APPENDIX II Compound Interest and the Concept of Present Value

ANSWERS TO REVIEW QUESTIONS

II-1 II-2 Compound interest is interest earned not only on the principal invested but also on the interest earned in previous periods. This formula says that the future value, Fn, is equal to the present value, P, multiplied by an accumulation factor equal to (1 + r)n. The accumulation factor is included in the formula to reflect compound interest. (In the formula, r denotes the interest rate per year, and n denotes the number of years.) The present value is the economic value now of a cash flow that will occur in the future. This statement is false. As the discount rate increases, the present value of a future cash flow decreases. A higher discount rate means a higher return on funds that are invested now. If funds invested now can earn a greater return, it is even more important to have the funds now, instead of in the future, than it is if the rate of return is lower. Also, you do not need to invest as much now to have a certain amount in the future if you have a higher return. Therefore, the greater the discount rate, or rate of return on invested funds, the lower will be the present value of any future cash flow. These two cash flows are economically equivalent in the sense that a $100 cash flow now will be equal to a $161.10 cash flow at the end of five years. If the $100 received now is invested for five years at 10%, it will accumulate to $161.10 at the end of five years. An annuity is a series of equally spaced, identical cash flows. For example, a fiveyear, $100 annuity is a series of $100 cash flows occurring at the end of each year for five years.

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SOLUTIONS TO EXERCISES
EXERCISE II-7 (25 MINUTES) 1. Use formula (1): Fn = P(1 + r)n = $2,500(1.14)6 The accumulation factor, (1.14) 6, is given in Table I of Appendix A to Chapter 16. It is 2.195. Thus, the calculation is as follows: Fn = $2,500(2.195) = $5,487.50 The future value of your investment will be $5,487.50. 2. Use formula (2): P = Fn
1 n (1 + r ) 1 = $10,000 5 (1.12)

The discount factor, 1/(1.12)5, is given in Table III of Appendix A to Chapter 16. It is . 567. Thus, the calculation is as follows: P = $10,000(.567) = $5,670 The present value of the gift is $5,670. 3. You need to invest an amount, A, each year so that the following equation is satisfied: A(4.375) = $52,500 The number 4.375 is the annuity accumulation factor, from Table II of Appendix A to Chapter 16, for n = 4 and r = .06. Rearranging the equation above, we solve for A as follows: A=
$52,500 4.375

= $12,000

You need to invest $12,000 per year.

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Solutions Manual

EXERCISE II-7 (CONTINUED) 4. You need an amount, P, now so that the following equation is satisfied. P = (2.487)$13,000 The number 2.487 is the annuity discount factor, from Table IV of Appendix A to Chapter 16, for n = 3 and r = .10. The solution is P = $32,331. You need to invest $32,331 now in order to fund your educational expenses.

EXERCISE II-8 (45 MINUTES) 1. Future value of investment: Time 0 Year 1 Time 1 Year 2 Time 2 Year 3 Time 3 Year 4 Time 4 Year 5 Time 5 Year 6 Time 6 Time * The discrepancy between $5,487.44 and $5,487.50 is due to rounding error. Amount at time 0 $2,500.00

Interest, year 1 (.14 x $2,500.00) 350.00 Amount at time 1 Interest, year 2 (.14 x $2,850.00) Amount at time 2 Interest, year 3 (.14 x $3,249.00) Amount at time 3 Interest, year 4 (.14 x $3,703.86) Amount at time 4 Interest, year 5 (.14 x $4,222.40) Amount at time 5 Interest, year 6 (.14 x $4,813.54) Amount at time 6 $2,850.00 399.00 $3,249.00 454.86 $3,703.86 518.54 $4,222.40 591.14 $4,813.54 673.90 $5,487.44*

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EXERCISE II-8 (CONTINUED) 2. Educational expense fund: Time 0 Year 1 Time 1 Year 2 Time 2 Year 3 Time 3 Time Deposit $32,331................................................... Earn interest ($32,331 x .10)............................... Accumulation at time 1....................................... Withdrawal to cover educational expenses...... Amount remaining to earn interest in year 2.... Earn interest (22,564 x .10)................................. Accumulation at time 2....................................... Withdrawal to cover educational expenses...... Amount remaining to earn interest in year 3.... Earn interest ($11,820 x .10)............................... Accumulation at time 3....................................... Withdrawal to cover educational expenses...... Amount remaining.............................................. $32,331 3,233 $35,564 (13,000) $22,564 2,256 $24,820 (13,000) $11,820 1,182 $13,002 (13,000) $ 2*

* The $2 remainder is due to rounding error.

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Solutions Manual

EXERCISE II-9 (20 MINUTES) 1. To determine the amount you need to accumulate by the time you retire, calculate the present value of a 40-year annuity in the amount of $225,000. (Use Table IV of Appendix A to Chapter 16.) Present value = (annuity discount factor for n = 40, r = .12)($225,000) = (8.244)($225,000) = $1,854,900 Thus, you need to accumulate $1,854,900 in your account by the time you retire. 2. To determine the amount you need to deposit each year for 15 years, calculate the annuity amount that will accumulate to a future value of $1,854,900 in 15 years. (Use Table II of Appendix A to Chapter 16.) Future value = (annuity accumulation factor for n = 15, r = .12)(annuity amount) $1,854,900 = (37.280)(annuity amount)
$1,854,900 37.280

Annuity amount =

= $49,755.90

Thus, you need to deposit $49,755.90 into your account each year from age 25 through age 39. 3. This is both a present-value and a future-value problem. The problem has two parts. Requirement (1) is a present-value problem; requirement (2) is a future-value problem.

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