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Chapter 04 - Future Value, Present Value, and Interest Rates

Chapter 4
Future Value, Present Value, and Interest Rates
Chapter Overview

This chapter continues the exploration of interest rates using the concept of present value and
future value. The concepts are applied to the valuation of bonds, and the relationship between
inflation and interest rates is also considered.

Reading this chapter will prepare students to:


Define present and future value.
Calculate present and future values given different values of relevant variables.
Apply the analysis of present and future values to basic financial decisions regarding
investments and debt.
Extend the analysis of present and future value to examine bond prices.
Comprehend real versus nominal interest.

Important Points of the Chapter

In todays world, interest rates are of enormous importance to virtually everyone; they link the
present to the future, allowing us to compare payments made on different dates. They also tell us
the future reward for lending today, as well as the cost of borrowing now and repaying in the
future. But to make sound financial decisions we must learn how to calculate and compare
different rates on various financial instruments.

Application of Core Principles

Principle #1: Time. A dollar deposited in an interest-bearing account today will earn a return and
grow into a future value. Future value is the value on some future date of an investment made
today.

Principle #1: Time. The present value is the value today of a payment that is promised to be
made in the future. It is the amount that must be invested today in order to realize a specific
amount on a given future date.

Principle #1: Time. The sooner a payment is to be made the more it is worth, and the rate of
decline in present value is related to the same phenomenon that gives us the rule of 72.

Principle #1: Time. The nominal rate agreed upon by a borrower and lender must be based on
expected inflation over the term of the loan.

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Chapter 04 - Future Value, Present Value, and Interest Rates

Teaching Tips/Student Stumbling Blocks

The biggest challenge in this chapter is the mathematics of calculating future value and
present value. The text does an excellent job in explaining the material, taking students
through the calculations step by step, but you will probably want to reinforce this with a
number of practice exercises.
Emphasize that if someone has funds now those funds can be invested and will earn
interest, growing into future value. Finding present value is, in essence, running that
process in reverse.
Discuss the material in the text with regard to credit card debt (Your Financial World: Pay
Off Your Credit Card Debt as Fast as You Can), and supplement the treatment in the text
with a consideration of the dollar amounts involved. How much does an impulse
purchase really cost someone?

Features in this Chapter

Your Financial World: How Long Does It Take to Double Your Investment?

The Rule of 72 can be used to find out how long it will take your money to double at any rate of
interest. Divide 72 by the rate of interest (as a whole number) and the answer is the number of
years. The Rule of 72 shows the power of compounding, and can be used for anything that is
growing at a constant rate.

Lessons from the Crisis: Risk Taking and the Search for Yield
Investors must understand the risks of what they buy. Many investors underestimate the risk
associated with particular investments. Several things may cause this underestimation. First,
investors may extrapolate from recent patterns that may not accurately reflect the long-term
trends of the risk of the investments. They may also underestimate default risk if using recent
history as their guide. Typically, the risk of default is lower during economic expansions.
Investors may also underestimate risk if their investment managers take risks that are not evident
or are purposely concealed.

Tools of the Trade: Computing Compound Annual Rates

Compounding means earning interest on interest. As a result of compounding we cant just


multiply a monthly rate by 12 to get an annual rate. Instead we need to compute a 12-month
compounded rate by raising the one-month rate to the twelfth power. Another use for
compounding is the calculation of the average annual rate; if you know how much an investment
has grown over a number of years we can use this calculation to find out the percentage change
per year.

Your Financial World: Should You Buy the New Car Now or Wait?

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Chapter 04 - Future Value, Present Value, and Interest Rates

This feature compares the decision to buy a car now as opposed to waiting a year, and given the
assumptions made in the calculations, shows that by waiting a year the consumer would have
more to spend. Should the consumer buy the car now or wait? The answer depends on how the
person feels about having the extra amount to spend and how much the old car may cost to repair
in the meantime.

Applying the Concept: Early Retirement

Early retirement is very expensive. If someone expects to live to be 85 and has $100,000 a year
in income, in order to retire at 40 he or she would need to accumulate about $2 million in assets.
As a rule of thumb, someone in his or her mid-20s should be putting away 10% of income
toward retirement in order to retire at the same pre-retirement standard of living by age 65. It
takes significant savings to live without a paycheck.

In the News: Pentagon Shows That It Doesn't Always Pay to Take the Money and Run

People who were downsized from the Defense Department were offered either an annual
payment of $8,000 for 30 years or a lump sun of $50,000 today. Despite being provided with
ample explanatory materials most people chose the lump sum even though the annual payments
were more to their advantage. The reason is that most people put excessive weight on a bird in
the hand. The Treasury saved billions by offering the lump sum option. From this it can be
calculated that the average personal discount rate was about 25 percent. Recognition of this
helps to explain other phenomena, like why people hold high credit card debt.

Lessons of the Article: This article explains a common problem faced by people who
are retiring. Should they take a lump sum payment offered by their employer or
pension fund, or a series of annual payments? Answering this question requires using
present value. The article also describes how most people are extremely impatient,
behaving as if their own personal discount rate is extraordinarily high and how that
explains the willingness to borrow at very high interest rates.

Your Financial World: Pay Off Your Credit Card Debt as Fast as You Can

This feature illustrates the advantage of paying off debts as fast as possible. For example,
someone with $2000 in credit card debt at a rate of 15% paying $50 a month will need 54.3
months to finish paying off the $2000. Increasing the payment to $60 a month will reduce the
time of repayment to 42.5 months, one full year sooner. The lesson is that making large
payments on credit card debt is more important than getting low interest rates. Pay off your
debts as fast as you can; procrastination is expensive.

Applying the Concept: High Interest Rates, Low Interest Rates

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Chapter 04 - Future Value, Present Value, and Interest Rates

Once we realize that nominal interest rates move with expected inflation rates, big swings in
interest rates become less of a mystery. It also makes it easier to understand why interest rates
can be very different in different countries.

Additional Teaching Tools

Kaja Whitehouse, writing for The Wall Street Journal (Student Loan 101: When Looking to
Consolidate, Discounts are Key, June 2, 2004), reports that interest rates on certain federal loans
(like the Stafford loans) will drop to historic lows in July, providing an opportunity for people to
consolidate their student loans into one, lower rate loan. The article points out that in addition to
deciding whether or not to consolidate, people must also look for the right consolidator, which
means finding the one that offers the best discounts. Under the Federal Consolidation Loan
Program you will always be quoted the same interest rate and zero fees but the competition is in
the discounts the lenders can offer. Discounts can drop interest rate or lower payments over
time; some lenders even offer cash back to borrowers who make regular payments on time for a
set period of time. A borrower can choose a cash rebate instead of a lower interest rate; as noted
in the article, This sort of discount may save you less over time, but it could work out better for
people who are unsure of their ability to pay their future bills, or for those who need cash. The
article also notes that several of the state guaranty agencies provide better-than-average
discounts.

Virtual Tools

Here is an online present value calculator that allows the user to change things like the future
value and the discount rate and see how the present value changes.
http://www.timevalue.com/tcalc.aspx

For more about the state guaranty agencies mentioned in the article above (in Additional
Teaching Tools, go to this page on the U.S. Department of Educations web site.
www.ed.gov

For More Discussion

This chapter points out that paying off credit card debt as soon as possible is worthwhile. Do
people really know the interest rates on their credit cards? Have your students find out; it can be
a real eye-opening exercise!

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Chapter 04 - Future Value, Present Value, and Interest Rates

Chapter Outline

I. Valuing Monetary Payments Now and in the Future


To compare the value of payments made on different dates we need a set of tools called
present value and future value.
A. Future Value and Compound Interest
1. Future value is the value on some future date of an investment made today.
2. To calculate future value we multiply the present value by the interest rate and add
that amount of interest to the present value. For example, $100 earning 5% interest
has a future value of $105 in one year.
a. We can also say that the $100 investment has a yielded a $5 return, which is why an
interest rate can be called a yield.
3. The higher the interest rate (or the amount invested) the higher the future value;
remember Core Principle 1: time has value.
4. When we consider investments with interest payments made for more than one year
we need to consider compound interest, or the fact that interest will be paid on
accumulated interest.
5. We can then calculate future value; we multiply the present value by one plus the
interest rate, raised to a power (exponent) that is equal to the number of years.
Remember, using an exponent is really shorthand for performing a series of
multiplications.
6. Fractions of percentage points are called basis points; a basis point is one one-
hundredth of a percentage point.
B. Present Value
How much is a payment promised in the future worth today? We can find out by
calculating present value or present discounted value.
1. The Definition
a. The present value is the value today of a payment that is promised to be made in
the future. It is the amount that must be invested today in order to realize a
specific amount on a given future date.
b. To calculate present value we invert the future value calculation; thus we divide
future value by one plus the interest rate (to find the present value of a payment to
be made one year from now).
c. For payments to be made more than one year from now we divide future value by
one plus the interest rate raised to the nth power where n is the number of years.
d. This tells us that present value is higher the higher the value of the future
payment, the shorter the time until payment, and the lower the interest rate.

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Chapter 04 - Future Value, Present Value, and Interest Rates

2. How Present Value Changes


a. Doubling the future value of the payment without changing the time involved or
the interest rate, results in a doubling of the present value.
b. The sooner a payment is to be made the more it is worth and the rate of decline in
present value is related to the same phenomenon that gives us the rule of 72.
c. Higher interest rates are associated with lower present values no matter what the
size or timing of the payment.
d. At any fixed interest rate, an increase in the time until a payment is made reduces
its present value.
e. Not only does the present value of a future payment fall with the interest rate; the
further in the future the promised payment is to be made, the more the present
value falls.
II. Applying Present Value
To use present value in practice we need to look at a sequence or stream of payments whose
present values must be summed. Present value is additive. To see how this is applied we
will look at internal rate of return and the valuation of bonds.
A. Internal Rate of Return
1. The internal rate of return is the interest rate that equates the present value of an
investment with its cost.
2. It is the interest rate at which the present value of the revenue stream equals the cost
of the investment project. In the calculation we solve for the interest rate.
3. The internal rate of return must be compared to a rate of interest that represents the
cost of funds to make the investment. These funds could be obtained from retained
earnings or borrowing. In either case there is an interest cost.
4. An investment will be profitable if its internal rate of return exceeds the cost of
borrowing.
B. Bonds: The Basics
1. One of the most common uses of the concept of present value is in the valuation of
bonds.
2. A bond is a promise to make a series of payments on specific future dates; it is a legal
contract issued as part of an arrangement to borrow.
3. The most common type is a coupon bond, which makes annual payments called
coupon payments (the percentage rate is called the coupon rate).
4. The bond also specifies a maturity date and has a final payment, which is the
principal, face value, or par value of the bond.
5. The price of a bond is the present value of its payments.

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Chapter 04 - Future Value, Present Value, and Interest Rates

6. To value a bond we need to value the repayment of principal and the payments of
interest.
a. Valuing the Principal Payment: a straightforward application of present value
where n represents the maturity of the bond.
b. Valuing the Coupon Payments: requires calculating the present value of the
payments and then adding them; remember, present value is additive.
c. Valuing the Coupon Payments plus Principal: means combining the above.
7. The value of the coupon bond rises when the yearly coupon payments rise and when
the interest rate falls.
8. Lower interest rates mean higher bond prices and vice versa. The value of a bond
varies inversely with the interest rate used to discount the promised payments.
III. Real and Nominal Interest Rates
1. So far we have been computing the present value using nominal interest rates, or
interest rates expressed in current-dollar terms.
2. But inflation affects the purchasing power of a dollar, so we need to consider the real
interest rate, which is the inflation-adjusted interest rate.
3. The Fisher equation tells us that the nominal interest rate is equal to the real interest
rate plus the expected rate of inflation.
4. The expected rate of inflation can be obtained from forecasts such as those done by the
Federal Reserve Bank of Philadelphia.
Appendix 4A: The Algebra of Present Value Formulas
This appendix shows the derivation of a formula for computing present value, which can be
used for any series of payments.

Terms Introduced in Chapter 4

basis point
bond
compound interest
coupon bond
coupon payment
coupon rate
face value
fixed-payment loan
future value
internal rate of return
maturity date
nominal interest rate

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Chapter 04 - Future Value, Present Value, and Interest Rates

par value
present value
principal
real interest rate
rule of 72
yield

Lessons of Chapter 4

1. The value of a payment depends on when it is made.


a. Future value is the present value of an initial investment times one plus the interest rate
for each year you hold it. The higher the interest rate, the higher the future value.
b. Present value is equal to the value today of a payment made on a future date.
i. The higher the payment, the higher the present value at a given interest rate.
ii. The higher the interest rate, the lower the present value of a given payment.
iii. The longer the time until the payment is made, the lower the present value of a given
payment at a given interest rate.
iv. For a given increase in the interest rate, the present value of a promised payment falls
more the farther into the future the payment is to be made.
v. In computing present value, the interest rate and the time until the payment is to be
made must be measured in the same time units.

2. Present value can be used to value any stream of future payments.


a. The internal rate of return is the interest rate that equates the present value of the future
payments or profits from an investment with its current cost.
b. A coupon bond is a promise to make periodic interest payments and a final principal
payment on specific future dates.
i. The present value of a bond depends on its coupon rate, date of maturity, and the
current interest rate.
ii. The higher the coupon rate, given the maturity and the interest rate, the higher the
present value of the bond.
iii. The price of a bond is inversely related to the interest rate. The higher the price, the
lower the interest rate that equates the price with the present value of the promised
payments.

3. The real interest rate is the nominal interest rate minus expected inflation. It expresses the
interest rate in terms of purchasing power rather than current dollars.

Chapter 4:

Conceptual Problems

1. Compute the future value of $100 at an 8 percent interest rate 5, 10, and 15 years into the
future. What would the future value be over these time horizons if the interest rate were 5
percent?

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Chapter 04 - Future Value, Present Value, and Interest Rates

Answer:
Future value in 5 years = $100*(1.08)5 = $146.93
Future value in 10 years = $100*(1.08)10 = $215.89
Future value in 15 years = $100*(1.08)15 = $317.22
Future value in 5 years = $100*(1.05)5 = $127.63
Future value in 10 years = $100*(1.05)10 = $162.89
Future value in 15 years = $100*(1.05)15 = $207.89

2. Compute the present value of a $100 investment made 6 months, 5 years, and 10 years from
now at 4 percent interest.

Answer:
6 months: Present Value = 100/(1.04)0.5 = $98.06
5 years: Present Value = 100/(1.04)5 = $82.19
10 years: Present Value = 100/(1.04)10 = $67.56

Remember, you are calculating the present value of an investment to be made in the future.
Notice that the exponent for the 6-months calculation is 0.5, representing one-half of one
year into the future.

3. Assuming that the current interest rate is 3 percent, compute the value of a five-year, 5
percent coupon bond with a face value of $1,000. What happens when the interest rate goes
to 4 percent? What happens when the interest rate goes to 2 percent?

Answer:
Present Value for 5-year 5 percent coupon bond with face value of $1000 (i=3%) =
$50/(1.03) + $50/(1.03)2 + $50/(1.03)3 + $50/(1.03)4 + $1050/(1.03)5 =
$1091.59

Present Value for 5-year 5 percent coupon bond with face value of $1000 (i=4%) =
$50/(1.04) + $50/(1.04)2 + $50/(1.04)3 + $50/(1.04)4 + $1050/(1.04)5 =
$1044.52

The present value falls when the interest rate rises to 4 percent.

Present Value for 5-year 5 percent coupon bond with face value of $1000 (i=2%) =
$50/(1.02) + $50/(1.02)2 + $50/(1.02)3 + $50/(1.02)4 + $1050/(1.02)5 =
$1141.40

The present value rises when the interest rate falls to 2 percent.

4. *Given a choice of two investments, would you choose one that pays a total return of 30
percent over the five years or one that pays 0.5 percent per month for five years?

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Chapter 04 - Future Value, Present Value, and Interest Rates

Answer: To compare the investments, you need to measure their returns in the same units.
One option would be to convert both these returns to annual rates.
The first investment gives us an annual increase of
(130/100)1/5 1 = .053873952 or 5.39% per year

while the second one gives


(1.005)12 1 = .061677812 or 6.17%

Therefore, choose this investment that pays 0.5% per month for five years.

Alternatively, you could convert the first investment to a monthly return


(130/100) 1/60 1 = .004382312 or 0.44% per month which is lower than the 0.5% on the
second investment.

A third option would be to convert the monthly rate on the second investment into a 5-year
rate
(1.005)60 1 = 0.348850152 or 34.88% - which is higher than the 30% on the first
investment.

When converted to a common unit of measurement, we see that the second investment gives
a higher return.

5. A financial institution offers you a one-year certificate of deposit with an interest rate of 5
percent. You expect the inflation rate to be 3 percent. What is the real return on your
deposit?

Answer: real interest rate equals the nominal rate less the expected rate of inflation; therefore
5% - 3% = 2%

6. Explain why choosing an investment manager based purely on their recent performance in
terms of generating high yields might not necessarily be the best idea.

Answer: Core principle 2 states that risk requires compensation. The higher returns
generated by some managers may simply reflect the adoption of more risk there is a trade-
off between risk and return. You should choose a manager whose behavior best matches your
own appetite for risk.

7. You decide you would like to retire at age 65, and expect to live until you are 85 (assume
there is no chance you will die younger or live longer). You figure that you can live nicely
on $50,000 per year.
a. Describe the calculation you need to make to determine how much you must save
to purchase an annuity paying $50,000 per year for the rest your life. Assume the
interest rate is 7 percent.
b. How would your calculation change if you expected inflation to average 2 percent
for the rest of your life?

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Chapter 04 - Future Value, Present Value, and Interest Rates

Answer:
a. $50,000/(1.07) + $50,000/(1.07)2 + $50,000/(1.07)3 ++ $50,000/(1.07)20
b. If you want to have $50,000 in purchasing power for each year of your retirement,
you would need to calculate:
$50,000/(1.07) + $50,000*(1.02)/(1.07)2 + $50,000*(1.02)2/(1.07)3 ++
$50,000*(1.02)19/(1.07)20

8. Most businesses replace their computers every two to three years. Assume that a computer
costs $2000 and that it fully depreciates in 3 years, at which point it has no resale value
whatsoever and is thrown away.
a. If the interest rate for financing the equipment is equal to i, show how to compute
the minimum annual cash flow that a computer must generate to be worth the
purchase. Your answer will depend on i.
b. Suppose the computer did not fully depreciate but still had a $250 value at the
time it was replaced. Show how you would adjust the calculation given in your
answer to part a.
c. What if financing can only be had at a 10 percent interest rate? Calculate the
minimum cash flow the computer must generate to be worth the purchase using
your answer to part a.

Answer:
a. If x = minimum annual cash flow:
$2000 = x/(1+i) + x/(1+i)2 + x/(1+i)3
x = $2000/[1/(1+i) + 1/(1+i)2 + 1/(1+i)3]
b. $2000 = x/(1+i) + x/(1+i)2 + x/(1+i)3 + $250/(1+i)3
x = [$2000 - $250/(1+i)3]/[1/(1+i) + 1/(1+i)2 + 1/(1+i)3]
c. x = $2000/[1/(1+0.1) + 1/(1+0.1)2 + 1/(1+0.1)3] = $804.23

9. Some friends of yours have just had a child. Thinking ahead, and realizing the power of
compound interest, they are considering investing for their childs college education, which
will begin in 18 years. Assume that the cost of a college education today is $125,000; there
is no inflation; and there are no taxes on interest income that is used to pay college tuition
and expenses.
a. If the interest rate is 5 percent, how much money will your friends need to put
into their savings account today to have $125,000 in 18 years?
b. What if the interest rate were 10% percent?
c. The chance that the price of a college education will be the same 18 years from
now as it is today seems remote. Assuming that the price will rise 3% per year,
and that todays interest rate is 8 percent, what will your friends investment need
to be?
d. Return to part a, the case with a 5 percent interest rate and no inflation. Assume
that your friends dont have enough financial resources to make the entire
investment at the beginning. Instead, they think they will be able to split their

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Chapter 04 - Future Value, Present Value, and Interest Rates

investment into two equal parts, one invested immediately and the second
invested in five years. Describe how you would compute the required size of the
two equal investments, made five years apart.

Answer:
a. PV = $125,000/(1.05)18 = $51,940.08
b. PV = $125,000/(1.10)18 = $22,482.35
c. If the price rises 3% per year, the cost of a college education in 18 years will be:
$125,000*(1.03)18 = $212,804.13
PV = $212,804.13/(1.08)18 = $53,254.03
d. If x is the size of each investment:
$125,000 = x(1.05)18 + x(1.05)13
x = $125,000/[(1.05)18 + (1.05)13] = $29,122.13

10. You are considering buying a new house, and have found that a $100,000, 30-year fixed-rate
mortgage is available with an interest rate of 7 percent. This mortgage requires 360 monthly
payments of approximately $651 each. If the interest rate rises to 8 percent, what will
happen to your monthly payment? Compare the percentage change in the monthly payment
with the percentage change in the interest rate.

Answer: If the annual interest rate is 8%, then the monthly rate is (1.08)1/12 1 = 0.006434

Using the equation from Appendix 4A:


C = ($100,000*0.006434)/[1 (1/(1.006434)360)] = $714. Monthly payments have
risen by ($714-$651)/$651 = 9.7% and the interest rate has risen by (8%-7%)/7% =
14.3%.

11. *Use the Fisher equation to explain in detail what a borrower is compensating a lender for
when he pays her a nominal rate of interest.

Answer: The Fisher equation illustrates that the nominal interest rate (i) can be broken down
into two components where i = r + e. Taking i to be an annual interest rate, the borrower is
compensating the lender for the inflation that is expected over the coming year, as this will
reduce the purchasing power of a given number of dollars. The borrower is also paying the
lender a real interest rate to compensate the lender for the use of her money. The lender is
foregoing the use of her money for the duration of the loan and so need to be compensated
for this opportunity cost.

Analytical Problems

12. If the current interest rate increases, what would you expect to happen to bond prices?
Explain.

Answer: Interest rates and bond prices are inversely related so bond prices will fall when
interest rates increase. Bond prices are the sum of the present values of the future payments

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Chapter 04 - Future Value, Present Value, and Interest Rates

associated with the bond. The higher the interest rate, the lower the present value of these
payments.

13. Which would be most affected in the event of an interest rate increase the price of a five-
year coupon bond that paid coupons only in years 3, 4, and 5 or the price of a five-year
coupon bond that paid coupons only in years 1, 2, and 3, everything else being equal?
Explain.

Answer: The price of the bond with the later payments will fall by relatively more. The
payments are made further into the future, so the change in the interest rate has a greater
impact on their present value. From the present value formula we can see, for example, that
a payment made in one year is divided by (1+i) while a payment made in five years time is
divided by (1+i)5, so the impact will be bigger in the latter case.

14. Under what circumstances might you be willing to pay more than $1,000 for a coupon bond
that matures in three years, has a coupon rate of 10 percent and a face value of $1,000?

Answer: If the interest rate in the market were less than 10%, the present value of the
payment flows associated with the bond would be higher than $1000. You can use the
present value formula to verify this. For example, suppose the interest rate were 8%. The
present value of the payment flows associated with the bond would be 100/1.08 +100/(1.08)2
+100/(1.08)3 +1000/(1.08)3 = $1051.54.

15. *Approximately how long would it take for an investment of $100 dollars to reach $800 if
you earned 5%? What if the interest rate were 10%? How long would it take an investment
of $200 to reach $800 at an interest rate of 5%? Why is there a difference between doubling
the interest rate and doubling the initial investment?

Answer: Using the rule of 72, we know that if the interest rate is 5%, it will take 72/5=14.4
years for the investment to double to $200. Repeating the exercise twice more (doubling
from $200 to $400 and then from $400 to $800), we see that the investment will take 43.2
years to reach $800.
If the interest rate is 10%, it will take 72/10 = 7.2*3 = 21.6 years to double exactly half the
time.
(You can check that your calculations are approximately correct using the future value
formula. Alternatively, you could have directly solved for n in the future value formula to
find the number of years needed to get to $800.)
If $200 is invested at 5%, it will take 72/5 = 14.4 *2 = 28.8 years reach $800 which is more
than half the time it took for $100 to reach $800 at the same interest rate.
The reason lies in the compounding the greater interest earnings having interest paid on
them in subsequent years has a bigger impact than the interest being calculated from a larger
initial investment.

16. Suppose two investors (A and B) are thinking about purchasing the same long-term bond.
When deciding what price he would be willing to pay for the bond, investor A takes into
account the behavior of interest rates over the previous 10 years, noting a period of interest-

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Chapter 04 - Future Value, Present Value, and Interest Rates

17. rate volatility before the low and stable interest rates of the most recent two years. Investor B
only looks at the past two years when making his decision. Everything else being equal,
which investor do you think would be willing to pay a higher price for the bond?

Answer: Investor B would be willing to pay a higher price. Investor A is likely to consider
the bond more risky that investor B because he is less likely than investor B to expect interest
rates to remain low and stable. Therefore, investor A will require more compensation for risk
in the form of a higher yield and so would be willing to pay a lower price for the bond than
investor B.

18. Recently, some lucky person won the lottery. The lottery winnings were reported to be $85.5
million. In reality, the winner got a choice of $2.85 million per year for 30 years or $46
million today.
a. Explain briefly why winning $2.85 million per year for 30 years is not equivalent to
winning $85.5 million.
b. The evening news interviewed a group of people the day after the winner was
announced. When asked, most of them responded that, if they were the lucky winner,
they would take the $46 million up-front payment. Suppose (just for a moment) that
you were that lucky winner. How would you decide between the annual installments
or the up-front payment?

Answer:
a) $2.85 million per year is not equivalent to winning $85.5 million because of the
time value of money. If you received all the money today, you could invest it and earn
interest on it. Given that you dont receive most of the money until some time in the
future, the value is less because of the foregone interest. The equivalent today is the sum
of the present values of the sequence of payments.
b) I would calculate which payment option gave me the highest present value. I
would look at the market to determine the appropriate interest rate to use and calculate
the PV of the installments over 30 years. I would compare this with $46 million to see
what is highest. Another factor to consider would be whether the tax treatment was the
same for the two options.

19. You are considering going to graduate school for a one-year masters program. You have
done some research and believe that the masters degree will add $5,000 per year to your
salary for the next 10 years of your working life, starting at the end of this year. From then
on, after the next 10 years, it makes no difference. Completing the masters program will
cost you $35,000, which you would have to borrow at an interest rate of 6%. How would
you decide if this investment in your education were profitable?

Answer: You should calculate the internal rate of return from completing the masters
program. If the IRR is greater than 6%, then it will be profitable. The calculation is
35,000 = 5,000/(1+i) +5,000/(1+i)2 +5,000/(1+i)3 5,000/(1+i)4 5,000/(1+i)5 5,000/(1+i)6 +
5,000/(1+i)7 + 5,000/(1+i)8 +5,000/(1+i)9 +5,000/(1+i)10

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Chapter 04 - Future Value, Present Value, and Interest Rates

Using a spreadsheet or financial calculator, we find the IRR is around 7%. As the IRR is
greater than the interest rate, it is profitable to invest in the masters program.

20. Assuming the chances of being paid back are the same, would a nominal interest rate of 10%
always be more attractive to a lender than a nominal rate of 5%? Explain.

Answer: Lenders are concerned with the real return they receive. If the higher nominal
interest rate represents a higher real interest rate, then the lender will find it more attractive.
If, on the other hand, the higher nominal interest rate merely reflects higher expected
inflation, this may not be to the benefit of the lender. For example, a nominal interest rate of
10% reflecting expected inflation of 8% and a real interest rate of 2% would not be preferred
by lenders over a nominal interest rate of 5% reflecting expected inflation of 1% and a real
interest rate of 4%. It is the real not the nominal interest rate that matters.

21. *Suppose two parties agree that the expected inflation rate for the next year is 3%. Based on
this, they enter into a loan agreement where the nominal interest rate to be charged is 7%. If
inflation for the year turns out to be 2%, who gains and who loses?

Answer: The ex ante real interest rate is 4%. This is what the borrower thinks he or she is
paying and the lender thinks he or she is earning. If inflation turns out to be lower than
expected, the ex post real interest rate will be 5%. This benefits the lender, as he or she is
earning more in real terms than he or she anticipated. The borrower loses when inflation is
lower than expected, as he or she is paying a higher real interest rate than he or she
anticipated.

* indicates more difficult problems

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