Time Value of Money Problems

1.

What is the PV of $100 received in:

a.
b.
c.
d.

Year 10 at a discount rate of 1 percent.

Year 10 at a discount rate of 13 percent.
Year 15 at a discount rate of 25 percent.
Each of years 1 through 3 at a discount rate of 12 percent.
a. PV = $100/1.0110 = $90.53
b. PV = $100/1.1310 = $29.46
c. PV = $100/1.2515 = $ 3.52
d. PV = $100/1.12 + $100/1.122 + $100/1.123 = $240.18

N=

10

10

15

I=

13

25

12

90.53

29.46

3.52

240.18

100

100

100

100

Cpt. PV =
Pmt =
FV =
2.

For each of the following, compute the future value:

Present Value

Years

Interest Rate

$1,000

10%

$2,500

12.25%

N=
I=
PV =
Pmt =
Cpt. FV =

322961247.doc

10%

12.25%

1,000

2,500

1,464.10

5,001.01

Future Value

Page 1

3.

For each of the following, compute the interest rate:

Present Value

Years

$5,500

$12,000

$7,500

15

$60,000

N=
Cpt. I =
PV =
Pmt =
FV =
4.

15

10.2433%

14.8698%

-5,500

-7,500

$12,000

$60,000

Interest Rate

Future Value

For each of the following, compute the number of years:

Present Value

Interest Rate

Future Value

$300

5%

450

$27,500

10.125%

$60,000

Cpt. N =
I=
PV =
Pmt =
FV =

322961247.doc

Years

8.3104

8.0891

10.125

-300

-27,500

450

60,000

Page 2

5.

A factory costs $800,000. You believe that it will produce a cash flow of $170,000 a year
for 10 years. If the opportunity cost of capital is 14 percent, what is the NPV of the factory?
What will the factory be worth at the end of five years?
The present value of the 10-year stream of cash inflows is:
1

1
PV $170,000

$886,739.6 6
10
0.14 0.14 (1.14)

Thus:
NPV = $800,000 + $886,739.66 = +$86,739.66
CF0 = -800,000
CF1 = 170,000

I = 14
F1= 10

Cpt NPV =
86,739.66

At the end of five years, the factorys value will be the present value of the five remaining
$170,000 cash flows:

1
1

$583,623.7 6
5
0.14 (1.14)
0.14

PV $170,000

N=

I=

14

Cpt. PV =
Pmt =
FV =

322961247.doc

583,623.76
170,000
0

Page 3

6.

A machine costs $380,000 and it is expected to produce the following cash flows.

Year

10

CF ($000S)

50

57

75

80

85

92

92

80

68

50

If the cost of capital is 12 percent, what is the machines NPV?

10

NPV
t0

Ct
$50,000 $57,000 $75,000 $80,000 $85,000
$380,000

t
1.12
(1.12)
1.12 2
1.12 3
1.12 4
1.12 5

$92,000 $92,000 $80,000 $68,000 $50,000

$23,696.15
1.12 6
1.12 7
1.12 8
1.12 9
1.1210

Or
CF0

-380

I=

12%

CF1

50

Cpt NPV =

23.69615

CF2

57

CF3

75

CF4

80

CF5

85

CF6

92

CF7

92

CF8

80

CF9

68

CF10

50

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7.

Mike Polanski is 30 years of age and his salary next year will be $40,000. Mike forecasts
that his salary will increase at a steady rate of 5 percent per year until his retirement at age
60.
a.
b.
c.

If the discount rate is 8 percent, what is the PV of these future salary payments?
If Mike saves 5 percent of his salary each year and invests these savings at an
interest rate of 8 percent, how much will he have saved by age 60?
If Mike plans to spend these savings in even amounts over the subsequent 20 years,
how much can he spend each year?
a.
Let St = salary in year t
St

(1.08) t

30

PV
t 1

30

t 1

30

t 1

40,000 (1.05) t 1
(1.08) t

(40,000/1. 05)

(1.08 / 1.05) t

30

t 1

38,095.24
(1.0286) t

1
1

$760,379.2 1
30
0.0286 (1.0286)
0.0286

38,095.24

PV(salary) x 0.05 = $38,018.96

Future value = $38,018.96 x (1.08)30 = $382,571.75
1

t
r (1 r)
r

PV C

1
1

20
0.08
0.08

(1.08)

$382,571.7 5 C

1
1

0.08
0.08 (1.08) 20

C $382,571.7 5

$38,965.78

Or
N=
I=

30

30

20

2.86

Cpt. PV = 760,379.21 (0.05)(760,379.21) = 38,018.96 382,571.75

Pmt =
FV =

322961247.doc

38,095.24

Cpt FV = 382,571.75

Cpt Pmt = 38,965.78

Page 5

8.

A factory costs $400,000. It will produce a cash inflow of $100,000 in year 1, $200,000 in
year 2, and $300,000 in year 3. The opportunity cost of capital is 12 percent. Calculate the
NPV
Period

Present Value
400,000.00

0
1

+100,000/1.12 =

+ 89,285.71

+200,000/1.122 =

+159,438.78

+300,000/1.123 =

+213,534.07

Total = NPV = $62,258.56

CF0

-400,000

I=

CF1

100,000

Cpt NPV =

CF2

200,000

CF3

300,000

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12%
$62,258.56

Page 6

9.

Halcyon Lines is considering the purchase of new bulk carrier for $8 million. The
forecasted revenues are $5 million a year and operating costs are $4 million. A major refit
costing $2 million will be required after both the fifth and tenth years. After 15 years, the
ship is expected to be sold for scrap at $1.5 million. If the discount rate is 8 percent, what is
the ships NPV?
We can break this down into several different cash flows, such that the sum of these separate
cash flows is the total cash flow. Then, the sum of the present values of the separate cash
flows is the present value of the entire project. (All dollar figures are in millions.)

Cost of the ship is $8 million

PV = $8 million

Revenue is $5 million per year, operating expenses are $4 million. Thus, operating
cash flow is $1 million per year for 15 years.

1
1

$8.559 million
15
0.08 (1.08)
0.08

PV $1 million

Major refits cost $2 million each, and will occur at times t = 5 and t = 10.
PV = ($2 million)/1.085 + ($2 million)/1.0810 = $2.288 million

Sale for scrap brings in revenue of $1.5 million at t = 15.

PV = $1.5 million/1.0815 = $0.473 million

Adding these present values gives the present value of the entire project:
NPV = $8 million + $8.559 million $2.288 million + $0.473 million
NPV = $1.256 million
CF0 = -8

I=8

CF1 = 1

F1= 4

CF2 = 1 2 = -1

F2 = 1

CF3 = 1

F3= 4

CF4 = 1 2 = -1

F4 = 1

CF5 = 1

F5= 4

Cpt NPV =1.2552

CF6 = 1 + 1.5 = 2.5 F6 = 1

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10.

As winner of a breakfast cereal competition, you can choose one of the following prizes:
a.
$100,000 now.
b.
$180,000 at the end of 5 years.
c.
$11,400 a year forever.
d.
$19,000 for each of 10 years.
e.
$6,500 next year and increasing thereafter by 5 percent a year forever.
If the interest rate is 12 percent, which is the most valuable prize?
a.
PV = $100,000
b.
PV = $180,000/1.125 = $102,137
c.
PV = $11,400/0.12 = $95,000
d.

1
1

$107,354
10
0.12 (1.12)
0.12

PV $19,000

e.
PV = $6,500/(0.12 0.05) = $92,857
Prize (d) is the most valuable because it has the highest present value.
a

N=

10

I=

12

12

12

Cpt. PV = 100,000 102,137 11,400/0.12 = 95,000 107,354

Pmt =
FV =

322961247.doc

100,000 180,000

19,000
0

Page 8

11.

Siegfried Basset is 65 years of age and has a life expectancy of 12 more years. He wishes to
invest $20,000 in an annuity that will make a level payment at the end of each year until his
death. If the interest rate is 8 percent, what income can Mr. Basset expect to receive each
year?
Mr. Basset is buying a security worth $20,000 now. That is its present value. The unknown
is the annual payment. Using the present value of an annuity formula, we have:
1

t
r (1 r)
r

PV C

1
1

12
0.08 (1.08)
0.08

$20,000 C

1
1

0.08
0.08 (1.08)12

C $20,000

N=

12

I=

PV =

$2,653.90

20,000

Cpt. Pmt = 2,653.90

FV =

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Page 9

12.

David and Helen Zhang are saving to buy a boat at the end of five years. If the boat costs
$20,000 and they can earn 10 percent a year on their savings, how much do they need to put
aside at the end of years 1 through 5?
Assume the Zhangs will put aside the same amount each year. One approach to
solving this problem is to find the present value of the cost of the boat and then
equate that to the present value of the money saved. From this equation, we can
solve for the amount to be put aside each year.
PV(boat) = $20,000/(1.10)5 = $12,418

PV(savings) = Annual savings

0.10 (1.10) 5
0.10

Because PV(savings) must equal PV(boat):

1
1

$12,418
5
0.10 (1.10)
0.10

Annual savings

$3,276
Annual savings $12,418
5
0.10 0.10 (1.10)

Another approach is to find the value of the savings at the time the boat is purchased.
Because the amount in the savings account at the end of five years must be the price
of the boat, or $20,000, we can solve for the amount to be put aside each year. If x is
the amount to be put aside each year, then:
x(1.10)4 + x(1.10)3 + x(1.10)2 + x(1.10)1 + x = $20,000
x(1.464 + 1.331 + 1.210 + 1.10 + 1) = $20,000
x(6.105) = $20,000
x = $ 3,276
Or
N=

I=

10

PV =

Cpt. Pmt = 3,275.95

FV =

322961247.doc

20,000

Page 10

13.

Kangaroo Autos is offering free credit on a new $10,000 car. You pay $1,000 down and then
$300 a month for the next 30 months. Turtle Motors next door does not offer free credit but
will give you $1,000 off the list price. If the rate of interest is 10 percent a year, which
company is offering the better deal?
The fact that Kangaroo Autos is offering free credit tells us what the cash
payments are; it does not change the fact that money has time value. A 10 percent
annual rate of interest is equivalent to a monthly rate of 0.83 percent:
rmonthly = rannual /12 = 0.10/12 = 0.0083 = 0.83%
The present value of the payments to Kangaroo Autos is:

1
1

$8,93 8
30
0.0083 (1.0083)
0.0083

$1,000 $300

A car from Turtle Motors costs $9,000 cash. Therefore, Kangaroo Autos offers the
better deal, i.e., the lower present value of cost.
Or
N=
I=

30
10/12 = 0.8333

Cpt. PV = 7,934.11 7,934.11 + 1,000 = 8,934.11

Pmt =
FV =

322961247.doc

300
0

Page 11

14.

You are building an office building and construction will require two years. The contractor
requires a $120,000 down payment now and commitment of the land with a market value of
$50,000. The contractor will be paid $100,000 in 1 year and a final payment of $100,000 at
the completion of construction in 2 years. Your real estate advisor estimates the office
building will be worth $420,000 when completed. What is the NPV if the cost of capital is 5
percent, 10 percent, and 15 percent? Draw a NPV profile. At what rate would the NPV be
zero? Check your answer.
Time

T=0

Land

-50,000

T=1

T=2

Construction -120,000 -100,000 -100,000

Payoff

420,000

Total CFs -170,000 -100,000

The NPVs are:
at 5 percent

NPV $170,000

320,000
$100,000 $320,000

$25,011
1.05
(1.05) 2

at 10 percent NPV $170,000

$100,000 320,000

$3,554
1.10
(1.10) 2

at 15 percent NPV $170,000

$100,000 320,000

$14,991
1.15
(1.15) 2

The figure below shows that the project has zero NPV at about 11 percent.
As a check, NPV at 11 percent is:
NPV $170,000

NPV

$100,000 320,000

$371
1.11
(1.11) 2

CF0

-170,000

I=

5%

10%

CF1

-100,000

Cpt NPV =

$25,011.34 $3,553.72

CF2

320,000

15%
-$14,990.55

30

20

10

-10

-20

0.05

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0.10

0.15 Rate of Interest

Page 12

15.

You have just read an advertisement stating, Pay us $100 a year for ten years and we will
pay you $100 a year thereafter in perpetuity. If this is a fair deal, what is the rate of
interest?
One way to approach this problem is to solve for the present value of:
(1)
$100 per year for 10 years, and
(2)
$100 per year in perpetuity, with the first cash flow at year 11.
If this is a fair deal, these present values must be equal, and thus we can solve for the
interest rate (r).
The present value of $100 per year for 10 years is:
1

10
(r) (1 r)
r

PV $100

The present value, as of year 10, of $100 per year forever, with the first payment in
year 11, is: PV10 = $100/r
At t = 0, the present value of PV10 is:

$100
1

10
r
(1 r)

PV

Equating these two expressions for present value, we have:

1

$100
1
1

10
10
(r) (1 r) (1 r)
r
r

$100

Using trial and error or algebraic solution, we find that r = 7.18%.

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16.

Which would you prefer?

a.
b.
c.

An investment paying interest of 12 percent compounded annually.

An investment paying interest of 11.7 percent compounded semiannually.
An investment paying 11.5 percent compounded continuously.

Assume the amount invested is one dollar.

Let A represent the investment at 12 percent, compounded annually.
Let B represent the investment at 11.7 percent, compounded semiannually.
Let C represent the investment at 11.5 percent, compounded continuously.
After one year:
FVA = $1 (1 + 0.12)1
FVB = $1 (1 + 0.0585)
FVC = $1 e(0.115 1)
After five years:

= $1.1200
2

= $1.1204

= $1.1219

FVA = $1 (1 + 0.12)5
FVB = $1 (1 + 0.0585)
FVC = $1 e(0.115 5)
After twenty years:

= $1.7623
10

= $1.7657

= $1.7771

FVA = $1 (1 + 0.12)20
FVB = $1 (1 + 0.0585)

= $9.6463
40

= $9.7193

FVC = $1 e(0.115 20) = $9.9742

The preferred investment is C.
b
Nom

c
11.7

Nom

c
11.5

Nom

11.5

Cpt. Eff. 12.0422%

Cpt.
Eff.

12.185%

Cpt.
Eff.

12.186%

C/Y

C/Y

365

C/Y

730

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17.

Fill in the blanks in the following table:

Nominal
Interest Rate

Inflation Rate

6.00%

1.00%

Real Interest Rate

10.00%

12.00%

9.00%

3.00%

1 + rnominal = (1 + rreal) (1 + inflation rate)

Nominal
Interest Rate
6.00%
23.20%
9.00%

Inflation Rate

Real Interest Rate

1.00%
10.00%
5.83%

4.95%
12.00%
3.00%

1.06 = (1 + rreal)(1.01) rreal = .0495

1 + rnominal = (1.1)(1.12) rnominal = 0.2320
1.09 = (1.03) (1 + inflation rate) inflation rate = 0.0583
18.

A leasing contract calls for an immediate payment of $100,000 and nine subsequent
$100,000 semiannual payments at six-month intervals. What is the PV of these payments if
the discount rate is 8 percent?
Because the cash flows occur every six months, we use a six-month discount rate, here
8%/2, or 4%. Thus:

1
1

$843,533
9
0.04 0.04 (1.04)

PV $100,000 $100,000

N=
I=

9
8/2 = 4

Cpt. PV = 743,533 743,533 + 100,000 =843,533

Pmt =
FV =

322961247.doc

100,000
0

Page 15

19.

You estimate that by the time you retire in 35 years, you will have accumulated savings of
$2 million. If the interest rate is 8 percent and you live 15 years after retirement, what
annual level of expenditure will these savings support?
Unfortunately, inflation will eat into the value of your retirement income. Assume a 4
percent inflation rate and work out a spending program for your retirement that will allow
you to maintain a level real expenditure during retirement.
This is an annuity problem with the present value of the annuity equal to $2 million (as of
your retirement date), and the interest rate equal to 8 percent, with 15 time periods. Thus,
your annual level of expenditure (C) is determined as follows:
1

t
r (1 r)
r

PV C

1
1

15
0.08
0.08 (1.08)

$2,000,000 C

C $2,000,000

1
1

0.08
0.08 (1.08)15

or

N=

15

I=

PV =

2,000,000

Cpt. Pmt = 233,659

FV =

$233,659

With an inflation rate of 4 percent per year, we will still accumulate $2 million as of our
retirement date. However, because we want to spend a constant amount per year in real
terms (R, constant for all t), the nominal amount (C t ) must increase each year. For each
year t:
R = C t /(1 + inflation rate)t
Therefore:
PV [all C t ] = PV [all R (1 + inflation rate)t] = $2,000,000
(1 0 .04)1 (1 0.04)2
(1 0 .04)15

.
.
.

$2,000,000
1
(1 0 .08)2
(1 0.08)15
(1 0.08)

R [0.9630 + 0.9273 + . . . + 0.5677] = $2,000,000

R 11.2390 = $2,000,000
R = $177,952
Thus C1 = ($177,952 1.04) = $185,070, C2 = $192,473, etc.
N=
I=
PV =

15

Remember:

3.8462

1 + rnominal = (1 + rreal) (1 + inflation rate)

2,000,000

1.08 = (1 + rreal)(1.04) rreal = .038462

Cpt. Pmt = 177,952

20.

FV = 0
You are considering the purchase of an apartment complex that currently generates a net
cash flow of $400,000 per year. You normally demand a 10 percent rate of return on such

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investments. Future cash flows are expected to grow with inflation at 4 percent year from
todays level. How much would you be willing to pay for the complex if it:
a.
b.

Will produce cash flows forever?

Will have to be torn down in 20 years? Assume that the site will be worth $5 million
at the time of demolition costs. (The $5 million includes 20 years inflation.)
Now calculate the real discount rate corresponding to the 10 percent nominal rate. Redo the
calculations for part (a) and (b) using real cash flows. (Your answers should not change.)
a.

First, with nominal cash flows:

The nominal cash flows form a growing perpetuity at the rate of inflation, 4%. Thus,
the cash flow in one year will be $416,000 and:

b.

PV = $416,000/(0.10 0.04) = $6,933,333

The nominal cash flows form a growing annuity for 20 years, with an additional
payment of $5 million at year 20:
1
1
( 1 g)t
$5,000 ,000
PV C1

t
( 1 r)
( 1 r)t
(r-g) (r g)

1
1
( 1.04 )20
$5,000,000
$ 416,000

20
( 1.10 )
( 1.10 )20
( 0.10-0.04 ) ( 0.10-0.04 )
$5,418,389

Second, with real cash flows:

a. Here, the real cash flows are $400,000 per year in perpetuity, and we can find the real
rate (r) by solving the following equation:

b.

(1 + 0.10) = (1 + r)(1 + 0.04) r = 0.05769 = 5.769%

PV = $400,000/0.057692 = $6,933,333
Now, the real cash flows are $400,000 per year for 20 years and $5 million (nominal)
in 20 years. In real terms, the $5 million dollar payment is:
$5,000,000/(1.04)20 = $2,281,935
Thus, the present value of the project is:

1
1
$ 2 ,281,935

$5,418,510
20
( 1.05769 ) 20
( 0.05769 ) ( 0.05769 )( 1.05769 )

PV $ 400 ,000

[As noted in the statement of the problem, the answers agree, to within rounding errors.]
N=
I=

20
5.7692

Cpt. PV = 5,418,389
Pmt =
21.

400,000

FV = 2,281,935
Vernal Pool, a self-employed herpetologist, wants to put aside a fixed fraction of her annual
income as savings for retirement. Ms. Pool is now 40 years old and makes $40,000 a year.

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She expects her income to increase by 2 percentage points over inflation (e. g., 4 percent
inflation means a 6 percent increase in income). She wants to accumulate $500,000 in real
terms to retire at age 70. What fraction of her income does she need to set aside? Assume
her retirement funds are conservatively invested at an expected real rate of return of 5
percent a year. Ignore taxes.
Let x be the fraction of Ms. Pools salary to be set aside each year. At any point in the
future, t, her real income will be:
($40,000)(1 + 0.02) t
The real amount saved each year will be:
(x)($40,000)(1 + 0.02) t
The present value of this amount is:

x $40,000 1 0.02 t
1 0.05 t
Ms. Pool wants to have $500,000, in real terms, 30 years from now. The present value of
this amount (at a real rate of 5 percent) is:
$500,000/(1 + 0.05)30
Thus:
30
x $40,0001.02
$500,000

30
1.05
1.05 t
t 1
30
$500,000
$40,0001.02

30
1.05
1.05 t
t 1

$115,688.72 = (x)($790,012.82)
x = 0.146

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22.

You own a pipeline which will generate a $2 million cash flow over the coming year. The
pipelines operating costs are negligible, and it is expected to last for a very long time.
Unfortunately, the volume of oil shipped is declining, and cash flows are expected to decline
by 4 percent per year. The discount rate is 10 percent.
a.
b.

What is the PV of the pipelines cash flows if its cash flows are assumed to last
forever?
What is the PV of the cash flows if the pipeline is scrapped after 20 years?
a.
PV

b.

This calls for the growing perpetuity formula with a negative growth rate
(g = 0.04):
$ 2 million
$ 2 million

$14.29 million
0.10 ( 0.04 )
0.14

The pipelines value at year 20 (i.e., at t = 20), assuming its cash flows last
forever, is:

PV20

C 21
C ( 1 g) 20
1
r g
r g

With C1 = $2 million, g = 0.04, and r = 0.10:

PV20

($ 2 million) ( 1 0.04 )20

$ 0.884 million

$ 6.314 million
0.14
0.14

Next, we convert this amount to PV today, and subtract it from the answer to Part (a):
PV $14.29 million

$ 6.314 million
$13.35 million
( 1.10 )20

Most of these problems and part of the solutions are from Chapter 3 in Principles of
Corporate Finance by Brealey, Myers, and Allen 8th edition. Part of the solutions were
generated by Dan Ervin

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