72 Chapter 2 Time Value of Money

Next, since inflation is expected to be 2% per year, then in 10 years the target
$100,000 will have a purchasing power of:

$100,000>11  0.022 10  $82,034.83.

Now we can find the size of the required initial payment by setting a financial cal-
culator to the “BEG” mode and then inputting N  10, I/YR  3.92157, PV  0,
and FV  82,034.83. Then, when we press the PMT key, we get PMT  6,598.87.
Thus, a deposit of $6,598.87 made at time zero and growing by 2 percent per year
will accumulate to $100,000 by Year 10 if the interest rate is 6%. Again, this result
is confirmed in the chapter model. The key to this analysis is to express I/YR, PV,
and PMT in real, inflation-adjusted terms.
SELF-TEST
Differentiate between a “regular” and a growing annuity.
What three methods can be used to deal with growing annuities?
If the nominal interest rate is 10% and the expected inflation rate is 5%, what is the expected real rate
of return? (4.7619%)

Summary
Most financial decisions involve situations in which someone pays money at one
point in time and receives money at some later time. Dollars paid or received at
two different points in time are different, and this difference is recognized and
accounted for by time value of money (TVM) analysis.

• Compounding is the process of determining the future value (FV) of a cash

flow or a series of cash flows. The compounded amount, or future value, is
equal to the beginning amount plus the interest earned.
Future value of a single payment: FV  PV(1  I) .
N
• N

• Discounting is the process of finding the present value (PV) of a future cash
flow or a series of cash flows; discounting is the reciprocal, or reverse, of
compounding.
FVN
Present value of a single payment: PV 
11  I2 N
• .

• An annuity is defined as a series of equal periodic payments (PMT) for a spec-

ified number of periods.
• Future value of an annuity:
11  I2 N
FVAN  PMT c d.
1

I I
• Present value of an annuity:

PVAN  PMT c d.
1 1

I I11  I2 N

• An annuity whose payments occur at the end of each period is called an ordi-
nary annuity. The formulas above are for ordinary annuities.
• If each payment occurs at the beginning of the period rather than at the end,
then we have an annuity due. The PV of each payment would be larger,
 Summary 73

because each payment would be discounted back one year less, so the PV of
the annuity would also be larger. Similarly, the FV of the annuity due would
also be larger because each payment would be compounded for an extra year.
The following formulas can be used to convert the PV and FV of an ordinary
annuity to an annuity due:
PVA (annuity due) = PVA of an ordinary annuity  (1 + I),
FVA (annuity due) = FVA of an ordinary annuity  (1 + I).
• A perpetuity is an annuity with an infinite number of payments.
PMT
Value of a perpetuity  .
I
• To find the PV or FV of an uneven series, find the PV or FV of each individ-
ual cash flow and then sum them.
• If you know the cash flows and the PV (or FV) of a cash flow stream, you can
determine the interest rate.
• When compounding occurs more frequently than once a year, the nominal
rate must be converted to a periodic rate, and the number of years must be
converted to periods.
IPER = Nominal annual rate/Periods per year
Periods = Years  Periods per year
The periodic rate and number of periods would be used for calculations and
shown on time lines.

• If comparing the costs of loans that require payments more than once a year,
or the rates of return on investments that pay interest more frequently, then
the comparisons should be based on equivalent (or effective) rates of return
using this formula:

INOM M
Effective annual rate 1EFF% 2  a 1  b  1.0.
M

• The general equation for finding the future value for any number of com-
pounding periods per year is

INOM MN
FVN  PV11  IPER 2 Number of periods  PV a 1  b
M
where
INOM  Nominal quoted interest rate,
M  Number of compounding periods per year,
N  Number of years.

• An amortized loan is one that is paid off in equal payments over a specified
period. An amortization schedule shows how much of each payment consti-
tutes interest, how much is used to reduce the principal, and the unpaid bal-
ance at each point in time.
74 Chapter 2 Time Value of Money

Questions
(2-1) Define each of the following terms:
a. PV; I; INT; FV ; PVA ; FVA ; PMT; M; I
N N N NOM

b. Opportunity cost rate

c. Annuity; lump sum payment; cash flow; uneven cash flow stream
d. Ordinary (deferred) annuity; annuity due
e. Perpetuity; consol
f. Outflow; inflow; time line; terminal value
g. Compounding; discounting
h. Annual, semiannual, quarterly, monthly, and daily compounding
i. Effective annual rate (EAR); nominal (quoted) interest rate; APR; periodic
rate
j. Amortization schedule; principal versus interest component of a payment;
amortized loan

(2-2) What is an opportunity cost rate? How is this rate used in discounted cash flow
analysis, and where is it shown on a time line? Is the opportunity rate a single
number that is used in all situations?

(2-3) An annuity is defined as a series of payments of a fixed amount for a specific num-
ber of periods. Thus, $100 a year for 10 years is an annuity, but $100 in Year 1, $200
in Year 2, and $400 in Years 3 through 10 does not constitute an annuity. However,
the second series contains an annuity. Is this statement true or false?

(2-4) If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total
growth would be 100%, but the annual growth rate would be less than 10%. True or
false? Explain.

(2-5) Would you rather have a savings account that pays 5% interest compounded
semiannually or one that pays 5% interest compounded daily? Explain.

Self-Test Problems Solutions Appear in Appendix A

(ST-1) Assume that 1 year from now, you will deposit $1,000 into a savings account that
Future Value pays 8%.
a. If the bank compounds interest annually, how much will you have in your
account 4 years from now?
b. What would your balance 4 years from now be if the bank used quarterly
compounding rather than annual compounding?
c. Suppose you deposited the $1,000 in 4 payments of $250 each at Year 1, Year
2, Year 3, and Year 4. How much would you have in your account at Year 4,
based on 8% annual compounding?
d. Suppose you deposited 4 equal payments in your account at Year 1, Year 2,
Year 3, and Year 4. Assuming an 8% interest rate, how large would each of
your payments have to be for you to obtain the same ending balance as you
calculated in part a?
(ST-2) Assume that 4 years from now you will need $1,000. Your bank compounds inter-
Time Value of Money est at an 8% annual rate.
 Problems 75

a. How much must you deposit 1 year from now to have a balance of $1,000 4
years from now?
b. If you want to make equal payments at Years 1 through 4 to accumulate the
$1,000, how large must each of the 4 payments be?
c. If your father were to offer either to make the payments calculated in part b
($221.92) or to give you a lump sum of $750 1 year from now, which would
you choose?
d. If you have only $750 1 year from now, what interest rate, compounded annu-
ally, would you have to earn to have the necessary $1,000 4 years from now?
e. Suppose you can deposit only $186.29 each at Years 1 through 4, but you still
need $1,000 at Year 4. What interest rate, with annual compounding, must you
seek out to achieve your goal?
f. To help you reach your $1,000 goal, your father offers to give you $400 1 year
from now. You will get a part-time job and make 6 additional payments of
equal amounts each 6 months thereafter. If all of this money is deposited in a
bank that pays 8%, compounded semiannually, how large must each of the 6
payments be?
g. What is the effective annual rate being paid by the bank in part f?

(ST-3) Bank A pays 8% interest, compounded quarterly, on its money market account.
Effective Annual Rates The managers of Bank B want its money market account to equal Bank A’s effec-
tive annual rate, but interest is to be compounded on a monthly basis. What nom-
inal, or quoted, rate must Bank B set?

Easy Problems 1–8

Problems Answers Appear in Appendix B
(2-1) If you deposit $10,000 in a bank account that pays 10% interest annually, how
Future Value much will be in your account after 5 years?
of a Single Payment
(2-2) What is the present value of a security that will pay $5,000 in 20 years if securities
Present Value of a of equal risk pay 7% annually?
Single Payment
(2-3) Your parents will retire in 18 years. They currently have $250,000, and they think
Interest Rate they will need $1,000,000 at retirement. What annual interest rate must they earn
of a Single Payment to reach their goal, assuming they don’t save any additional funds?

(2-4) If you deposit money today in an account that pays 6.5% annual interest, how long
Number of Periods will it take to double your money?
of a Single Payment
(2-5) You have $42,180.53 in a brokerage account, and you plan to deposit an additional
Number of Periods $5,000 at the end of every future year until your account totals $250,000. You
for an Annuity expect to earn 12% annually on the account. How many years will it take to reach
your goal?

(2-6) What is the future value of a 7%, 5-year ordinary annuity that pays $300 each
Future Value: Annuity year? If this were an annuity due, what would its future value be?
versus Annuity Due
(2-7) An investment will pay $100 at the end of each of the next 3 years, $200 at the end
Present and Future of Year 4, $300 at the end of Year 5, and $500 at the end of Year 6. If other invest-
Value of an Uneven ments of equal risk earn 8% annually, what is its present value? Its future value?
Cash Flow Stream
76 Chapter 2 Time Value of Money

(2-8) You want to buy a car, and a local bank will lend you $20,000. The loan would be
Annuity Payment and fully amortized over 5 years (60 months), and the nominal interest rate would be
EAR 12%, with interest paid monthly. What would be the monthly loan payment?
What would be the loan’s EAR?
Intermediate
Problems 9–30
(2-9) Find the following values, using the equations, and then work the problems using a
Present and Future financial calculator to check your answers. Disregard rounding differences. (Hint:
Values of Single Cash If you are using a financial calculator, you can enter the known values and then
Flows for Different
press the appropriate key to find the unknown variable. Then, without clearing the
Periods
TVM register, you can “override” the variable that changes by simply entering a
new value for it and then pressing the key for the unknown variable to obtain the
second answer. This procedure can be used in parts b and d, and in many other sit-
uations, to see how changes in input variables affect the output variable.)
a. An initial $500 compounded for 1 year at 6%.
b. An initial $500 compounded for 2 years at 6%.
c. The present value of $500 due in 1 year at a discount rate of 6%.
d. The present value of $500 due in 2 years at a discount rate of 6%.

(2-10) Use equations and a financial calculator to find the following values. See the hint
Present and Future Values for Problem 2-9.
of Single Cash Flows for a. An initial $500 compounded for 10 years at 6%..
Different Interest Rates
b. An initial $500 compounded for 10 years at 12%.
c. The present value of $500 due in 10 years at a 6% discount rate.
d. The present value of $500 due in 10 years at a 12% discount rate.

(2-11) To the closest year, how long will it take $200 to double if it is deposited and earns
Time for a Lump Sum to the following rates? [Notes: (1) See the hint for Problem 2-9. (2) This problem can-
Double not be solved exactly with some financial calculators. For example, if you enter PV
 200, PMT  0, FV  400, and I  7 in an HP-12C, and then press the N key,
you will get 11 years for part a. The correct answer is 10.2448 years, which rounds
to 10, but the calculator rounds up. However, the HP-10B gives the correct answer.]
a. 7%.
b. 10%.
c. 18%.
d. 100%.

(2-12) Find the future value of the following annuities. The first payment in these annuities
Future Value of an is made at the end of Year 1; that is, they are ordinary annuities. (Notes: See the hint
Annuity to Problem 2-9. Also, note that you can leave values in the TVM register, switch to
“BEG,” press FV, and find the FV of the annuity due.)
a. $400 per year for 10 years at 10%.
b. $200 per year for 5 years at 5%.
c. $400 per year for 5 years at 0%.
d. Now rework parts a, b, and c assuming that payments are made at the begin-
ning of each year; that is, they are annuities due.

(2-13) Find the present value of the following ordinary annuities (see note to Problem 2-9):
Present Value of an a. $400 per year for 10 years at 10%.
Annuity b. $200 per year for 5 years at 5%.
c. $400 per year for 5 years at 0%.
d. Now rework parts a, b, and c assuming that payments are made at the begin-
ning of each year; that is, they are annuities due.
 Problems 77

(2-14) a. Find the present values of the following cash flow streams. The appropriate
Uneven Cash interest rate is 8%. (Hint: It is fairly easy to work this problem dealing with the
Flow Stream individual cash flows. However, if you have a financial calculator, read the
section of the manual that describes how to enter cash flows such as the ones
in this problem. This will take a little time, but the investment will pay huge
dividends throughout the course. Note, if you do work with the cash flow reg-
ister, then you must enter CF0  0.)
Year Cash Stream A Cash Stream B
1 $100 $300
2 400 400
3 400 400
4 400 400
5 300 100

b. What is the value of each cash flow stream at a 0% interest rate?

(2-15) Find the interest rates, or rates of return, on each of the following:
Effective Rate of Interest a. You borrow $700 and promise to pay back $749 at the end of 1 year.
b. You lend $700 and receive a promise to be paid $749 at the end of 1 year.
c. You borrow $85,000 and promise to pay back $201,229 at the end of 10 years.
d. You borrow $9,000 and promise to make payments of $2,684.80 per year for
5 years.

(2-16) Find the amount to which $500 will grow under each of the following conditions:
Future Value for Various a. 12% compounded annually for 5 years.
Compounding Periods b. 12% compounded semiannually for 5 years.
c. 12% compounded quarterly for 5 years.
d. 12% compounded monthly for 5 years.

(2-17) Find the present value of $500 due in the future under each of the following
Present Value for Various conditions:
Compounding Periods a. 12% nominal rate, semiannual compounding, discounted back 5 years.
b. 12% nominal rate, quarterly compounding, discounted back 5 years.
c. 12% nominal rate, monthly compounding, discounted back 1 year.

(2-18) Find the future values of the following ordinary annuities:

Future Value of an a. FV of $400 each 6 months for 5 years at a nominal rate of 12%, compounded
Annuity for Various semiannually.
Compounding Periods b. FV of $200 each 3 months for 5 years at a nominal rate of 12%, compounded
quarterly.
c. The annuities described in parts a and b have the same amount of money paid
into them during the 5-year period and both earn interest at the same nomi-
nal rate, yet the annuity in part b earns $101.75 more than the one in part a
over the 5 years. Why does this occur?

(2-19) Universal Bank pays 7% interest, compounded annually, on time deposits. Regional
Effective versus Nominal Bank pays 6% interest, compounded quarterly.
Interest Rates a. Based on effective interest rates, in which bank would you prefer to deposit
your money?
b. Could your choice of banks be influenced by the fact that you might want to
withdraw your funds during the year as opposed to at the end of the year? In
answering this question, assume that funds must be left on deposit during the
entire compounding period in order for you to receive any interest.
78 Chapter 2 Time Value of Money

(2-20) a. Set up an amortization schedule for a $25,000 loan to be repaid in equal

Amortization Schedule installments at the end of each of the next 5 years. The interest rate is 10%.
b. How large must each annual payment be if the loan is for $50,000? Assume
that the interest rate remains at 10% and that the loan is paid off over
5 years.
c. How large must each payment be if the loan is for $50,000, the interest rate is
10%, and the loan is paid off in equal installments at the end of each of the
next 10 years? This loan is for the same amount as the loan in part b, but the
payments are spread out over twice as many periods. Why are these pay-
ments not half as large as the payments on the loan in part b?

(2-21) Hanebury Corporation’s current sales were $12 million. Sales were $6 million 5
Growth Rates years earlier.
a. To the nearest percentage point, at what rate have sales been growing?
b. Suppose someone calculated the sales growth for Hanebury Corporation in
part a as follows: “Sales doubled in 5 years. This represents a growth of 100%
in 5 years, so, dividing 100% by 5, we find the growth rate to be 20% per year.”
Explain what is wrong with this calculation.

(2-22) Washington-Pacific invests $4 million to clear a tract of land and to set out some
Expected Rate of Return young pine trees. The trees will mature in 10 years, at which time Washington-
Pacific plans to sell the forest at an expected price of $8 million. What is
Washington-Pacific’s expected rate of return?

(2-23) A mortgage company offers to lend you $85,000; the loan calls for payments of
Effective Rate of Interest $8,273.59 per year for 30 years. What interest rate is the mortgage company charg-
ing you?

(2-24) To complete your last year in business school and then go through law school, you
Required Lump Sum will need $10,000 per year for 4 years, starting next year (that is, you will need to
Payment withdraw the first $10,000 one year from today). Your rich uncle offers to put you
through school, and he will deposit in a bank paying 7% interest a sum of money
that is sufficient to provide the 4 payments of $10,000 each. His deposit will be
made today.
a. How large must the deposit be?
b. How much will be in the account immediately after you make the first with-
drawal? After the last withdrawal?

(2-25) While Mary Corens was a student at the University of Tennessee, she borrowed
Repaying a Loan $12,000 in student loans at an annual interest rate of 9%. If Mary repays $1,500 per
year, how long, to the nearest year, will it take her to repay the loan?

(2-26) You need to accumulate $10,000. To do so, you plan to make deposits of $1,250 per
Reaching a Financial year, with the first payment being made a year from today, in a bank account that
Goal pays 12% annual interest. Your last deposit will be less than $1,250 if less is needed
to round out to $10,000. How many years will it take you to reach your $10,000
goal, and how large will the last deposit be?

(2-27) What is the present value of a perpetuity of $100 per year if the appropriate dis-
Present Value of a count rate is 7%? If interest rates in general were to double and the appropriate dis-
Perpetuity count rate rose to 14%, what would happen to the present value of the perpetuity?

(2-28) Assume that you inherited some money. A friend of yours is working as an unpaid
PV and Effective intern at a local brokerage firm, and her boss is selling securities that call for 4 pay-
Annual Rate
 Problems 79

ments, $50 at the end of each of the next 3 years, plus a payment of $1,050 at the
end of Year 4. Your friend says she can get you some of these securities at a cost of
$900 each. Your money is now invested in a bank that pays an 8% nominal (quoted)
interest rate but with quarterly compounding. You regard the securities as being
just as safe, and as liquid, as your bank deposit, so your required effective annual
rate of return on the securities is the same as that on your bank deposit. You must
calculate the value of the securities to decide whether they are a good investment.
What is their present value to you?

(2-29) Assume that your aunt sold her house on December 31 and that she took a mort-
Loan Amortization gage in the amount of $10,000 as part of the payment. The mortgage has a quoted
(or nominal) interest rate of 10%, but it calls for payments every 6 months, begin-
ning on June 30, and the mortgage is to be amortized over 10 years. Now, 1 year
later, your aunt must inform the IRS and the person who bought the house of the
interest that was included in the two payments made during the year. (This interest
will be income to your aunt and a deduction to the buyer of the house.) To the clos-
est dollar, what is the total amount of interest that was paid during the first year?

(2-30) Your company is planning to borrow $1,000,000 on a 5-year, 15%, annual payment,
Loan Amortization fully amortized term loan. What fraction of the payment made at the end of the
second year will represent repayment of principal?
Challenging
Problems 31–34
(2-31) a. It is now January 1. You plan to make 5 deposits of $100 each, one every 6
Nonannual months, with the first payment being made today. If the bank pays a nominal
Compounding interest rate of 12% but uses semiannual compounding, how much will be in
your account after 10 years?
b. You must make a payment of $1,432.02 10 years from today. To prepare for
this payment, you will make 5 equal deposits, beginning today and for the
next 4 quarters, in a bank that pays a nominal interest rate of 12%, quarterly
compounding. How large must each of the 5 payments be?

(2-32) Anne Lockwood, manager of Oaks Mall Jewelry, wants to sell on credit, giving
Nominal Rate of Return customers 3 months in which to pay. However, Anne will have to borrow from her
bank to carry the accounts payable. The bank will charge a nominal 15%, but with
monthly compounding. Anne wants to quote a nominal rate to her customers (all
of whom are expected to pay on time) that will exactly cover her financing costs.
What nominal annual rate should she quote to her credit customers?

(2-33) Assume that your father is now 50 years old, that he plans to retire in 10 years, and
Required Annuity that he expects to live for 25 years after he retires, that is, until he is 85. He wants
Payments his first retirement payment to have the same purchasing power at the time he
retires as $40,000 has today. He wants all his subsequent retirement payments to
be equal to his first retirement payment (do not let the retirement payments grow
with inflation: he realizes that the real value of his retirement income will decline
year by year after he retires). His retirement income will begin the day he retires,
10 years from today, and he will then get 24 additional annual payments. Inflation
is expected to be 5% per year from today forward; he currently has $100,000 saved
up; and he expects to earn a return on his savings of 8% per year, annual com-
pounding. To the nearest dollar, how much must he save during each of the next
10 years (with equal deposits being made at the end of each year) to meet his
retirement goal? (Hint: Neither the amount he saves nor the amount he withdraws
upon retirement is a growing annuity.)
80 Chapter 2 Time Value of Money

(2-34) You wish to accumulate $1 million by your retirement date, which is 25 years from
Growing Annuity now. You will make 25 deposits in your bank, with the first occurring today. The
Payments bank pays 8% interest, compounded annually. You expect to get an annual raise of
3%, so you will let the amount you deposit each year also grow by 3% (i.e., your
second deposit will be 3% greater than your first, the third will be 3% greater than
the second, etc.). How much must your first deposit be to meet your goal?

Spreadsheet Problem
(2-35) Start with the partial model in the file FM12 Ch 02 P35 Build a Model.xls from
Build a Model: The Time the textbook’s Web site. Answer the following questions, using a spreadsheet
Value of Money model to do the calculations.
a. Find the FV of $1,000 invested to earn 10% after 5 years. Answer this question
by using a math formula and also by using the Excel function wizard.
b. Now create a table that shows the FV at 0%, 5%, and 20% for 0, 1, 2, 3, 4, and
5 years. Then create a graph with years on the horizontal axis and FV on the
vertical axis to display your results.
c. Find the PV of $1,000 due in 5 years if the discount rate is 10%. Again, work
the problem with a formula and also by using the function wizard.
d. A security has a cost of $1,000 and will return $2,000 after 5 years. What rate
of return does the security provide?
e. Suppose California’s population is 30 million people, and its population is
expected to grow by 2% per year. How long would it take for the population
to double?
f. Find the PV of an annuity that pays $1,000 at the end of each of the next
5 years if the interest rate is 15%. Then find the FV of that same annuity.
g. How would the PV and FV of the annuity change if it were an annuity due
rather than an ordinary annuity?
h. What would the FV and PV for parts a and c be if the interest rate were 10%
with semiannual compounding rather than 10% with annual compounding?
i. Find the PV and FV of an investment that makes the following end-of-year
payments. The interest rate is 8%.

Year Payment
1 $100
2 200
3 400
j. Suppose you bought a house and took out a mortgage for $50,000. The inter-
est rate is 8%, and you must amortize the loan over 10 years with equal end-
of-year payments. Set up an amortization schedule that shows the annual
payments and the amount of each payment that goes to pay off the principal
and the amount that constitutes interest expense to the borrower and interest
income to the lender.
(1) Create a graph that shows how the payments are divided between inter-
est and principal repayment over time.
(2) Suppose the loan called for 10 years of monthly payments, with the same
original amount and the same nominal interest rate. What would the
amortization schedule show now?
 Mini Case 81

Cyberproblem
Please go to the textbook’s Web site to access any Cyberproblems.

Mini Case

Assume that you are nearing graduation and that you have applied for a job with
a local bank. As part of the bank’s evaluation process, you have been asked to take
an examination that covers several financial analysis techniques. The first section
of the test addresses discounted cash flow analysis. See how you would do by
answering the following questions.
a. Draw time lines for (1) a $100 lump sum cash flow at the end of Year 2, (2) an
ordinary annuity of $100 per year for 3 years, and (3) an uneven cash flow
stream of $50, $100, $75, and $50 at the end of Years 0 through 3.
b. (1) What is the future value of an initial $100 after 3 years if it is invested in
an account paying 10% annual interest?
(2) What is the present value of $100 to be received in 3 years if the appropri-
ate interest rate is 10%?
c. We sometimes need to find how long it will take a sum of money (or anything
else) to grow to some specified amount. For example, if a company’s sales are
growing at a rate of 20% per year, how long will it take sales to double?
d. If you want an investment to double in 3 years, what interest rate must it
earn?
e. What is the difference between an ordinary annuity and an annuity due?
What type of annuity is shown below? How would you change it to the other
type of annuity?

0 1 2 3 Years

100 100 100

f. (1) What is the future value of a 3-year ordinary annuity of $100 if the appro-
priate interest rate is 10%?
(2) What is the present value of the annuity?
(3) What would the future and present values be if the annuity were an annu-
ity due?
g. What is the present value of the following uneven cash flow stream? The
appropriate interest rate is 10%, compounded annually.
0 1 2 3 4

0 100 300 300 –50

h. (1) Define (a) the stated, or quoted, or nominal rate (INOM) and (b) the peri-
odic rate (IPER).
(2) Will the future value be larger or smaller if we compound an initial
amount more often than annually, for example, every 6 months, or semi-
annually, holding the stated interest rate constant? Why?
82 Chapter 2 Time Value of Money

(3) What is the future value of $100 after 5 years under 12% annual com-
pounding? Semiannual compounding? Quarterly compounding? Monthly
compounding? Daily compounding?
(4) What is the effective annual rate (EFF%)? What is the EFF% for a nominal
rate of 12%, compounded semiannually? Compounded quarterly?
Compounded monthly? Compounded daily?
i. Will the effective annual rate ever be equal to the nominal (quoted) rate?
j. (1) Construct an amortization schedule for a $1,000, 10% annual rate loan
with 3 equal installments.
(2) What is the annual interest expense for the borrower, and the annual
interest income for the lender, during Year 2?
k. Suppose on January 1 you deposit $100 in an account that pays a nominal, or
quoted, interest rate of 11.33463%, with interest added (compounded) daily.
How much will you have in your account on October 1, or after 9 months?
l. (1) What is the value at the end of Year 3 of the following cash flow stream if
the quoted interest rate is 10%, compounded semiannually?
0 1 2 3 Years

100 100 100

(2) What is the PV of the same stream?
(3) Is the stream an annuity?
(4) An important rule is that you should never show a nominal rate on a time
line or use it in calculations unless what condition holds? (Hint: Think of
annual compounding, when INOM  EFF%  IPER.) What would be wrong
with your answer to Questions l-(1) and l-(2) if you used the nominal rate
(10%) rather than the periodic rate (INOM/2  10%/2  5%)?
m. Suppose someone offered to sell you a note calling for the payment of $1,000
fifteen months from today. They offer to sell it to you for $850. You have $850
in a bank time deposit that pays a 6.76649% nominal rate with daily com-
pounding, which is a 7% effective annual interest rate, and you plan to leave
the money in the bank unless you buy the note. The note is not risky—you are
sure it will be paid on schedule. Should you buy the note? Check the decision
in three ways: (1) by comparing your future value if you buy the note versus
leaving your money in the bank, (2) by comparing the PV of the note with
your current bank account, and (3) by comparing the EFF% on the note ver-
sus that of the bank account.