Finance I

Tutorial n°1: Time Value of Money

Professor: Mr. Ridha Esghaier

(Fall 2017)

Multiple Choices Questions:

Q1. Which of the following is/are NOT CORRECT?

a. In compound rate of interest, the interest earned on the principal during the specified period do not earn
interest in the subsequent periods.
b. In simple rate of interest, the interest earned on the principal during the specified period do not earn interest in the
subsequent periods.
c. If the nominal rate is of 12%, then the effective annual rate can never be less than 12%.
d. If there is annual compounding, then the effective, periodic, and nominal rates of interest are all the same.
e. An investment that compounds interest semiannually, and has a nominal rate of 10%, will have an effective
annual rate less than 10%.

Q2. Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years.
One is an ordinary (or deferred) annuity, while the other is an annuity due. Which of the following statements is/are
CORRECT?

a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an
ordinary annuity may be less than the future value of the annuity due.
b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the
annuity due is less than the future value of the ordinary annuity.
c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of
the annuity due also exceeds the future value of the ordinary annuity.
d. The present value of the annuity due equals the present value of the ordinary annuity and the future value of the
annuity due equals the future value of the ordinary annuity.
e. The present value of the ordinary annuity exceeds the present value of the annuity due, and the future value of an
ordinary annuity also exceeds the future value of the annuity due.

Q3. Which of the following is/are TRUE?

a. Investments with the same nominal interest rate but different compounding intervals provide different
effective annual returns.
b. To compare investments with different compounding intervals, you must look at their effective annual
returns
c. The effective annual rate of interest can be used in calculations when annuity payments don’t match
compounding periods.
d. The future value of a lump sum is larger if compounded more often, but its present value is smaller. (holding
the stated interest rate constant)
e. When the number of compounding periods per year increases, the effective annual rate of interest increases
and the periodic rate decreases

1
 EXERCISES:
Exercise n°1: Future Value calculation
A person places the following amounts in a savings account paying 7% interest compounded
annually :
- $5,000 in 1/1/2012
- $8,000 in 1/1/2013
- $10,000 in 1/1/2015
- $12,000 in 31/12/2015
a. Calculate the capital obtained in 1/1/2017.
b. Calculate the amount of Interest.

Solution 1

a. We have to find the future value (FV) of this mixed stream at the 1/1/2017:
FV = 5,000 (1.07)5 + 8,000 (1.07)4 + 10,000 (1.07)2 + 12,000 (1.07)1 = $41,788

b. The amount of interest is obtained by subtracting the amounts invested from the FV:
I = FV – (5,000 + 8,000 + 10,000 + 12,000)
= 41,788 – 35,000 = $6,788

Exercise n°2: present value and Future Value comparison of uneven cash flow stream
Find the present values (at t=0) and the future values (at t=3) of the following cash flow streams
under compound interest rate of 8%.
Which cash flow stream has the higher present value and the higher future value? Why?
YEAR CASH STREAM A CASH STREAM B
1 $100 $300
2 $200 $200
3 $300 $100
Solution 2
Cash Stream A Cash Stream B
0 8% 1 2 3 0 8% 1 2 3
| | | | | | | |
PV 100 200 300 PV 300 200 100
PVA = 100/1.08 + 200/1.082 + 300/1.083 = $502.20
PVB = 300/1.08 + 200/1.082 + 100/1.083 = $528.62

FVA = 100(1.08)2 + 200(1.08)1 + 300 = $632.64

FVB = 300(1.08)2 + 200(1.08)1 + 100 = $665.92

PVB is larger than PVA and FVB larger than FVA because in the cash flow streams the highest
amount ($300) occurs earlier in B compared to A.

Exercise n°3: future value of an annuity

A person places the two series of annuity at 6% compound interest:
- Four annual equal amount of $9,000 (first capital in 1/1/2010).
- Three annual equal amount of $5,000 (first capital in 1/1/2015).
a- Calculate the capital obtained in 31/12/2018.
b- Calculate the amount of interest.

2
Solution 3

a- in this case we have to compute the future value of these two series of annuity:
1st method:
- Treat the first annuity as annuity due (since the CFs are invested at the beginning of the periods)
with 4 equal CF of $9,000 each. When we apply the formula of the FV of an annuity due, we
obtain the FV ONE year after the date of the last deposit, which is the 31/12/2013.

1  i n  1 1  i   9,000
1.064  1 1.06 = 41,733
FV31/ 12 / 2013  CF
i 0.06
In order to obtain the FV at the 31/12/2018, we have to compound the obtained FV (31/12/2013) for
an additional period of 5 years. Hence:
FV31/12/ 2018  FV31/12/ 20131.06 = 41,733 (1.06)5 = 55,848
5

- Treat the second annuity also as an annuity due (since the CFs are invested at the beginning of
the periods) with 3 equal CF of $5,000 each. When we apply the formula of the FV of an annuity
due, we obtain the FV ONE year after the date of the last deposit, which is the 31/12/2017.

FV31/12/ 2017  CF
1  i n  1 1  i   5,000 1.063  1 1.06 = 16,873
i 0.06

In order to obtain the FV at the 31/12/2018, we have to compound the obtained FV (31/12/2017) for
an additional period of 1 year. Hence:

FV31/12/ 2018  FV31/12/ 20171.06 = 16,873 (1.06) = 17,885

The capital obtained at 31/12/2018 is merely the sum of the 2 obtained FV at 31/12/2018.
Capital Obtained 31/12/2010 = 55,848 + 17,885 = 73,733
nd
2 method

Compute the FV of an annuity at the date of its last deposit which gives FV  CF
1  i n  1
i
then compound the obtained FV for the additional number of years remaining until the
date desired.

- Compute FV1/1/2013 (date of the last deposit) of the 4 first deposits (apply the FV of an ordinary
annuity) then compound the FV1/1/2013 for an additional 6 years to obtain FV31/12/2018

FV31/12/ 2018  9,000

1.06  1
4
1.066  55,848
0.06
- Compute FV1/1/2017 (date of the last deposit) of the 3 second deposit (apply the FV of an ordinary
annuity) then compound the FV1/1/2017 for an additional 2 years to obtain FV31/12/2018

FV31/12/ 2018  5,000

1.06  1
3
1.062  17,885
0.06
Total FV31/12/2018 = 55,848 + 17,885 = 73,733

b- The amount of interest is obtained by subtracting the amounts invested (the sum of the CFs) from
the total FV (the sum of the 2 FV pertaining to the 2 annuities) at 31/12/2018:
I = FV – (4 x 9,000 + 3 x 5,000)
= 73,733 – 51,000 = 22,733

3
 Exercise n°4: present value of an annuity
You are given three investment alternatives to analyze. The cash flows from these three
investments are as follows:

End of Years 1 2 3 4 5 6 7 8 9
Invest A 10000 10000 10000 10000 10000
Invest B 10000 10000 10000 10000 10000
Invest C 10000 50000 10000

Assuming a 5% interest rate (discount rate), find the present value (at t=0) of each investment.

Solution 4

► Investment A:

- Investment A has 5 end of period CF of $10,000 each, which implies a case of an ordinary annuity.
The PV of these CF at the beginning of the first period (t=0), is given by the following formula:
1  1  i  1  1.05
n 5

PV0  CF  10,000 = 43,290

i 0.05
1  1  i 
n
- Or we know that the PV of an annuity at the date of its first deposit is CF (1  i )
i
The present value date (t=0) is ONE year before the date of the first deposit (t=1) so:
1  1  i  1  1.05
n 5

PV0  CF (1  i ) x (1+i)  10,000

-1
= 43,290
i 0.05
- Or PV0 = 10,000/1.051 + 10,000/1.052 +… + 10,000/1.055 = 43,290

►Investment B:

- Investment B has 5 end of period CF of $10,000 each, which implies a case of an ordinary annuity.
The first CF occurs at the end of the 5th period. The PV of these CF at the end of the fourth period
(one year before the date of the first deposit) is given by the following formula:
1  1  i  1  1.05
n 5

PV4  CF  10,000 = 43,290

i 0.05
 PV0  PV4 1  i  = 43,290 x (1.05)-4 = 35,627.67
4

1  1  i 
n
- Or we know that the PV of an annuity at the date of its first deposit is CF (1  i )
i
The present value date (t=0) is FIVE years before the date of the first deposit (t=5) so:
1  1  i  1  1.05
n 5

PV0  CF (1  i ) x (1+i)  10,000

-5
 (1.05) 4 = 35,627.67
i 0.05

- Or PV0 = 10,000/1.055 + 10,000/1.056 +… + 10,000/1.059 = 35,627.67

► Investment C:

The CFs of Investments C have different amounts and occur at non-consecutive periods. These
CFs represent, hence, a mixed stream. The PV is given, in this case, by the following formula:
PV0  10,0001.05  50,0001.05  10,0001.05 = 53,270
1 6 9

4
Exercise n°5: Compound interest
You would like to have $75,000 in 15 years. To accumulate this amount, you plan to deposit each
year an equal sum in the bank, which will earn 8% interest compounded annually. Your first payment
will be made at the end of the year.
a- How much must you deposit annually to accumulate this amount?
b- If you decide to make a lump-sum deposit today instead of the annual deposits, how large should this
lump-sum deposit be? (Assume you can earn 8% on this deposit.)
c- At the end of 5 years you will receive $20,000 and deposit this in the bank toward your goal of
$75,000 at the end of 15 years. In addition to this deposit, how much must you deposit in equal
annual deposits to reach your goal? (Again, assume that you can earn 8% on this deposit.)

Solution 5

a- FV  A.
1  i n  1 $75,000  A.
1  8%15  1
A  $2,762.215
i 8%
b- FV = PV. (1 +i)n $75,000 = PV (1+8%)15 PV = $23,643.12

c- FV  A.
1  i   1  $20,000 (1  i ) m
n

$75,000  A.
1  8%  1
15

 $20,000 (1  8%) 10
A.
1  8%  1
15

 $31,821.5
8% 8%
A= $1,171.97

Exercise n°6: Future value of an annuity for various compounding periods

Find the future values of the following ordinary annuities:
a- FV of $400 each 6 months for 5 years at a nominal rate of 12%, compounded semiannually
b- FV of $200 each 3 months for 5 years at a nominal rate of 12%, compounded quarterly
c- The annuities described in parts a and b have the same amount of money paid into them during
the 5-year period, and both earn interest at the same nominal rate, yet the annuity in part b earns
more than the one in part a over the 5 years.
Why does this occur?

Solution 6

0 1 2 3 9 10
a- | | | |  | | M=2 compounding periods per year
400 400 400 400 400
FV = ?
Number of periods nxM = 5  2 = 10, periodic rate = inominal /M = 12% /2 = 6%

FV= 400 x {[(1+6%)10 -1] / 6%} =$5,272.32.

0 1 2 3 19 20
b- | | | |  | | M=4 compounding periods per year
200 200 200 200 200

Now the number of periods is nxM = 5  4 = 20, periodic rate = inominal /M = 12% /4 = 3%,

FV= 200 x {[(1+3%)20 -1] / 3%} =$5,374.07.

c- The annuity in Part b earns more because the money is on deposit for a longer period of time
and thus earns more interest. Also, because compounding is more frequent, more interest is
earned on interest.

5
Exercise n°7: Future value of an annuity
In 10 years you are planning on retiring and buying a house. The house you are looking at
currently costs $100,000 and is expected to increase in value each year at a rate of 5%.
Assuming you can earn 10% in placing a same amount at the end of each of the next 10 years to
be able to buy your dream home when you retire. Compute this amount.

Solution 7

You deposit at the end of each period a constant amount A. the Future Value (FV) of your
investment must be equal to the FV of the house you are planning to buy in 10 years.
The price of the house is increasing annually with a rate (iHouse) of 5%. Hence its FV at the end of
FVHouse  PVHouse 1  iHouse   100,0001.0510 = 162,900
n
the 10th year is:

Your investment represents an ordinary annuity since you will invest a same amount (A) at the
end of each of the next 10 years. The rate of return (interest) you can earn on this annuity is 10%.
The FV of your investment (the annuity) must be equal to the FV of the house. Hence:

FV  A .
1  i  1
n
 FV House  FV  A .
1.10  1
10

 FVHouse =162,900
i 0.10
FV = A X 15.937 = 162,900
A= 162,900 / 15.937 = 10,221.49
The amount you must invest at the end of each of the following 10 years is A= 10.221,49

Exercise n°8 :Value of missing payments

You recently made a 20-year investment that pays you $100 at t = 1, $500 at t = 2, $750 at t = 3, and
some fixed cash flow, X, at the end of each of the remaining 17 years. You purchased this
investment for $5,544.87. Alternative investments of equal risk have a required return of 9% (that is,
the annual interest rate is 9%). What is the annual cash flow received at the end of each of the final
17 years, that is, what is X?

Solution 8:
𝟏𝟎𝟎 𝟓𝟎𝟎 𝟕𝟓𝟎 𝑿 𝑿
𝟓, 𝟓𝟒𝟒. 𝟖𝟕 = + + + +⋯+
𝟏. 𝟎𝟗 𝟏. 𝟎𝟗𝟐 𝟏. 𝟎𝟗𝟑 𝟏. 𝟎𝟗𝟒 𝟏. 𝟎𝟗𝟐𝟎
𝟏 − (𝟏. 𝟎𝟗)−𝟏𝟕
𝟏𝟎𝟎 𝟓𝟎𝟎 𝟕𝟓𝟎 𝐗[ ] (𝟏. 𝟎𝟗)
𝟎. 𝟎𝟗
𝟓, 𝟓𝟒𝟒. 𝟖𝟕 = + + +
𝟏. 𝟎𝟗 𝟏. 𝟎𝟗𝟐 𝟏. 𝟎𝟗𝟑 𝟏. 𝟎𝟗 𝟒

𝟏 − (𝟏. 𝟎𝟗)−𝟏𝟕
𝐗[ ]
𝟎. 𝟎𝟗
𝟒𝟒𝟓𝟑, 𝟏𝟒𝟗 = 3
𝟏. 𝟎𝟗
𝟏. 𝟎𝟗𝟑
𝑿 = 𝟒𝟒𝟓𝟑, 𝟏𝟒𝟗 × = $𝟔𝟕𝟓
𝟏 − (𝟏. 𝟎𝟗)−𝟏𝟕
𝟎. 𝟎𝟗

Exercise n°9 : Effective annual rate

You want to borrow $1,000 from a friend for one year, and you propose to pay her $1,120 at the end
of the year. She agrees to lend you the $1,000, but she wants you to pay her $10 of interest at the
end of each of the first 11 months plus $1,010 at the end of the 12th month. How much higher is the
effective annual rate under your friend’s proposal than under your proposal?
Solution 9
- 1st alternative: 1,000 (1+i) = 1,120 i annual = (1,120/1,000) -1 = 12% (annual nominal = effective annual rate)
- 2nd alternative: The monthly interest rate (Periodic rate) i Monthly = $10/$1000= 1%

So the annual nominal rate = 12x 1% = 12% and the effective annual rate EAR = (1+1%)12 – 1 = 12.68%

The difference between the annual effective rate under my friend’s proposal and mine is (12.68% - 12% ) = 0.68%
6
 Exercise n°10: Nominal and effective rates
An investment pays you 9% interest compounded semiannually. A second investment of equal risk,
pays interest compounded quarterly. What annual nominal rate of interest would you have to receive
on the second investment in order to make you indifferent between the two investments?

Solution 10
- Under the First investment:
The Effective annual rate EAR= (1+ 9%/2)2 -1 = 9.2025%
- Under the Second investment:
The effective annual rate EAR = (1+ 𝒊𝒂𝒏 4
𝑵𝑶𝑴/4) -1

To be indifferent between the two investments (1+ 𝒊𝒂𝒏 4

𝑵𝑶𝑴 /4) - 1 must equal 9.2025%

𝑎𝑛
𝑖𝑁𝑂𝑀⁄ ) = 4√(1 + 9.2025%
(1 + 4
𝒊𝒂𝒏
𝑵𝑶𝑴 = 𝟎. 𝟎𝟖𝟗 = 𝟖. 𝟗%

Exercise n°11: Loan Amortization

You just borrowed $45,000 from a bank at an annual interest rate of 6% to be reimbursed over 5 years.
Construct the amortization schedule in each of the following cases:
A/ reimbursement through Fixed Principal
B/ reimbursement through constant Payment
C/ Interest-only loan (reimbursement through constant interest)
Solution 11

A) Constant Principal Loan:

Beginning Principal Payment Ending

Years Interest (2)
Balance (1) (3) (4) Balance (5)
1 45000 2700 9000 11700 36000
2 36000 2160 9000 11160 27000
3 27000 1620 9000 10620 18000
4 18000 1080 9000 10080 9000
5 9000 540 9000 9540 0

Annual Constant Principal = 45000/5 = 9000 each year

Interest = 6% x Beginning balance (1)
Payment (4) = Principal (3) + interest (2)
Ending Balance (5) = Beginning Balance (1) – Principal (3)

B) Constant Payment Loan:

Beginning Principal Payment Ending

Years Interest (2)
Balance (1) (3) (4) Balance (5)
1 45000 2700 7982.88 10682.84 37017.12
2 37017.12 2221.02 8461.82 10682.84 28555.30
3 28555.30 1713.32 8969.52 10682.84 19585.78
4 19585.78 1175.14 9507.70 10682.84 10078.08
5 10078.08 ≈604.76 10078.08 10682.84 0

1  1  i 
n
i
Loan  Payment This implies that: Payment  Loan
1  1  i 
n
i
7
 6%
Annual Constant Payment (4)  45000  10682.84 each year
1  1  6% 
5

Interest (2) = 6% x Beginning balance (1)

Principal (3) = Payment (4) – interest (2)
Ending Balance (5) = Beginning Balance (1) – Principal (3)

C) Interest-Only Loan: (constant interest)

Each year we reimburse only a constant interest computed on the basis of the amount borrowed
(constant interest = i% x amount borrowed). The amount borrowed is reimbursed in its totality only
at the last year (in the last principal portion of the last year).

Beginning Interest Principal Payment Ending

Years
Balance (1) (2) (3) (4) Balance (5)
1 45000 2700 0 2700 45000
2 45000 2700 0 2700 45000
3 45000 2700 0 2700 45000
4 45000 2700 0 2700 45000
5 45000 2700 45000 47700 0

Annual Constant interest = 6% x 45000 = 2700 each year

Principal 1, 2, 3 and 4 = 0
Principal 5 = amount borrowed = 45000
Payment (4) = Principal (3) + interest (2)
Ending Balance (5) = Beginning Balance (1) – Principal (3)

Exercise n°12 : constant payments Vs constant principals amortization

A five-year loan of $2,000 is to be repaid with payments at the end of each year. It can be repaid
under the following two options:
(a) Equal annual payments at an annual rate of 8%.
(b) Installments of $400 each year plus interest on the unpaid balance at an annual rate of i.
The sum of the payments under option (a) equals the sum of the payments under option (b)
Determine i.

Solution 12
- For method (a), Using n = 5, i = 8%, L0 = $2,000,
1  1  i 
n
i 0,08
L0  PMT so PMT  Lo  2,000 = $500.91
1  1  i  1  1,08 
n 5
i
So the total payment for the 5 years is: 5 x 500.91 = $2504.55
- For method (b), we have

year Capital interest principal Annual Capital

remaining at payment remaining at
the beginning the end
1 2000 2000i 400 400 + 2000i 1600
2 1600 1600i 400 400 + 1600i 1200
3 1200 1200i 400 400 + 1200i 800
4 800 800i 400 400 + 800i 400
5 400 400i 400 400 + 400i 0
The total payment for the 5 years is
(400 + 2000i) + (400 + 1600i) + (400 + 1200i) + (400 + 800i) + (400 + 400i)
= 5× 400 + 6000i = 2000 + 6000i
= 2000 + 6000i must equal the sum of PMTs under the method (a) (= 2504.55)
2000 + 6000i=2504.55  i = 0.084 = 8.4%. 8
Exercise n°13: Loan amortization
A company borrows $100,000 at 8% interest. Equal annual payments are to be made for 6 years.
However at the time of 4th payment, the company decides to pay off the entire loan.
a- Find the equal annual installment (annual payment).
b- Compute the amount of the first principal portion to be repaid at the end of the first year.
b- Calculate the amount of the loan to be paid at the end of the 4th year (the rest).

Solution 13

a- i = 8% , n = 6 , L0 = 100,000
1  1  i 
n
i 8%
L0  PMT PMT  Lo  100,000
1  1  i  1  1  8%
n 6
i
PMT = $21,631.53 = PMT1 = PMT2= … = PMT6

b- We know that PMT1 = 100,000i + P1  P1= PMT1 -100,000i = 21,631.53 – 8% x100,000

P1=$13,631.53
i
We can also compute P1 as follow: P1  Lo  $13,631.53
1  i 6  1
c- Since Pk = Pj (1+i)k-j P1= 13,631.53
P2= P1(1.08)1 =14,722.05
P3= P1(1.08)2 =15,899.81
P4= P1(1.08)3 =17,171.80
After 4 years the amount of the loan already reimbursed is P1 + P2 + P3 + P4 = 61,425.19
 the Rest (L4) = L0-( P1 + P2 + P3 + P4) = 100,000 – 61,425.19 = $38,574.81
we can also compute the remaining balance at the end of year 4 : (the Rest L4) = P5 + P6
P5= P1(1.08)4 =18,545,55
P6= P1(1.08)5 =20,029.26
we can also compute the remaining balance at the end of year 4 (the Rest) using :

Lk  L0  P1
1  i k  1 which gives: L  100,000  13,631,53 1  8%4  1 = $38,574.81
4
i 8%
Amount to be paid at the end of year 4 = PMT at the end of year 4 + Rest (L4)
= 21,631.53 + 38,574.81 = $60,206.34
Exercise n°14: Time to pay off loan
A mortgage of $50,000, with monthly payments $657.07 at 6% annual interest is contemplated.
What amount of time will be required to pay off the mortgage?

Solution 14
1  1  i 
n
PMTmonthly = $657.07; imonthly = 6% /12 = 0.5% ; n = ? months L0  PMT
i
1  1  0.5% 
n
$50,000 = $657.07 x
0.5%
1  1  0.5%
n
 = 76.095
0.5%
1-(1.005)-n = 0.3804  1.005-n = 0.6196

 n = -ln(0.6196) / ln(1.005) = 96 months = 8 years