09:09 22/11/24 213841945 Chapter 5 Time Value of Money Multiple Choice Questions

Chapter 5: Time Value of Money

Multiple Choice Questions

1. What is the total amount accumulated after three years if someone invests $1,000 today with a
simple annual interest rate of 5 percent? With a compound annual interest rate of 5 percent?
A. $1,150, $1,103
B. $1,110, $1,158
C. $1,150, $1,158
D. $1,110, $1,103
Level of difficulty: Easy
Solution: C.
Simple interest rate: $1,000 + ($1,000)(5%)(3) = $1,150
Compound interest rate: $1,000(1.05)3 = $1,158

2. Which of the following has the largest future value if $1,000 is invested today?
A. Five years with a simple annual interest rate of 10 percent
B. 10 years with a simple annual interest rate of 8 percent
C. Eight years with a compound annual interest rate of 8 percent
D. Eight years with a compound annual interest rate of 7 percent
Level of difficulty: Easy
Solution: C.
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)8 = $1,718
Therefore, C is the largest.

Interest rates in the following questions are compound rates unless otherwise stated

3. Suppose an investor wants to have $10 million to retire 45 years from now. How much would
she have to invest today with an annual rate of return equal to 15 percent?
A. $18,561
B. $17,844
C. $20,003
D. $21,345
Level of difficulty: Medium
Solution: A.
PV=$10,000,000/(1.15)45=10,000,000/538.7693=$18,561
Or using a financial calculator (TI BAII Plus),
N=45, I/Y=15, PMT=0, FV=10,000,000, CPT PV= –18,561
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4. Which of the following is false?

A. The longer the time period, the smaller the present value, given a $100 future value and
holding the interest rate constant.
B. The greater the interest rate, the greater the present value, given a $100 future value and
holding the time period constant.
C. A future dollar is always less valuable than a dollar today if interest rates are positive.
D. The discount factor is the reciprocal of the compound factor.
Level of difficulty: Medium
Solution: B. The greater the interest rate, the smaller the present value, given a $100 future
value and holding time period constant.

5. Maggie deposits $10,000 today and is promised a return of $17,000 in eight years. What is the
implied annual rate of return?
A. 6.86 percent
B. 7.06 percent
C. 5.99 percent
D. 6.07 percent
Level of difficulty: Medium
Solution: A.
FV=PV(1+k)n
17,000=10,000(1+ k)8
8ln(1+k)=ln(1.7), therefore k=6.86%
Or using a financial calculator (TI BAII Plus),
N=8, PV= –10,000, PMT=0, FV=17,000, CPT I/Y=6.86%

6. To triple $1 million, Mika invested today at an annual rate of return of 9 percent. How long
will it take Mika to achieve his goal?
A. 15.5 years
B. 13.9 years
C. 12.7 years
D. 10 years
Level of difficulty: Medium
Solution : C.
FV=PV(1+k)n
(3)(1,000,000)=1,000,000(1.09) n
ln(3)=(n)ln(1.09)
n=12.7 years
Or using a financial calculator (TI BAII Plus),
I/Y=9, PV= –1,000,000, PMT=0, FV=3,000,000, CPT N=12.7

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expected annual rate of return equal to 12 percent?

A. $14,000
B. $13,500
C. $11,400
D. $12,500
Level of difficulty: Easy
Solution: D.
PV0=PMT/k=$1,500/.12=$12,500

Practice Problems
11. After a summer of travelling (and not working), a student finds himself $1,500 short for this
year’s tuition fees. His parents have agreed to loan him the money for three years at a simple
interest rate of 6 percent, with interest due at the end of each year.
A. How much interest will he owe his parents after one year?
B. How much will he owe, in total, after three years?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
A. In one year you will own P x k = $1500 x 6% = $90 of interest.
B. After three years, the total (principal and interest) owing will be: P + (n x P x k) = $1500 +
(3 x $1500 x 6%) = $1770.

12. Your sister has been forced to borrow money to pay her tuition this year. If she makes annual
payments on the loan at year end for the next three years, and the loan is for $2,500 at a
simple interest rate of 6 percent, how much will she pay each year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
As the exact amount of interest owing each year will be paid, there is no “compounding.”
The amount of each annual payment will be P x k = $2500 x 6% = $150. Unfortunately, these
payments never reduce the principal owing, so the loan will never be paid off!

13. Khalil’s summer job has given him $1,200 more than he needs for tuition this year. The local
bank pays simple interest at a rate of 0.5 percent per month. How much interest will he earn
in one year?
Topic: Simple Interest
Level of difficulty: Easy
Solution:
Khalil will be paid interest each month for 12 months, but without compounding. The total
interest earned is (n x P x k) = (12 x $1200 x 0.5%) = $72.

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09:09 22/11/24 213841945 Chapter 5 Time Value of Money Multiple Choice Questions

14. A new Internet bank pays compound interest of 0.5 percent per month on deposits. How
much interest will Khalil’s summer savings of $1,200 earn in one year with this online bank
account?
Topic: Compound Interest
Level of difficulty: Easy
Solution:
The payment of compound interest means that we must compound (or find the future value)
of the amount invested (the present value):
FV12months  $1200  (1  0.005)12  $1274.01
Of this amount, $1,200 was the original amount invested, so $74.01 of interest will be
earned.

15. History tells us that a group of Dutch colonists purchased the island of Manhattan from the
Native American residents in 1626. Payment was made with wampum (likely glass beads and
trinkets), which had an estimated value of $24. Suppose the Dutch had invested this money
back home in Europe and earned an average return of 5 percent per year. How much would
this investment be worth today, 380 years later, using:
A. Simple interest?
B. Compound interest?
Topic: Simple and Compound Interest
Level of difficulty: Easy
Solution:
A. Value = P + (n x P x k) = $24 + (380 x $24 x 5percent) = $480

B. FV
$
24
(
10
.
years
380 
05
) $
2
,
70,
86,
6 .
7 380

16. David has been awarded a scholarship that will pay $2,500 one year from now. However, he
really needs the money today, and has decided to take out a loan. If the interest rate is 8
percent, how much can he borrow so that the scholarship will just pay off the loan?
Topic: Discounting
Level of difficulty: Easy
Solution:
The future value of the loan (the amount to be repaid) is $2,500. The amount that can be
borrowed is the present value amount, calculated as:
1 1
PV0  FV1   $2500   $2314.81
(1  k )1 (1  .08)1
Or using a financial calculator (TI BAII Plus),
N=1, I/Y=8, PMT=0, FV= -2500, CPT PV=2314.81

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4
0 . 
0720

For Bank B, k
1 
17.
4 %
 4
12
0 .  
0715

For Bank C, k 
1 17.
3 %
 12 
Bank B pays the highest effective annual rate.

20. Jimmie is buying a new car. His bank quotes a rate of 9.5 percent per year for a car loan.
Calculate the effective annual rate if the compounding occurs:
A. Annually
B. Quarterly
C. Monthly
Topic: Determining Effective Annual Rates
Level of difficulty: Easy
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 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 

21. If Alysha puts $50,000 in a savings account paying 6 percent per year, how much money will
she have in total at the end of the first year if interest is compounded:
A. Annually?
B. Monthly?
C. Daily?
Topic: Effective vs. Quoted Rates
Level of difficulty: Easy
Solution:
A. k  Quoted Rate  6%  FV1 year  PV0 (1  k )  $50,000  (1.06)  $53,000

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12

B. k   1
QR 
  1  6.1678%  FV1year  $50,000  (1.061678)  $53,083.90
 12 
365

C. k   1
QR 
 1  6.1831%  FV1year  $50,000  (1.061831)  $53,091.55

 365 

22. Tony started a small business and was too busy to consider saving for retirement. Tony sold
the business for $550,000 when he was 55 years old. He thought he could fund his retirement,
because this was a lot more than his friend had amassed in his account. Tony can invest this
total sum and earn 10 percent per year. How much will his investment be worth in five years?
Topic: Investing Early
Level of difficulty: Easy
Solution:
FV5 years  $550,000  (1  0.10) 5  $885,780.50

Tony will have less than his friend in five years because he is not adding more savings to his
account.

23. Public corporations have no fixed life span; as such, they are often viewed as entities that
will pay dividends to their shareholders in perpetuity. Suppose KashKow Inc. pays a
dividend of $2 per share every year. If the discount rate is 12 percent, what is the present
value of all the future dividends?
Topic: Perpetuities
Level of difficulty: Easy
Solution:
The value of any perpetual stream of payments can be valued as a perpetuity:
PMT $2
PV0    $16.67
k 0.12
Each share is worth $16.67.

24. Mary-Beth is planning to live in a university residence for four years while completing her
degree. The annual cost for food and lodging is $5,800 and must be paid at the start of each
school year. What is the total present value of Mary-Beth’s residence fees if the discount rate
(interest rate) is 6 percent per year?
Topic: Annuities Due
Level of difficulty: Easy
Solution:
Because the fees are paid at the start of the year, this is not an ordinary annuity, but rather, an
annuity due.

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A. one year?
B. five years?
C. ten years?
Topic: Compound Interest
Level of difficulty: Medium
Solution:
A. FV1year  $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

27. Your investment research has turned up an interesting mutual fund. It has had an average
annual return 0.5 percent greater than the one Gilda’s friend recommended (see Problem 26).
For each time period from Problem 26, calculate how much better off Gilda would be if she
invested $20,000 in this mutual fund.
Topic: Compound Interest
Level of difficulty: Medium
Solution:
First find the value of the investment after each period of time, and then compare to the
values from Problem 26 to determine how much difference a small change in the interest rate
can make.
A. FV1year  $20,000  (1  0.105)  $22,100.00 . You are ($22,100 – $22,000) = $100 better off
1

after one year.

B. FV5 years  $20,000  (1  0.105)  $32,948.94 . You are ($32,948.94 – $32,210.20) = $738.74
5

better off after five years.

C. FV10years  $20,000 (1  0.105)  $54,281.62 You are ($54,281.62 – $51,874.85) = $2,406.77
10

better off after 10 years.

28. When Jon graduates in three years, he wants to throw a big party, which will cost $800. To
have this amount available, how much does he have to invest today if he can earn a
compound return of 5 percent per year?
Topic: Discounting
Level of difficulty: Medium
Solution:
Jon needs $800 in three years; that is the future value amount. The present value equivalent
is:

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1 1
PV0  FV3   $800   $691.07
(1  k ) 3 (1  .05)3
Or using a financial calculator (TI BAII Plus),
N=3, I/Y=5, PMT=0, FV= -800, CPT PV=691.07

29. In Problem 28, suppose Jon had only $500 to invest. How much can he plan to spend on the
graduation party in three years, if the return on the investment will be:
A. simple interest at 5 percent per year?
B. compound interest at 5 percent per year?
Topic: Simple and Compound Interest
Level of difficulty: Medium
Solution:
A. Jon will earn $500 5%  $25 per year in interest. The value of his investment (or the
amount available to spend on the party) will be:
Value  P  (n  P  k )  $500  (3  500  0.05)  $575

B. The interest earned grows (compounds) each year; the total available in three years is:
FV3  PV0  (1  k )3  $500  (1  .05)3  $578.81

30. At the age of 10, Felix decided that he wanted to attend a very prestigious (and expensive)
university. How much will his parents have to save each year to accumulate $40,000 by the
time Felix needs the funds in eight years? Assume Felix’s parents can earn 7 percent
(compounded annually) on their savings, and that each year’s savings are deposited at the end
of the year.
Topic: Ordinary Annuities
Level of difficulty: Medium
Solution:
The future value amount is $40,000. The amount to be saved each year is really the payment
on an ordinary annuity:
 (1 0.07)8  1
$40,000  PMT    PMT  $3898.71
 0.07 
Or using a financial calculator (TI BAII Plus),
N=8, I/Y=7, PV=0, FV= -40,000, CPT PMT= 3898.71

31. Felix’s parents can only afford to save $3,000 per year for his university education, which
begins in eight years. What rate of return would they require on these savings if they must
accumulate $40,000?
Topic: Ordinary Annuities (Solving for IRR)
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payable on the interest income. This RESP account provides a return of 6 percent per year.
A. How much will Jane’s account be worth when she begins her university studies?
B. As an incentive to save for higher education, the government will add 20 percent to any
money contributed to an RESP each year. Including these grants, how much will Jane have in
her account?
Topic: Ordinary Annuity (Future Value)
Level of difficulty: Medium
Solution:
A. The future value of Jane’s account will be:
 (1 0.06)17  1
FV17  $1000     $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  $1200     $33,855.46
 0.06 

35. Jane’s parents used an RESP account to save for her post-secondary education. Based on the
amount accumulated (from your answer in Problem 340), Jane would like to withdraw the
same amount of money at the beginning of each year of her four-year degree program. All
funds (interest and principal) withdrawn from this account are taxed at a rate of 15 percent,
and the account will earn 6 percent per year on any remaining funds. How much will Jane
have available for tuition each year?
Topic: Annuities Due
Level of difficulty: Medium
Solution:
Each year, Jane can withdraw:
  1 
1 (1 0.06)4 
33,855.46  PMT   (1  0.06)  PMT  $9217.36
 0.06 
 
However, this amount will be subject to income tax at a rate of 15%. The net amount that
Jane will have available for tuition is then:
9217.36%  (1  0.15)  $7834.75

36. Stephen has learned that his great-aunt (see Problem 18Error! Reference source not found.)
intends to give him $4,000 each year he is studying at university. Tuition must be paid in
advance, so Stephen would like to receive his payments at the beginning of each school year.
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How much will his great-aunt have to invest today at 7 percent, to make the four annual
(start-of-year) payments?
Topic: Annuities Due
Level of difficulty: Medium
Solution:
Find the present value of the four-year annuity due:
  1    1 
1 (1  k )n  1 (1  0.07) 4 
PV0  PMT   (1  k )  $4000     (1  0.07)  $14,497.26
 k   0.07 
   
Now, discount this amount back three years:
 1   1 
PV0  FV  3 
 $14,497.26   3
 $11,834.08
 (1  k )  (1.07) 
37. Rather than give her grand-nephew some money each year while he is studying, Stephen’s
great-aunt has decided to save the money and pay off Stephen’s student loans when he
finishes his degree. The total amount owing at that time will be $16,000. How much will she
have to save each year until that time if her investments earn a return of 7 percent per year?
Topic: Ordinary Annuities
Level of difficulty: Medium
Solution:
Assuming the savings are invested at the end of each year, find the payment (amount to be
saved) for an ordinary annuity with a future value of $16,000.
 (1  0.07)7  1
FV 4  $16,000  PMT    PMT  $1,848.85
 0.07 

38. Jimmie’s new car (see Problem 20) will cost $29,000. How much will his monthly car
payments be if he obtains a loan that is amortized over 60 months, and the nominal interest
rate is 8.5 percent per year with monthly compounding?
Topic: Effective Interest Rates and Loan Arrangements
Level of difficulty: Medium
Solution:
First, find the effective interest corresponding to the frequency of Jimmie’s car payments (f
=12); with monthly compounding, set m=12,
m 12
 QR  f
 8.5%  12
k monthly  1    1  1    1  0.7083%
 m   12 
The 60 car payments form an “annuity” whose present value is the amount of the loan (the
price of the car):
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Topic: Loan Arrangements and Discounting

Level of difficulty: Medium
Solution:
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 
PV0  $13,089.22     $10,152.30
36 
 (1  0.007083) 

41. Jimmie would like to pay off his car loan in three years (see Problem 38), but can only afford
monthly payments of $594.98. How big a down-payment must Jimmie make on the $29,000
car if the nominal interest rate is 8.5 percent with monthly compounding?
Topic: Loan Arrangements
Level of difficulty: Medium
Solution:
Use the effective monthly interest rate from Problem 38, k=0.7083%
Find the present value of Jimmie’s 36 payments:
  1 
1 (1 0.007083) 36 
PV0  $594.98   $18,847.95
 0.007083 
 
Therefore, Jimmie must make a down payment of
$29,000.00  $18,847.95  $10,152.05

42. Jimmie is offered another loan of $29,000 that requires 60 monthly payments of $588.02 (see
Problem 38Error! Reference source not found.). What is the effective annual interest rate
on this loan? What would the quoted rate be?
Topic: Loan arrangements and Effective Annual Rates
Level of difficulty: Medium
Solution:
The 60 monthly payments form an annuity whose present value is $29,000. Finding the
interest rate is most easily done with a financial calculator (TI BAII Plus):
N=60, PMT=588.027, PV= -29,000, CPT I/Y = 0.6667%
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  kmonthly )12 1  (1  0.006667)12  1  8.30%

The quoted rate would be:

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