The Theory of Interest - Solutions Manual

Chapter 4
1. The nominal rate of interest convertible once every two years is j, so that

.07 1 + j = 1 + 2

and j = (1.035 ) 1 = .14752.

4

The accumulated value is taken 4 years after the last payment is made, so that

2000 s8 j (1 + j ) = 2000 (13.60268 )(1.31680 )

2

= $35,824 to the nearest dollar.

2. The quarterly rate of interest j is obtained from

(1 + j )

= 1.12 so that j = .02874.

The present value is given by 600a40 j 200a20 j

= 600 ( 24.27195 ) 200 (15.48522 ) = $11, 466 to the nearest dollar.

3. The equation of value at time t = 8 is

100 [(1 + 8i ) + (1 + 6i ) + (1 + 4i ) + (1 + 2i )] = 520

so that

4 + 20i = 5.2, or 20i = 1.2, and i = .06, or 6%.

4. Let the quarterly rate of interest be j. We have

400a40 j = 10,000 or a40 j = 25.

Using the financial calculator to find an unknown j, set N = 40 PV = 25 PMT = 1 and CPT I to obtain j = .02524, or 2.524%. Then

i (12 ) 4 (12 ) 1 + = (1.02524 ) and i = .100, or 10.0%. 12

5. Adapting formula (4.2) we have

12

2000

s32 .035 s4 .035

(1.035 )8

57.33450 ( = ( 2000 ) 1.31681) = $35,824 to the nearest dollar. 4.21494

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6. (a) We use the technique developed in Section 3.4 that puts in imaginary payments and then subtracts them out, together with adapting formula (4.1), to obtain

200 ( a176 a32 ) . s4

Note that the number of payments is

176 32 = 36, which checks. 4

(b) Similar to part (a), but adapting formula (4.3) rather than (4.1), we obtain

200 ( a a36 ) . a4 180 Again we have the check that

180 36 = 36. 4

d 12 .09 7. The monthly rate of discount is d j = = = .0075 and the monthly discount 12 12 factor is v j = 1 d j = .9925. From first principles, the present value is

( ) 1 + (.9925 ) + (.9925 ) + + (.9925 ) = 300 1 .9925 300 6 1 (.9925 ) upon summing the geometric progression.
6 12 114

120

8. Using first principles and summing an infinite geometric progression, we have

v3 1 125 v + v + v + = = = 3 3 1 v (1 + i ) 1 91
3 6 9

and

(1 + i )3 1 = 91 or (1 + i )3 = 216 125 125 1 3 6 216 and 1 + i = = = 1.2 which gives i = .20, or 20%. 5 125
9. Using first principles with formula (1.31), we have the present value

100 [1 + e .02 + e .04 +

and summing the geometric progression

+ e .38 ]

100

1 e .4 . 1 e .02
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Chapter 4

10. This is an unusual situation in which each payment does not contain an integral number of interest conversion periods. However, we again use first principles 8 140 4 measuring time in 3-month periods to obtain 1 + v 3 + v 3 + + v 3 and summing the geometric progression, we have

1 v 48 4 . 1 v 3
11. Adapting formula (4.9) we have
4 2400a10 800a54.12 . .12

( )

( )

Note that the proper coefficient is the annual rent of the annuity, not the amount of ( ) each installment. The nominal rate of discount d 4 is obtained from
1 d ( 4) ( 4) 4 1 (1.12 ) = .11174. 1 = 1 + i = 1.12 and d = 4 4 The answer is

1 (1.12 ) 2400 .11174

10

1 (1.12 ) 800 .11174

= $11, 466 to the nearest dollar.

12. (a) (b)

m 1 m tm 1 1m 1 vn 1 v 1 vn ( m) ( ) v a = a v = a a = ( m ) = ( m ) = anm . n n n 1 m t =1 d i i t =1 m

The first term in the summation is the present value of the payments at times 1 ,1 + 1 ,, n 1 + 1 . The second term is the present value of the m m m 2 ,1 + 2 ,, n 1 + 2 . This continues until the last term payments at times m m m is the present value of the payments at times 1, 2,, n. The sum of all these payments is anm .
( )

13. The equation of value is

1000 n a2 = 10,000 or
where n is the deferred period. We then have

( )

a2 = 10,

( )

vn ( 2) n . n ( 2 ) = 10 or v = 10d d Now expressing the interest functions in terms of d, we see that a2 = v n a2 =

( ) ( )

v = 1 d and d

( 2)

2 = 2 1 (1 d ) . 1

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Chapter 4

We now have
.5 (1 d )n = 20 1 (1 d ) .5 n ln (1 d ) = ln 20 1 (1 d )

and

n=

.5 ln 20 1 (1 d ) . ( ) ln 1 d

14. We have

3an2 = 2a22 = 45s1 2 n

( )

( )

( )

1 vn 1 v2n i or 3 ( 2 ) = 2 ( 2 ) = 45 ( 2 ) . i i i
Using the first two, we have the quadratic

3 (1 v n ) = 2 (1 v 2 n ) or 2v 2 n 3v n + 1 = 0
which can be factored ( 2v n 1)( v n 1) = 0 or v n = 1 , rejecting the root v = 1. Now 2 using the first and third, we have

3 (1 v ) = 45i or i =
n

3 1 1

2 = 1. 45 30

15. Using a similar approach to Exercise 10, we have

1+ v 4 + v 4 +
3 6

+v

141

1 v 36 3 . 1 v 4
( ) ( )

16. Each of the five annuities can be expressed as 1 v n divided by i, i m , , d m , and d, respectively. Using the result obtained in Exercise 32 in Chapter 1 immediately establishes the result to be shown. All five annuities pay the same total amount. The closer the payments are to time t = 0, the larger the present value.

17. The equation of value is

2400an = 40,000 or an = 50 . 3
Thus

an =
or

1 e .04 n 50 = .04 3

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Chapter 4

1 e .04 n =
and

2 3

e .04 n =

1 3

.04n = ln 3 = 1.0986, so that n = 27.47.

18. We have

an =
and

1 vn

= 4 or v n = 1 4

(1 + i )n 1 n sn = = 12 or (1 + i ) = 1 + 12 .
Thus, 1 + 12 =

1 8 1 leading to the quadratic 1 + 8 48 2 = 1, so that = = . 1 4 48 6

19. Using formula (4.13) in combination with formula (1.27), we have

an = v dt =
t 0

n 0

n (1+ r ) r dr e 0 = e 0 0

dr

dt

Now
(1+ r ) e 0

t 1

dr

= e ln 1+t = (1 + t ) .
( )
n

Thus,
1 an = (1 + t ) dt = ln (1 + t )]0 = ln ( n + 1) . n 0

20. Find t such that v t = a1 =

1 v

iv

. Thus, t ln v = ln v + ln

and t = 1

i ln .

21. Algebraically, apply formulas (4.23) and (4.25) so that

( Ia )n =

an nv n i

and

( Da )n =

n an i

. Thus,

( Ia )n + ( Da )n = 1 ( an nv n + n an ) i 1 vn 1 = ( an + 1 v n nv n + n an ) = ( n + 1) = ( n + 1) an . i i

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Diagrammatically, Time: ( Ia )n : ( Da )n : Total: 0 1 1 n n +1 2 2 3 3

n 1 n 1
2 n +1

n n 1 n +1

n 1 n +1

n2 n +1

22. Applying formula (4.21) directly with P = 6, Q = 1, and n = 20

Pan + Q
23. The present value is

an nv n i

= 6a20 +

a20 20v 20 i

v 4 ( Da )10 =

v4 1 10 a10 ) = (10v 4 a14 + a4 ) ( i i 1 = 10 (1 ia4 ) a14 + a4 i 1 10 a14 + a4 (1 10i ) = . i

24. Method 1:

Method 2:

1 an nv n + nv n ) ( i (1 + i ) an an a = n = = . i i d 1 1 PV = ( Ia ) v n ( Ia ) = (1 v n ) + 2 i i n n a 1 v 1 1 v = = n. 1 + = id d i i PV = ( Ia )n + v n na =

25. We are given that 11v 6 = 13v 7 from which we can determine the rate of interest. We have 11(1 + i ) = 13, so that i = 2 /11. Next, apply formula (4.27) to obtain

P Q 1 2 11 11 + 2 = + 2 = + 2 = 66. i i i i 2 2
26. We are given:

v v2 2 ( ) X = va = and 20 X = v Ia = . i id

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Chapter 4

Therefore,

v v2 X= = i 20id

or 20d = v = 1 d and d = 1/ 21.

27. The semiannual rate of interest j = .16 / 2 = .08 and the present value can be expressed as 10 a10 300a10 .08 + 50 ( Da )10 .08 = 300a10 .08 + 50 .08 10 A = 300 A + 50 = 6250 325 A. .08 28. We can apply formula (4.30) to obtain
2 1.05 1.05 + PV = 600 1 + + 1.1025 1.1025 19 1.05 + 1.1025

1 (1.05 /1.1025 )20 = 600 = $7851 to the nearest dollar. 1 (1.05 /1.1025 )
29. We can apply formula (4.31)

i =
which is the answer.

i k .1025 .05 = = .05, or 5%, 1+ k 1 + .05

Note that we could have applied formula (4.32) to obtain PV = 600a20 .05 = $7851 as an alternative approach to solve Exercise 28. 30. The accumulated value of the first 5 deposits at time t = 10 is

1000 s5 .08 (1.08 ) = (1000 )( 6.33593)(1.46933) = 9309.57.

5

The accumulated value of the second 5 deposits at time t = 10 is

5 2 4 1000 (1.05 )(1.08 ) + (1.05 ) (1.08 ) + 5 5 + (1.05 ) (1.08 )

1 (1.05 /1.08 )5 = 1000 (1.05 )(1.08 ) = 7297.16. 1 1.05 /1.08

The total accumulated value is 9309.57 + 7297.16 = $16, 607 to the nearest dollar.

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Chapter 4

31. We have the equation of value

2 1 1 + .01k (1 + .01k ) 4096 = 1000 + + + 5 (1.25 )7 (1.25 )6 (1.25 )

or

4.096 =

1/ (1.25 ) 1 = 4 1 (1 + .01k ) /1.25 (1.25 ) (.25 .01k )

5

upon summing the infinite geometric progression. Finally, solving for k

10 =

1 .25 .01k

and k = 15%.

32. The first contribution is ( 40,000 ) (.04 ) = 1600. These contributions increase by 3% each year thereafter. The accumulated value of all contributions 25 years later can be obtained similarly to the approach used above in Exercise 30. Alternatively, formula (4.34) can be adapted to an annuity-due which gives

(1.05 )25 (1.03)25 (1.05 ) = $108,576 to the nearest dollar. 1600 .05 .03
33. Applying formula (4.30), the present value of the first 10 payments is

1 (1.05 /1.07 )10 100 (1.07 ) = 919.95. .07 .05

9 The 11th payment is 100 (1.05 ) (.95 ) = 147.38 . Then the present value of the second 1 (.95 /1.07 )10 10 10 payments is 147.38 (1.07 )(1.07 ) = 464.71 . The present value .07 .05 of all the payments is 919.95 + 464.71 = $1385 to the nearest dollar.

34. We have

PV =

1 2 1 m v + 2v m + 2 m

+ nmv m
nm

1 1 n 1 1 + 2v m + + nmv m 2 m 1 nm 1 1 n 1 PV 1 + v m + + v m nmv m (1 + i ) m 1 = 2 m 1 ( m) an nv n = . m

PV (1 + i ) m =
1

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The Theory of Interest - Solutions Manual

Chapter 4

Therefore

PV =

anm nv n m (1 + i ) m 1
1

( )

anm nv n im
( )

( )

35. (a)

1 ( (12 terms ) ) ( (12 terms ) ) 1 ( 12 + 24 ) = 3. 1+1+ +1 + 2 + 2 + + 2 = 12 12 1 ( [ 1+ 2 + 144 + 12 ) + (13 + 14 + + 24 )] =

(b)

( 24 ) ( 25 ) 25 = . ( 2 )(144 ) 12

36. We have

PV = [ v 5 + v 6 + 2v 7 + 2v8 + 3v 9 + 3v10 + v5 1 5 7 9 ( ) = v +v +v + a = 2 1 v d = v v 1 = . 2 1 v iv i vd
5 4

37. The payments are 1,6,11,16,. This can be decomposed into a level perpetuity of 1 starting at time t = 4 and on increasing perpetuity of 1, 2,3, starting at time t = 8 . Let i4 and d 4 be effective rates of interest and discount over a 4-year period. The present value of the annuity is

1 1 4 1 where i4 = (1 + i ) 1. + 5 (1 + i4 ) i4 i4 d 4
We know that
1 (1 + i )4 = (.75 )1 = 4 / 3, or i4 = 4 1 = 1 and d 4 = 3 = 1 . 3 3 1 + 13 4

Thus, the present value becomes

3 1 3 + ( 5 ) 1 1 = 3 + 45 = 48. 4 3 4
38. Let j be the semiannual rate of interest. We know that (1 + j ) = 1.08, so that j = .03923 . The present value of the annuity is
2

1.03 1.03 1+ + + 1.03923 1.03923

1 = 112.59 1 1.03 /1.03923

upon summing the infinite geometric progression.

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Chapter 4

39. The ratio is

10 5 5 0

tdt

tdt

10 1 2 5 2 5 2 1 0 2

] 75 / 2 = = 3. 25 / 2 ] t

40. Taking the limit of formula (4.42) as n , we have

( Ia ) =

(.08 )2

= 156.25.

41. Applying formula (4.43) we have the present value equal to

t 1+ k t 1+ k t 1+ i ( ) f t v dt dt = = 0 0 1+ i 1+ k ln 1+ i 0 1 1 1 . = = = 1 + k ln (1 + i ) ln (1 + k ) i k ln 1+ i

Note that the upper limit is zero since i > k . 42. (a) ( Da )n = ( n t )v t dt.
n

(b)

n 0

( n t )v t dt = nan ( Ia )n

n (1 v n )

The similarity to the discrete annuity formula (4.25) for ( Da )n is apparent. 43. In this exercise we must adapt and apply formula (4.44). The present value is

an nv n

n an

14 1

( t 2 1)e

t 0

(1+ r )1 dr

dt.

1 The discounting function was seen to be equal to (1 + t ) in Exercise 19. Thus, the answer is

14 1

14 ( t 1)( t + 1) 14 t2 1 dt = dt = ( t 1) dt 1 1 t +1 t +1 14

1 1 = t 2 t = ( 98 14 ) 1 = 84.5. 2 1 2
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The Theory of Interest - Solutions Manual

Chapter 4

44. For perpetuity #1 we have

1 + v.5 + v + v1.5 +

1 = 20 1 v.5 so that 1 v.5 = .05 and v.5 = .95. =

For perpetuity #2, we have

X [1 + v 2 + v 4 +

] = X 1 2 = 20
1 v
2

4 so that X = 20 (1 v ) = 20 1 (.95 ) = 3.71.

45. We have

n
0

at dt =

n
0

(1 vt ) dt =

n an

n ( n 4) = 40. .1

46. For each year of college the present value of the payments for the year evaluated at the beginning of the year is

1200a912 . /12
The total present value for the payments for all four years of college is
( ) ) (1 + v + v 2 + v3 ) = 1200a4 a9(12 1200a912 . /12 /12

47. For annuity #1, we have PV1 =

P . i 1 1 For annuity #2, we have PV2 = q + 2 . i i Denote the difference in present values by D. D = PV1 PV2 =
(a) If D = 0 , then

pq q 2. i i

pq q q q or i = . 2 = 0 or p q = i i i pq

(b) We seek to maximize D.

dD d = ( p q ) i 1 qi 2 di di = ( p q ) i 2 + 2qi 3 = 0.
Multiply through by i 3 to obtain

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The Theory of Interest - Solutions Manual

Chapter 4

( p q ) i + 2q = 0 or i =

2q . pq

48. We must set soil (S) posts at times 0,9,18,27. We must set concrete posts (C) at times 0,15,30. Applying formula (4.3) twice we have

PVS = 2

a36 a9

and PVC = ( 2 + X )

a45 a15

Equating the two present values, we have

a36 a9

= (2 + X )

a45 a15

so that

a a a a a X = 2 36 45 45 = 2 36 15 1 . a9 a15 a15 a9 a45

49. We know an =

1 vn

= a, so that v = 1 a . Similarly, a2 n =
n

1 v2n

= b, so that

2 v 2 n = 1 b . Therefore, 1 b = (1 a ) = 1 2a + a 2 2 , or a 2 2 = ( 2a b ) so 2a b . Also we see that n ln v = ln (1 a ) n = ln (1 a ) so that that = a2 an nv n ln (1 a ) . We now n= . From formula (4.42) we know that ( Ia )n = substitute the identities derived above for an , n, v n , and . After several steps of tedious, but routine, algebra we obtain the answer a3 a 2a b ( b a ) ln . 2 ( 2a b ) b a

50. (a) (1) (2) (b) (1) (2)

n n d d n d n t t 1 an = v t = (1 + i ) = t (1 + i ) = v tv t = v ( Ia )n . di di t =1 di t =1 t =1 t =1

d a di n

i =0

= v ( Ia )n

i =0

= t =
t =1

n ( n + 1) . 2

n n d d n d n t t 1 an = v t dt = (1 + i ) dt = t (1 + i ) dt = v tv t dt = v ( Ia )n . 0 0 di di 0 di 0

d a di n

i =0

= v ( Ia )n

t =0

= tdt =
0

n2 . 2

45