Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Chapter 5: Time Value of Money Multiple Choice Questions 1. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning Objective: 5.2; 5.3 Level of difficulty: Basic Solution: C. Simple interest rate: $1,000 + ($1,000)(8%)(6) = $1,480 Compound interest rate: $1,000(1+.08)6 = $1,586.87 = $1,587 rounded Or using a financial calculator (TI BA II Plus), N=6, I/Y=8, PV=-1,000, PMT = 0, CPT FV= 1,586.87 2. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning Objective: 5.2; 5.3 Level of difficulty: Intermediate Solution: C Simple interest: Total interest paid over three years: $6,200 - $5,000 = $1,200 Annual interest = $1,200/3 = $400 $400/$5,000 = 8% Compound interest: 1 6,200 ⁄3 ( ) − 1=7.43% 5,000 3. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning Objective: 5.2; 5.3 Level of difficulty: Intermediate Solution: B 4. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning Objective: 5.2; 5.3 Level of difficulty: Basic Solution: D. A) $1,000 + ($1,000)(10%)(5) = $1,500 B) $1,000 + ($1,000)(8%)(10) = $1,800 C) $1,000(1.08)8 = $1,851 D) $1,000(1.07)10 = $1,967 Therefore, D is the largest. Solutions Manual 1 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 5. Section: 5.3 Compound Interest Learning Objective: 5.3 Level of difficulty: Intermediate Solution: B. PV=$15,000,000/(1.05)25=$4,429,541.58 = $4,429,542 rounded Or using a financial calculator (TI BA II Plus), N=25, I/Y=5, FV=15,000,000, PMT = 0, CPT PV= –4,429,541.58 6. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning Objective: 5.2; 5.3 Level of difficulty: Intermediate Solution: B. The greater the interest rate, the smaller the present value, given a $100 future value and holding the time period constant. 7. Section: 5.3 Compound Interest Learning Objective: 5.3 Level of difficulty: Intermediate Solution: D. FV=PV(1+k)n 16,000=10,000(1+ k)8 8ln(1+k)=ln(1.6), therefore k=6.05% Or using a financial calculator (TI BA II Plus), N=8, PV= –10,000, FV=16,000, PMT = 0, CPT I/Y=6.05% 8. Section: 5.3 Compound Interest Learning Objective: 5.3 Level of difficulty: Intermediate Solution: C. FV=PV(1+k)n Assume that the initial investment is $1. (3)(1)=1 (1.09) n ln(3)=(n)ln(1.09) n=12.7 years Or using a financial calculator (TI BA II Plus), I/Y=9, PV= –1, FV=3, PMT = 0, CPT N=12.7 9. Section: 5.4 Annuities and Perpetuities Learning objective: 5.4 Level of difficulty: Intermediate Solution: D. An annuity due has a greater PV because it pays one year earlier than an ordinary annuity. Solutions Manual 2 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 10. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Intermediate Solution: C. (1 k )20 1 (1+.15)20 −1 =$2,000 [ ] = $2,000(102.4436) = $204,887 FV20 PMT .15 k Or using a financial calculator (TI BA II Plus), N=20, I/Y=15, PMT= -2,000, PV = 0, CPT FV=204,887 11. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Intermediate Solution: B. 1 1 (1 k ) n PV0 PMT k 1 = $2,000 [ 1 − (1.15)20 . 15 ] = $2,000(6.25933) = $12,519 Or using a financial calculator (TI BA II Plus), N=20, I/Y=15, PMT= –2,000, FV = 0, CPT PV=12,519 12. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Basic Solution: D. PV0=PMT/k=$1,500/.12=$12,500 13. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Basic Solution: A. PV0=PMT/k=$1,500/.12 + $1,500 =$14,000 14. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Intermediate Solutions Manual 3 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Solution: B PV of annuity of 120 remaining payments at 1% per month: 1 1 1 (1 k ) n 1− (1.01)120 = $3,303.26 [ ] = $3,303.26(69.7005) = $230,238.95 PV0 PMT .01 k Or using a financial calculator (TI BA II Plus), N = 120, I/Y = 1, PMT = -3,303.26, FV = 0, CPT PV = 230,238.95 15. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Challenging Solution: A. The future value of a perpetuity cannot be computed as it is infinite. Practice Problems Basic 16. Section: 5.2 Simple Interest Learning Objective: 5.2 Level of difficulty: Basic Solution: As this is simple interest, Dmitri will earn the same amount of interest each year. The annual amount of interest is 8% x initial investment = .08 x $25,000 = $2,000 a. $2,000 b. $2,000 17. Section: 5.2 Simple Interest Learning Objective: 5.2 Level of difficulty: Basic Solution: a. In one year, he will owe interest of P x k = $1,500 x 6% = $90 b. After three years, the total principal and interest paid will be: P + (n x P x k) = $1,500 + (3 x $1,500 x 6%) = $1,770 18. Section: 5.2 Simple Interest Learning Objective: 5.2 Level of difficulty: Basic Solution: As the exact amount of interest owing each year will be paid, there is no “compounding.” The Solutions Manual 4 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita amount of each annual payment will be P x k = $2,500 x 6% = $150. 19. Section: 5.2 Simple Interest Learning Objective: 5.2 Level of difficulty: Basic Solution: Khalil will be paid interest each month for 12 months without compounding. The total interest earned is n x P x k = 12 x $1,200 x 0.5% = $72 20. Section: 5.3 Compound Interest Learning Objective: 5.3 Level of difficulty: Basic Solution: The payment of compound interest means that we must compound (or find the future value of) the amount invested (the present value): FV12 months $1,200 (1 0.005)12 $1,274.01 Of this amount, $1,200 was the original amount invested, so $74.01 of interest will be earned. 21. Section: 5.2 Simple Interest; 5.3 Compound Interest Learning outcome: 5.2; 5.3 Level of difficulty: Basic Solution: A. Value = P + (n x P x k) = $24 + (394 x $24 x 5%) = $497 B.𝐹𝑉394𝑦𝑒𝑎𝑟𝑠 = $24 × (1 + 0.05)394 = $5,355,438,979 22. Section: 5.3 Compound Interest Learning outcome: 5.3 Level of difficulty: Basic Solution: The future value of the loan (the amount to be repaid) is $5,000. The amount that can be borrowed is the present value amount, calculated as: PV0 FV1 1 1 $5,000 $4,716.98 1 (1 k ) (1 .06)1 Or using a financial calculator (TI BA II Plus), N=1, I/Y=6, FV= -5,000, PMT = 0, CPT PV=4,716.98 Solutions Manual 5 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 23. Section: 5.3 Compound Interest Learning Objective: 5.3 Level of difficulty: Basic Solution: a. FV1 year $20,000 (1 0.10)1 $22,000.00 b. FV5 years $20,000 (1 0.10)5 $32,210.20 c. FV10 years $20,000 (1 0.10)10 $51,874.85 24. Section: 5.3 Compound Interest Learning Objectives: 5.3 Level of difficulty: Basic Solution: Jon needs $800 in three years; that is the future value amount. The present value equivalent is: PV0 FV3 1 1 $800 $691.07 3 (1 k ) (1 .05) 3 Or using a financial calculator (TI BA II Plus), N=3, I/Y=5, FV= -800, PMT = 0, CPT PV=691.07 25. Section: 5.4 Annuities and Perpetuities Learning outcome: 5.4 Level of difficulty: Basic Solution: Present value of the perpetual scholarship payment: 1 1 𝑃𝑉0 = 𝑃𝑀𝑇 [ ] = $5,000 × [ ] = $166,667 𝑘 0.03 26. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Basic Solution: 2 . 0725 0 1 1 7 . 38 % For Bank A, k 2 Solutions Manual 6 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 4 . 0720 0 1 1 7 . 40 % For Bank B, k 4 12 . 0715 0 1 1 7 . 39 % For Bank C, k 12 Bank B pays the highest effective annual rate. 27. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Basic Solution: a. For annual compounding, the effective annual rate will be the same as the quoted rate. To check this: m 1 QR 9.5% k 1 1 1 1 9.5% m 1 b. With quarterly compounding, set m=4, 4 9.5% k 1 1 9.84% 4 c. With monthly compounding, set m=12, 12 9.5% k 1 1 9.92% 12 28. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Basic Solution: a. 𝑘 = Quoted Rate = 6% ⇒ 𝐹𝑉1𝑦𝑒𝑎𝑟 = 𝑃𝑉0 (1 + 𝑘) = $50,000 × (1.06) = $53,000 12 QR b. k 1 1 6.16778% FV1 year $50,000 (1.0616778) $53,083.89 12 QR c. k 1 365 365 1 6.18313% FV1 year $50,000 (1.0618313) $53,091.57 29. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Basic Solutions Manual 7 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Solution: The value of any perpetual stream of payments can be valued as a perpetuity: PMT $2 PV0 $16.67 k 0.12 30. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Basic Solution: Because the fees are paid at the start of the year, this is an annuity due. 1 1 (1 0.06) 3 PV0 $9,500 (1 0.06) $26,917.23 0.06 Or using a financial calculator (TI BA II Plus), Hit [2nd] [BGN] [2nd] [Set] N=3, I/Y=6, PMT= -9,500, FV = 0, CPT PV=26,917.23 31. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Basic Solution: The future value amount is $60,000. The amount to be saved each year is really the payment on an ordinary annuity: (1 0.07)8 1 $60,000 PMT PMT $5,848.07 0.07 Or using a financial calculator (TI BA II Plus), N=8, I/Y=7, PV =0, FV= 60,000, CPT PMT= -5,848.07 32. Section: 5.5 Growing Annuities and Perpetuities Learning Objective: 5.5 Level of difficulty: Basic Solution: Solutions Manual 8 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita $100 𝑃𝑉 = .09−.03 = $1,666.67. The most I would be willing to pay for the investment is the present value, therefore, $1,666.67. 33. Section: 5.8 Comprehensive Examples Learning Objective: 5.8 Level of difficulty: Basic Solution: Annual investment = Annual income – Annual expenditure = $45,000 – $36,000 = $9,000 This is an annuity due. (1 k )n 1 FVn PMT (1 k ) k (1 + .126)35 − 1 = $9,000 [ ] (1.126) = $(9,000)(497.2749)(1.126) = $5,039,384 . 126 Or using a financial calculator (TI BA II Plus), Hit [2nd] [BGN] [2nd] [Set] N=35, I/Y=12.6, PV = 0, PMT= -9,000, CPT FV=5,039,384 34. Section: 5.8 Comprehensive Examples Learning Objective: 5.8 Level of difficulty: Basic Solution: This is an ordinary annuity. (1 0.10)15 1 FV15 $30,000 $953,174.45 0 . 10 No, Tommy will not achieve his goal before retirement. Intermediate 35. Section: 5.1 Opportunity Cost Learning Objective: 5.1 Level of difficulty: Intermediate Solution: Cost = tuition + textbook + loss of income = $800+$300+$900 (0.30 x $3,000) = $2,000 The rent and food are expenses that he will face regardless of taking the course. We are assuming that the extra time he spends studying for the philosophy course will not have any impact on his grades in his other courses and are not placing any value on his enjoyment of Solutions Manual 9 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita the subject. 36. Section: 5.4 Annuities and Perpetuities Learning outcome: 5.4 Level of difficulty: Intermediate Solution: Present value of the perpetual scholarship payment at the end of 4 years: 1 1 𝑃𝑉4 = 𝑃𝑀𝑇 [ ] = $5,000 × [ ] = $166,667 𝑘 0.03 The present value today is $166,667 / (1.03)4 $148,081 . Grace will need to endow $148,081 today for the scholarship to start in 5 years. 37. Section: 5.4 Annuities and Perpetuities Learning outcome: 5.4 Level of difficulty: Intermediate Solution: Find the present value of the four-year annuity at year 3: 1 1 1 (1 k ) n 1 (1 0.05) 4 $6,000 $21,275.70 PV3 PMT k 0.05 Or using a financial calculator (TI BA II Plus), N=4, I/Y=5, PMT= -6,000, FV = 0, CPT PV= 21,275.70 Now, find the present value of this amount today: 1 1 PV0 FV $21,275.70 $18,378.75 3 3 (1 k ) (1.05) Or using a financial calculator (TI BAII Plus), N=3, I/Y=5, PMT = 0, FV= 21,275.70, CPT PV= 18,378.75 38. Section: 5.4 Annuities and Perpetuities Solutions Manual 10 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Learning outcome: 5.4 Level of difficulty: Intermediate Solution: To be indifferent between the two options means that the present value of the annuity must equal $40 million (the immediate payout). $40 = $5 ( 1− 1 (1+𝑘)10 𝑘 ). Solving this using the calculator is the easiest way. N=10, PMT = -5, PV = 40, FV = 0, CPT I/Y. We find an interest rate of 4.28%. If the interest rate is greater than 4.28%, I prefer the immediate payout of $40 million because the present value of the 10-year annuity is less than $40 million. If the interest rate is less than 4.28%, I prefer the annuity because the present value will be greater than $40 million. 39. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Intermediate Solution: Step 1: determine monthly effective rate .09 4 k monthly 1 4 1 / 12 1 0.7444% Step 2: given the monthly effective rate, determine the quoted rate compounded monthly. QR monthly = 12 x 0.7444 = 8.9333% Therefore, 9% compounded quarterly is equivalent to 8.9333% compounded monthly. 40. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Intermediate. Solution: a. m = 365: .24 𝑘 = (1 + 365)365 − 1 = 27.11% Solutions Manual 11 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita .24 b. m = 4: 𝑘 = (1 + 4 )4 − 1 = 26.25% c. m = 3: 𝑘 = (1 + 3 )3 − 1 = 25.97% d. m = 2: 𝑘 = (1 + 2 )2 − 1 = 25.44% .24 .24 𝑘 = 𝑒 .24 − 1 = 27.12% e. Continuous compounding: f. The effective monthly rates for a. to d. are: m i. m=365, f=12 365 QR f .24 12 ) 1=2.02% k (1 ) 1= (1 365 m ii. m=4, f=12 4 QR f .24 12 ) 1 =1.96% k (1 ) 1= (1 4 m iii. m=3, f=12 k (1 iv. m=2, f=12 2 QR f .24 12 ) 1 =1.91% k (1 ) 1= (1 2 m m m 3 QR f .24 12 ) 1 =1.94% ) 1= (1 3 m m 41. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Intermediate Solution: A. The future value of Jane’s account will be: (1 0.06)17 1 FV17 $1,000 $28,212.88 0.06 B. The grant has the effect of increasing the amount saved from $1,000 to $1,200. The future value of the account will now be: (1 0.06)17 1 FV17 $1,200 $33,855.46 0.06 42. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Intermediate Solution: Solutions Manual 12 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Find the present value of the four-year annuity due: 1 1 1 (1 k ) n 1 (1 0.05) 4 (1 k ) $5,000 (1 0.05) $18,616.24 PV5 PMT k 0.05 Or using a financial calculator (TI BA II Plus), Hit [2nd] [BGN] [2nd] [Set] N=4, I/Y=5, PMT= -5,000, FV = 0, CPT PV=18,616.24 Now, discount this amount back five years: 1 1 PV0 FV $18,616.24 $14,586.31 5 5 (1 k ) (1.05) Or using a financial calculator (TI BA II Plus), N=5, I/Y=5, PMT =0, FV= 18,616.24, CPT PV=-14,586.31 43. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Intermediate Solution: We have two separate annuities to consider: the tuition payments, and the savings amounts. First, find the present value of the four annual tuition payments (at time 8, when Felix is due to begin his university studies): 1 1 − (1+0.07)4 𝑃𝑉8 = $15,000 × ( ) = $50,808.17 0.07 This is the amount of savings required at time 8. From the perspective of time 0, this is a future value amount. Next, find the annual savings amount: (1 + 0.07)8 − 1 $50,808.17 = 𝑃𝑀𝑇 [ ] ⇒ 𝑃𝑀𝑇 = $4,952.16 0.07 44. Section: 5.5 Growing Annuities and Perpetuities Learning Objective: 5.5 Level of difficulty: Intermediate Solution: Solutions Manual 13 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita $100 Present value of Grow: 𝑃𝑉𝐺𝑅𝑂𝑊 = .05−.04 = $10,000 $1,000 Present value of Shrink:𝑃𝑉𝑆𝐻𝑅𝐼𝑁𝐾 = .05−(−.02) = $14,285.71 Grow’s present value exceeds the cost by $9,000, while Shrink exceeds the cost by $13,285.71. Shrink is preferred, as it exceeds the investment cost more. 45. Section: 5.5 Growing Annuities and Perpetuities Learning Objective: 5.5 Level of difficulty: Intermediate Solution: PV= $100(1+.03) 0.09−0.3 + $100 = $1,816.67 The most I would pay is $1,816.67, the present value of the investment. In this case, the cash flows start immediately ($100) and then grow by 3% per year. 46. Section: 5.5 Growing Annuities and Perpetuities Learning Objective: 5.5 Level of difficulty: Intermediate Solution: To solve this, we need to realize that the present value of a perpetuity (growing or otherwise) occurs one period prior to the first cash flow. Hence, using the growing perpetuity formula will give us the value of the cash flows in year 4. We need to discount those back to time 0. = $1,180.71 The most I would be willing to pay for this investment is $1,180.71. Solutions Manual 14 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 47. Section: 5.4 Annuities and Perpetuities 5.6; Quoted versus Effective Rates Learning Objective: 5.4; 5.6 Level of difficulty: Intermediate Solution: Solve the annuity equation to find k, the interest rate: 1 1 (1 k ) 5 k ? $25,000.00 $6,935.24 k The calculations are most easily done with a financial calculator (TI BA II Plus), PV = 25,000, PMT=-6,935.24, N= 5, FV = 0, CPT I/Y = 12% The effective annual interest rate is 12 percent. With annual compounding, the nominal (annual) rate will also be 12 percent per year. 48. Section: 5.4 Annuities and Perpetuities; 5.6 Quoted versus Effective Rates Learning Objective: 5.4; 5.6 Level of difficulty: Intermediate Solution: a. There will be 5 x 12 = 60 monthly payments. The calculations are most easily done with a financial calculator (TI BAII Plus), PV = 25,000, PMT=-556.11, N= 60, CPT I/Y = 1.0% Because we used monthly payments, and months as the time period, 1.0% is the effective monthly rate. b. The compounding period matches the payment frequency, so the nominal (annual) rate is: QR m kmonthly 12 1.0% 12.0% 49. Section: 5.6 Quoted versus Effective Rates Learning Objective: 5.6 Level of difficulty: Intermediate Solution: a. Scott will pay interest of ($800–$750) = $50 after one week. This implies a nominal interest rate of $50/$750 = 6.67% per week. With 52 weeks in the year, the nominal rate per year is then 52 x 6.67% = 346.84% b. The effective annual interest rate is k (1 0.0667) 52 1 27.7210 2,772.10% Solutions Manual 15 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 50. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Intermediate Solution: a. In Canada, fixed-rate mortgages use semi-annual compounding of interest, so m=2. The effective annual rate is therefore: m 2 QR 0.064 k 1 1 1 1 6.5024% m 2 b. With monthly payments, f=12. We can find the effective monthly interest rate from the effective annual rate, k: kmonthly 1 k f 1 1 6.5024% 12 1 0.5264% 1 1 c. The amortization period is 20 years, or 20 x 12 = 240 months. Josephine’s monthly payments can be computed as: 1 1 (1 0.005264) 240 PMT $1,322.69 $180,000 PMT 0.005264 Or using a financial calculator (TI BA II Plus), N=240, I/Y=.5264, PV=180,000, FV = 0, CPT PMT = -1,322.69 d. With monthly compounding and payments, the effective monthly interest rate is: m 12 QR f 0.0636 12 kmonthly 1 1 1 1 0.530% m 12 The monthly payments can be computed using a financial calculator (TI BA II Plus), N=240, I/Y=0.53, PV=180,000, FV = 0, CPT PMT = -1,327.24 Although the quoted rate is lower at the credit union than at the bank, the effective rate is higher. Josephine should take the mortgage loan from Providence Bank. The monthly payment for the credit union mortgage would be $1,327.24, which is higher than that at Providence Bank. 51. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Intermediate Solution: With semi-annual compounding (the norm in Canada) and monthly payments, m=2 and f=12.The effective monthly rate is: Solutions Manual 16 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition m Booth, Cleary, Rakita 2 QR f 0.039 12 kmonthly 1 1 1 1 0.3224% m 2 The present value of the mortgage payments over the amortization period (25 years x 12 = 300 months) is: 1 1 (1 0.003224) 300 $576,236.50 PV0 $3,000.00 0.003224 Or using a financial calculator (TI BA II Plus), N=300, I/Y=.3224, PMT=-3,000, FV = 0, CPT PV = $576,236.50 In addition, Charlie has $130,000 available as a down payment. The most he can pay for the house is $576,236.50 + $130,000 = $706,236.50. 52. Section: 5.8 Comprehensive Examples Learning Objective: 5.8 Level of difficulty: Intermediate Solution: a. This is an annuity due. Timmy makes his first payment on his 21st birthday and the last payment on his 60th birthday. When Timmy turns 61, the value of these 40 annuity payments is: (1 0.10) 40 1 FV40 $3,000 (1.10) $1,460,555.43 0.10 Yes, Timmy will achieve his goal by a comfortable margin. b. In the equation for part a, set FV = $1,000,000, and solve for the number of years, n. This is easiest done with a financial calculator (TI BA II Plus), Hit [2nd] [BGN] [2nd] [Set]FV = 1,000,000, I/Y = 10, PMT = -3,000, PV = 0, CPT N = 36.1 Timmy will hit the $1 million-dollar mark in just over 36 years, or shortly after his 57th birthday. 53. Section: 5.8 Comprehensive Examples Learning Objective: 5.8 Level of difficulty: Intermediate Solution: a. 1st Calculate their yearly income available for investment: Monthly income available = $9,000 – $3,000 – $850 –$1,450 = $3,700 Yearly available = $(3,700)(12) = $44,400 2nd Calculate the FV of their investment when they retire: Solutions Manual 17 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition 𝐹𝑉30 = $44,400 [ Booth, Cleary, Rakita (1+.1)30 −1 .1 ]=$7,303,535 Or using a financial calculator (TI BA II Plus), N=30, I/Y=10, PV = 0, PMT=- 44,400, CPT FV=7,303,535 3rd Calculate the amount they will have when they retire: $7,303,535 + $150,000 = $7,453,535 b. This is an annuity due problem. PV=7,453,535, k=10%, n=30 1 $7,453,535 = 𝑃𝑀𝑇 [ 1 − (1+.1)30 .1 ] (1 + .1) PMT=$718,787 Or using a financial calculator (TI BA II Plus), Hit [2nd] [BGN] [2nd] [Set] N=30, I/Y=10, PV= 7,453,535, FV = 0, CPT PMT=-718,787 Challenging 54. Section: 5.1 Opportunity Cost; 5.3 Compound Interest Learning Objective: 5.1; 5.3 Level of difficulty: Challenging Solution: Find the present value of the money paid back to Veda by each investment, using the interest rate on the alternative (the bank account) as the discount rate. For Investment A: PV0 $500 $800 $453.51 $691.07 $1,144.58 2 (1 0.05) (1 0.05)3 For Investment B: PV0 $200 $400 $700 $190.48 $362.81 $604.69 $1,157.98 1 2 (1 0.05) (1 0.05) (1 0.05)3 Veda would prefer Investment B, because it has the higher present value. 55. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Challenging Solution: The dividends for the first five years form an ordinary annuity. Starting in year 6, the reduced dividend stream can be thought of as a perpetuity. However, the value of this perpetuity, as determined by our formula, occurs at year 5 (one year before the first $2 dividend), and must be discounted to the present: Solutions Manual 18 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 1 1 − (1+0.12)5 $2.00 1 𝑃𝑉0 = [$3.00 ( )] + [( ) ] = $10.81 + [$16.67 × 0.5674] 0.12 0.12 (1 + 0.12)5 = $20.27 56. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Challenging Solution: 0.045 k monthly 0.375% 12 Rent payments are typically made at the start of each month (so this is an annuity due). Over three years, we would expect 36 monthly rent payments. However, the last month’s rent must be paid up front, so the annuity includes only 35 payments. The present value of the last month’s rent is $950 because it will be paid today. 1 1 (1 0.00375)35 PV0 $950 (1 0.00375) $950 $32,172.48 0.00375 57. Section: 5.4 Annuities and Perpetuities Learning Objective: 5.4 Level of difficulty: Challenging Solution: It is tempting to view the first option as a perpetuity, but this would be incorrect as the man will die at some time, and the payment will then cease. Thus, option one is an ordinary annuity, with an uncertain number of payments. Option two is much easier to value; it includes exactly 240 monthly payments. kmonthly 0.06 0.5% 12 Using a financial calculator (TI BA II Plus), N = 240, PMT = 3,500, I/Y = 0.5, FV = 0, CPT PV = –488,532.70 For the first option to be a better deal, it must include enough payments so that its present value is at least as great as for option two. Again, using the calculator, PV = –488,532.70, PMT = 2,785, I/Y = 0.5, CPT N = 420.29 Solutions Manual 19 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita So, option one must continue for over 420 monthly payments to equal the value of option two. This is just over 35 years. Hence, the man must live to be at least 100 years old for option one to be a better deal. 58. Section: 5.4 Annuities and Perpetuities Learning outcome: 5.4 Level of difficulty: Challenging Solution: Step 1: determine Betty’s annual deposits: (1 0.05) 40 1 $1,000,000 PMT PMT $8,278.16 0.05 Or using a financial calculator (TI BA II Plus), N=40, I/Y=5, FV= 1,000,000, PV = 0, CPT PMT= -8,278.16 Betty will have to make annual deposits of $8,278.16 per year for 40 years at 5% in order to have $1 million. Step 2: Abe will be making deposits of 2 x 8,278.16 = $16,556.32. How many annual deposits will he need to make in order for the future value to be $1 million? (solve for N) The number of deposits is: 28.52. 1,000,000×.05 𝑙𝑛 [ 16,556.32 + 1] (1 + 0.05)𝑛 − 1 $1,000,000 = $16,556.32 [ ]⇒𝑛= = 28.52 0.05 𝑙𝑛( 1.05) Or using a financial calculator (TI BA II Plus), I/Y=5, PMT= -16,556.32, FV= 1,000,000, PV = 0, CPT N=28.52 Therefore, Abe can afford to wait 11 years (40 – 28.52 = 11.48) before he has to start making his larger deposits. 59. Section: 5.1 Opportunity Cost; 5.2 Simple Interest; 5.3 Compound Interest; 5.4 Annuities and Perpetuities Learning outcome: 5.1; 5.2; 5.3; 5.4 Level of difficulty: Challenging Solution: The manager is confused. To make the choice between the two options you should consider the present value of each set of payments, not the sum of the payments. Summing the payments assumes that the opportunity cost is zero. For example, if your opportunity cost is 10%, then the PV of the long option is $161,009. The value of the house is $250,000 but the cost of the loan (to you) is only $161,009 – a net benefit Solutions Manual 20 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita of $88,991. The PV of the short option is $216,289 – in this case, with an opportunity cost of 10%, the short option costs you $55,280 more. If instead, your opportunity cost is 1%, then the PV of the long option is $390,647, while the PV of the short option is only $333,390. By taking the short option, you will save $57,257. 60. Section: 5.4 Annuities and Perpetuities; 5.6 Quoted versus Effective Rates Learning Objective: 5.4; 5.6 Level of difficulty: Challenging Solution: Step 1: make the payment frequency match the compounding frequency. We need to convert the 6% compounded monthly to a quarterly effective rate. 12 .06 1 kannual 1 12 1 kquarterly 1 kannual 4 1 1 .06 12 4 1 12 12 4 .06 1 12 kquarterly 1.5075% Step 2: Now we have an annuity of 5 x 4 = 20 quarterly payments, a present value of $50,000, and an effective quarterly rate of 1.5075%. Solving for the payments, we get $2,914.44. 61. Section: 5.4 Annuities and Perpetuities; 5.6 Quoted versus Effective Rates Learning Objective: 5.4; 5.6 Level of difficulty: Challenging Solution: Step 1: make the payment frequency match the compounding frequency. We need to convert the 6% compounded quarterly to a monthly effective rate. Solutions Manual 21 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition .06 1 kannual 1 4 Booth, Cleary, Rakita 4 1 kmonthly 1 kannual 12 1 1 .06 4 12 1 4 .06 1 4 kmonthly 0.4975% 4 12 Step 2: Now we have an annuity of 10 x 12 = 120 monthly payments, a present value of $250,000, and an effective monthly rate of 0.4975%. Solving for the payments, we get $2,771.75. 1 1 (1 0.004975)120 PMT $2,771.75 $250,000 PMT 0.004975 Or using a financial calculator (TI BA II Plus), N=120, I/Y=.4975, PV= 250,000, FV = 0, CPT PMT= -2,771.75 62. Section: 5.3 Compound Interest; 5.4 Annuities and Perpetuities Learning Objective: 5.3; 5.4 Level of difficulty: Challenging Solution: a. We know the future value and present value amounts, as well as the monthly interest rate. Finding the number of time periods (months) is most easily done with a financial calculator (TI BAII Plus), PV = 15,000, FV = -20,000, I/Y = 0.5, PMT = 0, CPT N = 57.68 It will take approximately 58 months before Roger can afford to buy the car. b. Solving the following equation for “n” we get: $20,000 = $15,000(1.005)𝑛 + $250 [ (1.005)𝑛 −1 .005 ] n= 14.86. Or using a financial calculator (TI BA II Plus), I/Y=0.5, PV=15,000, FV= -20,000, PMT = 250, CPT N = 14.86 63. Section: 5.3 Compound Interest; 5.6 Quoted versus Effective Rates Learning Objective: 5.3; 5.6 Level of difficulty: Challenging Solution: Solutions Manual 22 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Let’s assume the present value of the investment is $1. The future value, after doubling, is then $2. a. Annually: With annual compounding, the effective rate is the same as the quoted rate, 9%. Using a financial calculator (TI BA II Plus), PV = –1, FV = 2, I/Y = 9, PMT =0, CPT N = 8.04 So the investment will double in 8.04 years. b. Quarterly: With quarterly compounding, the effective annual rate is: 4 0.09 k 1 1 9.3083% , and a financial calculator allows us to find: 4 PV = -1, FV = 2, I/Y = 9.3083, PMT = 0, CPT N = 7.79 The higher effective rate means that only 7.79 years are needed to double the value of the investment. 64. Section: 5.4 Annuities and Perpetuities Learning Objectives: 5.4 Level of difficulty: Challenging Solution: a. The present value of the annual payments can be found with a financial calculator, (TI BAII Plus): N=9, PMT = -6,000, I/Y = 5.0, FV = 0, CPT PV = 42,646.93 As this is less than $50,000, the immediate payment alternative is better. b. This problem can be solved by trial and error, but the task is much easier with a financial calculator, (TI BA II Plus), N=9, PMT = –6,000, PV = 50,000, FV = 0, CPT I/Y = 1.5675%. At an interest rate below 1.5675% per year, the nine-year annuity would be preferable; above that rate, the immediate payment is better. 65. Section: 5.5 Growing Annuities and Perpetuities Learning Objective: 5.5 Level of difficulty: Challenging Solution: Solutions Manual 23 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita n PMT1 1 g PV0 1 k g 1 k n PMT1 1 g n FVn PV0 (1 k ) 1 (1 k ) k g 1 k n $1,000,000 = PMT1 1 .04 1 .06 .04 1 .06 PMT1 .02 25 (1 .06) 25 PMT1 1 .0625 1 .0425 .02 *1.62603439 The initial deposit is $12,299.86 (1 0.06) 25 1 $1,000,000 PMT PMT $18,226.72 0.06 If Xiang made constant deposits (i.e., no growth), he would have to deposit $18,226.72 per year for the next 25 years. 66. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Challenging Solution: a. The effective monthly interest rate is, 2 0.051 12 kmonthly 1 1 0.4206% 2 The amount of the mortgage loan will be ($380,000 – $150,000) = $230,000, and there will be 12 x 25 = 300 monthly payments, the value of which can be found with a financial calculator, (TI BAII Plus), N=300, PV = –230,000, I/Y = 0.4206, FV = 0, CPT PMT = 1,350.89. Alysha’s two friends will be paying 2 x $475 = $950 in rent, so she will need an additional $1,350.89 – $950 = $400.89 to make the mortgage payments. b. In two years, Alysha will have made 24 payments, leaving 276. The present value of these payments is the outstanding value of the mortgage loan. Use the calculator again: N=276, I/Y = 0.4206, PMT = 1,350.89, FV = 0, CPT PV = 220,336.58. To pay off the loan, and recoup her down payment, Alysha would have to sell the house for at least $220,336.58 + $150,000 = $370,336.58. Solutions Manual 24 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 67. Section: 5.6 Quoted versus Effective Rates; 5.7 Loan or Mortgage Arrangements Learning Objective: 5.6; 5.7 Level of difficulty: Challenging Solution: a. First, find the effective interest corresponding to the frequency of Jimmie’s car payments (f =12); with monthly compounding, set m=12, QR k monthly 1 m m f 12 8.5% 1 1 12 12 1 0.70833% The 60 car payments form an “annuity” whose present value is the amount of the loan (the price of the car): 1 1 60 (1 0.0070833) $29,000 PMT PMT $594.98 0.0070833 Or using a financial calculator (TI BA II Plus), N=60, I/Y=.70833, PV= 29,000, FV = 0, CPT PMT= -594.98 b. Use the effective monthly interest rate from part a, k=0.70833% Period 1 2 3 4 5 6 7 8 9 10 11 12 13 ... 35 36 (1) Principal Outstanding (2) Payment (3) Interest =k*(1) 29,000.00 28,610.44 28,218.12 27,823.01 27,425.11 27,024.40 26,620.84 26,214.42 25,805.13 25,392.94 24,977.82 24,559.77 24,138.76 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 594.98 205.42 202.66 199.88 197.08 194.26 191.42 188.56 185.69 182.79 179.87 176.93 173.97 170.98 14,083.18 13,587.95 594.98 594.98 99.76 96.25 (4) Principal Ending Principal Repayment = (2)= (1)-(4) (3) 389.56 28,610.44 392.32 28,218.12 395.10 27,823.01 397.90 27,425.11 400.72 27,024.40 403.56 26,620.84 406.42 26,214.42 409.29 25,805.13 412.19 25,392.94 415.11 24,977.82 418.05 24,559.77 421.01 24,138.76 424.00 23,714.76 495.22 498.73 13,587.95 13,089.22 Solutions Manual 25 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition 37 ... 59 60 Booth, Cleary, Rakita 13,089.22 594.98 92.72 502.26 12,586.96 1,177.43 590.79 594.98 594.98 8.34 4.18 586.64 590.79 590.79 0.00 The first monthly payment repays $389.56 of the principal amount of the loan and the last payment repays $590.79. c. After three years, or 36 monthly payments, the principal outstanding is $13,089.22 (from the amortization table). The present value of this amount is: 1 $10,152.19 PV0 $13,089.22 (1 0.0070833) 36 68. Section: 5.6 Quoted versus Effective Rates; 5.7 Loan or Mortgage Arrangements Learning Objective: 5.6, 5.7 Level of difficulty: Challenging Solution: The 60 monthly payments form an annuity whose present value is $30,000. Finding the interest rate is most easily done with a financial calculator (TI BA II Plus), N=60, PMT=-622.75, PV= 30,000, FV =0, CPT I/Y = 0.75% Note that we used N=60 months, so the solution is a monthly interest rate, however, the problem asks for the effective annual rate. k (1 k monthly)12 1 (1 0.0075)12 1 9.38% The quoted rate would be: 1 1 QR m [(1 k ) 12 1] 12 [(1 0.0938) 12 1] 9.00% Or simply: QR m k monthly 12 0.0075 9.00% 69. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Challenging Solution: Solutions Manual 26 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Part 1: determine the principal outstanding after the 60th payment (i.e., How much will the next mortgage be for?) Step 1: determine effective monthly rate: 1 .06 2 12 kmonthly 1 1 0.00493862 2 Step 2: determine the monthly payments: 1 1 (1 0.00493862) 300 $250,000 PMT 0.00493862 PMT $1,599.5162 Or using a financial calculator (TI BA II Plus), N=300, I/Y=.493862, PV=250,000, FV =0, CPT PMT = -1,599.5162 Step 3: determine the present value of remaining (300 – 60) payments of $1,599.5162 1 1 (1 0.00493862) 30060 $224,591.7542 PV $1,599.5162 0.00493862 Or using a financial calculator (TI BA II Plus), N=240, I/Y=.493862, PMT=-1,599.5162, FV = 0, CPT PV = $224,591.7542 Part 2: determine new monthly payment Step 1: determine new effective monthly rate 1 .08 2 12 kmonthly 1 1 0.00655820 2 Step 2: determine the new monthly payment Solutions Manual 27 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 1 1 (1 0.00655820) 30060 $224,591.7542 PMT 0.00655820 PMT $1,860.4231 Or using a financial calculator (TI BA II Plus), N=240, I/Y=.65582, PV=224,591.7542, FV = 0, CPT PMT = -1,860.4231 Franklin’s new monthly payment is $1,860.42. 70. Section: 5.7 Loan or Mortgage Arrangements Learning Objective: 5.7 Level of difficulty: Challenging Solution: a. PV=$200,000, monthly rate=12%/12=1%, N = (10)(12) =120 months 1 $200,000 = 𝑃𝑀𝑇 [ 1 − (1+.01)120 . 01 ] 1 𝑃𝑀𝑇 = $200,000/ [ 1 − (1+.01)120 . 01 ] So, PMT=$2,869.42 Or using a financial calculator (TI BA II Plus), N=120, I/Y=1, PV= 200,000, FV = 0, CPT PMT=-2,869.42 b. Remaining months to pay=120 – 18=102 months 1− 𝑃𝑉0 = $2,869.42 [ 1 (1+.01)102 .01 ]=$182,946.63 Or using a financial calculator (TI BA II Plus), N=102, I/Y=1, PMT=- 2,869.42, FV = 0, CPT PV=182,946.63 2 c. kmonthly= (1 .12 12 ) 1 =.9759% 2 1 $200,000 = 𝑃𝑀𝑇 [ 1 − (1+.009759)120 . 009759 ] Solutions Manual 28 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 1 𝑃𝑀𝑇 = $200,000/ [ 1 − (1+.009759)120 . 009759 ] So, PMT=$2,836.08 Or using a financial calculator (TI BA II Plus), N=120, I/Y=.9759, PV=200,000, FV = 0, CPT PMT=-2,836.08 71. Section: 5.8 Comprehensive Examples Learning Objective: 5.8 Level of difficulty: Challenging Solution: Investor A: k=e.15 – 1=16.183424%. 1st, consider an ordinary annuity and the present value of the investment when A turns 25 years old is: 1 1 8 (1 .16183424) =$23,749.19 PV25 $5,500 .16183424 Or using a financial calculator (TI BA II Plus), N=8, I/Y=16.183424, PMT=-5,500, FV = 0, CPT PV= 23,749.19 2nd, discount this amount for five years back to today when she is 20. PV0 FV5 1 1 $23,749.19 $11,218.3231 5 (1 k ) (1.16183424) 5 Or, N=5, I/Y=16.183424, PMT = 0, FV=- 23,749.19, CPT PV=11,218.3231 Investor B: .16 4 k= (1 ) 1 =16.985856% 4 1 1 10 (1 .16985856) $11,218.3231 PMT (1.16985856) .16985856 PMT=$2,057.38 Or using a financial calculator (TI BA II Plus), Solutions Manual 29 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Hit [2nd] [BGN] [2nd] [Set] N=10, I/Y=16.985856, PV=11,218.3231, FV = 0, CPT PMT= - 2,057.38 Therefore, Investor B has to make a yearly payment of $2,057.38 so that the present value of the two investments is the same. Solutions Manual 30 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Answers to Concept Review Questions 5.1 Opportunity Cost Concept Review Questions 1. Why does money have a “time value”? An investor can simply store dollars (tuck them under the bed!) and spend them in the future. In this sense a dollar is always worth at least a dollar in the future. However, this ignores the fact that the saver has other uses for that dollar, which in economics we call an “opportunity cost” or simply an “alternative use.” This results in a “time value” of money. 2. What is an “opportunity cost”? The opportunity cost of money is the interest rate you can earn by investing a dollar today. 5.2 Simple Interest Concept Review Questions 1. Explain how simple interest payments are determined. Simple interest payments are n × P × k, where n is the number of periods in years, P is the principal, and k is the simple annual interest rate. 2. Does simple interest take into account the time value of money? Explain. Simple interest can be used to calculate the future value of money assuming that only the principal is reinvested. In practice, compound interest is more realistic. 5.3 Compound Interest Concept Review Questions 1. Explain how to compute future values and present values when using compound interest. FVn = PV0 (1 + 𝑘)𝑛 , where PV0 is the present value, k is the compound value interest factor, n is the number of periods, and FVn is the future value in year n. 2. What is the relationship between FVIFs and PVIFs? Why does this make sense? FVIF=1/PVIF. This relationship make sense because by definition, FVIF = (1 + 𝑘)𝑛 and PVIF = 1/(1 + 𝑘)𝑛 . 3. Why does compound interest result in higher future values than simple interest? Compound interest refers to a process whereby interest is earned on the invested principal amount and on any accrued interest. However, simple interest is only earned on the principal amount. Solutions Manual 31 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita 5.4 Annuities and Perpetuities Concept Review Questions 1. Explain how to calculate the present value and future value of an ordinary annuity and an annuity due. (1 k )n 1 FVn PMT gives the future value of an ordinary annuity. k Since each flow gets one extra period of compounding in an annuity due, the FV (annuity due) = [FV (ordinary annuity)](1 + k). The present value of both an annuity and an annuity due is PV0 = FVn /(1 + 𝑘)𝑛 . 2. Define “perpetuity.” Perpetuities are special annuities in that they go on forever, so n goes to infinity in the annuity equation. 3. Why is the present value of $1 million in 50 years’ time worth very little today? If the required return is 12% a year, the present value of $1 million in 50 years’ time is only $3,460. The small present value is caused by the discounting process. 5.5 Growing Perpetuities and Annuities Concept Review Questions 1. Explain how to evaluate a growing perpetuity. Estimate the payment (PMT), the required rate of return (k), and the expected growth rate to infinity (g), and apply Equation 5.10. 2. Explain how to calculate the present value of a growing annuity. Estimate the payment (PMT), the required rate of return (k), the number of years for the annuity (n), the expected growth rate per period over a given period of time (g), and apply Equation 5.12. 5.6 Quoted Versus Effective Rates Concept Review Questions 1. Why can effective rates often be very different from quoted rates? If the quoted rates are not annually compounded, the effective rates are different from the quoted rates because of the different number of compounding periods. 2. Explain how to calculate the effective rate for any period. m QR The effective annual rate for any given compounding interval: k 1 1 , where k = m effective annual rate, QR = quoted rate, and m = the number of compounding intervals per year. Rates for payments that are other than annual payments require an effective period rate. The Solutions Manual 32 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita m QR f effective period rate for payments other than annual is given as k 1 1 , where k = m effective period rate, QR is the nominal quoted rate, m = the number of compounding periods per year, and f = the frequency of payments per year. 5.7 Loan or Mortgage Arrangements Concept Review Questions 1. Explain how loan and mortgage payments can be determined using annuity concepts. Since these loans involve equal payments at regular intervals based on one fixed interest rate specified when the loan is taken out, the payments can be viewed as annuities. 2. What complications arise when dealing with mortgage loans in Canada? In Canada, the interest rates are quoted semi-annually and the payments are made monthly. Mortgages are amortized over long periods of time, but the rates are set for terms or periods that may be shorter than the amortization period. When the term expires, a new rate of interest needs to be negotiated and interest rates may have increased. 5.8 Comprehensive Examples Concept Review Questions 1. Explain how timelines can be used to break a complicated time value of money problem into manageable components. You can visualize the problem and break complicated cash flows into its three constituent parts since you should develop an understanding of what is approximately the right answer. 2. Demonstrate how to solve a typical retirement problem. There are three steps. First, calculate the present value of retirement funds in the year of retirement. Second, calculate the cash you need to raise through investment in the year of retirement. Third, determine the required year-end payments to give you the future value of the amount that is calculated in the second step. Solutions Manual 33 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Case 5.1 1. a. Effective annual interest rate is: ( k= 1+ QR m m ) ( -1= 1+ 0.045 2 2 ) - 1 = 4.5506% Effective monthly interest rate is: kmonthly = (1 + k)1/f - 1 = (1 + 4.5506%)1/12 - 1 = 0.37153% Shanna would pay an effective monthly interest rate of 0.37153%. b. The mortgage principal is $325,000 – $48,750 = $276,250 There are 25 x 12 = 300 monthly payments. Using a financial calculator (TI BA II Plus), N = 300, I/Y = 0.37153, PV = 276,250, FV = 0, CPT PMT = –1,528.97 The monthly mortgage payment would be $1,528.97. 2. a. Shanna has $840 in savings each month over 48 months earning interest at 1.5% annually, compounded monthly (1.5%/12 = 0.125%). Using a financial calculator (TI BA II Plus), N = 48, I/Y = 0.125%, PV = 0, PMT = 840, CPT FV = 41,527 Shanna will have $41,527 at the end of four years. b. Shanna’s down payment will be the sum of her grandparents’ gift and her savings: $48,750 + $41,527 = $90,277 c. The mortgage principal is $325,000 – $90,277 = $234,723 Solutions Manual 34 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Using a financial calculator (TI BA II Plus), N = 300, I/Y = 0.37153, PV = 234,723, FV = 0, CPT PMT = –1,299.13 The monthly mortgage payment would be $1,299.13. 3. a. Shanna will make 48 monthly payments of $840 into her RRSP, earning interest at 6.5% annually, compounded monthly (6.5%/12 = 0.5417%). Using a financial calculator (TI BA II Plus), N = 48, I/Y = 0.5417%, PV = 0, PMT = 840, CPT FV = 45,906 Shanna will have $45,906 at the end of four years. b. Shanna will make a total of 43 x 12 = 516 payments of $840 each. Using a financial calculator (TI BA II Plus), N = 516, I/Y = 0.5417%, PV = 0, PMT = 840, CPT FV = 2,363,608 Shanna will have $2,363,608 at age 65. 4. a. Shanna will make 36 monthly payments of $840 into her RRSP and her opening balance of $5,386 will grow as well at 0.5417% per month. Using a financial calculator (TI BA II Plus), N = 36, I/Y = 0.5417%, PV = 0, PMT = 840, CPT FV = 33,291 N = 36, I/Y = 0.5417%, PV = -5,386, PMT = 0, CPT FV = 6,542 Shanna’s account at age 26 will be $33,291 + $6,542 = $39,833 b. Without the Caribbean trip, Shanna had accumulated $45,906. She would have saved $6,073 less ($45,906 – $39,833) by going on the trip. This is the correct answer because the $5,000 would have grown to $6,073 over 36 months. c. Shanna will make a further 39 x 12 = 468 payments of $840 each. Solutions Manual 35 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita Using a financial calculator (TI BA II Plus), N = 468, I/Y = 0.5417%, PV = 0, PMT = 840, CPT FV = 1,788,293 N = 468, I/Y = 0.5417%, PV = -39,833, PMT = 0, CPT FV = 499,202 Shanna will have $1,788,293 + $499,202 = $2,287,495 at age 65. She will have $76,113 ($2,363,608 – $2,287,495) less money saved at age 65. This is confirmed by calculating the future value of $5,000 over 504 months (42 years). Shanna must weigh the advantages of enjoying a Caribbean vacation one year from now versus allowing that $5,000 expenditure from either being invested and growing to $76,113 at age 65 or growing for a further three years to be used as a down payment. The mortgage payment of $1,299 represents 32.5% of her gross monthly income of $4,000. This is a higher percentage than is generally recommended. Her goal of acquiring a house in four years seems to be too aggressive, even without the Caribbean vacation. However, she may be able to acquire a house that lends itself to a rental opportunity, possibly to university students. She needs to find a way to increase her gross income or lower her expenditures, or both. She will benefit from the RRSP contributions for the first four years, but then the RRSP one-time withdrawal of the accumulated amount will be punitive for income tax purposes. The grandparents’ gift of $48,750 is an opportunity that is significant, and she should strive to achieve her goal of home ownership. Her financial picture would be much improved thanks to the time value of money if the Caribbean vacation did not take place. Solutions Manual 36 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited. Introduction to Corporate Finance, Fifth Edition Booth, Cleary, Rakita LEGAL NOTICE Copyright © 2020 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved. The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence. The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd. MMXX ii F1 Solutions Manual 37 Chapter 5 Copyright © 2020 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission is strictly prohibited.