CHAPTER 8

The Time Value of Money

THINKING BEYOND THE QUESTION How much will it cost to borrow money? A shorter borrowing period means that a creditor will receive repayment of a loan sooner than if the borrowing period is longer. Consequently, the money that is borrowed is at risk over a shorter period. The lender has the opportunity to lend the money out again and renegotiate the interest rate on the loan when it is paid back sooner. Interest rates depend on the lenders evaluation of the ability of the borrower to repay the loan on a timely basis. A borrower with high operating cash flows and net income and relatively low amounts of debt is less likely to have difficulty repaying a loan than a company with low cash flows and profits and high amounts of debt. A good credit history also is important. A borrower who has a history of repaying loans and interest on a timely basis is likely to obtain lower interest loans than one who has had payment problems. Lenders examine the income statement to determine a companys profitability and whether profits are increasing or decreasing over time. They examine the statement of cash flows to determine the amount of operating cash flow a company is generating, how it is using that cash flow, and how much debt and interest the borrower is paying. They examine the balance sheet to determine how much debt and other liabilities the company has outstanding. Good financial statement numbers usually result in lower interest costs. QUESTIONS Q8-1 Future value and present value are based on the concept of interest. Both recognize that, when invested at a rate of interest, an amount of money will grow to a larger amount as time passes. Future value is the amount that an investment will grow to over time. Higher rates of interest or longer investment periods result in higher future value. Present value is the amount that must be invested today to grow to a desired amount in the future. Higher interest rates or longer investment periods result in lower present value.
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Q8-2 The concept of future value assumes that money has a time value. It assumes, for example, that a specific amount of money invested today will grow to a larger amount over time. Therefore, $1,000 invested today at a rate of return greater than zero will grow to an amount larger than the amount originally deposited.

Q8-3 The concept of present value assumes that money has a time value. It assumes, for example, that a specific amount of money to be received at some future time has a lesser value (or benefit) than if that same amount were available to be received today. Q8-4 Any interest factor found on Table 1 reveals the amount that $1 will grow to if invested at the given interest rate for the number of periods indicated. Here, the number 5.55992 reveals that $1 invested at 10% for 18 periods will grow to approximately $5.56. Q8-5 Each year the interest earned will be larger than the interest earned in the previous year. This is because the balance in the account gets larger each year as the interest from the previous year is added to it. Each year 7% interest is earned on a larger and larger account balance. Q8-6 Table 1 reveals what happens to $1 when it is invested at varying periods and interest rates. As one moves from the upper left corner of the table to the lower right corner of the table, the number of periods increases as does the interest rate. An increase in either one, while not reducing the other, results in additional return to the investor. Q8-7 The problem can be solved in two steps using Table 1 only. First, find the answer for a 25 period investment ($8,000 8.62308 = $68,984.64). Second, determine how much that amount will grow to over an additional 4 periods ($68,984.64 1.41158 = $97,377.34). Q8-8 $572,066.55 FVA = Amount Interest Factor = $5,000 114.41331 = $572,066.55

Q8-9 Any interest factor found on Table 2 reveals the amount that a $1 ordinary annuity will grow to if invested at the given interest rate for the number of periods indicated. Here, the number 18.88214 reveals that a 13-period, $1 ordinary annuity, invested at 6%, will grow to approximately $18.88. Q8-10 Table 3 reveals what happens to $1 when it is discounted for varying periods and rates. In general, the farther (in time) that money is away from being collected, the less its present value. Similarly, the higher the

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discount rate, the less is the present value. As one moves from the upper left corner of Table 3 to the lower right corner of Table 3, the number of periods increases as does the discount rate. Therefore, such movement causes the present value factors to decrease. Q8-11 The problem can be solved in two steps using Table 3 only. First, discount the future cash flow for 25 periods at 8% ($350,000 0.14602 = $51,107). Second, discount that result for another 7 periods at 8% ($51,107 0.58349 = $29,820.42). Q8-12 Table 4 reveals what happens to an ordinary annuity of $1 when it is discounted for varying periods and rates. In general, the higher the discount rate, the less is the present value. One would expect, therefore, that the interest factors would get smaller as one moves from left to right in Table 4. This is correct. But, as the length of the annuity increases, the effect of the higher discount rate is offset by the effect of the additional annuity cash flows. As one moves down Table 4, there is an additional cash flow each period adding to the value of the annuity. Overall, therefore, as one moves from left to right in Table 4, the interest factors get smaller and smaller. As one moves from top to bottom of Table 4, the interest factors get larger and larger. Q8-13 If part of Jeraldos capital was returned to him at the end of each year ($1,000 per year), the amount of his investment decreased each year. If his investment got smaller each year, it is only reasonable that the interest earned each year would also get smaller. Q8-14 The rows in time value of money tables (whether in textbooks or programmed into calculators or computers) represent periods rather than years. This is done so that the tables can also be used for compounding periods other than annual. For example, by denominating the rows in periods, the tables can be used for monthly, quarterly, or semiannual compounding. The table merely reflects what happens during a period. It is up to the user to define the length of the period depending on the circumstances of the event or transaction under consideration. Q8-15 The size of the monthly payment is fixed at $288. When a payment is made, the interest incurred since the previous payment is deducted first and the remainder is subtracted from the balance of the loan. Therefore, as each payment is made, the amount she owes decreases. This causes the amount of interest owed for the following month to decrease also. Since each months interest cost is always smaller than the prior months interest cost, the amount of the payment left over to repay principal goes up each month. As the months go by, each payment contains less interest and more repayment of principal.

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EXERCISES E8-1 Definitions of terms are provided in the glossary. E8-2 Owed on March 31, 2008 March 31, 2009 March 31, 2009

$26,750 $28,622.50 $26,750

FV = $25,000 (1.07)1 = $26,750 FV = $25,000 (1.07)2 = $28,622.50 If the interest incurred during the first year is paid off before the second year begins, interest will accrue only on the principal balance of $25,000 during year 2. The computation is $25,000 (1.07)1 = $26,750.

E8-3

a.

The future value $10,000 deposited for 25 years at 6% is computed as follows: FVA = A IF = $10,000 4.29187 = $42,918.70

b.

The amount of interest earned is computed as follows: Ending balance in the account $42,918.70 Amount originally deposited 10,000.00 Interest earned $32,918.70 The future value of a seven-year, 5%, $2,000 annuity is computed as follows: FVA = A IF = $2,000 8.14201 = $16,284.02 Amount resulting from deposits: $2,000 7 deposits = $14,000 Amount resulting from interest: Ending balance $16,284.02 Amount from deposits 14,000.00 $ 2,284.02

E8-4

a.

b.

E8-5

a.

$1,829,252

Future value of a four-year, 9%, $400,000 annuity: FVA = Amount Interest Factor = $400,000 4.57313 = $1,829,252 Future value of a seven-year, 9%, $400,000 annuity: FVA = Amount Interest Factor = $400,000 9.20043 = $3,680,172

b.

$3,680,172

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205

c.

The future value of an annuity grows from the contribution of additional deposits and by the compounding of interest on the existing balance. As the length of the annuity increases, the compounding of interest on the existing balance begins to contribute more to the annuitys value than do the additional deposits. Therefore, the length of an annuity does not need to double in order for the annuity balance to double. $226,566 $237,991 $244,129 $17,563 $23,941 $166,566 $271,547 =FV(0.08, 30, 2,000) =FV(0.04, 60, 1,000) =FV(0.02, 120, 500) $244,129 $226,566 = $17,563 =FV(0.08/365,30365,2000/365) (using a 365-day year) $250,507 $226,566 = $23,941 $226,566 ($2,000 30 deposits) = $166,566 $518,113 ($2,000 40 deposits) = $438,113 $438,113 $166,566 = $271,547 additional interest

E8-6

a. b. c. d. e. f. g.

E8-7

$925.93 $917.43 $909.09

$1,000 1.08 = $925.93 (or $1,000 0.92593) $1,000 1.09 = $917.43 (or $1,000 0.91743) $1,000 1.10 = $909.09 (or $1,000 0.90909)

As the rate of return increases, the present value of a future cash flow decreases. E8-8 $740.74 $800 1.08 = $740.74 (or $800 0.92593) $833.33 $900 1.08 = $833.33 (or $900 0.92593) $1,388.89 $1,500 1.08 = $1,388.89 (or $1,500 0.92593) As the amount of the expected cash flow increases, the present value of a future cash flow increases. E8-9 $952.38 $907.03 $863.84 $1,000 1.05 = $952.38 (or $1,000 0.95238) $1,000 (1.05)2 = $907.03 (or $1,000 0.90703) $1,000 (1.05)3 = $863.84 (or $1,000 0.86384)

As the time until expected cash flow is received increases, the present value of a future cash flow decreases. E8-10 E8-11 $600.00 The present value of $802.93 at 6% for five years is $802.93 0.74726 = $600. PV of $50,000 received today PV of 19 period, $50,000 annuity @ 7% Total $ 50,000.00 497,953.91 $547,953.91

$547,953.91

E8-12

$798.54 $758.16

$200 3.99271 (from Table 4, 8%, 5 years) = $798.54 $200 3.79079 (from Table 4, 10%, 5 years) = $758.16

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E8-13 a. b.

$408.15 $410.02

$500 0.81630 (from Table 3, 7%, 3 years) = $408.15 $100 4.10020 (from Table 4, 7%, 5 years) = $410.02

The annuity (b) has a slightly higher present value. The alternatives are approximately the same, however. [Note: One consideration may be expected investment opportunities at the end of three years. Since there is little difference between (a) and (b), (a) may be the better choice since the $500 could be reinvested sooner than in (b).] E8-14 a. No. The present value of the net cash inflows to be received is less than the present value of the investment made to obtain those cash inflows. Proof: Expected additional cash inflow per year $50,500 Expected additional cash outflow per year 30,200 Net new cash inflow $20,300 The present value of an annuity of $20,300 for six years at 8% is: PVA = Amount IF (Table 4) PVA = $20,300 4.62288 PVA = $93,844.46 Since the present value of the expected net cash inflows ($93,844.46) is less than the investment required ($100,000), this was not a wise business decision. b. $21,631.54 Proof: To earn exactly 8%, the present value of the future net cash flows must be equal to the $100,000 investment. Therefore, the present value of the annuity (future cash flows) = $100,000 at 8% for six years. PVA = Amount IF (Table 4) $100,000 = Amount 4.62288 Amount = $100,000 4.62288 Amount = $21,631.54 c. $1,331.54 Current expectations Expected new cash inflows Expected new cash outflows Net expected cash flow Cash flow needed to earn 8% Amount of additional cash inflows needed

$50,500.00 30,200.00 $20,300.00 21,631.54 $ 1,331.54

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E8-15 a. $19,738.20 $9,738.20 b. i. $2,464.51 FV = Amount of single sum IF (Table 1) FV = $10,000 1.97382 FV = $19,738.20 $19,738.20 $10,000 = $9,738.20 FV = Amount of annuity IF (Table 2) $20,000 = Amount 8.11519 Amount = $2,464.51

ii. Column E in the table that follows identifies the amount the investment is worth at the end of each year. iii. The total of column D is the amount invested over the six years. iv. The total of column C is the amount of interest earned over the six years. A B Value at Beg. of Year 0.00 2,464.51 5,224.76 8,316.24 11,778.70 15,656.65 C Int. Earned (Col. B Int. Rate) 0.00 295.74 626.97 997.95 1,413.44 1,878.80 5,212.90 D Amount Invested at End of Year 2,464.51 2,464.51 2,464.51 2,464.51 2,464.51 2,464.51 14,787.06 E Future Value at End of Year (Cols. B + C + D) 2,464.51 5,224.76 8,316.24 11,778.70 15,656.65 19,999.96

Year 1 2 3 4 5 6 Totals E8-16 a.

Present value of Option 1: PV = Amount of single sum IF (Table 3) = $140,000 0.56447 = $79,025.80 Present value of Option 2: PV = Amount of annuity IF (Table 4) = $20,000 4.35526 = $87,105.20

b.

Option 2 is worth more (has a higher present value) even though he will receive $20,000 more in the long run from Option 1 ($140,000 versus 6 payments of $20,000 each).

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E8-17 a. Compounding Frequency Annual Semiannual Quarterly Monthly b. Interest Factor (Table 1) 1.25440 1.26248 1.26677 1.26973 Future Value $1,254.40 1,262.48 1,266.77 1,269.73

The more frequent the compounding, the greater is the increase in the future value of a single sum. Compounding refers to the earning of interest on interest. When the compounding period is shorter, the earning of interest on interest begins sooner. The same effect should take place. An annuity is merely a series of several single sums. Whatever happens to one single sum would also happen with a series of them. Compounding Frequency Annual Semiannual Quarterly Monthly Interest Factor (Table 3) 0.79719 0.79209 0.78941 0.78757 Present Value $797.19 792.09 789.41 787.57

c.

d.

e.

The more frequent the compounding period, the smaller is the present value of the sum involved. This is reasonable because computing present value is the exact opposite of computing future value. Because more frequent compounding causes future value to increase, it should cause present value to decrease. More frequent compounding reduces the interest earned each period, but the annuity payments are received more frequently. The total effect depends on frequency and interest rates. PVA = $100 4.10020 (from Table 4, 5 periods, 7%) = $410.02 PVA = $100 7.02358 (from Table 4, 10 periods, 7%) = $702.36 PVA = $100 10.59401 (from Table 4, 20 periods, 7%) = $1,059.40 + $1,000 + $508.35 = + $1,000 + $463.19 =

f.

E8-18

$410.02 (5 years) $702.36 (10 years) $1,059.40 (20 years)

E8-19

$1,070.24 $1,000.00

$80 7.02358 (from Table 4, 7%, 10 years) 0.50835 (from Table 3, 7%, 10 years) = $561.89 $1,070.24 $80 6.71008 (from Table 4, 8%, 10 years) 0.46319 (from Table 3, 8%, 10 years) = $536.81 $1,000.00

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209

$935.82

$80 6.41766 (from Table 4, 9%, 10 years) + $1,000 0.42241 (from Table 3, 9%, 10 years) = $513.41 + $422.41 = $935.82 PVA = $10 6.71008 (from Table 4, 10 years, 8%) = $67.10 PVA = $100 6.71008 (from Table 4, 10 years, 8%) = $671.00

E8-20

$67.10 ($10 per year) $671.00 ($100 per year)

E8-21

$1,081,434

The present value of an annuity of $300,000 per year for five years at 12% is $300,000 3.60478 (Table 4) = $1,081,434. This is the maximum price a company should be willing to pay. At any price above this amount, the company will earn less than a 12% return on its investment. If the company is able to pay less than this amount, its rate of return will be higher than 12%. Because the three payments will pay off the amount borrowed, $1 million is the present value of the three payments. PVA = A IF (3 periods, 9%) $1,000,000 = A 2.53129 A = $1,000,000 2.53129 A = $395,055 $1,000,000 9% $694,945 9% $362,435 9% Interest Expense at 9% $90,000 $62,545 $32,619

E8-22

a.

$395,055

b.

Year 1 = $90,000 Year 2 = $62,545 Year 3 = $32,619 Proof: Present Value at Beginning of Period $1,000,000 $694,945 $362,435

= $90,000 = $62,545 = $32,619

Value Repayment of Debt at of Principal End of Period $305,055 $694,945 $332,510 $362,435 $362,436 01 (continued)

Period Year 1 Year 2 Year 3

1

Payment $395,055 $395,055 $395,055

Ignore $1 rounding difference.

c. Journal
Date Cash Notes Payable Accounts Debits 1,000,0 00 1,000,000 Credits

Effect on Accounting Equation

A 1,000,000 1,000,000 = L+ OE CC + RE

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d. Journal
Date Accounts Interest Expense Notes Payable Cash Debits 90,000 305,055 395,055 395,055 Credits

Effect on Accounting Equation

A = L+ 305,055 OE CC + RE 90,000

E8-23 a.

The size of the payment is solved by the following equation: PVA = Payment IF (3 periods, 9%) $46,000 = Payment 2.53129 Payment = $46,000 2.53129 Payment = $18,173 ($18,172.55 before rounding to the nearest dollar) The loan would be entered into the accounting system as follows: Journal Effect on Accounting Equation
Debits 46,000 46,000 Credits A 46,000 46,000 = L+ OE CC + RE

b.

Date

Accounts Cash Loan Payable

The three payments would be entered into the accounting system as follows: Journal
Date Accounts Interest Expense Loan Payable Cash Debits 4,140 14,033 18,173 18,173 Credits

Effect on Accounting Equation

A = L+ 14,033 OE CC + RE 4,140

Journal
Date Accounts Interest Expense Loan Payable Cash Debits 2,877 15,296 18,173 Credits

Effect on Accounting Equation

A = L+ 15,296 18,173 OE CC + RE 2,877

Journal
Date Accounts Interest Expense Loan Payable Cash Debits 1,502 16,671 18,173 Credits

Effect on Accounting Equation

A = L+ 16,671 18,173 OE CC + RE 1,502

Presentation of an amortization table was not part of the requirements. The following table, however, explains the entries to the accounting system above.

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211

Beginning of Interest Year Year Balance Expense 1 $46,000 $4,140 2 31,967 2,877 3 16,671 1,500 *Ignore $2 rounding difference.

Cash Reduction in End of Year Payment Loan Balance Balance $18,173 $14,033 $31,967 18,173 15,296 $16,671 18,173 16,671 0*

E8-24 a.

b.

PV = Amount IF i. $251.89 $300 0.83962 (Table 3) ii. $237.63 $300 0.79209 (Table 3) iii. $246.81 $300 0.82270 (Table 3) iv. $1,039.53 $300 3.46511 (Table 4) v. $999.48 $100 0.94340 = $ 94.34 (Table 3) $200 0.89000 = 178.00 (Table 3) $300 0.83962 = 251.89 (Table 3) $600 0.79209 = 475.25 (Table 3) Total $999.48 Implications: 1. The present value of an investment decreases as the time until the investment is received increases. 2. The present value of an investment decreases as the interest rate increases. A higher interest rate results in a higher amount of interest being earned for investment ii ($62.37 = $300 $237.63) than for investment iii ($53.19 = $300 $246.81). 3. The present value of an investment increases as the number of payments received increases. Thus, an annuity is more valuable than a single payment when each annuity payment is as large as the single payment.

E8-25 a. b. c. d. e. f. g. h. i. $3,851 $114,545 $80,610 $1,215 $273,555 $6,637 $2,655 $9,214 $1,209 PV(.11,18,500) FV(.05,25,2400) FV(.064,30,950) PMT(.09,8,13400) PV(.02,40,10000) FV(.07,16,238) PV(.06375,3,1000) PV(.05,22,700) PMT(.065,12,9860)

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j. PROBLEMS P8-1 A.

$60,486,857

FV(.08,200,1)

$8,289.87 FVA = $600 13.81645 FVA = $8,289.87

FVA = Amount of annuity IF (Table 2)

B.

$44,992.69 FV = PV IF (Table 1) FV = $8,289.87 5.42743 FV = $44,992.69 $1,790.47 FVA = Amount of annuity IF (Table 2) $44,992.69 = Amount of annuity 25.12902 Amount = $44,992.69 25.12902 Amount = $1,790.47

C.

D.

Total cash payments (parts A & B) = $6,000 [$600 10 years = $6,000] Total cash payments (part C) = $26,857.05 [$1,790.47 15 years = $26,857.05] The difference relates to the length of time the money is invested. Time is a powerful component of the value of money. Even though an investor may be able to save only small amounts, it is important to begin investing early rather than wait until later and have to invest larger amounts or look for higher paying, but riskier investments.

P8-2 Future value of plan #1: Employee contribution per year Employer matching contribution @ 20% Total annual end-of-year contribution Future value annuity factor (25 periods, 8%) Future value of plan #1 at age 65 Future value of plan #2: Employee contribution per year Employer matching contribution @ 85% Total annual end-of-year contribution Future value annuity factor (25 periods, 6%) Future value of plan #2 at age 65 Choosing between plan #1 and plan #2: $2,500 2,125 $4,625 54.86451 $253,748.35 $3,000 600 $3,600 73.10594 $263,181.38

Effective arguments can be made in favor of either alternative. Plan #1 has the advantage of a future value that is $9,433.03 larger ($263,181.38 $253,748.35). If the sole criterion is to choose the alternative with the higher future value, the choice is to select plan #1.

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213

Plan #2 has an advantage too. Under plan #2, the employee contributes a lesser amount each year and the employer a greater amount. In fact, under plan #2, the employee contributes $12,500 ($500 25 years) less than he would under plan #1. At retirement, however, the fund balance is only $9,433.03 smaller. In other words, as compared to plan #2, plan #1 requires $12,500 more employee contribution but yields only $9,433.03 in additional benefit. By this analysis, plan #2 is more favorable than plan #1. P8-3 A. Prudence = $16,000 Margo = $80,000 B. $539,053.35 $2,000 on each of 8 birthdays starting with her 16th and ending with her 23rd. $2,000 on 40 birthdays starting on her 26th and ending with her 65th. FV single sum = Amount IF = $21,273.26 IF (42 periods @ 8%) = $21,273.26 25.33948 = $539,053.35 FV annuity = Amount IF = $2,000 IF (40 periods @ 8%) = $2,000 259.05652 = $518,113.04 = Amount IF = $2,000 IF (50 periods @ 8%) = $2,000 573.77016 = $1,147,540.32

C.

$518,113.04

D.

$1,147,540.32

FV annuity

E.

Compound interest is a powerful financial tool when savings are started early and continue over a long period of time. Here we see two examples. First, Prudence invested only $16,000 yet ended up with a higher balance at age 65 than did her sister Margo who invested $80,000. The difference is the timing. Second, if Prudence had continued making deposits to her IRA she would have contributed only $84,0001 more, yet her ending balance would have been $608,486.972 higher. Time is your best friend when investing. 1 $2,000 42 deposits (birthdays 24 through 65) = $84,000 2 $1,147,540.32 $539,053.35 = $608,486.97 FV = PV IF = 44,400 2.25219 = 99,997. Almost. She will fall just short of her goal. No Starla would deposit $3,700 annually ($44,400 12). Then using this amount to calculate the future value of an annuity, the relationship would be:

P8-4 A. B.

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FV = Amount of annuity IF (Table 2) FV = $3,700 17.88845 FV = $66,187.27 This amount is considerably less than the desired $100,000 because the initial investment of $44,400 is not on deposit for the entire 12-year period. Therefore, it earns substantially less interest and does not grow to the desired $100,000 in the time allowed. C. 16 years To determine the approximate number of equal annual deposits of $3,700 to equal $100,000 at the 7% rate determined above, the relationship for the future value of an annuity would be required. FV = Amount of annuity IF (Table 2) $100,000 = $3,700 IF IF = $100,000 $3,700 IF = 27.02703 In the 7% column of Table 2, this factor lies between 15 and 16 periods (closer to 16 periods). Because an additional $3,700 payment would be made in the 16th year, a 15-year annuity would fall considerably short.

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215

P8-5 Investment A: PVA = $1,000 3.31213 (from Table 4, 8%, 4 years) = Investment B: PV = $4,500 0.73503 (from Table 3, 8%, 4 years) = Investment C: PVA = $600 2.57710 (from Table 4, 8%, 3 years) + PV = $2,400 0.73503 (from Table 3, 8%, 4 years)

$3,312 $3,308 $1,546 1,764 $3,310

The amount an investor should pay for each investment is the present value of the cash flows expected from the investment. Investment A is an annuity. Investment B is a single amount, and investment C is a combination of an annuity and a single amount. The present value provides a way of equating the cash flows of each alternative. In this problem, the alternative investments all have approximately the same present values. Therefore, an investor would be relatively indifferent toward the choices, assuming the uncertainty of payments was the same for each investment. P8-6 A. Account balance = $45,578.79 The future value of an annuity: FVA = Amount of annuity IF (Table 2) Interest = $15,578.79 FVA = $3,000 15.19293 FVA = $45,578.79 Interest = $45,578.79 $30,000 = $15,578.79 Account balance = $49,680.84 see proof below Interest = $19,680.84 $49,680.84 $30,000

B.

Use the future value of the annuity formula in this problem. The payments can be treated as 10 separate calculations of the future value of a single amount. The relationship used is: FV = PV IF (Table 1) PV Amount Deposited $ 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 Years on Deposit 10 9 8 7 6 5 4 3 IF Interest Factor 2.36736 2.17189 1.99256 1.82804 1.67710 1.53862 1.41158 1.29503 FV Future Value $ 7,102.08 6,515.67 5,977.68 5,484.12 5,031.30 4,615.86 4,234.74 3,885.09

Year 1 2 3 4 5 6 7 8

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9 10 Totals C.

3,000 3,000 $30,000

2 1

1.18810 1.09000

3,564.30 3,270.00 $49,680.84

Laura earned $19,680.84 in interest. The amounts are larger in part B because the amount of interest earned is greater. The reason for the greater amount of interest is that each $3,000 IRA contribution was on deposit one extra period. That is, in part B all 10 deposits were made at the beginning of the year, while in part A the 10 deposits were made at the end of the year. Each deposit, therefore, earned interest for one less period. Making deposits at the first of the year rather than at the end of the year allows interest for each deposit to accumulate over a longer period of time. $3,000,000 It is convenient to group the benefits by retirement dates. The total cash payments required is obtained by multiplying column (a) by column (b) by column (c). (a) Number of employee s 10 20 30 (b) Annual pension benefit $10,000 10,000 10,000 (c) Years to be paid 5 5 5 Cash required $ 500,000 1,000,000 1,500,000 $3,000,000

P8-7 A.

Group 2011 2016 2021 B.

$1,235,890.49

It is convenient to group the benefits by retirement dates. The present value of each groups benefits, if payments started at year-end 2007, is obtained by multiplying column (a) by column (b) by column (c). Because the benefits dont start until 2011, 2016, or 2021, however, each groups amount must be discounted as a single sum to the date their payments do start.

(b) (c) (d) (e) (f) Annual PV factor for PV @ PV factor Year-end pension 5 period year-end for 4, 9 or 2007 pension Group # benefit annuity @ 7% 2007 14 years liability 2011 10 $10,000 4.10020 $ 410,020 0.76290 $ 312,804.26 2016 20 10,000 4.10020 820,040 0.54393 446,044.36 2021 30 10,000 4.10020 1,230,060 0.38782 477,041.87 $1,235,890.49

(a)

The Time Value of Money

217

C. Journal
Date Accounts Pension Expense Pension Liability Debits 1,235,890 1,235,890 1,235,890 Credits

Effect on Accounting Equation

A = L+ OE CC + RE 1,235,890

P8-8 A. and B. Dealer financing Bank financing Credit union financing C. Monthly rate (annual 12) 0.011667 0.008333 0.006667 Number of periods 72 60 48 Amount borrowed $35,000 29,750 26,250 Monthly payment $721.21 632.09 640.84

Responses will vary. Many students will automatically select the option with the lowest monthly payment, bank financing. Some will note, however, that in order to save $8.75 per month, as compared to the credit union option, they will have to make 12 more payments. This leads some to select the slightly higher payment associated with the credit union option. Dealer financing (72 payments of $721.21) Bank financing (60 payments of $632.09) Credit union financing (48 payments of $640.84) $51,927.12 37,925.40 30,760.32

D.

E. Dealer financing Bank financing Credit union financing F. Total payments $51,927.12 37,925.40 30,760.32 Amount borrowed $35,000 29,750 26,250 Interest $16,927.12 8,175.40 4,510.32

Responses will vary. Many students will select credit union financing once they see the comparative interest cost. Others may select the bank financing, even with the higher interest cost, because they would prefer to have the extra money available for other uses.

P8-9 A. B. C. D. PMT(0.08/12,360,250000) = $1,834.41 monthly payment Payments remaining = $1,834.41 324 = $594,348.84 $243,200 + $2,432 = $245,632 = new loan amount PMT(0.065/12,180,245632) = $2,139.72 = new payment $2,139.72 180 = $385,149.60 payments remaining If the Taylors can afford the additional $305.31 per month, they will pay a total of $209,200 less for the loan and pay it off 12 years earlier. If possible, they should do it.

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P8-10

A.

The amortization table is based on required monthly payments of $53,309.26 as determined below. PVA = Payment Interest factor $600,000 = Payment 11.25508 (Table 4, 1%, 12 months) Payment = $600,000 11.25508 Payment = $53,309.26 Interest Expense $6,000.00 5,526.90 5,049.08 4,566.48 4,079.05 3,586.75 3,089.53 2,587.33 2,080.11 1,567.82 1,050.40 527.82 Total Payment $53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 53,309.26 Principal Payment $47,309.26 47,782.36 48,260.18 48,742.78 49,230.21 49,722.51 50,219.73 50,721.93 51,229.15 51,741.44 52,258.86 52,781.44 Value (End) $552,690.74 504,908.38 456,648.20 407,905.42 358,675.21 308,952.70 258,732.97 208,011.04 156,781.89 105,040.45 52,781.59 01

Present Month Value (Beg.) May $600,000.00 June 552,690.74 July 504,908.38 August 456,648.20 September 407,905.42 October 358,675.21 November 308,952.70 December 258,732.97 January 208,011.04 February 156,781.89 March 105,040.45 April 52,781.59
1

Note: Students may observe slight rounding errors between their solutions and the solutions presented here. Rounding errors typically occur because of the number of significant digits Excel uses in its calculations. B. C. D. E. Interest expense for the 2007 fiscal year would be the sum of interest expense for MayDecember, $34,485.12. Interest expense for the 2008 fiscal year would be the sum of interest expense for JanuaryApril, $5,226.15. The liability reported at the end of 2007 would be the present value of the loan at the end of December, $208,011.04. The company would have no liability at the end of 2008 for this loan because it would have been repaid. $2,577.10 8% The principal amount of the note was for the entire purchase price of the machinery. The first years interest was $206.17 on a principal balance of $2,577.10. ($206.17 $2,577.10 = 8%). The same rate applies to the other years also. The difference between the beginning of year 1 balance and the beginning of year 2 balance is amount of reduction ($2,577.10 $1,783.27 = $793.83).

P8-11

A. B.

C.

$793.83

The Time Value of Money

219

Alternatively, end-of-year payment minus the year 1 interest expense yields the same result ($1,000 $206.17 = $793.83). D. E. F. $142.66 Interest Expense $1,000 $1,783.27 Liabilities Note Payable The year 2 interest expense will be reported on the income statement at $142.66. The year-end cash payment of $1,000 will be reported on the statement of cash flows. The year 1 ending balance will be reported on the balance sheet under the category of liabilities. The ending balance can be computed as follows: Beginning balance + Year 1 interest expense End of year 1 payment ($2,577.10 + $206.17 $1,000 = $1,783.27).

P8-12

A.

$147,763

PVA = Payment Interest factor $750,000 = Payment 5.07569 (from Table 4) Payment = $750,000 5.07569 Payment = $147,763

B.

The amortization table follows.

Balance Interest at Payment of at End of Period Amount 5% Payment Principal Period Year 2007 $750,000 $37,500 $147,763 $110,263 $639,737 Year 2008 639,737 31,987 147,763 115,776 523,961 Year 2009 523,961 26,198 147,763 121,565 402,396 Year 2010 402,396 20,120 147,763 127,643 274,753 Year 2011 274,753 13,738 147,763 134,025 140,728 Year 2012 140,728 7,036 147,763 140,727 1* * Rounding difference because of using whole numbers in the amortization schedule. C. P8-13 A. 2007 interest = $37,500 2008 interest = $31,987 $13,529 PVA = Payment Interest factor $50,000 = Payment 3.69590 (from Table 4) Payment = $50,000 3.69590 Payment = $13,529 $50,000 11% = $5,500. The difference between the amount paid and the interest on the note is a repayment of principal: $13,529 $5,500 = $8,029. Thus, the balance of

B.

First-year interest = $5,500

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the note at the end of the first year would be $41,971 ($50,000 $8,029). (continued) Second-year interest = $4,617 Beginning of second year principal balance 11% interest ($41,971 11%) C. Journal
Date Accounts Interest Expense Loan Payable Cash Debits 5,500 8,029 13,529 13,529 Credits

Effect on Accounting Equation

A = L+ 8,029 OE CC + RE 5,500

Journal
Date Accounts Interest Expense Loan Payable Cash Debits 4,617 8,912 13,529 Credits

Effect on Accounting Equation

A = L+ 8,912 13,529 OE CC + RE 4,617

P8-14

A.

$305.98

The amount of monthly payments can be determined from the present value of an annuity equation: PVA = Payment Interest factor (Table 4) $8,500 $2,000 = $6,500 = Payment 21.24339 (1%, 24 periods) Payment = $6,500 21.24339 Payment = $305.98 per month

B. C.

$7,343.52 24 payments of $305.98 = $7,343.52 $843.52 Total amount paid ($7,343.52) Amount borrowed ($6,500)

The Time Value of Money

221

D.

$3,443.77 An amortization schedule is useful for determining the amount owed at the end of any period of a loan. The first 12 months are shown here. Amount of Principal Amount Paid Owed at End $240.98 $6,259.02 243.39 6,015.63 245.82 5,769.81 248.28 5,521.53 250.76 5,270.77 253.27 5,017.50 255.81 4,761.69 258.36 4,503.33 260.95 4,242.38 263.56 3,978.82 266.19 3,712.63 268.85 3,443.78

Amount Owed at 1% Interest Period Beginning Expense Payment 1 $6,500.00 $65.00 $305.98 2 6,259.02 62.59 305.98 3 6,015.63 60.16 305.98 4 5,769.81 57.70 305.98 5 5,521.53 55.22 305.98 6 5,270.77 52.71 305.98 7 5,017.50 50.17 305.98 8 4,761.69 47.62 305.98 9 4,503.33 45.03 305.98 10 4,242.38 42.42 305.98 11 3,978.82 39.79 305.98 12 3,712.63 37.13 305.98

Therefore, the amount owed at the end of the first year would be $3,443.78. Alternatively, it could be pointed out that the amount owed at any point in the life of the loan is equal to the present value of the remaining payments. Here, there are 12 remaining payments of $305.98. The present value is computed as follows: PVA = $305.98 11.25508 (Table 4, 1%, 12 periods) = $3,443.83 (ignore $0.05 rounding difference) Note: Students may observe slight rounding errors between their solutions and the solutions presented here. Rounding errors typically occur because of the number of significant digits Excel uses in its calculations. P8-15 A. Column (i) refers to the year. This is customary. Column (iv) has to be the annual cash payment because that is the only item that is constant over time. If column (iv) is the annual cash payment, there are two other columns (interest and reduction of principal) that must add up to the amount of the annual cash payment. These have to be column (iii), interest and column (v), reduction of principal. Since column (vi) decreases by the amount of column (v) (reduction of principal) each year, column (vi) must be the ending balance of the note. This leaves only column (ii), which has to be the beginning balance of the note each year. (continued)

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The complete amortization table is as follows: (ii) Beginning of Year Year Balance 1 130,000 2 89,956 3 46,708 B. C. D. $130,000 8% Any column (iii) entry divided by its corresponding column (ii) entry. For example, $10,400 $130,000 = 8%. (i) (iii) Interest at 8% 10,400 7,196 3,737 (iv) Annual Cash Payment 50,444 50,444 50,444 (v) (vi)

Reduction End of Year of Principal Balance 40,044 89,956 43,248 46,708 46,708 0

Cannot tell This table fits either side of the transaction. A note amortizes exactly the same way for the borrower (Note Payable) as for the lender (Note Receivable). The only possible difference in the amortization table would be in the manner in which column (iii) was labeled. It might be labeled interest expense if prepared by the borrower. It might be labeled interest revenue if prepared by the lender. Here, neither expense nor revenue was specified, making the amortization table equally applicable to either party. $7,196 $46,708 It will be reported as interest expense by the borrower and as interest revenue by the lender. It will be reported as a short-term note payable by the borrower and as a short-term note receivable by the lender. Cash outflows totaling $50,444 will be reported by the borrower ($7,196 interest expense under operating activities and $43,248 repayment of loan under financing activities). Cash inflows of $50,444 will be reported by the lender ($7,196 interest revenue under operating activities and $43,248 collection on loan under investing activities).

E. F.

G.

$50,444

P8-16

A.

$80,603.62 This problem must be split into pieces. One approach is to assume two different annuities. The first annuity is $4,000 for 12 years. A second annuity is $3,000 for four years. Compute the future value of each annuity and add the totals together. Annuity 1: FVA = $4,000 16.86994 (12 years @ 6%) = Annuity 2: FVA = $3,000 4.37462 (4 years @ 6%) = Balance in the account after 12 deposits $67,479.76 13,123.86 $80,603.62

The Time Value of Money

223

Alternatively, one could treat the two annuities completely separately. The first annuity grows for eight years (to $39,589.88) and then continues to grow as a single sum for four additional years (to a total of $49,981.43). The second annuity grows to a balance of $30,622.34 over its four-year life. Added together, the two annuities total to the same amount as the first approach (subject to 15 cents of rounding difference). Annuity 1: FVA = $4,000 9.89747 (8 years, 6%) = $39,589.88 Annuity 1: FV = $39,589.88 1.26248 (4 years, 6%) = Annuity 2: FVA = $7,000 4.37462 (4 years, 6%) = Balance in the account after 12 deposits B. C. $144,348.99 FV = $ 80,603.62 1.79085 (10 years, 6%) = = $144,348.99 $80,603.62 $32,000.00 28,000.00 60,000.00 $20,603.62 $49,981.43 30,622.34 $80,603.77

$20,603.62 Balance after 12th deposit Less: 8 deposits of $4,000 4 deposits of $7,000 Amount of interest earned $8,856.77

P8-17

A.

The four equal annual withdrawals constitute an annuity. The $30,000 gift is the present value of that annuity. PVA = Amount IF (Table 4) $30,000 = Amount 3.38724 Amount = $30,000 3.38724 Amount = $8,856.77

B.

$5,427.08

Total withdrawals ($8,856.77 4) Less: Amount deposited Total interest earned Balance after 1 year, just before first withdrawal ($30,000 1.07) First withdrawal Remaining balance

$35,427.08 30,000.00 $ 5,427.08 $32,100 12,000 $20,100

C.

$7,659.13

$20,100 is the present value of the remaining withdrawals: PVA = Amount IF (Table 4) $20,100 = Amount 2.62432 Amount = $20,100 2.62432 Amount = $7,659.13

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P8-18

A.

$13,490.05 To determine the maximum purchase price for the investment, it is necessary to combine the present value of the annuity of $1,050 ($5,284.60) and the present value of the lump sum to be received at the end of seven years ($8,205.45), using a 9% interest rate. PVA = Amount of annuity IF (Table 4) PVA = $1,050 5.03295 PVA = $5,284.60 PV = FV IF (Table 3) PV = $15,000 0.54703 PV = $8,205.45

B.

$16,735.89 The calculation is the same as in part A, except that a 5% interest rate is used. The cost of the investment to Milo would be $16,735.89 ($6,075.69 + $10,660.20) PVA = Amount of annuity IF (Table 4) PVA = $1,050 5.78637 PVA = $6,075.69 PV = FV IF (Table 3) PV = $15,000 0.71068 PV = $10,660.20

C.

The investment in part B has the higher cost. The cash flows to be received by Milo are generated from two sources. First, he will receive the money he put in. Second, he will receive earnings on his investment. When the interest rate is low, the amount of earnings on the investment will be low. Therefore, to get back the same amount of money as in part A, he must put more in. That is, he must pay more for the investment. 0.007 360 $188,000 $1,432.25 8.4% 12 = 0.007 interest rate per month 30 years 12 months per year = 360 months $209,500 $21,500 down payment = $188,000 (from the PMT function in Excel) $ 1,432.25 $188,000.00 0.007 $ 1,316.00 $116.25

P8-19

A. B. C. D. E.

Interest = $1,316 Amount of payment Amount owed during first month Principal = $116.25 Times: monthly interest rate First months interest cost Amount remaining for reduction of principal

The Time Value of Money

225

F.

$1,796.63

Rate is 0.00666666 (8% 12). The number of periods is 180 (15 years 12 months). The amount of the loan is still $188,000. 30-year mortgage: Total payments ($1,432.25 360) $515,610 Less: Mortgage amount 188,000 Total interest paid $327,610 15 year mortgage: Total payments ($1,796.63 180) $323,393 Less: Mortgage amount 188,000 Total interest paid Difference

G.

$192,217

135,393 $192,217

P8-20

A.

Bob and Lisa can calculate the sales price of the vehicle as follows: Loan amount = PV (interest rate, term, payment) $25,862.78 = PV (0.06/12,60,500) $25,862.78 Loan amount 2,000.00 (plus) Down payment $27,862.78 Total sales price

B.

The dealers behavior is not ethical because he is not telling Bob and Lisa the whole story. The dealer reduces the amount of the monthly payment, but does not tell Bob and Lisa that the present value of the payments plus the down payment exceeds the agreed-upon price of $24,500. Unscrupulous businesses can take advantage of customers who do not understand the relationship among interest rate, term, and payment amount. The present value of the payments (plus down payment, if any) is the amount actually paid for a good or service. By focusing on the amount of the payment, Bob and Lisa are not getting the sales price that they negotiated. If the loan is paid off over 30 years at 8%, the monthly payment would be $1,174.02. The amount owed on 12/31/08 after the monthly payment is $158,663.48. The total interest incurred in the first year would be $12,751.72. Principal 160,000 Period 360 Interest Rate 0.00667 Payment 1,174.02 (continued)

C.

P8-21

A. B.

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Present Value Value at at Beginning of Interest Amount Principal End of Month Month Incurred Paid Paid Month 1 160,000.00 1,066.67 1,174.02 107.35 159,892.65 2 159,892.65 1,065.95 1,174.02 108.07 159,784.58 3 159,784.58 1,065.23 1,174.02 108.79 159,675.79 4 159,675.79 1,064.51 1,174.02 109.51 159,566.28 5 159,566.28 1,063.78 1,174.02 110.24 159,456.04 6 159,456.04 1,063.04 1,174.02 110.98 159,345.06 7 159,345.06 1,062.30 1,174.02 111.72 159,233.34 8 159,233.34 1,061.56 1,174.02 112.46 159,120.88 9 159,120.88 1,060.81 1,174.02 113.21 159,007.67 10 159,007.67 1,060.05 1,174.02 113.97 158,893.70 11 158,893.70 1,059.29 1,174.02 114.73 158,778.97 12 158,778.97 1,058.53 1,174.02 115.49 158,663.48 Total 12,751.72 14,088.24 Note: Students may observe slight rounding errors between their solutions and the solutions presented here. Rounding errors typically occur because of the number of significant digits Excel uses in its calculations. C. If the loan is paid off over 15 years at 8%, the monthly payment would be $1,529.04. The amount owed on 12/31/08 after the monthly payment is $154,243.48. The total interest incurred in the first year would be $12,591.96. Principal Period Interest Rate Payment 160,000 180 0.00667 1,529.04

Month 1 2 3 4 5 6 7 8 9 10 11 12 Total

Present Value at Beginning Interest In- Amount Principal Value at End of Month curred Paid Paid of Month 160,000.00 1,066.67 1,529.04 462.37 159,537.63 159,537.63 1,063.58 1,529.04 465.46 159,072.17 159,072.17 1,060.48 1,529.04 468.56 158,603.61 158,603.61 1,057.36 1,529.04 471.68 158,131.93 158,131.93 1,054.21 1,529.04 474.83 157,657.10 157,657.10 1,051.05 1,529.04 477.99 157,179.11 157,179.11 1,047.86 1,529.04 481.18 156,697.93 156,697.93 1,044.65 1,529.04 484.39 156,213.54 156,213.54 1,041.42 1,529.04 487.62 155,725.92 155,725.92 1,038.17 1,529.04 490.87 155,235.05 155,235.05 1,034.90 1,529.04 494.14 154,740.91 154,740.91 1,031.61 1,529.04 497.43 154,243.48 12,591.96 18,348.48

The Time Value of Money

227

D.

If the loan is paid off over 30 years at 9%, the monthly payment would be $1,287.40. The amount owed on 12/31/08 after the monthly payment is $158,906.83. The total interest incurred in the first year would be $14,355.63. Principal Period Interest Rate Payment 160,000 360 0.00750 1,287.40 Amount Paid 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 1,287.40 15,448.80 Principal Value at End Paid of Month 87.40 159,912.60 88.06 159,824.54 88.72 159,735.82 89.38 159,646.44 90.05 159,556.39 90.73 159,465.66 91.41 159,374.25 92.09 159,282.16 92.78 159,189.38 93.48 159,095.90 94.18 159,001.72 94.89 158,906.83

Month 1 2 3 4 5 6 7 8 9 10 11 12 Total P8-22 1 b 2 a

Present Value at Beginning Interest Inof Month curred 160,000.00 1,200.00 159,912.60 1,199.34 159,824.54 1,198.68 159,735.82 1,198.02 159,646.44 1,197.35 159,556.39 1,196.67 159,465.66 1,195.99 159,374.25 1,195.31 159,282.16 1,194.62 159,189.38 1,193.92 159,095.90 1,193.22 159,001.72 1,192.51 14,355.63

3 b

4 a

5 d

6 c

7 b

8 b

9 a

10 c

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CASES C8-1 The essential facts of the two alternatives can be summarized as follows: Dealer Cost of car Rebate Trade-in Net price 1 $20,500 1,400 3,600 15,500 2 $20,000 1,000 3,000 16,000

Annual payments, dealer 1: $15,500 3.03735 (Table 4, 12%, 4 years) = $5,103.13 Annual payments, dealer 2: $16,000 3.16987 (Table 4, 10%, 4 years) = $5,047.53 Darren would be better off trading with dealer 2. His payments would be about $55 less each year. C8-2 DATE: TO: FROM: SUBJECT: MEMORANDUM (todays date) Harold (students name) Evaluation of loan options

Your two financing options will result in different payments. 25-year loan: The payments will be $8,144.50 as determined by the following calculations: PVA $80,000 Payment Payment

= Payment Interest factor = Payment 9.82258 (Table 4, 9%, 25 years) = $80,000 9.82258 = $8,144.50

15-year loan: The payments will be $9,346.36 as determined by the following calculations: PVA $80,000 A A

= A IF = A 8.55948 (Table 4, 8%, 15 years) = $80,000 8.55948 = $9,346.36

As a result of these payments differences, the total payments over the life of the loans and the total interest associated with them will be quite different:

The Time Value of Money

229

Total payments Less: Cost of house Interest paid

25-year loan $203,612.50 80,000.00 $123,612.50

15-year loan $140,195.40 80,000.00 $ 60,195.40

It is apparent that you will pay more than twice as much interest over the life of the loan if you finance your mortgage for 25 years rather than for 15 years. Therefore, if you can afford the higher payment of about $1,200 each year (about $100 a month), you should finance your loan for the shorter period. C8-3 To analyze the various contract proposals, we use present value concepts. We used Excel for our analysis; however, present value tables also can be used. The following analysis assumes a 4% discount rate. Proposal 1. The present value of Proposal 1 is $2,823,769. The contract guarantees $1 million per year to be paid quarterly. Thus, the quarterly cash flow is $250,000 ($1,000,000 4 = $250,000). The discount rate is 1% (4% 4 periods per year = 1%). The contract specifies 12 periods (3 years 4 quarters per year). Using Excel, the present value is determined as follows: =PV(0.01, 12, 250,000) = $2,813,769 Proposal 2. The present value of Proposal 2 is $3,629,895. The contract guarantees $1 million per year in each of four years. Using Excel, the present value is determined as follows: =PV(0.04, 4, 1,000,000) = $3,629,895 Excel formula values were computed as follows: 0.04 = discount rate 4 = number of periods over which the payments are made 1,000,000 = Annual payment Proposal 3. The present value of Proposal 3 is $2,739,734. The contract guarantees a signing bonus of $900,000. Since the bonus is paid upon signing the contract, the present value of the signing bonus is $900,000 (the value today). In addition to a signing bonus, quarterly payments of $125,000 will be paid for four years. The present value of the proposal is the sum of the present value of the signing bonus and the present value of the quarterly payments. Using Excel, the present value is determined as follows: =PV(0.01, 16, 125,000) = $1,839,734 Excel formula values were computed as follows: 1% (0.04/4 payments per year) 16 periods (4 periods per year 4 years), 125,000 = quarterly payment

(continued)

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Proposal 4. The present value of Proposal 4 is $10,487,956. The contract guarantees three annual payments of $400,000 plus a lump sum payment of $25 million in 25 years. The present value of the contract is calculated by adding the present value of the annual payments and the present value of the lump sum payment. Excel formula values were computed as follows: =PV(0.04, 3, 400,000) = $1,110,036 Plus 25,000,000*(1/1.04^25) = $9,377,920 The present value of $25,000,000 received in 25 years, discounted at 4%, as shown in Chapter 8.

Proposal 5. The present value of Proposal 5 is $2,500,000. No discount ing is necessary because all cash is received upon signing. The present value of $1 today is $1. Proposal 6. The present value of Proposal 6 is $7,966,270. The contract is not guaranteed. If Fleet continues to play, the contract will pay $1,500,000 a year ($375,000 per quarter) for six years. Using Excel, the present value is determined as follows: =PV(0.01, 24, 375,000) = $7,966,270 Excel formula values were computed as follows: 1% (0.04/4 payments per year) 24 periods (4 periods per year 6 years), 375,000 = quarterly payment. Cash Flow Each Period Proposal 1 3-year contract at $1 million Payable quarterly Quarterly payment Proposal 2 4-year contract at $1 million Payable at the end of the year Proposal 3 4-year contract 900,000 signing bonus 125,000 end-of-quarter payments Proposal 4 3-year contract of $400,000 at each year-end $25 million to be paid 25 years after signing Present Value

$ 0,250,000 $ 2,813,769

$ 1,000,000 $ 3,629,895

900,000 $ 900,000 125,000 $1,839,734 $2,739,734 400,000 $ 1,110,036 25,000,000 $09,377,920 $10,487,956

The Time Value of Money

231

Cash Flow Each Period Proposal 5 3-year contract $2.5 million signing bonus, no payments Proposal 6 6-year contract at $1,500,000 Payable quarterly Cancelable if injured or cut

Present Value

$ 2,500,000 $ 2,500,000 $ 375,000 $ 7,966,270

Key points: The proposals with the highest present value (4 and 6) also have the greatest risk. Proposal 4 requires Fleet to wait 25 years to collect the majority of his contract. This contract is risky because Fleet (or the NFL) may not be around in 25 years. Proposal 6 is risky because the contract is cancelable. If Fleet is risk averse, Proposal 2 is the most attractive.