Chapter 05

Chapter5
TimeValueofMoney
Instructors Resources
Overview
Thischapterintroducesanimportantfinancialconcept:thetimevalueofmoney.Thepresentvalueand
futureofasum,aswellasthepresentandfuturevaluesofanannuity,areexplained.Specialapplications
oftheconceptsincludeintrayearcompounding,mixedcashflowstreams,mixedcashflowswithan
embeddedannuity,perpetuities,depositstoaccumulateafuturesum,andloanamortization.Numerous
businessandpersonalfinancialapplicationsareusedasexamples.Thechapterdriveshometheneedto
understandtimevalueofmoneyattheprofessionallevelbecausefundingfornewassetsandprograms
mustbejustifiedusingthesetechniques.Decisionsinastudentspersonallifeshouldalsobeacceptableon
thebasisofapplyingtimevalueofmoneytechniquestoanticipatedcashflows.
Suggested Answer to Opener in Review Question

Assumethatthe$1billioncostofbringinganewdrugtomarketisspreadoutevenlyover10years,
andthen10yearsremainforEliLillytorecovertheinvestment.Howmuchcashwouldanewdrug
havetogenerateinthelast10yearstojustifythe$1billionspentinthefirst10years?
Someassumptionshavetobemadetoanswerthisproblem.Letsassumethattherequiredrateofreturnis
10percentandthatallcashflowsoccurattheendoftheyear.Thatis,itisanordinaryannuity.Thefuture
valueofthe$100millionannualcostwouldbe$1,593.7billion,asshownbelow.
N10,I10,PMT$100million.SolveforFV$1,593.7billion
TheamountthatEliLillyhastoearneachyeartojustifythiscostwouldbeanannualannuitypaymentof
$259.4million,ascalculatedbelow.
N10,I10,PV$1,593.7billion.SolveforPMT$259.4million
Statedanotherway,$2.6billioninsalesarerequiredtojustifyadrugcosting$1billionspreadoutover
10yearsofdevelopment.Itobviouslytakesalargecashinflowstreamtojustifydevelopmentofanewdrug.
Answers to Review Questions
Chapter5TimeValueofMoney71
1. Futurevalue(FV),thevalueofapresentamountatafuturedate,iscalculatedbyapplying
compoundinterestoveraspecifictimeperiod.Presentvalue(PV)representsthedollarvaluetoday
ofafutureamount,ortheamountyouwouldinvesttodayatagiveninterestrateforaspecifiedtime
periodtoequalthefutureamount.Financialmanagerspreferpresentvaluetofuturevaluebecause
theytypicallymakedecisionsattimezero,beforethestartofaproject.
2012PearsonEducation,Inc.PublishingasPrenticeHall
2. Asingleamountcashflowreferstoanindividualstandalonevalueoccurringatonepointintime.An
annuityconsistsofanunbrokenseriesofcashflowsofequaldollaramountoccurringovermorethan
oneperiod.Amixedstreamisapatternofcashflowsovermorethanonetimeperiod,andtheamount
ofcashassociatedwitheachperiodwillvary.
3. Compoundingofinterestoccurswhenanamountisdepositedintoasavingsaccountandtheinterest
paidafterthespecifiedtimeperiodremainsintheaccount,therebybecomingpartoftheprincipalfor
thefollowingperiod.Thegeneralequationforfuturevalueinyearn(FVn)canbeexpressedusingthe
specifiednotationasfollows:
FVnPV(1r)n
4. Adecreaseintheinterestratelowersthefutureamountofadepositforagivenholdingperiod,since
thedepositearnslessatthelowerrate.Anincreaseintheholdingperiodforagiveninterestrate
wouldincreasethefuturevalue.TheincreasedholdingperiodincreasestheFVsincethedeposit
earnsinterestoveralongerperiodoftime.
5. Thepresentvalueofafutureamountindicateshowmuchmoneytodaywouldbeequivalenttothe
futureamountifonecouldinvestthatamountataspecifiedrateofinterest.Usingthegivennotation,
thepresentvalueofafutureamount(FVn)canbedefinedasfollows:
PVFVn(1r)n
6. Anincreasingrequiredrateofreturnwouldreducethepresentvalueofafutureamount,sincefuture
dollarswouldbeworthlesstoday.LookingattheformulaforpresentvalueinQuestion5,itshould
beclearthatbyincreasingtheivalue,whichistherequiredreturn,thepresentvalueofthefuture
sumwoulddecrease.
7. Presentvaluecalculationsaretheexactinverseofcompoundinterestcalculations.Usingcompound
interest,oneattemptstofindthefuturevalueofapresentamount;usingpresentvalue,oneattempts
tofindthepresentvalueofanamounttobereceivedinthefuture.
8. Anordinaryannuityisoneforwhichpaymentsoccurattheendofeachperiod.Anannuitydueis
oneforwhichpaymentsoccuratthebeginningofeachperiod.
Theordinaryannuityisthemorecommon.Forotherwiseidenticalannuitiesandinterestrates,the
annuitydueresultsinahigherFVbecausecashflowsoccurearlierandhavemoretimetocompound.
9. Themostefficientwaystocalculatepresentvalueofanordinaryannuityareusinganalgebraic
shortcutorExcelspreadsheet.
10. Youcancalculatethefuturevalueofanannuityduebymultiplyingthevaluecalculatedforan
ordinaryannuitybyoneplustheinterestrate.
11. Youcancalculatethepresentvalueofanannuityduebymultiplyingthevaluecalculatedforan
ordinaryannuitybyoneplustheinterestrate.
73Gitman/ZutterPrinciplesofManagerialFinance,Thirteenth Edition
12. Aperpetuityisaninfinitelivedannuity.IfyoumultiplethePVbytherequiredrateofreturn,i,one
isidentifyingtheannualrequirerequiredonagivenvalue.TheunknownisthePV,sotheknown
cashflowisdividedbytherequiredreturn.
13. Thefuturevalueofamixedstreamofcashflowsiscalculatedbymultiplyingeachyearscashflow
bycompoundingattheappropriateinterestrate.Tofindthepresentvalueofamixedstreamofcash
flowsmultiplyeachyearscashflowbydiscountingattheappropriatediscountrate.Withouta
calculatortherewouldbeasmanycalculationsasthenumberofcashflows.
14. Asinterestiscompoundedmorefrequentlythanonceayear,both(a)thefuturevalueforagiven
holdingperiodand(b)theeffectiveannualrateofinterestwillincrease.Thisisduetothefactthat
themorefrequentlyinterestiscompounded,thegreaterthequantityofmoneyaccumulatedand
reinvestedastheprincipalvalue.Insituationsofintrayearcompounding,theactualrateofinterestis
greaterthanthestatedrateofinterest.
15. Continuouscompoundingassumesinterestwillbecompoundedaninfinitenumberoftimesperyear,
atintervalsofmicroseconds.Continuouscompoundingofagivendepositatagivenrateofinterest
resultsinthelargestvaluewhencomparedtoanyothercompoundingperiod.
16. Thenominalannualrateisthecontractualratethatisquotedtotheborrowerbythelender.The
effectiveannualrate,sometimescalledthetruerate,istheactualratethatispaidbytheborrowerto
thelender.Thedifferencebetweenthetworatesisduetothecompoundingofinterestatafrequency
greaterthanonceperyear.
APRistheannualpercentagerateandisrequiredbytruthinlendinglawstobedisclosedto
consumers.Thisrateiscalculatedbymultiplyingtheperiodicratebythenumberofperiodsin
oneyear.Theperiodicrateisthenominalrateovertheshortesttimeperiodinwhichinterestis
compounded.TheAPY,orannualpercentageyield,istheeffectiverateofinterestthatmustbe
disclosedtoconsumersbybanksontheirsavingsproductsasaresultofthetruthinsavingslaws.
Theselawsresultinbothfavorableandunfavorableinformationtoconsumers.Thegoodnewsisthat
ratequotesonbothloansandsavingsarestandardizedamongfinancialinstitutions.Thenegativeis
thattheAPR,orlendingrate,isanominalrate,whiletheAPY,orsavingrate,isaneffectiverate.
Theseratesarethesamewhencompoundingoccursonlyonceperyear.
17. Thesizeoftheequalannualendofyeardepositsneededtoaccumulateagivenamountoveracertain
timeperiodataspecifiedratecanbefoundbyinputtingthenumberofyearsintheinvestment
horizon,discountrate,anddesiredfutureamountintothecalculator.Problemslikethisalways
requireacalculatororExcelspreadsheet.
18. Amortizingaloanintoequalannualpaymentsinvolvesfindingthefuturepaymentswhosepresent
valueattheloaninterestratejustequalstheamountoftheinitialprincipalborrowed.
19. Thebestwaytodetermineanunknownnumberofperiodsisthoughuseofacalculatoror
spreadsheet.Inbothinstances,youenterthecashflowsandinterestrate,andthencomputethe
numberofperiodsneededtoequatecashinflowsandoutflows.Ifthefuturecashflowisalumpsum,
thefuturecashflowisenteredasaFVamount.Ifthefuturecashflowsareanannuity,youenterthe
sizeofanysinglepaymentasthePMTamount.Ifthereisbothaseriesofpaymentsandfinalcash
flowofadifferentsize,boththeFVandPMTamountsareinput.Itiscriticaltocorrectlyenterthe
sizeofthecashflows.
Suggested Answer to Focus on Practice Box:

New Century Brings Trouble for Subprime Mortgages
Asareactiontoproblemsinthesubprimearea,lendersarealreadytighteninglendingstandards.
Whateffectwillthishaveonthehousingmarket?
Thetighteningoflendingstandardsfollowingthesubprimefiascofurtherdepressedhomeprices,whichin
2007werealreadyundergoingtheirsteepest,widestdeclineinhistory.Asthehousingmarketslump
persisted,companiesthatareheavilyinvolvedwiththemanufactureandsaleofdurablehouseholdgoods
alsowillfeeltheimpactoftheslowhousingmarket.Tolimititsimpact.Thefederalgovernmentoffereda
varietyofprograms,includingcashpaymentsof$8,000tofirsttimehomebuyersand$6,500torepeat
homebuyers.
Suggested Answer to Focus on Ethics Box:

How Fair Is Check into Cash?
The391%mentionedisanannualnominalrate[15%(365/14)].Shouldthe2weekrate(15%)be
compoundedtocalculatetheeffectiveannualinterestrate?
No,therolloverfeeisasimple$15per2weekperiod.Inotherwords,the15%2weekrateisonlyapplied
totheoriginalprincipal.Inthiscase,interestisnotcompoundingwitheachadditionalrolloverperiod,and
thereforetheeffectiveannualratewillbeequalto15%365/14.Thatisstillawhopping391%,orover
1%eachday!
Answers to Warm-Up Exercises

E51.
Futurevalueofalumpsuminvestment
Answer: FV$2,500(10.007)$2,517.50
E52.
Findingthefuturevalue
Answer: Sincetheinterestiscompoundedmonthly,thenumberofperiodsis41248andthe
monthlyinterestrateis1/12thoftheannualrate.
FV48 PV(1I)48whereIisthemonthlyinterestrate
I
0.02120.00166667
FV48 ($1,260$975)(10.00166667)48
FV48 ($2,235)1.083215$2,420.99
Ifusingafinancialcalculator:
PV$2,235;N48(months)
SolveforFV$2,420.99
Note:Notallfinancialcalculatorsworkinthesamemanner.Somerequiretheusertousethe
CPT(Compute)button.Othersrequiretheusertocalculatethemonthlyinterestrateandinput
thatamountratherthantheannualrate.Thestepsshowninthesolutionmanualwillbethe
inputsneededtousetheHewlettPackard10Bor10BIImodels.Theyaresimilartothesteps
followedwhenusingtheTexasInstrumentsBAIIcalculators.
Ifusingaspreadsheet,thesolutionis:
ColumnA
ColumnB
Cell1
Futurevalueofasingleamount
Cell2
Presentvalue
Cell3
Interestrate,%peryearcompoundedmonthly
2/12
Cell4
Numberofmonths
412
Cell5
Futurevalue
FV(B3,B4,0,B2,0)
$2,235
CellB5$2,420.99
E53.
Comparingalumpsumwithanannuity
Answer: Thisproblemcanbesolvedineitheroftwoways.Bothalternativescanbecomparedaslump
sumsinnetpresentvaluetermsorbothalternativescanbecomparedasa25yearannuity.
Ineachcase,oneofthealternativesneedstobeconverted.
Method1:Performalumpsumcomparison.Compare$1.3millionnowwiththepresent
valueofthe25paymentsof$100,000peryear.Inthiscomparison,thepresentvalueof
the$100,000annuitymustbefoundandcomparedwiththe$1.3million.(Besuretoset
thecalculatortoonecompoundingperiodperyear.)
PMT $100,000
N 25
I 5%
SolveforPV
PV$1,409,394(greaterthan$1.3million)
Choosethe$100,000annuityoverthelumpsum.
Method2:Comparetwoannuities.Sincethe$100,000peryearisalreadyanannuity,allthat
remainsistoconvertthe$1.3millionintoa25yearannuity.
PV $1.3million
N 25years
I
5%
SolveforPMT
PMT$92,238.19(lessthan$100,000)
Choosethe$100,000annuityoverthelumpsum.
Youmayusethetablemethodoraspreadsheettodothesameanalysis.
E54.
Comparingthepresentvalueoftwoalternatives
Answer: Tosolvethisproblemyoumustfirstfindthepresentvalueoftheexpectedsavingsoverthe
5yearlifeofthesoftware.
Year
SavingsEstimate
PresentValue
ofSavings
$35,000
$32,110
50,000
42,084
45,000
34,748
25,000
17,710
15,000
9,749
$136,401
Sincethe$136,401presentvalueofthesavingsexceedsthe$130,000costofthesoftware,
thefirmshouldinvestinthenewsoftware.
Youmayuseafinancialcalculator,thetablemethod,oraspreadsheettofindthePVof
thesavings.
E55.
Compoundingmorefrequentlythanannually
Answer: PartnersSavingsBank:
mn
i
FV1 PV 1
m
FV1 $12,000 (1 0.03/2)2

FV1 $12,000 (1 0.03/2)2 $12,000 1.030225 $12,362.70
Selwyns:
FV1 PV (e rxn ) $12,000 (2.71830.02751 )
$12,000 1.027882 $12,334.58
Josephshouldchoosethe3%ratewithsemiannualcompounding.
E56.
Determiningdepositsneededtoaccumulateafuturesum
Answer: Thefinancialcalculatorinputisasfollows:
FV$150,000
I
N18
6%
SolveforPMT$4,853.48
Solutions to Problems
P51.
Usingatimeline
LG1;Basic
a,b,andc
d. Financialmanagersrelymoreonpresentvaluethanfuturevaluebecausetheytypicallymake
decisionsbeforethestartofaproject,attimezero,asdoesthepresentvaluecalculation.
P52.
Futurevaluecalculation
LG2;Basic
Case
A N2,I12%,PV$1,SolveforFV1.2544
B
N3,I6%,PV$1,SolveforFV1.1910
N2,I9%,PV$1,SolveforFV1.1881
D N4,I3%,PV$1,SolveforFV1.1259
P53.
Timetodouble
LG1;Basic
CaseA:ComputerInputs:I12%,PV$100;FV$200
SolveforN6.12years
CaseB:ComputerInputs:I6%,PV$100;FV$200
N11.90years
Ittakesjustshortoftwiceaslongtodoubleinvalue.Onereasonforitbeingshorteristhatin
CaseBtherearemoreperiodsoverwhichcompoundingoccurs.
Note:YoucouldusetheRuleof72tocompletetheproblem.Simplydivide72bytheinterest
ratetogetthenumberofyearsitwouldtaketodoubleaninitialbalance.
CaseA:72126years
CaseB:72612years
P54.
Futurevalues
LG2;Intermediate
Case
Case
A N20,I5%,PV$200.
SolveforFV$530.66
C N10;I9%;PV$10,000.
SolveforFV$7,712.21
D N12;I10%,PV$25,000
SolveforFV$23,673.64
E
N5,I11,PV$37,000
P55.
N7,I/Y8%;PV$4500.
F
N9,I12,PV$40,000
Personalfinance:Timevalue
LG2;Intermediate
a.
(1) N3,I7%,PV$1,500
b. (1)
SolveforFV3$1,837.56
InterestearnedFV3PV
Interestearned$1,837.56
$1,500.00
$337.56
(2) N6,I7%,PV$1,500
(2)
InterestearnedFV6FV3
Interestearned$2,251.10
$1,837.56
$413.54
(3) N9,I7%,PV$1,500
(3)
Interestearned FV9FV6
Interestearned $2,757.69
$2,251.10
$506.59
c.
Thefactthatthelongertheinvestmentperiodis,thelargerthetotalamountofinterest
collectedwillbe,isnotunexpectedandisduetothegreaterlengthoftimethattheprincipal
sumof$1,500isinvested.Themostsignificantpointisthattheincrementalinterestearned
per3yearperiodincreaseswitheachsubsequent3yearperiod.Thetotalinterestforthefirst
3yearsis$337.56;however,forthesecond3years(fromyear3to6)theadditionalinterest
earnedis$413.54.Forthethird3yearperiod,theincrementalinterestis$506.59.This
increasingchangeininterestearnedisduetocompounding,theearningofintereston
previousinterestearned.Thegreaterthepreviousinterestearned,thegreatertheimpactof
compounding.
P56.
LG2;Challenge
a.
(1) N5,I2%,PV$14,000
(2) N5,I4%,PV$14,000
b. Thecarwillcost$1,576.01morewitha4%inflationratethananinflationrateof2%.This
increaseis10.2%more($1,576$15,457)thanwouldbepaidwithonlya2%rateof
inflation.
c.
Futurevalueatendoffirst2years:
N2,I2%,PV$14,000
Priceriseatendof5thyear:
N3,I4%,PV$14,565.60
Asonewouldexpect,theforecastpriceisbetweenthevaluescalculatedwith2%and4%
interest.
P57.
LG2;Challenge
DepositNow:
Depositin10Years:
N40,I9%,PV$10,000
N30,I9%,PV$10,000
Youwouldbebetteroffby$181,417($314,094$132,677)byinvestingthe$10,000now
insteadofwaitingfor10yearstomaketheinvestment.
P58.
LG2;Challenge
a.
N5,PV$10,200,FV15,000
SolveforI8.02%
c.
b. N5,PV$8,150,FV$15,000
SolveforI12.98%
N5,PV$7150,FV$15,000
SolveforI15.97%
P59.
Personalfinance:Singlepaymentloanrepayment
LG2;Intermediate
a.
N1,I14%,PV$200
SolveforFV1$228
c.
b. N4,I14%,PV$200
SolveforFV4$337.79
N8,I14%,PV$200
SolveforFV8$570.52
PVIF
1
(1 i)n
P510. Presentvaluecalculation:
LG2;Basic
Case
A
N4,I2,FV$1.00,SolveforPV$0.9238
P511. Presentvalues
LG2;Basic
Case
PV
N4,I12%,FV$7,000
$4,448.63
N20,I8%,FV$28,000
$6,007.35
N12,I14%,FV$10,000
$2,075.59
N6,I11%,FV$150,000
$80,196.13
N8,I20%,FV$45,000
$10,465.56
P512. Presentvalueconcept
LG2;Intermediate
a.
N6,I12%,FV$6,000
SolveforPV$3,039.79
c.
b. N6,I12%,FV$6,000
SolveforPV$3,039.79
N6,I12%,FV$6,000
SolveforPV$3,039.79
d. Theanswertoallthreepartsisthesame.Ineachcasethesamequestionisbeingaskedbutin
adifferentway.
P513. Personalfinance:TimeValue
LG2;Basic
a.
N3,I7%,FV$500
SolveforPV$408.15
b. Jimshouldbewillingtopaynomorethan$408.15forthisfuturesumgiventhathis
opportunitycostis7%.
c.
IfJimpayslessthen408.15,hisrateofreturnwillexceed7%.
P514. Timevalue:Presentvalueofalumpsum
LG2;Intermediate
I6,I8,FV$100
SolveforPV$63.02
P515. Personalfinance:Timevalueanddiscountrates
LG2;Intermediate
a.
(1) N10,I6%,FV$1,000,000
(2) N10,I9%,FV$1,000,000
SolveforPV$558,394.78
(3) N10,I12%,FV$1,000,000
b.
(1) N15,I6%,FV$1,000,000
(2) N15,I9%,FV$1,000,000
(3) N15,I12%,FV$1,000,000
c.
Asthediscountrateincreases,thepresentvaluebecomessmaller.Thisdecreaseisdueto
thehigheropportunitycostassociatedwiththehigherrate.Also,thelongerthetimeuntilthe
lotterypaymentiscollected,thelessthepresentvalueduetothegreatertimeoverwhichthe
opportunitycostapplies.Inotherwords,thelargerthediscountrateandthelongerthetime
untilthemoneyisreceived,thesmallerwillbethepresentvalueofafuturepayment.
P516. Personalfinance:Timevaluecomparisonsoflumpsums
LG2;Intermediate
a.
A N3,I11%,FV$28,500
B N9,I11%,FV$54,000
C N20,I11%,FV$160,000
b. AlternativesAandBarebothworthgreaterthan$20,000intermofthepresentvalue.
c.
ThebestalternativeisBbecausethepresentvalueofBislargerthaneitherAorCandisalso
greaterthanthe$20,000offer.
P517. Personalfinance:Cashflowinvestmentdecision
LG2;Intermediate
A N5,I10%,FV$30,000
C N10,I10%,FV$10,000
SolveforPV$3,855.43
Purchase
B N20,I10%,FV$3,000
SolveforPV$445.93
D N40,I10%,FV$15,000
SolveforPV$331.42
DoNotPurchase
P518. Calculatingdepositneeded
LG2;Challenge
Step1: Determinationoffuturevalueofinitialinvestment
N7,I5%,PV$10,000
Step2: Determinationoffuturevalueofsecondinvestment
$20,000$14,071$5,929
Step3: Calculationofinitialinvestment
N4,I5%,FV$5,929
SolveforPV$4877.80
P519. Futurevalueofanannuity
LG3;Intermediate
a.
Futurevalueofanordinaryannuityvs.annuitydue
(1) OrdinaryAnnuity
A
(2) AnnuityDue
N10,I8%,PMT$2,500
$36,216.411.08$39,113.72
B
N6,I12%,PMT$500
$4,057.591.12$4,544.51
SolveforFV$4,057.59
C
N5,I20%,PMT$30,000
$223,2481.20$267,897.60
SolveforFV$223,248
D
N8,I9%,PMT$11,500
$126,827.471.09$138,241.92
E
N30,I14%,PMT$6,000
$2,140,721.081.14$2,440,442/03
SolveforFV$2,140,721.08
b. Theannuitydueresultsinagreaterfuturevalueineachcase.Bydepositingthepaymentat
thebeginningratherthanattheendoftheyear,ithasoneadditionalyearofcompounding.
P520. Presentvalueofanannuity
LG3;Intermediate
a.
Presentvalueofanordinaryannuityvs.annuitydue
(1) OrdinaryAnnuity
A
N3,I7%,PMT$12,000
(2) AnnuityDue
$31,491.791.07$33,696.22
SolveforPV$31,491,79
B
N15,I12%,PMT$55,000
$374,597.551.12$419,549.25
C
N9,I20%,PMT$700
$2,821.681.20$3,386.02
SolveforPV$2,821.68
D
N7,I5%,PMT$140,000
$810,092.281.05$850,596.89
E
N5,I10%,PMT$22,500
$85,292.701.1$93,821.97
b. Theannuitydueresultsinagreaterpresentvalueineachcase.Bydepositingthepaymentat
thebeginningratherthanattheendoftheyear,ithasonelessyeartodiscountback.
P521. Personalfinance:Timevalueannuities
LG3;Challenge
a.
AnnuityC(Ordinary)
AnnuityD(Due)
(1) N10,I10%,PMT$2,500
N10,I10%,PMT$2,200
AnnuityDueAdjustment
$35,062.331.1$38,568.57
(2) N10,I20%,PMT$2,500
N10,I20%,PMT$2,200
$57,109.101.2$68,530.92
b. (1) Attheendofyear10,atarateof10%,AnnuityChasagreatervalue($39,843.56vs.
$38,568.57).
(2) Attheendofyear10,atarateof20%,AnnuityDhasagreatervalue($68,530.92vs.
$64,896.71).
c.
AnnuityC(Ordinary)
AnnuityD(Due)
(1) N10,I10%,PMT$2,500
N10,I10%,PMT$2,200
$13,518.051.1$14,869.85
(2) N10,I20%,PMT$2,500
SolveforPV$10.481.18
N10,I20%,PMT$2,200
SolveforPV$9,223.44
$9,223.441.2$11,068.13
d. (1) Atthebeginningofthe10years,atarateof10%,AnnuityChasagreatervalue
($15,361.14vs.$14,869.85).
(2) Atthebeginningofthe10years,atarateof20%,AnnuityDhasagreatervalue
($11,068.13vs.$10,481.18).
e.
AnnuityC,withanannualpaymentof$2,500madeattheendoftheyear,hasahigherpresent
valueat10%thanAnnuityDwithanannualpaymentof$2,200madeatthebeginningofthe
year.Whentherateisincreasedto20%,theshorterperiodoftimetodiscountatthehigher
rateresultsinalargervalueforAnnuityD,despitethelowerpayment.
P522. Personalfinance:Retirementplanning
LG3;Challenge
a.
N40,I10%,PMT$2,000
b. N30,I10%,PMT$2,000
c.
Bydelayingthedepositsby10yearsthetotalopportunitycostis$556,197.Thisdifferenceis
duetoboththelostdepositsof$20,000($2,00010years)andthelostcompoundingof
interestonallofthemoneyfor10years.
d. AnnuityDue:
N40,I10%,PMT$2,000
AnnuityDueAdjustment:$885,185.111.10$973,703.62
N30,I10%,PMT$2,000
AnnuityDueAdjustment:$328,988.051.10$361,886.85
Bothdepositsincreasedduetotheextrayearofcompoundingfromthebeginningofyear
depositsinsteadoftheendofyeardeposits.However,theincrementalchangeinthe40year
annuityismuchlargerthantheincrementalcompoundingonthe30yeardeposit($88,518
vs.$32,898)duetothelargersumonwhichthelastyearofcompoundingoccurs.
P523. Personalfinance:Valueofaretirementannuity
LG3;Intermediate
N25,I9%,PMT$12,000
P524. Personalfinance:Fundingyourretirement
LG2,3;Challenge
a.
N30,I11%,PMT$20,000
b. N20,I9%,FV$173.875.85
c.
Bothvalueswouldbelower.Inotherwords,asmallersumwouldbeneededin20yearsfor
theannuityandasmalleramountwouldhavetobeputawaytodaytoaccumulatetheneeded
futuresum.
d. N30,I10%,PMT$20,000
b. N20,I10%,FV$188,538.29
Moremoneywillberequiredtosupportthe$20,000annuityinretirement,becausetheinitial
amountwillearn1%lessperyear.However,morelessmoneywillhavetobedeposited
duringthenext20years,becausethereturnonsavedfundswillbe1%higher.
P525. Personalfinance:Valueofanannuityvs.asingleamount
LG2,3;Intermediate
a.
N25,I5%,PMT$40,000
At5%,takingtheawardasanannuityisbetter;thepresentvalueis$563,760,comparedto
receiving$500,000asalumpsum.However,onehastoliveatleast23.5years[25(63,757.78
excess/$40,000)]tobenefitmorefromtheannuitystreamofpayments.
b. N25,I7%,PMT$40,000
SolveforNPV$466,143.33
At7%,takingtheawardasalumpsumisbetter;thepresentvalueoftheannuityisonly
$466,160,comparedtothe$500,000lumpsumpayment.
c.
Viewthisproblemasaninvestmentof$500,000togeta25yearannuityof$40,000.The
discountratethatequatesthetwosumsis6.24%,calculatedatfollows:
N25,PV$500,000,PMT$40,000
SolveforI6.24
P526. Perpetuities
LG3;Basic
Equation
Case
Value
$20,0000.08
$250,000
$100,0000.10
$1,00,000
$3,0000.06
$50,000
$60,0000.05
$1,200,000
P527. Personalfinance:Creatinganendowment
LG3;Intermediate
a.
6%interestrate
($6003)0.06$30,000
b. 9%percentinterestrate
($6003)0.09$20,000
P528. Valueofamixedstream
LG4;Challenge
a.
CashFlow
Stream
Year
Numberof
Years
toCompound
1
2
3
2
1
0
$900
1,000
1,200
Sum
1
2
3
4
5
4
3
2
1
0
$30,000
25,000
20,000
10,000
5,000
$47,205.58
35,123.20
25,088.00
11,200.00
5,000.00
Sum $123,616.78
1
2
3
4
3
2
1
0
$1,200
1,200
1,000
1,900
$1,685.91
1,505.28
1,120.00
1,900.00
Sum $6,211.19
Cashflow
Interest
Rate
FutureValue
$1,128.96
1,120.00
1,200.00
$3,448.96
b. Ifpaymentsaremadeatthebeginningofeachperiodthepresentvalueofeachoftheendof
periodcashflowstreamswillbemultipliedby(1i)togetthepresentvalueofthebeginning
ofperiodcashflows.
$3,862.83
$3,448.96(10.12)
$123,616.78(10.12) $138,450.79
$6,211.19(10.12)
$6,956.53
P529. Personalfinance:Valueofasingleamountvs.amixedstream
LG4;Intermediate
LumpSumDeposit
N5,I7,PV$24,000
MixedStreamofPayments
Beginningof
Year
1
2
3
4
5
Numberof
Years
toCompound
CashFlow
InterestRate
FutureValue
5
4
3
2
1
$2,000
$4,000
$6,000
$8,000
$10,000
7%
7%
$2,805.10
$5,243.18
$7,350.25
$9,159.20
$10,700.00
$35,257.73
Sum
Ginashouldselectthestreamofpaymentsoverthefrontendlumpsumpayment.Herfuture
wealthwillbehigherby$1,596.49.
P530. Valueofmixedstream
LG4;Basic
ProjectA
CF1$2,000,CF2$3,000,CF3$4,000,CF4$6,000,CF5$8,000
SetI12
ProjectB
CF1$10,000,CF2$5,000,F24,CF3$7,000
SetI12
ProjectC
CF1$10,000,F15,CF2$8,000,C25
SetI12
P531. PresentvalueMixedstream
LG4;Intermediate
a.
StreamA
CF1$50,000,CF2$40,00,CF3$30,000,CF4$20,000,CF5$10,000
SetI15
StreamB
CF1$10,00,CF2$20,000,CF3$30,000,CF4$40,000,CF5$50,000
SetI15
b. CashflowstreamA,withapresentvalueof$109,890,ishigherthancashflowstreamBs
presentvalueof$91,290becausethelargercashinflowsoccurinAintheearlyyearswhen
theirpresentvalueisgreater,whilethesmallercashflowsarereceivedfurtherinthefuture.
P532. Valueofamixedstream
LG1,4;Intermediate
a.
b. CF1$30,000,CF2$25,000,CF3$15,000,F37,CF4$10,000
SetI12
c.
Harteshouldaccepttheseriesofpaymentsoffer.Thepresentvalueofthatmixedstreamof
paymentsisgreaterthanthe$100,000immediatepayment.
P533. Personalfinance:Fundingbudgetshortfalls
LG4;Intermediate
a.
CF1$5,000,CF2$4,000,CF3$6,000,CF4$10,000,CF5$3,000
SetI8
Adepositof$22,215wouldbeneededtofundtheshortfallforthepatternshowninthetable.
b. Anincreaseintheearningsratewouldreducetheamountcalculatedinparta.Thehigherrate
wouldleadtoalargerinterestincomebeingearnedeachyearontheinvestment.Thelarger
interestamountswillpermitadecreaseintheinitialinvestmenttoobtainthesamefuture
valueavailableforcoveringtheshortfall.
P534. Relationshipbetweenfuturevalueandpresentvaluemixedstream
LG4;Intermediate
a.
CF1$800,CF2$900,CF3$1,000,CF4$1,500,CF5$2,000
SetI5
b. Themaximumyoushouldpayis$5,243.17.
c.
Ahigher7%discountratewillcausethepresentvalueofthecashflowstreamtobelower
than$5,243.17.
P535. Relationshipbetweenfuturevalueandpresentvalue
LG4;Intermediate
Step1: Calculationofpresentvalueofknowncashflows
Year
CFt
PV@4%
$10,000
$9,615.38
$5,000
$4,622.78
$20,000
$17,096.08
$3,000
$2,465.78
Sum
$33,800.02
Step2: IdentifydifferencebetweentotalamountandsuminStep1.
$32,911.03$33,800.02$888.99
Step3: Calculatetheamountneededin3yearsthatisworththeStep2valuetoday
N3,I4%,PV$888.99
SolveforFV$999.99
P536. Changingcompoundingfrequency
LG5;Intermediate
a.
Compoundingfrequency
(1) Annual
Semiannual
N5,I12%,PV$5,000
N5210,I12%26%,PV$5,000
SolveforFV$8,811.71
SolveforFV$8,954.24
Quarterly
N5420periods,I12%43%,PV$5,000
SolveforFV$9,030.56
(2) Annual
Semiannual
N6,I16%,PV$5,000
N6212,I16%28%,PV$5,000
Quarterly
N6424periods,I16%44%,PV$5,000
(3) Annual
Semiannual
N10,I20%,PV$5,000
N10220,I20%210%,PV$5,000
Quarterly
N10440periods,I20%45%,PV$5,000
b. Effectiveinterestrate:ieff(1r/m)m1
(1) Annual
Semiannual
ieff(10.12/1)11
ieff(112/2)21
ieff(1.12)11
ieff(1.06)21
ieff(1.12)1
ieff(1.124)1
ieff0.1212%
ieff0.12412.4%
Quarterly
ieff(112/4)41
ieff(1.03)41
ieff(1.126)1
ieff0.12612.6%
(2) Annual
Semiannual
ieff(10.16/1)11
ieff(10.16/2)21
ieff(1.16)11
ieff(1.08)21
ieff(1.16)1
ieff(1.166)1
ieff0.1616%
ieff0.16616.6%
Quarterly
ieff(10.16/4)41
ieff(1.04)41
ieff(1.170)1
ieff0.17017%
(3) Annual
Semiannual
ieff(10.20/1)11
ieff(10.20/2)21
ieff(1.20)11
ieff(1.10)21
ieff(1.20)1
ieff(1.210)1
ieff0.2020%
ieff0.21021%
Quarterly
Ieff(10.20/4)41
Ieff(1.05)41
Ieff(1.216)1
Ieff0.21621.6%
P537. Compoundingfrequency,timevalue,andeffectiveannualrates
LG5;Intermediate
a.
Compoundingfrequency:
A
N10,I3%,PV$2,500
C
N10,I5%,PV$1,000
N18,I2%,PV$50,000
N24,I4%,PV$20,000
b. Effectiveinterestrate:ieff(1r%/m)m1
A
ieff(10.06/2)21
ieff(10.12/6)61
iefff(10.03)21
ieff(10.02)61
ieff(1.061)1
ieff(1.126)1
ieff0.06106.1%
ieff0.12612.6%
ieff(10.05/1)11
ieff(10.16/4)41
ieff(10.05)11
ieff(10.04)41
ieff(1.05)1
ieff(1.170)1
ieff0.055%
ieff0.1717%
c. Theeffectiveratesofinterestriserelativetothestatednominalratewithincreasing
compoundingfrequency.
P538. Continuouscompounding:FVcont.PVex(e2.7183)
LG5;Intermediate
A
FVcont.$1,000e0.18
$1,197.22
FVcont.$600e1
$1,630.97
FVcont.$4,000e
0.56
$7,002.69
FVcont.$2,500e0.48
$4,040.19
Note:Ifcalculatordoesnthaveexkey,useyxkey,substituting2.7183fory.
P539. Personalfinance:Compoundingfrequencyandtimevalue
LG5;Challenge
a.
(1) N10;I8%,PV$2,000
(2) N20,I4%,PV$2,000
SolveforFV$4,317.85
SolveforFV$4,382.25
(3) N3650;I83650.022,PV$2,000
SolveforFV$4,450.69
b. (1) ieff(10.08/1) 1
1
(4) FV10$2,000(e0.8)
SolveforFV$4,451.08
(2) ieff(10.08/2)21
ieff(10.08)11
ieff(10.04)21
ieff(1.08)1
ieff(1.082)1
ieff0.088%
(3) ieff(10.08/365)3651
c.
ieff0.0828.2%
(4) ieff(ek1)
ieff(10.00022)3651
ieff(e0.081)
ieff(1.0833)1
ieff(1.08331)
ieff0.08338.33%
ieff0.08338.33%
Compoundingcontinuouslywillresultin$134moredollarsattheendofthe10yearperiod
thancompoundingannually.
d. Themorefrequentthecompoundingthelargerthefuturevalue.Thisresultisshowninparta
bythefactthatthefuturevaluebecomeslargerasthecompoundingperiodmovesfrom
annuallytocontinuously.Sincethefuturevalueislargerforagivenfixedamountinvested,
theeffectivereturnalsoincreasesdirectlywiththefrequencyofcompounding.Inpartbwe
seethisfactastheeffectiveratemovedfrom8%to8.33%ascompoundingfrequencymoved
fromannuallytocontinuously.
P540. Personalfinance:Comparingcompoundingperiods
LG5;Challenge
a.
(1) Annually:N2,I12%,PV$15,000
SolveforFV$18,816
(2) Quarterly:N248;I1243%,PV$15,000
(3) Monthly:N21224;I12121%;PV$15,000
(4) Continuously:FVcont.PVerx t
FVPV2.71830.1220.24$15,0001.27125$19,068.74
b. Thefuturevalueofthedepositincreasesfrom$18,816withannualcompoundingto$19,068.74
withcontinuouscompounding,demonstratingthatfuturevalueincreasesascompounding
frequencyincreases.
c.
Themaximumfuturevalueforthisdepositis$19,068.74,resultingfromcontinuous
compounding,whichassumescompoundingateverypossibleinterval.
P541. Personalfinance:Annuitiesandcompounding
LG3,5;Intermediate
a.
(1) Annual
N10,I8%,PMT$300
SolveforFV$4,345.97
(2) Semiannual
N10220;I824%,PMT$3002$150
SolveforFV$4,466.71
(3) Quarterly
N10440;I842%;PMT$3004$75
SolveforFV$4,530.15
b. Thesooneradepositismade,thesoonerthefundswillbeavailabletoearninterestand
contributetocompounding.Thus,thesoonerthedepositandthemorefrequentthe
compounding,thelargerthefuturesumwillbe.
P542. Depositstoaccumulategrowingfuturesum
LG6;Basic
Case
Terms
Calculation
Payment
12%,3yrs.
N3,I12,FV$5,000
$1,481.74
7%,20yrs.
N20,I7%,FV100,000
$2,439.29
10%,8yrs.
N8,I10%,FV$30,000
$2,623.32
8%,12yrs.
N12,I8%,FV$15,000
$790.43
P543. Personalfinance:Creatingaretirementfund
LG6;Intermediate
a.
N42,I8%,FV$220,000
b. N42,I8%,PMT$600
SolveforPMT$723.10
P544. Personalfinance:Accumulatingagrowingfuturesum
LG6:Intermediate
Step1: Determiningthecostofahomein20years.
N20,I6%,PV$185,000
Step2: Determininghowmuchhastobesavedannualtoaffordhome.
Step2: Determininghowmuchhastobesavedannuallytoaffordhome.
N20,I10%,FV$593,295
P545. Personalfinance:Depositstocreateaperpetuity
LG3,6;Intermediate
a.
Presentvalueofaperpetuity PMTr
$6,0000.10
$60,000
b. N10,I10%,FV$60,000
SolvePMT$3,764.72
P546. Personalfinance:Inflation,timevalue,andannualdeposits
LG2,3,6;Challenge
a.
N25,I5%,PV$200,000
b. N25,I9%,FV$677,270.99
c.
SinceJohnwillhaveanadditionalyearonwhichtoearninterestattheendofthe25years,
hisannuityduedepositwillbesmallereachyear.Todeterminetheannuityamount,Johnwill
firstdiscountbackthe$677,200oneperiod.
N1,I9%,FV25$677,270.99
ThisistheamountJohnmustaccumulateoverthe25years.Johncansolveforhisannuity
amountusingthesamecalculationasinpartb.
N25,I9,FV$621,349.53
SolveforPMT7,335.80
Tocheckthisvalue,multiplytheannualpaymentby1plusthe9%discountrate.
$7,335.80(1.09)$7,996.03
P547. Loanpayment
LG6;Basic
Loan
A
N3,I8%,PV$12,000
N10,I12%,PV$60,000
N30,I10%,PV$75,000
N5,I15%,PV$4,000
P548. Personalfinance:Loanamortizationschedule
LG6;Intermediate
a.
N3,I14%,PV$15,000
b.
Endof
Year
Loan
Payment
Payments
Beginningof
YearPrincipal
Interest
Principal
Endof
Year
Principal
$6,460.97
$15,000.00
$2,100.00
$4,360.97
$10,639.03
6,460.97
10,639.03
1,489.46
4,971.51
5,667.52
6,460.97
5,667.52
793.45
5,667.52
(Thedifferenceinthelastyearsbeginningandendingprincipalisduetorounding.)
c.
Throughannualendoftheyearpayments,theprincipalbalanceoftheloanisdeclining,
causinglessinteresttobeaccruedonthebalance.
P549. Loaninterestdeductions
LG6;Challenge
a.
N3,I13%,PV$10,000
b.
Endof
Year
Loan
Beginningof
Payment YearPrincipal
Payments
Interest
Principal
$1,300.00 $2,935.22
EndofYear
Principal
$4,235.22
$10,000.00
$7,064.78
4,235.22
7,064.78
918.42
3,316.80
3,747.98
4,235.22
3,747.98
487.24
3,747.98
P550. Personalfinance:Monthlyloanpayments
LG6;Challenge
a.
N12224,I12%/121%,PV$4,000($4,500500)
SolveforPMT$188.29
b. N12224,I9%/120.75%,PV$4,000
SolveforPMT$182.74
P551. Growthrates
LG6;Basic
a.
Case
A
N4,PV$500,FV$800.
SolveforI12.47%
N9,PV$1,500,FV$2,280
SolveforI4.76%.
N6,PV$2,500,FV$2,900
SolveforI2.50%
b.
Case
A Sameasina
B
Sameasina
C Sameasina
c.
Thegrowthrateandtheinterestrateshouldbeequal,sincetheyrepresentthesamething.
P552. Personalfinance:Rateofreturn
LG6,Intermediate
a.
N3,PV$1,500,FV$2,000
SolveforI10.06%
b. Mr.Singhshouldaccepttheinvestmentthatwillreturn$2,000becauseithasahigherreturn
forthesameamountofrisk.
P553. Personalfinance:Rateofreturnandinvestmentchoice
LG6;Intermediate
a.
A N6,PV5,000,FV$8,400
SolveforI9.03%
C N4,PV$5,000,FV$7,600
SolveforI11.04%
N15,PV$5,000,FV$15,900
SolveforI8.02%
N10,PV$5,000,FV$13,000
SolveforI10.03%
b. InvestmentCprovidesthehighestreturnofthefouralternatives.Assumingequalriskforthe
alternatives,ClareshouldchooseC.
P554. Rateofreturnannuity
LG6;Basic
N10,PV$2,000,FV$10,606
SolveforI18.16%
P555. Personalfinance:Choosingthebestannuity
LG6;Intermediate
a.
AnnuityA
AnnuityB
N20,PV$30,000,PMT$3,100
N10,PV$25,000,PMT$3,900
SolveforI8.19%
SolveforI9.03%
AnnuityC
AnnuityD
N15,PV$40,000,PMT$4,200
N12,PV$35,000,PMT4,000
SolveforI6.3%
SolveforI5.23%
b. AnnuityBgivesthehighestrateofreturnat9%andwouldbetheoneselectedbasedupon
Rainascriteria.
P556. Personalfinance:Interestrateforanannuity
LG6;Challenge
a.
Defendantsinterestrateassumption
N25,PV$2,000,000,PMT$156,000
SolveforI5.97%
b. Prosecutioninterestrateassumption
N25,PV$2,000,000,PMT$255,000
SolveforI12.0%
c.
N25,I9%,PV$2,000,000
P557. Personalfinance:Loanratesofinterest:PVAnPMT(PVIFAi%,n)
LG6;Intermediate
a. LoanA
LoanB
N5,PV$5,000,PMT$1,352.81
SolveforI11.0%
PV$5,000PMT$1,543.21
SolveforI9.0%
LoanC
N3,PV$5,000,PMT$2,010.45
SolveforI10.0%
b. Mr.FlemingshouldchooseLoanB,whichhasthelowestinterestrate.
P558. Numberofyearstoequalfutureamount
LG6;Intermediate
A
I7%,PV$300,FV$1,000
SolveforN17.79years
SolveforN4.573years
D
I10%,PV$9,000,FV$20,000
SolveforN8.38years
I5%,PV$12,000,FV$15,000
I9%,PV$100,FV$500
SolveforN18.68years
I15%,PV$7,500,FV$30,000
SolveforN9.92years
P559. Personalfinance:Timetoaccumulateagivensum
LG6;Intermediate
a.
I10%,PV$10,000,FV$20,000
SolveforN7.27years
b. I7%,PV$10,000,FV$20,000
SolveforN10.24years
c. I12%,PV$10,000,FV$20,000
SolveforN6.12years
d. Thehighertherateofinterest,thelesstimeisrequiredtoaccumulateagivenfuturesum.
P560. Numberofyearstoprovideagivenreturn
LG6;Intermediate
A I11%,PV$1,000,PMT$250
SolveforN5.56years
C I10%,PV$80,000,PMT$10,000
SolveforN16.89years
E
I15%,PV$150,000,PMT$30,000
SolveforN9.92years
I9%,PV$600,PMT275
SolveforN2.54years
I6%,PV$17,000,PMT$3,500
SolveforN5.91years
P561. Personalfinance:Timetorepayinstallmentloan
LG6;Intermediate
a.
I12%,PV$14,000,PMT$2,450
SolveforN10.21years
b. I9%,PV$14,000,PMT$2,450
SolveforN8.38years
c.
I15%,PV$14,000,PMT$2,450
SolveforN13.92years
d. Thehighertheinterestrate,thegreaterthenumberoftimeperiodsneededtorepaytheloan
fully.
P562. Ethicsproblem
LG6;Intermediate
Thisisatoughissue.EvenbackintheMiddleAges,scholarsdebatedtheideaofajustprice.
Theethicaldebatehingeson(1)thebasisforusurylaws,(2)whetherfulldisclosureismadeof
thetruecostoftheadvance,and(3)whethercustomersunderstandthedisclosures.Usurylaws
arepremisedonthenotionthatthereissuchathingasaninterestrate(priceofcredit)thatistoo
high.Acenturiesoldfairnessnotionguidesusintonottakingadvantageofsomeoneinduress
orfacinganemergencysituation.Onemustask,too,whytherearenotmarketsuppliedcredit
sourcesforborrowers,whichwouldchargelowerinterestratesandreceiveanacceptablerisk
adjustedreturn.Onissues#2and#3,thereisnoassurancethatborrowerscomprehendorare
givenadequatedisclosures.Seetheboxforthekeyethicsissuesonwhichtorefocusattention.
(Somewouldviewtheobjectioncitedasasmokescreentotakeourattentionoffthetrueethical
issuesinthiscreditoffer.)
Case
Casestudiesareavailableonwww.myfinancelab.com.
Finding Jill Morans Retirement Annuity

Chapter5scasechallengesthestudenttoapplypresentvalueandfuturevaluetechniquestoarealworld
situation.ThefirststepinsolvingthiscaseistodeterminethetotalamountSunriseIndustriesneedsto
accumulateuntilMs.Moranretires,rememberingtotakeintoaccounttheinterestthatwillbeearnedduring
the20yearpayoutperiod.Oncethatiscalculated,theannualamounttobedepositedcanbedetermined.
a.
b.
Totalamounttoaccumulatebyendofyear12
N20,I12%,PMT$42,000
c.
Endofyeardepositsat9%interest
N12,I9%,FV$313,716.63
SunriseIndustriesmustmakea$15,576.24annualendofyeardepositinyears112inorderto
provideMs.Moranaretirementannuityof$42,000peryearinyears13to32.
d.
Endofyeardeposits,10%interest
N12,I10%,FV$313,716.63
Thecorporationmustmakea$14,670.43annualendofyeardepositinyears112inorderto
provideMs.Moranaretirementannuityof$42,000peryearinyears13to32.
e.
Initialdepositifannuityisaperpetuityandinitialdepositearns9%:
PVperpPMTr
PVperp$42,0000.12
PVperp$350,000
Endofyeardeposit:
N12,I9%,FV$350,000
Spreadsheet Exercise
TheanswertoChapter5sUmaCorporationspreadsheetproblemislocatedontheInstructorsResource
Centeratwww.pearsonhighered.com/ircundertheInstructorsManual.
Group Exercise
Groupexercisesareavailableonwww.myfinancelab.com.
Thissetofdeliverablesconcernseachgroupsfictitiousfirm.Thefirstscenarioinvolvesthereplacement
ofacopymachine.Thefirstdecisionpertainstoachoicebetweencompetingleases,whilethesecond
ischoosingamongpurchaseplanstobuythemachineoutright.Inthefirstcase,leasinginformationis
provided,whileforthesecondoptionstudentsareaskedtogetpricinginformation.Thisinformationis
readilyavailableontheWeb,asistheneededinformationregardinginterestratesforboththepossible
savingsplansregardingthecopymachineandthecomputerupgradescenario.
Forthesavingsplanthegroupsareaskedtolookatseveraldepositoptions,whileforthecomputerupgrade
purchaseanamortizationschedulemustbedeveloped.Modificationsoreveneliminationofoneofthese
scenariosisperfectlyallowableandshouldntaffectfuturework.Thesamecanbesaidofthefinaldeliverable,
involvingasimplecalculationofthepresentvalueofacourtorderedsettlementofapatentinfringement
case.
Integrative Case 2: Track Software, Inc.

IntegrativeCase2,TrackSoftware,Inc.,placesthestudentintheroleoffinancialdecisionmakertointroduce
thebasicconceptsoffinancialgoalsetting,measurementofthefirmsperformance,andanalysisofthe
firmsfinancialcondition.Sincethis7yearoldsoftwarecompanyhascashflowproblems,thestudent
mustprepareandanalyzethestatementofcashflows.Interestexpenseisincreasing,andthefirmsfinancing
strategyshouldbeevaluatedinviewofcurrentyieldsonloansofdifferentmaturities.Aratioanalysisof
Tracksfinancialstatementsisusedtoprovideadditionalinformationaboutthefirmsfinancialcondition.
Thestudentisthenfacedwithacost/benefittradeoff:Istheadditionalexpenseofanewsoftwaredeveloper,
whichwilldecreaseshorttermprofitability,agoodinvestmentforthefirmslongtermpotential?Inconsidering
thesesituations,thestudentbecomesfamiliarwiththeimportanceoffinancialdecisionstothefirmsday
todayoperationsandlongtermprofitability.
a.
1.
Stanleyisfocusingonmaximizingprofit,asshownbytheincreaseinnetprofitsoverthe
period2006to2012.Hisdilemmaaboutaddingthesoftwaredesigner,whichwoulddepress
earningsforthenearterm,alsodemonstrateshisemphasisonthisgoal.Maximizingwealth
shouldbethecorrectgoalforafinancialmanager.Wealthmaximizationtakesalongterm
perspectiveandalsoconsidersriskandcashflows.Profitsmaximizationdoesnotintegratethese
threevariables(cashflow,timing,risk)inthedecisionprocess.
2. Anagencyproblemexistswhenmanagersplacepersonalgoalsaheadofcorporategoals.Since
Stanleyowns40%oftheoutstandingequity,itisunlikelythatanagencyproblemwouldariseat
TrackSoftware.
b.
Earningspershare(EPS)calculation:
Year
NetProfits
afterTaxes
EPS
(NPAT50,000shares)
2006
($50,000)
$0
2007
(20,000)
2008
15,000
0.30
2009
35,000
0.70
2010
40,000
0.80
2011
43,000
0.86
2012
48,000
0.96
Earningspersharehasincreasedsteadily,confirmingthatStanleyisconcentratinghiseffortson
profitmaximization.
c.
CalculationofOperatingandFreeCashFlows
OCFEBIT(1T)depreciation
OCF$89(10.2)11$82.2
FCFOCFnetfixedassetinvestment*netcurrentassetinvestment**
FCF$82.21547$20.2
*
NFAIChangeinnetfixedassetsdepreciation
NFAI(132128)1115
**
NCAIChangeincurrentassetschangein(accountspayableaccruals)
NCAI59(102)47
TrackSoftwareisprovidingagoodpositivecashflowfromitsoperatingactivities.TheOCFislarge
enoughtoprovidethecashneededfortheneededinvestmentinbothfixedassetsandtheincreasein
networkingcapital.Thefirmstillhas$20,200availabletopayinvestors(creditorsandequityholders).
d.
RatioAnalysis
TrackSoftware,Inc.
Industry
Ratio
2011
Actual
2012
Average
2012
TS:TimeSeries
CS:CrossSectional
TS:Improving
CS:Poor
Networking
capital
$21,000
$58,000
$96,000
Currentratio
1.06
1.16
1.82
TS:Improving
CS:Poor
Quickratio
0.63
0.63
1.10
TS:Stable
CS:Poor
Inventoryturnover
10.40
5.39
12.45
Averagecollection
period
29.6days
35.8days
20.2days
Totalasset
turnover
2.66
2.80
3.92
Debtratio
0.78
0.73
0.55
Timesinterest
earned
Grossprofit
margin
3.0
32.1%
3.1
33.5%
5.6
12.4%
Netprofitmargin
3.0%
3.1%
4.0%
Returnon
equity(ROE)
36.4%
31.6%
TS:Decreasing
CS:Poor
TS:Stable
CS:Poor
TS:Improving
CS:Poor
5.7%
8.7%
TS:Improving
CS:Poor
42.3%
5.5%
8.0%
TS:Deteriorating
CS:Poor
TS:Improving
CS:Fair
Operatingprofit
margin
Returnontotal
assets(ROA)
TS:Deteriorating
CS:Poor
TS:Stable
CS:Fair
15.6%
TS:Improving
CS:Poor
34.7%
TS:Deteriorating
CS:Fair
Analysis of Track Software based on ratio data:

1.
Liquidity:TrackSoftwaresliquidityasreflectedbythecurrentratio,networkingcapital,and
acidtestratiohasimprovedslightlyorremainedstable,butoverallissignificantlybelowthe
industryaverage.
2.
Activity:Inventoryturnoverhasdeterioratedconsiderablyandismuchworsethantheindustry
average.Theaveragecollectionperiodhasalsodeterioratedandisalsosubstantiallyworsethan
theindustryaverage.Totalassetturnoverimprovedslightlybutisstillwellbelowtheindustry
norm.
3.
Debt:Thefirmsdebtratioimprovedslightlyfrom2008butishigherthantheindustry
averages.Thetimesinterestearnedratioisstable,andalthoughitprovidesareasonablecushion
forthecompany,isbelowtheindustryaverage.
4.
Profitability:Thefirmsgross,operating,andnetprofitmarginshaveimprovedslightlyin
2009butremainlowcomparedtotheindustry.Returnontotalassetshasimprovedslightlybut
isabouthalftheindustryaverage.Returnonequitydeclinedslightlyandisnowbelowthe
industryaverage.
TrackSoftware,whileshowingimprovementinmostliquidity,debt,andprofitabilityratios,
shouldtakestepstoimproveactivityratios,particularlyinventoryturnoverandaccounts
receivablecollection.Itdoesnotcomparefavorablytoitspeergroup.
5.
Stanleyshouldmakeeveryefforttofindthecashtohirethesoftwaredeveloper.Sincethemajor
goalisprofitmaximization,theabilitytoaddanewproductwouldincreasesalesandleadto
greaterprofitsforTrackSoftwareoverthelongterm.
e.
StanleyisseekingtomaximizethevalueofTrackSoftware,nottheearningsofanyoneperiod.As
such,heshouldfocusonmorethanthenegativeinitialimpactsimpact,butthepotentialfora
significantriseinsalesandearningsoncethedevelopment,production,andmarketingprocesswas
completed.
f.
Theinvestorwouldtreatthe$5,000annualpaymentasanannuity.Dividingthatpaymentbythe10%
requiredrateofreturnresultsina$50,000offer.
g.
Thefreecashflowis$20,200annually.Treatingthatamountasanannuityanddividingbythe10%
requiredrateofreturnresultsina$202,000valueforTrackSoftware.

Chapter 05

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 05

Uploaded by

Copyright:

Available Formats

Chapter5

Suggested Answer to Opener in Review Question

Answers to Review Questions

Suggested Answer to Focus on Practice Box:

Suggested Answer to Focus on Ethics Box:

Answers to Warm-Up Exercises

FV1 $12,000 (1 0.03/2)2

Finding Jill Morans Retirement Annuity

Integrative Case 2: Track Software, Inc.

Analysis of Track Software based on ratio data:

You might also like