Seminar 5

Time Value of Money : Part 2

1
Q1:
How much money will you accumulate by the end of
year 5 if you deposit $5,000 each for the next 5 years in
a savings account that earns 7% per year?

2
FV = $5000 {[ (1+.07) - 1] ÷ (.07)}
5

= $5,000 { [0.403] ÷ (.07) }

= $5,000 {5.751}
= $28753.695

3
Q2:

If you can earn 12 percent on your investments, and

you would like to accumulate $100,000 for your
child’s education at the end of 18 years, how much
must you invest annually to reach your goal?

4
$100,000 = PMT {[ (1+.12) 18
- 1] ÷ (.12)}
= PMT{ [6.69] ÷ (.12) }
= PMT {55.75}
$100,000 ÷ 55.75 =
PMT = $1,793.73

5
Q3:

What is the present value of an annuity of $10,000 to

be received at the end of each year for 10 years given a
10 percent discount rate?

6
Using the Mathematical Formula

[
PV = $10,000 { 1-(1/(1.10)10 ] ÷ (.10)}
= $10,000 {[ 0.6145] ÷ (.10)}
= $10,000 {6.145)
= $ 61,445

7
Q4:

What is the present value of stream of payments

equal to $90,000 paid annually and discounted
back to the present at 9 percent?

8
PV = $90,000 ÷ .09 = $1,000,000

9
Q5:
What is the present value of cash flows of $500 at
the end of years 1 through 3, a cash flow of a
negative $800 at the end of year 4, and cash flows
of $800 at the end of years 5 through 10 if the
appropriate discount rate is 5%?

10
Using the Mathematical Formula

(Step 1) PV of $500 ordinary annuity

11
 [
PV = $500 { 1-(1/(1.05)3 ] ÷ (.05)}
= $500 {[ 0.136] ÷ (.05)}
= $500 {2.723)
= $ 1361.62

12
Step 3: Solve (cont.)
Step (2) PV of -$800 at the end of year 4

PV = FV ÷ (1+i)n

PV = -$800 ÷ (1.05)4

= -$658.16

13
Step (3): PV of $800 in years 5-10
First, find PV of ordinary annuity of $800 for 6 years.

[
PV = $800 { 1-(1/(1.05)6 ] ÷ (.05)}
= $800 {[.254] ÷ (.05)}
= $800 {5.076)
= $4060.55

14
Step 3: Solve (cont.)
Second, find the present value of $4060.55
discounted back at 10%.

PV = FV ÷ (1+i)n
PV = $4060.55 ÷ (1.05)4
= $3340.62

15
Present value of complex cash flow stream
= sum of step (1), step (2), step (3)
= $1361.62 - $658.16 + $3340.62
= $4044.08

16
Q6: Value of an annuity versus a single amount

Assume that you just won the state lottery. Your prize can
be taken either in the form of US$40,000 at the end of each
of the next 25 years (i.e., US$1,000,000 over 25 years) or as a
single amount of US$500,000 paid immediately.

a.If you expect to be able to earn 5 percent annually on your

investments over the next 25 years, ignoring taxes and other
considerations, which alternative should you take? Why?
b. Would your decision in part a change if you could earn 7
percent rather than 5 percent on your investments over the
next 25 years? Why?
17
a. N = 25, I = 5%, PMT = $40,000
PV = $563,757.78
At 5%, taking the award as an annuity is better; the present
value is $563,760, compared to
receiving $500,000 as a lump sum. However, one has to live at
least 23.5 years [25 – (63,757.78 excess/ $40,000)] to benefit
more from the annuity stream of payments.

b. N = 25, I = 7%, PMT = $40,000

Solve for NPV = $466,143.33
At 7%, taking the award as a lump sum is better; the present
value of the annuity is only
$466,160, compared to the $500,000 lump-sum payment.
18
Q7:Inflation, time value, and annual deposits
While vacationing in Morocco, Mohammad Jassim saw the vacation
home of his dreams. It was listed with a sale price of US$200,000. The
only catch is that Mohammad is 40 years old and plans to continue
working until he is 65. Still, he believes that prices generally increase
at the overall rate of inflation. Mohammad believes that he can earn 9
percent annually after taxes on his investments. He is willing to invest
a fixed amount at the end of each of the next 25 years to fund the cash
purchase of such a house (one that can be purchased today for
US$200,000) when he retires.
a. Inflation is expected to average 5 percent per year for the next 25
years. What will Mohammad’s dream house cost when he retires?
b. How much must Mohammad invest at the end of each of the next
25 years to have the cash purchase price of the house when he retires?
c. If Mohammad invests at the beginning instead of at the end of each
of the next 25 years, how much must he invest each year?

19
a. N = 25, I = 5%, PV $200,000
FV = $677,270.99

b. N = 25, I = 9%, FV = $677,270.99

PMT = $7,996.03

c. Since Mohammad will have an additional year on which to earn interest at the end of the 25 years his annuity
deposit will be smaller each year. To determine the annuity amount Mohammad will first discount back the
$677,200 one period.

N = 1, I = 9%, FV25 = $677,270.99

PV = $621,349.53

This is the amount Mohammad must accumulate over the 25 years. Mohammad can solve for his annuity
amount using the same calculation as in part b.
N = 25, I = 9, FV = $621,349.53
PMT = 7,335.80

To check this value, multiply the annual payment by 1 plus the 9% discount rate.
$7,335.81 (1.09) = $7996.03

20
Q8: Accumulating a growing future sum

A retirement home at West Island Estates now costs US$185,000. Inflation is

expected to cause this price to increase at 6 percent per year over the 20 years
before Shawqi Dalal retires.

How large an equal, annual, end of-year deposit must be made each year into an
account paying an annual interest rate of 10 percent for Shawqi to have the cash
needed to purchase a home at retirement?

21
Q7: Accumulating a growing future sum

Step 1:Determining the cost of a home in 20 years.

N = 20, I = 6%, PV = $185,000
Solve for FV20 = $593,320.06
Step 2: Determining how much has to be saved annual to afford
home.
Step 2: Determining how much has to be saved annually to afford
home.
N = 20, I = 10%, FV = $593,320.06
Solve for PMT = $10,359.15

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