ECON 4400

Chapter 5: End-of-Chapter Questions 1-11, 14, 15, 17, 19-24, 26, 29-33, 36, 37, 39, 42-44, 46, 48,
50, 52-55, 58, 60, and 75
Note: Questions are the same in the 7th, 8th and 9th edition of the book

5.1 The time line for the cash flows is:

0 10
$5,000 FV

The simple interest per year is:

$5,000 × 0.08 = $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:

$10,794.62 – $9,000 = $1,794.62

5.2 a. To find the future value of a lump sum, we use:

FV = PV(1 + r)t

i.
0 10
$1,000 FV

FV = $1,000(1.05)10 = $1,628.89

ii.
0 10
$1,000 FV

FV = $1,000(1.10)10 = $2,593.74

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 iii.
0 20
$1,000 FV

FV = $1,000(1.05)20 = $2,653.30

b. Because interest compounds on the interest already earned, the interest earned in part c is
more than twice the interest earned in part a. With compound interest, future values grow
exponentially.

5.3 To find the PV of a lump sum, we use:

PV = FV / (1 + r)t

0 6
PV $13,827

PV = $13,827 / (1.07)6 = $9,213.51

0 9
PV $43,852

PV = $43,852 / (1.15)9 = $12,465.48

0 18
PV $725,380

PV = $725,380 / (1.11)18 = $110,854.15

0 23
PV $590,710

PV = $590,710 / (1.18)23 = $13,124.66

5.4 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

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 0 4
–$242 $307

FV = $307 = $242(1 + r)4; r = ($307 / $242)1/4 – 1 = 0.0613 or 6.13%

0 8
–$410 $896

FV = $896 = $410(1 + r)8; r = ($896 / $410)1/8 – 1 = 0.1027 or 10.27%

0 16
–$51,700 $162,181

FV = $162,181 = $51,700(1 + r)16; r = ($162,181 / $51,700)1/16 – 1 = 0.0741 or 7.41%

0 27
–$18,750 $483,500

FV = $483,500 = $18,750(1 + r)27; r = ($483,500 / $18,750)1/27 – 1= 0.1279 or 12.79%

5.5 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)

0 ?
–$625 $1,284

FV = $1,284 = $625(1.09)t; t = ln($1,284/ $625) / ln 1.09 = 8.35 years

0 ?
–$810 $4,341

FV = $4,341 = $810(1.11)t; t = ln($4,341/ $810) / ln 1.11 = 16.09 years

0 ?
–$18,400 $402,662

FV = $402,662 = $18,400(1.17)t; t = ln($402,662 / $18,400) / ln 1.17 = 19.65 years

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 0 ?
–$21,500 $173,439

FV = $173,439 = $21,500(1.08)t; t = ln($173,439 / $21,500) / ln 1.08 = 27.13 years

5.6 To find the length of time for money to double, triple, etc., the present value and future value are
irrelevant as long as the future value is twice the present value for doubling, three times as large
for tripling, 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:

0 ?
–$1 $2

FV = $2 = $1(1.08)t
t = ln 2 / ln 1.08 = 9.01 years

The length of time to quadruple your money is:

0 ?
–$1 $4

FV = $4 = $1(1.08)t
t = ln 4 / ln 1.08 = 18.01 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.

5.7 To find the PV of a lump sum, we use:

PV = FV / (1 + r)t
PV = $750,000,000 / (1.082)20 = $155,065,808.54

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5.8 The time line is:

0 4
–$1,680,000 $1,100,000

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 = ($1,100,000 / $1,680,000)1/3 – 1 = – 0.1317 or –13.17%

5.9 The time line is:

0 1 ∞
…
PV $150 $150 $150 $150 $150 $150 $150 $150 $150

A consol is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $150 / .046
PV = $3,260.87

5.10 To find the future value with continuous compounding, we use the equation:

FV = PVert

a.
0 7
$1,900 FV

FV = $1,900e0.12(7)= $4,401.10

b.
0 5
$1,900 FV

FV = $1,900e0.10(5)= $3,132.57
c.
0 12
$1,900 FV

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 FV = $1,900e0.05(12)= $3,462.03

d.
0 10
$1,900 FV

FV = $1,900e0.07(10)= $3,826.13

5.11 The time line is:

0 1 2 3 4
PV $960 $840 $935 $1,350

To solve this problem, we must find the PV of each cash flow and add them. To find the PV of a
lump sum, we use:

PV = FV / (1 + r)t

PV@10% = $960 / 1.10 + $840 / 1.102 + $935 / 1.103 + $1,350 / 1.104 = $3,191.49

PV@18% = $960 / 1.18 + $840 / 1.182 + $935 / 1.183 + $1,350 / 1.184 = $2,682.22

PV@24% = $960 / 1.24 + $840 / 1.242 + $935 / 1.243 + $1,350 / 1.244 = $2,381.91

5.14 This cash flow is a perpetuity. To find the PV of a perpetuity, we use the equation:

PV = C / r
PV = $20,000 / 0.065 = $307,692.31

To find the interest rate that equates the perpetuity cash flows with the PV of the cash flows. Using
the PV of a perpetuity equation:

PV = C / r
$340,000 = $20,000 / r

We can now solve for the interest rate as follows:

r = $20,000 / $340,000 = 0.0588 or 5.88%

5.15 For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + (0.08 / 4)]4 – 1 = 0.0824 or 8.24%

EAR = [1 + (0.18 / 12)]12 – 1 = 0.1956 or 19.56%

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 EAR = [1 + (0.12 / 365)]365 – 1 = 0.1275 or 12.75%

To find the EAR with continuous compounding, we use the equation:

EAR = er – 1
EAR = e0.14 – 1 = 0.1503 or 15.03%

5.17 For discrete compounding, to find the EAR, we use the equation:

EAR = [1 + (APR / m)]m – 1

So, for each bank, the EAR is:

First National: EAR = [1 + (0.1120 / 12)]12 – 1 = 0.1179, or 11.79%

First United: EAR = [1 + (0.1140 / 2)]2 – 1 = 0.1173, or 11.73%

A higher APR does not necessarily mean the higher EAR. The number of compounding periods
within a year will also affect the EAR. I would choose the cheaper loan offered by First United
Bank.

5.19 The time line is:

0 1 ?
…
–$21,500 $700 $700 $700 $700 $700 $700 $700 $700 $700

Here, we need to find the length of an annuity. We know the interest rate, the PV, and the
payments. Using the PVA equation:

PVA = C({1 – [1/(1 + r) t] } / r)

$21,500 = $700{ [1 – (1/1.013 t) ] / 0.013}

Now, we solve for t:

1/1.013t = 1 – [($21,500)(.013) / ($700)]

1.013t = 1/(0.601) = 1.665
t = ln 1.665 / ln 1.013 = 39.46 months

5.20 Here, we are trying to find the interest rate when we know the PV and FV. Using the FV equation:

FV = PV(1 + r)
$4 = $3(1 + r)
r = 4/3 – 1 = 0.3333 or 33.33% per week

The interest rate is 33.33% per week. To find the APR, we multiply this rate by the number of
weeks in a year, so:
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 APR = (52)33.33% = 1,733.33%

And using the equation to find the EAR:

EAR = [1 + (APR / m)]m – 1

EAR = [1 + 0.3333]52 – 1 = 3,135,086.84 or 313,508,684%

5.21 To find the FV of a lump sum with discrete compounding, we use:

FV = PV(1 + r)t

a.
0 6
$1,000 FV

FV = $1,000(1.09)6 = $1,677.10
b.
0 12
$1,000 FV

FV = $1,000(1 + 0.09/2)12 = $1,695.88

c.
0 72
$1,000 FV

FV = $1,000(1 + 0.09/12)72 = $1,712.55

d.
0 6
$1,000 FV

To find the future value with continuous compounding, we use the equation:

FV = PVert
FV = $1,000e0.09(6) = $1,716.01
e. The future value increases when the compounding period is shorter because interest is earned
on previously accrued interest. The shorter the compounding period, the more frequently
interest is earned, and the greater the future value, assuming the same stated interest rate.

5.22 The total interest paid by First Simple Bank is the interest rate per period times the number of
periods. In other words, the interest by First Simple Bank paid over 10 years will be:

0.05(10) = 0.5

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 First Complex Bank pays compound interest, so the interest paid by this bank will be the FV factor
of $1, or:

(1 + r)10

Setting the two equal, we get:

(0.05)(10) = (1 + r)10 – 1

r = 1.51/10 – 1 = 0.0414, or 4.14%

5.23 We need to find the annuity payment in retirement. Our retirement savings ends at the same time
the retirement withdrawals begin, so the PV of the retirement withdrawals will be the FV of the
retirement savings. So, we find the FV of the stock account and the FV of the bond account and
add the two FVs.

Stock account: FV = $700[{[1 + (0.10/12)] 360 – 1} / (0.10/12)] = $1,582,341.55

Bond account: FV = $300[{[1 + (0.06/12) ]360 – 1} / (0.06/12)] = $301,354.51

So, the total amount saved at retirement is:

$1,582,341.55 + $301,354.51 = $1,883,696.06

Solving for the withdrawal amount in retirement using the PV of an annuity equation gives us:

PV = $1,883,696.06 = C[1 – {1 / [1 + (0.08/12)] 300 } / (0.08/12)]

C = $1,883,696.06 / 129.5645 = $14,538.67 withdrawal per month

5.24 Since we are looking to quadruple our money, the PV and FV are irrelevant as long as the FV is
four times as large as the PV. The number of periods is four, the number of quarters per year. So:

FV = $4 = $1(1 + r)(12/3)
r = 0.4142 or 41.42%

5.26 This is a growing perpetuity. The present value of a growing perpetuity is:

PV = C / (r – g)
PV = $215,000 / (0.10 – 0.04)
PV = $3,583,333.33

It is important to recognize that when dealing with annuities or perpetuities, the present value
equation calculates the present value one period before the first payment. In this case, since the
first payment is in two years, we have calculated the present value one year from now. To find the
value today, we simply discount this value as a lump sum. Doing so, we find the value of the cash
flow stream today is:

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 PV = FV / (1 + r)t
PV = $3,583,333.33 / (1 + 0.10)1
PV = $3,257,575.76

5.29 The time line is:

0 1 2 3 4 5 6 7 20
…
PV $650 $650 $650 $650

We need to find the present value of an annuity. Using the PVA equation, and the 13 percent
interest rate, we get:

PVA = C({1 – [1/(1 + r) t] } / r )

PVA = $650({1 – [1/(1 + 0.13)]15 } / 0.13)
PVA = $4,200.55

This is the value of the annuity in Year 5, one period before the first payment. Finding the value
of this amount today, we find:

PV = FV/(1 + r)t
PV = $4,200.55 / (1 + 0.11)5
PV = $2,492.82

5.30 The amount borrowed is the value of the home times one minus the down payment, or:

Amount borrowed = $450,000(1 – 0.20)

Amount borrowed = $360,000

The monthly payments with a balloon payment loan are calculated assuming a longer amortization
schedule, in this case, 30 years. The payments based on a 30-year repayment schedule would be:

PV = $360,000 = C({1 – [1 / (1 + 0.075/12) 360] } / (0.075/12))

C = $2,517.17

Now, at time = 8, we need to find the PV of the payments which have not been made. The balloon
payment will be:

PV = $2,517.17({1 – [1 / (1 + 0.075/12) 22(12)] } / (0.075/12))

PV = $325,001.45

5.31 The time line is:

0 12
$7,500 FV

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 Here, we need to find the FV of a lump sum, with a changing interest rate. We must do this
problem in two parts. After the first six months, the balance will be:

FV = $7,500 [1 + (0.024/12)]6 = $7,590.45

This is the balance in six months. The FV in another six months will be:

FV = $7,590.45 [1 + (0.18/12)]6 = $8,299.73

The problem asks for the interest accrued, so, to find the interest, we subtract the beginning
balance from the FV. The interest accrued is:

Interest = $8,299.73 – $7,500 = $799.73

5.32 The time line is:

0 1 ∞
…
–$2,500,000 $227,000 $227,000 $227,000 $227,000 $227,000 $227,000

The company would be indifferent at the interest rate that makes the present value of the cash
flows equal to the cost today. Since the cash flows are a perpetuity, we can use the PV of a
perpetuity equation. Doing so, we find:

PV = C / r
$2,500,000 = $227,000 / r
r = $227,000 / $2,500,000
r = 0.0908, or 9.08%

5.33 The company will accept the project if the present value of the increased cash flows is greater
than the cost. The cash flows are a growing perpetuity, so the present value is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $21,000{[1/(0.10 – 0.04)] – [1/(0.10 – 0.04)] × [(1 + 0.04)/(1 + 0.10)]5}
PV = $85,593.99

The company should accept the project since the cost is less than the increased cash flows.

5.36 The time line is:

0 1 ?
…
–$35,000
$350 $350 $350 $350 $350 $350 $350 $350 $350

Here, we are given the FVA, the interest rate, and the amount of the annuity. We need to solve for
the number of payments. Using the FVA equation:

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 FVA = $35,000 = $350[{[1 + (0.10/12)]t – 1 } / (0.10/12)]

Solving for t, we get:

1.00833t = 1 + [($35,000)(0.10/12) / $350]

t = ln 1.83333 / ln 1.00833 = 73.04 payments

5.37 The time line is:

0 1 60
…
–$65,000 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320 $1,320

Here, we are given the PVA, number of periods, and the amount of the annuity. We need to solve
for the interest rate. Using the PVA equation:
PVA = $65,000 = $1,320[{1 – [1 / (1 + r) 60] }/ r]

To find the interest rate, we need to solve this equation on a financial calculator, using a
spreadsheet, or by trial and error. If you use trial and error, remember that increasing the interest
rate lowers the PVA, and decreasing the interest rate increases the PVA. Using a spreadsheet, we
find:

r = 0.672%

The APR is the periodic interest rate times the number of periods in the year, so:

APR = 12(0.672%) = 8.06%

5.39 The time line is:

0 1 2 3 4
–$7,300 $1,500 ? $2,700 $2,900

We are given the total PV of all four cash flows. If we find the PV of the three cash flows we
know, and subtract them from the total PV, the amount left over must be the PV of the missing
cash flow. So, the PV of the cash flows we know are:

PV of Year 1 CF: $1,500 / 1.08 = $1,388.89

PV of Year 3 CF: $2,700 / 1.083 = $2,143.35

PV of Year 4 CF: $2,900 / 1.084 = $2,131.59

So, the PV of the missing CF is:

$7,300 – $1,388.89 – $2,143.35 – $2,131.59 = $1,636.17

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 The question asks for the value of the cash flow in Year 2, so we must find the future value of
this amount. The value of the missing CF is:

$1,636.17(1.08)2 = $1,908.43

5.42 The profit the firm earns is just the PV of the sales price minus the cost to produce the asset. We
find the PV of the sales price as the PV of a lump sum:

PV = $135,000 / 1.133 = $93,561.77

And the firm’s profit is:

Profit = $93,561.77 – $96,000.00 = –$2,438.23

To find the interest rate at which the firm will break even, we need to find the interest rate using
the PV (or FV) of a lump sum. Using the PV equation for a lump sum, we get:

$96,000 = $135,000 / ( 1 + r)3

r = ($135,000 / $96,000)1/3 – 1 = 0.1204 or 12.04%

5.43 The time line is:

0 1 5 6 25
… …
$5,000 $5,000 $5,000 $5,000

We want to find the value of the cash flows today, so we will find the PV of the annuity, and
then bring the lump sum PV back to today. The annuity has 20 payments, so the PV of the
annuity is:

PVA = $5,000{[1 – (1/1.06)20] / 0.06} = $57,349.61

Since this is an ordinary annuity equation, this is the PV one period before the first payment, so
it is the PV at T = 5. To find the value today, we find the PV of this lump sum. The value today
is:

PV = $57,349.61 / 1.065 = $42,854.96

5.44 The time line for the annuity is:

0 1 180
…
$1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500 $1,500

This question is asking for the present value of an annuity, but the interest rate changes during
the life of the annuity. We need to find the present value of the cash flows for the last eight years
first. The PV of these cash flows is:

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 PVA2 = $1,500 [{1 – 1 / [1 + (0.06/12)]96} / (0.06/12)] = $114,142.83

Note that this is the PV of this annuity exactly seven years from today. Now, we can discount
this lump sum to today as well as finding the PV of the annuity for the first 7 years. The value of
this cash flow today is:

PV = $114,142.83 / [1 + (0.12/12)]84 + $1,500 [{1 – 1 / [1 + (0.12/12)]84} / (0.12/12)]

PV = $134,455.36

5.46 The time line is:

0 1 7 14 15 ∞
… … …
PV $2,500 $2,500 $2,500 $2,500

To find the value of the perpetuity at T = 7, we first need to use the PV of a perpetuity equation.
Using this equation we find:

PV = $2,500 / 0.061 = $40,983.61

0 1 7 14
… …
PV $40,983.61

Remember that the PV of a perpetuity (and annuity) equations give the PV one period before the
first payment, so, this is the value of the perpetuity at t = 14. To find the value at t = 7, we find the
PV of this lump sum as:

PV = $40,983.61 / 1.0617 = $27,077.12

5.48 The time line is:

0 1 18 19 28
… … …
$5,300 $5,300 $5,300 $5,300

The cash flows in this problem are semiannual, so we need the effective semiannual rate. The
interest rate given is the APR, so the monthly interest rate is:

Monthly rate = 0.12 / 12 = 0.01

To get the semiannual interest rate, we can use the EAR equation, but instead of using 12
months as the exponent, we will use 6 months. The effective semiannual rate is:

Semiannual rate = (1.01)6 – 1 = 6.15%

We can now use this rate to find the PV of the annuity. The PV of the annuity is:

PVA @ t = 9: $5,300{[1 – (1 / 1.061510)] / .0615} = $38,729.05

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 Note, that this is the value one period (six months) before the first payment, so it is the value at
t = 9. So, the value at the various times the questions asked for uses this value 9 years from now.

PV @ t = 5: $38,729.05 / 1.06158 = $24,022.10

Note, that you can also calculate this present value (as well as the remaining present values)
using the number of years. To do this, you need the EAR. The EAR is:

EAR = (1 + 0.01)12 – 1 = 12.68%

So, we can find the PV at t = 5 using the following method as well:

PV @ t = 5: $38,729.05 / 1.12684 = $24,022.10

The value of the annuity at the other times in the problem is:

PV @ t = 3: $38,729.05 / 1.061512 = $18,918.99

PV @ t = 3: $38,729.05 / 1.12686 = $18,918.99

PV @ t = 0: $38,729.05 / 1.061518 = $13,222.95

PV @ t = 0: $38,729.05 / 1.12689 = $13,222.95

5.50 The time line is:

0 1 59 60
…
–$73,000
C C C C C C C C C

We need to use the PVA due equation, that is:

PVAdue = (1 + r) PVA

Using this equation:

PVAdue = $73,000 = [1 + (0.0645/12)] × C[{1 – 1 / [1 + (0.0645/12)]60} / (0.0645/12)

C = $1,418.99

Notice, to find the payment for the PVA due we simply compound the payment for an ordinary
annuity forward one period.

5.52 The time line is:

0 1 15 16 17 18 19 20
…
$45,000 $45,000 $45,000 $45,000
$45,000 $45,000 $45,000 $45,000
C C C C

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 First, we will calculate the present value of the college expenses for each child. The expenses are
an annuity, so the present value of the college expenses is:

PVA = C({1 – [1/(1 + r)]t } / r )

PVA = $45,000({1 – [1/(1 + 0.075) 4] } / 0.075)
PVA = $150,719.68

This is the cost of each child’s college expenses one year before they enter college. So, the cost
of the oldest child’s college expenses today will be:

PV = FV/(1 + r)t
PV = $150,719.68/(1 + 0.075)14
PV = $54,758.49

And the cost of the youngest child’s college expenses today will be:

PV = FV/(1 + r)t
PV = $150,719.68/(1 + 0.075)16
PV = $47,384.31

Therefore, the total cost today of your children’s college expenses is:

Cost today = $54,758.49 + $47,384.31

Cost today = $102,142.80

This is the present value of your annual savings, which are an annuity. So, the amount you must
save each year will be:

PVA = C({1 – [1/(1 + r) t] } / r )

$102,142.80 = C({1 – [1/(1 + 0.075) 15] } / 0.075)
C = $11,571.48

5.53 The salary is a growing annuity, so we use the equation for the present value of a growing annuity.
The salary growth rate is 3.5 percent and the discount rate is 9 percent, so the value of the salary
offer today is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $55,000{[1/(0.09 – 0.035)] – [1/(0.09 – 0.035)] × [(1 + 0.035)/(1 + 0.09)]25}
PV = $725,939.59

The yearly bonuses are 10 percent of the annual salary. This means that next year’s bonus will be:

Next year’s bonus = 0.10($55,000)

Next year’s bonus = $5,500

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 Since the salary grows at 3.5 percent, the bonus will grow at 3.5 percent as well. Using the growing
annuity equation, with a 3.5 percent growth rate and a 9 percent discount rate, the present value
of the annual bonuses is:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

PV = $5,500{[1/(0.09 – 0.035)] – [1/(0.09 – 0.035)] × [(1 + 0.035)/(1 + 0.09)]25}
PV = $72,593.96

Notice the present value of the bonus is 10 percent of the present value of the salary. The present
value of the bonus will always be the same percentage of the present value of the salary as the
bonus percentage. So, the total value of the offer is:

PV = PV(Salary) + PV(Bonus) + Bonus paid today

PV = $725,939.59 + 72,593.96 + 10,000
PV = $808,533.55

5.54 Here, we need to compare two options. In order to do so, we must get the value of the two cash
flow streams to the same time, so we will find the value of each today. We must also make sure
to use the aftertax cash flows, since it is more relevant. For Option A, the aftertax cash flows are:

Aftertax cash flows = Pretax cash flows(1 – tax rate)

Aftertax cash flows = $250,000(1 – 0.28)
Aftertax cash flows = $180,000
So, the cash flows are:

0 1 30 31
…
PV
$180,000 $180,000 $180,000 $180,000 $180,000 $180,000 $180,000 $180,000 $180,000

The aftertax cash flows from Option A are in the form of an annuity due, so the present value of
the cash flows today is:

PVAdue = (1 + r) C({1 – [1/(1 + r) t] } / r )

PVAdue = (1 + 0.07)$180,000({1 – [1/(1 + 0.07) 31] } / 0.07 )
PVAdue = $2,413,627.41

For Option B, the after-tax cash flows are:

After-tax cash flows = Pretax cash flows(1 – tax rate)

After-tax cash flows = $200,000(1 – 0.28)
After-tax cash flows = $144,000

The cash flows are:

0 1 29 30
…
PV

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$530,000 $144,000 $144,000 $144,000 $144,000 $144,000 $144,000 $144,000 $144,000 $144,000

The aftertax cash flows from Option B are an ordinary annuity, plus the cash flow today, so the
present value is:

PV = C({1 – [1/(1 + r)]t } / r ) + CF0

PV = $144,000{1 – [1/(1 + 0.07)]30 } / .07 ) + $530,000
PV = $2,316,901.93

You should choose Option A because it has a higher present value on an aftertax basis.

5.55 We need to find the first payment into the retirement account. The present value of the desired
amount at retirement is:

PV = FV/(1 + r)t
PV = $2,000,000/(1 + 0.09)30
PV = $150,742.27

This is the value today. Since the savings are in the form of a growing annuity, we can use the
growing annuity equation and solve for the payment. Doing so, we get:

PV = C {[1/(r – g)] – [1/(r – g)] × [(1 + g)/(1 + r)]t}

$150,742.27 = C{[1/(0.09 – 0.03)] – [1/(0.09 – 0.03)] × [(1 + 0.03)/(1 + 0.09)]30}
C = $11,069.69

This is the amount you need to save next year. So, the percentage of your salary is:

Percentage of salary = $11,069.69/$70,000

Percentage of salary = 0.1581 or 15.81%

Note that this is the percentage of your salary you must save each year. Since your salary is
increasing at 3 percent, and the savings are increasing at 3 percent, the percentage of salary will
remain constant.

5.58 To answer this question, we should find the PV of both options, and compare them. Since we are
purchasing the car, the lowest PV is the best option. The PV of the leasing is simply the PV of the
lease payments, plus the $1,500. The interest rate we would use for the leasing option is the same
as the interest rate of the loan. The PV of leasing is:

0 1 36
…
$1,500 $405 $405 $405 $405 $405 $405 $405 $405 $405

PV = $1,500 + $405{1 – [1 / (1 + 0.06/12)12(3)]} / (0.06/12) = $14,812.76

The PV of purchasing the car is the current price of the car minus the PV of the resale price. The
PV of the resale price is:

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 0 1 36
$31,000 … –
$20,000

PV = $20,000 / [1 + (0.06/12)]12(3) = $16,712.90

The PV of the decision to purchase is:

$31,000 – $16,712.90 = $14,287.10

In this case, it is cheaper to buy the car than lease it since the PV of the leasing cash flows is
higher. To find the breakeven resale price, we need to find the resale price that makes the PV of
the two options the same. In other words, the PV of the decision to buy should be:

$31,000 – PV of resale price = $14,812.76

PV of resale price = $16,187.24

The resale price that would make the PV of the lease versus buy decision equal is the FV of this
value, so:

Breakeven resale price = $16,187.24[1 + (0.06/12)]12(3) = $19,370.95

5.60 The time line for the cash flows is:

0 1
–$17,000 $20,000

To find the APR and EAR, we need to use the actual cash flows of the loan. In other words, the
interest rate quoted in the problem is only relevant to determine the total interest under the terms
given. The cash flows of the loan are the $20,000 you must repay in one year, and the $17,000
you borrow today. The interest rate of the loan is:

$20,000 = $17,000(1 + r)
r = ($20,000 / 17,000) – 1 = 0.1765 or 17.65%

Because of the discount, you only get the use of $17,000, and the interest you pay on that amount
is 17.65%, not 15%.

5.75 Since it is only an approximation, we know the Rule of 72 is exact for only one interest rate. Using
the basic future value equation for an amount that doubles in value and solving for t, we find:

FV = PV(1 + r)t
$2 = $1(1 + r)t
ln(2) = t ln(1 + r)
t = ln(2) / ln(1 + r)

We also know the Rule of 72 approximation is:

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t = 72 / r

We can set these two equations equal to each other and solve for r. We also need to remember that
the exact future value equation uses decimals, so the equation becomes:

0.72 / r = ln(2) / ln(1 + r)

0 = (0.72 / r) / [ ln(2) / ln(1 + r)]

It is not possible to solve this equation directly for R, but using Solver, we find the interest rate
for which the Rule of 72 is exact is 7.846894 percent.

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