CHAPTER 5
INTRODUCTION TO VALUATION: THE TIME VALUE
OF MONEY
Learning Objectives
LO1
LO2
LO3
LO4
How to determine the future value of an investment made today.
How to determine the present value of cash to be received at a future date.
How to find the return on an investment.
How long it takes for an investment to reach a desired value.
Answers to Concepts Review and Critical Thinking Questions
1.
(LO2) The four parts are the present value (PV), the future value (FV), the discount rate (r), and the
number of payments or periods (t).
2.
(LO1, 2) Compounding refers to the growth of a dollar amount through time via reinvestment of
interest earned. It is also the process of determining the future value of an investment. Discounting is
the process of determining the value today of an amount to be received in the future.
3.
(LO1, 2) Future values grow (assuming a positive rate of return); present values shrink.
4.
(LO1, 2) The future value rises (assuming it’s positive); the present value falls.
5.
(LO2) It’s a reflection of the time value of money. The Province of Ontario gets to use the $76.04
immediately. As payment for deferring his own use of that money, the investor receives one interest
payment of $23.96 plus return of the principal amount of $76.04 on the maturity date.
6.
(LO2) The key considerations would be: (1) Is the rate of return implicit in the offer attractive relative
to other, similar risk investments? and (2) How risky is the investment; i.e., how certain are we that
we will actually get the $10,000? Thus, our answer does depend on who is making the promise to
repay.
7.
(LO2) The Province of Alberta security would have a somewhat higher price because Alberta is a
stronger borrower than Ontario, as reflected in a AAA credit rating for Alberta and a lower AA credit
rating for Ontario.
8.
(LO2) The price would be higher because, as time passes, the price of the security will tend to rise
toward $100. This rise is just a reflection of the time value of money. As time passes, the time until
receipt of the $100 grows shorter, and the present value rises. In 2010, the price will probably be
higher for the same reason. We cannot be sure, however, because interest rates could be much higher,
or Ontario’s financial position could deteriorate. Either event would tend to depress the security’s
price.
301
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this solutions
manual, rounding may appear to have occurred. However, the final answer for each problem is found
without rounding during any step in the problem.
Basic
1.
(LO1) The simple interest per year is:
$5,000 × .08= $400
So after 10 years you will have:
$400 × 10 = $4,000 in interest.
The total balance will be $5,000 +4,000 = $9,000
With compound interest we use the future value formula:
FV = PV(1 +r)t
FV = $5,000(1.08)10 = $10,794.62
The difference is:
$10,794.629,000 = $1,794.62
2.
(LO1) To find the FV of a lump sum, we use:
FV = PV(1 + r)t
FV = $2,250(1.10)11
FV = $8,752(1.08)7
FV = $76,355(1.17)14
FV = $183,796(1.07)8
3.
= $ 6,419.51
= $ 14,999.39
= $687,764.17
= $315,795.75
(LO2) To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $15,451 / (1.07)6
PV = $51,557 / (1.13)7
PV = $886,073 / (1.14)23
PV = $550,164 / (1.09)18
= $10,295.65
= $21,914.85
= $43,516.90
= $116,631.32
302
4.
(LO3) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
FV = $297 = $240(1 + r)2;
FV = $1080 = $360(1 + r)10;
FV = $185,382 = $39,000(1 + r)15;
FV = $531,618 = $38,261(1 + r)30;
5.
r = ($297 / $240)1/2 – 1
r = ($1080 / $360)1/10 – 1
r = ($185,382 / $39,000)1/15 – 1
r = ($531,618 / $38,261)1/30 – 1
= 11.24%
= 11.61%
= 10.95%
= 9.17%
(LO5) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for t, we get:
t = ln(FV / PV) / ln(1 + r)
FV = $1,284 = $560(1.09)t;
FV = $4,341 = $810(1.10)t;
FV = $364,518 = $18,400(1.17)t;
FV = $173,439 = $21,500(1.15)t;
6.
t = ln($1,284/ $560) / ln 1.09
= 9.63 years
t = ln($4,341/ $810) / ln 1.10
= 17.61 years
t = ln($364,518 / $18,400) / ln 1.17 = 19.02 years
t = ln($173,439 / $21,500) / ln 1.15 = 14.94 years
(LO3) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
r = ($290,000 / $55,000)1/18 – 1 = 9.68%
7.
(LO4) To find the length of time for money to double, quadruple, etc., the present value and future
value are irrelevant as long as the future value is twice the present value for doubling, fourtimes as
large for quadrupling, etc. To answer this question, we can use either the FV or the PV formula. Both
will give the same answer since they are the inverse of each other. We will use the FV formula, that
is:
FV = PV(1 + r)t
Solving for t, we get:
t = ln(FV / PV) / ln(1 + r)
The length of time to double your money is:
FV = $2 = $1(1.07)t
t = ln 2 / ln 1.07 = 10.24 years
303
The length of time to quadruple your money is:
FV = $4 = $1(1.07)t
t = ln 4 / ln 1.07 = 20.49 years
Notice that the length of time to quadruple your money is twice as long as the time needed to double
your money (the difference in these answers is due to rounding). This is an important concept of time
value of money.
8.
(LO3) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
r = ($34,958 / $27,641)1/5 – 1 = 4.81%
9.
(LO4) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for t, we get:
t = ln(FV / PV) / ln(1 + r)
t = ln ($170,000 / $40,000) / ln 1.053 = 28.02 years
10. (LO2) To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $650,000,000 / (1.074)20 = $155,893,400.10
11. (LO2) To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $1,000,000 / (1.10)80 = $488.19
12. (LO1) To find the FV of a lump sum, we use:
FV = PV(1 + r)t
FV = $50(1.045)105 = $5,083.71
13. (LO1, 3) To answer this question, we can use either the FV or the PV formula. Both will give the
same answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
r = ($2,648,700 / $15000)1/42 – 1 = 13.11%
304
To find the FV of the first prize, we use:
FV = PV(1 + r)t
FV = $2,648,700(1.1311)28 = $83,379,797.94
14. (LO2) To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $485,000 / (1.2590)67 = $0.10
15. (LO3) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
r = ($10,311,500 / $12,377,500)1/4 – 1 = – 4.46%
Notice that the interest rate is negative. This occurs when the FV is less than the PV.
Intermediate
16. (LO3) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for r, we get:
r = (FV / PV)1 / t – 1
a. PV = $100 / (1 + r)6 = $76.04
r = ($100 / $76.04)1/6 – 1 = 4.67%
b. PV = $81 / (1 + r)1 = $76.04
r = ($81 / $76.04)1/1 – 1 = 6.52%
c. PV = $100 / (1 + r)5 = $81.00
r = ($100 / $81)1/5 – 1 = 4.30%
17. (LO2) To find the PV of a lump sum, we use:
PV = FV / (1 + r)t
PV = $170,000 / (1.11)10 = $59,871.36
18. (LO1) To find the FV of a lump sum, we use:
FV = PV(1 + r)t
FV = $4,000 (1.11)45 = $438,120.97
FV = $4,000 (1.11)35 = $154,299.40
305
Better start early!
19. (LO1) We need to find the FV of a lump sum. However, the money will only be invested for six
years, so the number of periods is six.
FV = PV(1 + r)t
FV = $20,000(1.084)6 = $32,449.33
20. (LO4) To answer this question, we can use either the FV or the PV formula. Both will give the same
answer since they are the inverse of each other. We will use the FV formula, that is:
FV = PV(1 + r)t
Solving for t, we get:
t = ln(FV / PV) / ln(1 + r)
t = ln($75,000 / $10,000) / ln(1.11) = 19.31
So, the money must be invested for 19.31 years. However, you will not receive the money for another
two years.
From now, you’ll wait:
2 years + 19.31 years = 21.31 years
306
Calculator Solutions
1. (LO1)
Enter
10
N
8%
I/Y
$5,000
PV
PMT
FV
$10,794.62
$2,250
PV
PMT
FV
Solve for
$10,794.62 – 9,000 = $1,794.62
2. (LO1)
Enter
11
10%
N
I/Y
Solve for
Enter
7
N
8%
I/Y
$8,752
PV
PMT
FV
$14,999.39
14
N
17%
I/Y
$76,355
PV
PMT
FV
$687,764.17
8
N
7%
I/Y
$183,796
PV
PMT
FV
$315,795.75
6
N
7%
I/Y
7
N
13%
I/Y
23
N
14%
I/Y
18
9%
Solve for
Enter
Solve for
Enter
Solve for
3. (LO2)
Enter
Solve for
Enter
Solve for
Enter
Solve for
Enter
$6,419.51
PV
$10,295.65
PMT
$15,451
FV
PV
$21,914.85
PMT
$51,557
FV
PV
PMT
$886,073
FV
$ 43,516.90
$550,164
307
N
I/Y
PMT
FV
$240
PV
PMT
$297
FV
$360
PV
PMT
$1080
FV
$39,000
PV
PMT
$185,382
FV
$38,261
PV
PMT
$531,618
FV
9%
I/Y
$560
PV
PMT
$1,284
FV
10%
I/Y
$810
PV
PMT
$4,341
FV
17%
I/Y
$18,400
PV
PMT
$364,518
FV
15%
I/Y
$21,500
PV
PMT
$173,439
FV
$55,000
PV
PMT
$290,000
FV
Solve for
4. (LO3)
Enter
2
N
Solve for
Enter
10
N
Solve for
Enter
15
N
Solve for
Enter
30
N
Solve for
5. (LO4)
Enter
Solve for
N
9.63
Enter
Solve for
N
17.61
Enter
Solve for
N
19.02
Enter
Solve for
6. (LO3)
Enter
Solve for
N
14.94
18
N
I/Y
11.24%
I/Y
11. 61%
I/Y
10.95%
I/Y
9.17%
I/Y
9.68%
PV
$116,631.32
308
7. (LO4)
Enter
Solve for
N
10.24
Enter
Solve for
8. (LO3)
Enter
N
20.49
5
N
Solve for
9. (LO4)
Enter
Solve for
10. (LO2)
Enter
N
28.02
7%
I/Y
$1
PV
PMT
$2
FV
7%
I/Y
$1
PV
PMT
$4
FV
$27,641
PV
PMT
$34,958
FV
$40,000
PV
PMT
$170,000
FV
PV
$155,893400.13
PMT
$650,000,000
FV
PV
$488.19
PMT
$1,000,000
FV
I/Y
4.8%
5.3%
I/Y
20
N
7.4%
I/Y
80
N
10%
I/Y
105
N
4.50%
I/Y
Solve for
11. (LO2)
Enter
Solve for
12. (LO1)
Enter
$50
PV
PMT
$15000
PV
PMT
$2,648,700
PV
PMT
Solve for
13. (LO1, 3)
Enter
42
N
Solve for
Enter
I/Y
13.11%
28
N
13.11%
I/Y
67
N
25.90%
I/Y
Solve for
14. (LO2)
Enter
Solve for
15. (LO3)
Enter
Solve for
4
N
I/Y
–4.46%
PV
$0.10
$12,377,500
PV
309
FV
$5083.71
$2,648,700
FV
FV
$83,379,792.91
PMT
$485,000
FV
PMT
$10,311,500
FV
16. a. (LO3)
Enter
6
N
Solve for
16. b.
Enter
1
N
Solve for
16. c.
Enter
5
N
Solve for
17. (LO2)
Enter
I/Y
4.67%
I/Y
6.52%
I/Y
4.3%
PMT
$100
FV
$81
PV
PMT
$76.04
FV
PMT
$100
FV
PMT
$170,000
FV
$81
PV
10
N
11%
I/Y
45
N
11%
I/Y
$4,000
PV
PMT
FV
$438,120.97
35
N
11%
I/Y
$4,000
PV
PMT
FV
$154,299.40
6
N
8.40%
I/Y
$20,000
PV
PMT
FV
$32,449.33
11%
I/Y
$10,000
PV
Solve for
18. (LO1)
Enter
$76.04
PV
PV
$59,871.36
Solve for
Enter
Solve for
19. (LO1)
Enter
Solve for
20. (LO4)
Enter
Solve for
N
19.31
From now, you’ll wait 2 + 19.31 = 21.31 years
310
PMT
$75,000
FV