PV  15,702.058.469174265(1.05640786)  140,484.7066  140,484.71

You require $140,484.71 to be saved upon the child entering university.

Savings period – monthly deposits require a monthly interest rate.
m 12
 k f  0.055 
12

k effective  1    1  1    1  0.004583333
 m  12 
The future value of the savings is 140,484.71 and we require the monthly payment.
 (1  k ) n  1 FV
Using FV  PMT  we can isolate the payment as PMT 
 k   (1  k ) n  1
 
 k 
n = 17 * 12 = 204

FV 140,484.71 140,484.71
PMT     417.6272327  417.63
 (1  k )  1
n
 (1.00458333)  1 204
336.3877856
   
 k   0.00458333 

Therefore, you will need to deposit $417.63 per month to meet your savings goal.

6)
The Smith's have just purchased a new sailboat for $120,000.00 and they are able to provide a
$30,000.00 down payment. The loan is to be amortised over a 15-year period at an 8.375%
interest rate.
a) How large is their monthly payment? * remember compounding frequency for loans is
the same as the payment frequency
Monthly payments require a monthly interest rate.
k effective  1    1  1  .08375
m 12
k
m
f
12
12
 1  .006979167  .6979167%
 n = 12 * 15 = 180 periods *use PV of an annuity formula, solve for payment
PV 120,000  30,000 90,000.00
PMT     879.6835831  879.68
1  1 k n  1  1.006979167180  102.3095142
1 1

   
 k   .006979167 

b) How much interest will be paid over the entire life of the loan?

Total Payments 180 x 879.68 158,342.40

Principal repaid 90,000.00
Total Interest 68,342.40

c) Prepare an amortisation table for the first year’s loan payments.

Opening Mortgage Interest Principal Closing
Num. Balance Payment 0.006979167 Repayment Balance
1 90,000.00 879.68 628.13 251.55 89,748.45
2 89,748.45 879.68 626.37 253.31 89,495.13
3 89,495.13 879.68 624.60 255.08 89,240.06
4 89,240.06 879.68 622.82 256.86 88,983.20
5 88,983.20 879.68 621.03 258.65 88,724.55
6 88,724.55 879.68 619.22 260.46 88,464.09
7 88,464.09 879.68 617.41 262.27 88,201.81
8 88,201.81 879.68 615.58 264.10 87,937.71
9 87,937.71 879.68 613.73 265.95 87,671.76
10 87,671.76 879.68 611.88 267.80 87,403.96
11 87,403.96 879.68 610.01 269.67 87,134.28
12 87,134.28 879.68 608.12 271.56 86,862.73
d) Use the annuity formula to determine the balance owing after making one year's worth
of payments. Does this agree with the amortisation schedule in part c)? Why or Why
not? n = 180 – 12 = 168 remaining payments
1  11k n  1  1.006979167
1
168

PV  PMT   879.68   86,862.33
 k   .006979167 

Difference is rounding

e) What is the value of the outstanding principal (amount owing) after 5 years of
payments have been made? n = 180 – 60 = 120 remaining payments

1  11k n  1  1.006979167
1
120

PV  PMT   879.68   71,334.18
 k   .006979167 
7) The Smith's have just purchased a new home for $120,000.00 and they are able to provide a
$30,000.00 down payment. The loan is to be amortised over a 15-year period at an 8.375%
interest rate.
a) How large is their monthly payment?
Monthly payments require a monthly interest rate. Remember, fixed rate mortgages are
compounded semi-annually.
k effective  1  mk  f  1  1  .08375 12  1  .006860421  .6860421%
m 2

PV 120,000  30,000 90,000.00

PMT     872.2105726  872.21
1  1 k n  1  1.006860421180  103.1860916
1 1

   
 k   .006860421 

b) How much interest will be paid over the entire life of the mortgage?

Total Payments 180 x 872.21 156,997.80

Principal repaid 90,000.00
Total Interest 66,997.80

c) Prepare an amortisation table for the first year’s mortgage payments.

Opening Mortgage Interest Principal Closing
Num. Balance Payment 0.006860421 Repayment Balance
1 90,000.00 872.21 617.44 254.77 89,745.23
2 89,745.23 872.21 615.69 256.52 89,488.71
3 89,488.71 872.21 613.93 258.28 89,230.43
4 89,230.43 872.21 612.16 260.05 88,970.38
5 88,970.38 872.21 610.37 261.84 88,708.54
6 88,708.54 872.21 608.58 263.63 88,444.91
7 88,444.91 872.21 606.77 265.44 88,179.47
8 88,179.47 872.21 604.95 267.26 87,912.21
9 87,912.21 872.21 603.11 269.10 87,643.11
10 87,643.11 872.21 601.27 270.94 87,372.17
11 87,372.17 872.21 599.41 272.80 87,099.37
12 87,099.37 872.21 597.54 274.67 86,824.70

d) Use the annuity formula to determine the balance owing after making one year's worth
of payments. Does this agree with the amortisation schedule in part c)? Why or Why
not?
1  11k n  1  1.006860421
1
168

PV  PMT   872.21   86,824.63
 k   .006860421 

Difference is rounding
e) What is the value of the outstanding principal (amount owing) after 5 years of
payments have been made?

1  11k n  1  1.006860421
1
120

PV  PMT   872.21   71,166.17
 k   .006860421 
8)
Jack from Stewiacke has decided that he will retire in 20 years time. After retirement, Jack
form Stewiacke will require a monthly income of $6,000 per month to maintain his luxurious
lifestyle, to be withdrawn at the beginning of the month. It is expected that Jack from
Stewiacke will live for 20 years after retirement and that interest rates will be 8% compounded
monthly.
a) How much will Jack from Stewiacke need to save to meet his future retirement goals
of being able to withdraw $6,000 per month during his retirement?

Step 1: Determine the effective monthly interest rate:

k effective  1  mk  f  1  1  .12   1  0.0066666667
m 12
08 12

n = 20 years * 12 pmts per year = 240 payments

Step 2: Determine how much he will need in his retirement account, when he retires:

 1 
1  (1  k ) n 
PV  PM T  (1  k )
 k 
 
 1 
1  (1.006666667) 240 
 6,000  (1.006666667)  722,107.90
 0.006666667 
 

b) Jack from Stewiacke has decided that he will put a monthly amount into an account to
meet his savings goal. If interest rates are 8% compounded monthly, how much
should Jack from Stewiacke deposit in his account each month until retirement?
 (1  k ) n  1
Using FV  PMT  we need to solve for PMT
 k 

FV 722,107.90 722,107.90
PMT     1,225.95
 (1  k )  1
n
 (1.006666667)  1 240
589.0204449
   
 k   0.00666667 

c) If Jack from Stewiacke decides to put a lump sum amount into the account today
instead of making monthly payments, what is the value of the lump sum payment?

Find the PV of the savings

FV 722,107.90 722,107.90
PV     146,567.24
(1  k ) n
(1.00666667) 240
(1.082999507) 20
d) Jack from Stewiacke decided to make the monthly deposits that were calculated in part
b). After making payments for 2 years, Jack from Stewiacke won a $25,000 prize in
Lotto 6/49. Jack from Stewiacke decided to take his winnings and deposit all of the
cash into his retirement account and to reduce his monthly payments. If Jack from
Stewiacke plans to exactly meet his savings goal, what are his new monthly payments
into the retirement account.
Find the value in the account at the end of 2 years:
 (1  k ) n  1  (1.00666667) 24  1
FV  PMT   1, 225.95    31,792.79
 k   0.00666667 
Depositing the winnings into the account will provide a balance of
31,792.79 + 25,000.00 = 56,792.79.
The future value of the balance is
FV  PV(1  k) n  56,792.79(1.00666667) 216  238,562.34
The amount of the savings gaol that remains to be saved is
722,107.90 – 238,562.34 = 483,545.56

FV 483,545.56 483,545.56
PMT     1,007.21
 (1  k )  1
n
 (1.006666667)  1 216
480.0861492
   
 k   0.00666667 

9) CapInc. has $75,000 invested in securities that earn a return of 15% compounded
quarterly. The company is developing a new product that they plan to launch in
two years at a cost of $500,000. Management of the firm wants to save money
from now until the launch to be sure of having the $500,000 in time for the
launch. The money the firm has invested in securities can be used to provide part
of the launch fund. CapInc.’s bank has offered an account that will pay 5%
compounded monthly. How much should CapInc. deposit with the bank each
month to have enough reserved for the product launch?

Step 1: Determine the future value of the investment in securities:

k effective  1  mk  f  1  1  .15   1  .15865  15.865%
m 4
4

FVn  PV0 1  k   75,000 1  .15865  $100,685.31

n 2

Step 2: Determine how much the savings annuity must provide:

$500,000 - $100,685.31 = $399,314.69

Step 3: Determine the monthly deposit:

Since deposits will be monthly, we need an effective monthly rate:
k effective  1  mk  f  1  1  .12   1  .004166666
m 12 / 12
05

n =2 * 12 = 24 periods
  (1  k ) n  1 FV
Using FV  PMT  we can isolate the payment as PMT 
 k   (1  k ) n  1
 
 k 
FV $399,314.69
PMT  =
 (1  k ) n  1  (1  .0041666) 24  1
   
 k   .0041666 

PMT = $15,854.68 per month

10) The Tower family wants to make a home improvement that is expected to cost
$60,000. They want to fund as much of the cost as possible with a home equity loan but
can afford payments of only $600 per month. Their bank offers equity loans at 12%,
compounded monthly for a maximum of 10 years.
a. How much cash do they need as a down payment?
b. Their bank account pays 8% per year. If they delay starting the project for two years,
how much would they have to save each quarter to make the required down payment
if the loan rate and the estimated cost remain the same?

a) Step 1: Determine the amount of the home equity loan:

k effective  1  mk  f  1  1  .12   1  .01  1% per month
m 12 / 12
12

n =10 years * 12 = 120 periods

1  11k n  1  1.011120 
PV  PMT   600   $41,820.31
 k   .01 

Step 2: Determine the down payment:

$60,000 – 41,820.31 = $18,179.69

b) Determine the amount they need to save each quarter, to save enough for the down
payment:

Since deposits are quarterly, we need an effective quarterly interest rate:

k effective  1  mk  f  1  1  .08   1  .0194265
m 1/ 4
1

n = 2 years * 4 = 8 periods
 (1  k ) n  1 FV
Using FV  PMT  we can isolate the payment as PMT 
 k   (1  k ) n  1
 
 k 
FV $18,179.69
PMT  =  $2,122.41
 (1  k )  1  (1  .0194265) 8  1
n

   
 k   .0194265 
11) Ted wants to buy a car when he graduates from SMU in two years. He has the
following sources of money:
1. He has $5,000 now in the bank in an account paying 8%, compounded
quarterly.
2. He will receive $2,000 in one year from a trust. This payment will be deposited
into the bank account indicated above.
3. He’ll take out a car loan at the time of purchase on which he’ll make four years
of monthly payments of $500 at 18%, compounded monthly.
4. Ted’s uncle is going to give him $1,500 a quarter starting today for one year.
These payments will also be deposited in the bank account indicated above.
In addition, Ted will save money in a credit union through monthly payroll
deductions at his part-time job. The credit union pays 12%, compounded monthly.
If the car is expected to cost $40,000, how much must he save each month?

In order to determine how much must be save each month, we first need to determine
how much he will have saved in year 2 (when he plans on purchasing the $40,000 car)
from all his current sources of funds.

Step 1: Determine the future value (in year 2) of the $5,000 in his bank account.
k effective  1  mk  f  1  1  .08   1  .08243216 (this is the effective annual rate)
m 4 /1
4

FVn  PV0 1  k   $5,0001  .08243216  $5,858.30

n 2

Step 2: Determine the future value of the trust: Since it is deposited in the same account,
we can use the same effective interest rate.

FVn  PV0 1  k   $2,0001  .08243216  $2,164.89

n 1

Step 3: Determine the amount of the car loan.

k effective  1  mk  f  1  1  .12   1  .015 (effective monthly rate on car loan)
m 12 / 12
18

n = 12 payments per year * 4 years = 48 payments

1  11k n  1  1.015
1
48

PV  PMT   500   $17,021.28
 k   .015 

Step 4: Determine the future value of the $ received from his uncle:

k effective  1  mk  f  1  1  .48   1  .02 (effective quarterly interest rate)

m 4/ 4

n = 4 quarters * 1 year = 4 periods

  (1  k ) n  1  (1  .02) 4  1
FV  PMT  (1+k)  $1,500  (1.02)  $6,306.06
 k   .02 
(annuity due since first payment is today)

FVn  PV0 1  k   $6,306.061  .02  $6,825.88

n 4

Step 5: Determine the total amount saved: (total value in year 2)

$5,858.30+ $2,164.89 + $17,021.28 + $6,825.88 = $31,870.35

Step 6: Determine the additional amount he needs to save in order to purchase the car:
$40,000 - $31,870.35 = $8,129.65

Step 7: Determine the amount he must save each month (payroll deduction):

k effective  1  mk  f  1  1  .12   1  .01 (effective monthly rate)

m 12 / 12
12

n = 12 payments per year * 2 years = 24 payments

 (1  k ) n  1 FV
Using FV  PMT  we can isolate the payment as PMT 
 k   (1  k ) n  1
 
 k 
FV $8,129.65
PMT  =  $301.39 per month
 (1  k ) n  1  (1  .01) 24  1
   
 k   .01 