BU 111: Time Value of Money

Practice Problems
Challenge Questions

Lazaridis School of Business & Economics

Wilfrid Laurier University

Fall 2018
Time Value of Money: Challenge Questions BU 111 - Fall 2018

Contents
1 Monday Problem Set 2

2 Tuesday Problem Set 3

3 Wednesday Problem Set 4

4 Notes 5
4.1 Interest Paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
4.2 Outstanding Balance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

5 Solutions 7
5.1 Monday . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
5.2 Tuesday . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
5.3 Wednesday . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

1 Monday Problem Set

1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 5.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?

2. A friend negotiates a loan to borrow $50,000 at a rate of 8% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?

3. You borrowed $1000 dollars at a rate of 8% compounded yearly. You make yearly payments of $250.46
for 5 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after three years?

4. You borrowed $1000 dollars at a rate of 6.5% compounded yearly. You make yearly payments for 10
years to pay off the loan beginning at the end of the year. How much interest do you pay in total over
the term of the loan? What is the outstanding balance on the loan after eight years?

5. You managed to negotiate a price of $35,000 on your dream car. You need to make monthly payments
for five years at an APR of 6%. The residual value of the car is $11,000. What are your monthly
payments for this car?

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

2 Tuesday Problem Set

1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 4.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?

2. A friend negotiates a loan to borrow $60,000 at a rate of 7% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?

3. You borrowed $1000 dollars at a rate of 7% compounded yearly. You make yearly payments of $209.80
for 6 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after four years?

4. You borrowed $1000 dollars at a rate of 6% compounded yearly. You make yearly payments of $161.04
to pay off the loan beginning at the end of the year. You pay $288.29 in interest over the life of the
loan. How many years will it take you to pay off the loan? What is the outstanding balance on the
loan after six years?

5. You managed to negotiate a price of $45,000 on your dream car. You need to make monthly payments
for five years at an APR of 5%. The residual value of the car is $11,000. What are your monthly
payments for this car?

3
Time Value of Money: Challenge Questions BU 111 - Fall 2018

3 Wednesday Problem Set

1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 6.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?

2. A friend negotiates a loan to borrow $55,000 at a rate of 9% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?

3. You borrowed $1000 dollars at a rate of 9% compounded yearly. You make yearly payments of $308.67
for 4 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after two years?

4. You borrowed money at a rate of 11% compounded yearly. You make yearly payments of $236.38 for
6 years to pay off the loan beginning at the end of the year. You pay 418.26 in interest over the life of
the loan. How much did you borrow? What is the outstanding balance on the loan after four years?

5. You managed to negotiate a price of $40,000 on your dream car. You need to make monthly payments
for five years at an APR of 7%. The residual value of the car is $11,000. What are your monthly
payments for this car?

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

4 Notes
4.1 Interest Paid
When thinking about how to calculate interest paid over the life of a loan, consider the following situation:
You borrow $1000 at 10% compounded annually, for 5 years, to be paid back as a lump sum at the end.
In 5 years, you would have to pay
1000(1.1)5 = 1610.51
but you only borrowed $1000. This means that you paid

1610.51 − 1000 = 610.51

in interest over the life of the loan.

Now consider the same loan, but instead of a lump sum you choose to make annual payments. Since
it’s an ordinaryh annuity andi it’s a loan, we can find the annual payments using the usual TVM formulas
1−(1+r)−n
P VOA = P M T r :
P VOA 1000
PMT = 1−(1+r)−n
= 1−1.1−5
= 263.80
r 0.1

In the first year, the loan would accrue 1000 ∗ 0.1 = 100 in interest to be 1100 but you make a payment
of 263.80, so your remaining balance is 1100 − 264.80 = 836.20. Then in the next period, the loan accrues
836.20 ∗ 0.1 = 83.62 in interest and your payment is 264.80, reducing the amount owing. You can continue
this for all payments and you get the following table:

Period Amt Outstanding Interest Total Owing PMT Remaining

1 1,000.00 100.00 1,100.00 263.80 836.20
2 836.20 83.62 919.82 263.80 656.03
3 656.03 65.60 721.63 263.80 457.83
4 457.83 45.78 503.61 263.80 239.82
5 239.82 23.98 263.80 263.80 -
318.99 1319.00

So if you sum up each interest amount, you get $318.99 paid in interest. But notice that if you multiply
the payments you made my the number of periods you get $1319.00. This means you paid $1319.00 to
payback the loan of $1000, and your interest is 319.00 (off by 1 cent because of rounding). So if you ever
need to calculate the interest paid, just add up all of the payments and subtract the amount borrowed to
get interest:
P M T · n − P V = Interest
For those who are interested in the math see why it works below NOTE THIS IS NOT REQUIRED
KNOWLEDGE, it’s just interesting to know:

The balance of the loan at time 0 ≤ t ≤ n is given by Bt = Bt−1 +It −P M T . That is, the previous balance
(Bt−1 ), plus interest earned (It ), minus the payment made (P M T ). (Note that Bt−1 + It = Bt−1 (1 + r))
Rearranging we get
It = P M T − (Bt−1 − Bt )

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

If we add all these interest terms up we get

n
X n
X
It = (P M T − (Bt−1 − Bt ))
t=1 t=1
n
X
= PMT · n − (Bt−1 − Bt )
t=1
= P M T · n − (B0 − B1 + B1 − B2 + · · · + Bn−1 − Bn )
= P M T · n − (B0 − Bn )
= P M T · n − B0
= PMT · n − PV

as above. This is because each of the balance terms cancel and Bn = 0 (we assume we pay off the loan).
Therefore you can always calculate interest payed as

PMT · n − PV

4.2 Outstanding Balance

When you have a loan that you pay off with periodic payments, its often helpful to know how much you
have owing left after a certain number of payments. As seen in the previous example, each payment you
make contributes partly to the repayment of interest, and partly to the repayment of the actual loan.

Period Amt Outstanding Interest Total Owing PMT Remaining

1 1,000.00 100.00 1,100.00 263.80 836.20
2 836.20 83.62 919.82 263.80 656.03
3 656.03 65.60 721.63 263.80 457.83
4 457.83 45.78 503.61 263.80 239.82
5 239.82 23.98 263.80 263.80 -
318.99 1319.00

As you can see in year 3, for example, 65.60 of the payment went to interest and the remaining 198.20
went to repay a bit of the outstanding loan. You don’t have to go through the trouble of making this table
if you want to calculate the last column (loan remaining) for any given period. This would be especially
difficult if we considered a 25 year mortgage with 300 monthly payments.
Instead, consider this - when we start out at time 0, we assume that all of the payments we make in
the future will exactly pay off the loan we’ve taken out. Thus the present value of the payments (P VOA ) is
exactly the present value of the loan (P Vloan ). We often drop this equality and just set P Vloan = P VOA .
Now consider the loan a few years down the road. We’ve made some payments and so the amount of the
loan we still owe is less than what we started. Furthermore, we assume that all of the remaining payments
we make will pay off the loan (otherwise if there’s still loan left over at the end we haven’t done the payment
calculation at the beginning correct). So we can calculate the amount owing for any period t as the present
value of the remaining payments (n − t)
 
1 1
P Vperiod t = P M T −
r r(1 + r)(n−t)

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

5 Solutions
5.1 Monday
1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 5.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?
Amount owing today: 265, 000 − 35, 000 = 230, 000; rnom = 5.50%; m = 2; p = 12
 2
0.055 12
Use the effective rate formula: EIR = 1 + − 1 = 0.0045316817
2
n = 25 · 12 = 300; P M T =?; P VOA = 230, 000
Plug it all in:
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
230000 = P M T −
0.0045316817 0.0045316817(1.0045316817)300
230000 = P M T (163.8292850639)
230000
PMT =
163.8292850639
P M T = 1, 403.90

Therefore the monthly mortgage payment will be $1,403.90.

2. A friend negotiates a loan to borrow $50,000 at a rate of 8% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?

 4/12
0.08
rnom = 0.08; m = 4; p = 12; EIR = 1+ − 1 = 0.0066227096
4
P M T = 499.08; P VOA = 50000
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
50000 = 499.08 −
0.0066227096 0.0066227096(1.0066227096)n
1 1
100.1843391841 − =−
0.0066227096 0.0066227096(1.0066227096)n
(−50.8112593546)(−0.0066227096) = (1.0066227096)−n
0.3365082151 = (1.0066227096)−n
ln(0.3365082151) = −n ln(1.0066227096)
ln(0.3365082151)
n=−
ln(1.0066227096)
n = 165

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

But n is in months, so to convert to years we divide by 12 to get 165/12 = 13.75 years or 13 years and
9 months. (Note we round up to the next compounding period which in this case is months, not years)
3. You borrowed $1000 dollars at a rate of 8% compounded yearly. You make yearly payments of $250.46
for 5 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after three years?

r = 0.08; n = 5; P M T = 250.46; P VOA = 1000

Over the term of the loan we pay a total of 5 · 250.46 = 1252.3. We pay back $1000 in principle so the
interest paid is 1252.3 − 1000 = 252.30. (See the note on interest paid for further details)
The outstanding balance on the loan after three years is the present value of the remaining payments
(since they should cover the remaining amount owing). Thus n = 2 since there are two years remaining.
 
1 1
P VYear 3 = 250.46 − = 446.64
0.08 0.08(1.08)2

Therefore the outstanding loan balance after three years is $446.64.

4. You borrowed $1000 dollars at a rate of 6.5% compounded yearly. You make yearly payments for 10
years to pay off the loan beginning at the end of the year. How much interest do you pay in total over
the term of the loan? What is the outstanding balance on the loan after eight years?

r = 0.065, n = 10, P VYear 0 = 1000, P M T = ?

 
1 1
PV = PMT −
r r(1 + r)n
 
1 1
1000 = P M T −
0.065 0.065(1.065)10
P M T = 139.10

Total interest paid is anything paid above the additional loan value: 10·139.10−1000 = 1391.00−1000 =
391.00
The outstanding balance on the loan is given by the present value of the remaining payments, which
is 2 years remaining after 8 years. It’s given by:

1 − (1.065)−2
 
P VYear 8 = 139.10 = 253.25
0.065

Thus, the outstanding balance on the loan after eight years is $253.25
5. You managed to negotiate a price of $35,000 on your dream car. You need to make monthly payments
for five years at an APR of 6%. The residual value of the car is $11,000. What are your monthly
payments for this car?

AP R 0.06
r= = = 0.005, n = 5 years · 12 payments = 60, F Vresidual = 11000
12 12

P Vlease = P VAD + P VSA

1 − (1.005)−60
 
11000
35000 = P M T +
0.005 (1.005)60

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

1 − (1.005)−60
 
11000
35000 − = P M T
(1.005)60 0.005
26, 844.91 = P M T (51.72556)
P M T = 518.99

Therefore you should expect to pay $518.99 per month for this car.

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

5.2 Tuesday
1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 4.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?
Amount owing today: 265, 000 − 35, 000 = 230, 000; rnom = 4.50%; m = 2; p = 12
 2
0.045 12
Use the effective rate formula: EIR = 1 + − 1 = 0.003715319575
2
n = 25 · 12 = 300; P M T =?; P VOA = 230, 000
Plug it all in:
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
230000 = P M T −
0.003715319575 0.003715319575(1.003715319575)300
230000 = P M T (180.6773017965)
230000
PMT =
180.6773017965
P M T = 1, 272.99

Therefore the monthly mortgage payment will be $1,403.90.

2. A friend negotiates a loan to borrow $60,000 at a rate of 7% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?
 4/12
0.07
rnom = 0.07; m = 4; p = 12; EIR = 1+ − 1 = 0.00579963257
4
P M T = 499.08; P VOA = 60000
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
60000 = 499.08 −
0.00579963257 0.00579963257(1.00579963257)n
1 1
120.2212070209 − =−
0.00579963257 0.00579963257(1.00579963257)n
(−52.2035091883)(−0.00579963257) = (1.00579963257)−n
0.3027611722 = (1.00579963257)−n
ln(0.3027611722) = −n ln(1.00579963257)
ln(0.3027611722)
n=−
ln(1.00579963257)
n = 206.6117764185 = 207 months

But n is in months, so to convert to years we divide by 12 to get 207/12 = 17.25 years or 17 years and
3 months. (Note we round up to the next compounding period which in this case is months, not years)

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

3. You borrowed $1000 dollars at a rate of 7% compounded yearly. You make yearly payments of $209.80
for 6 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after four years?

r = 0.07; n = 5; P M T = 209.80; P VOA = 1000

Over the term of the loan we pay a total of 6 · 209.80 = 1258.80. We pay back $1000 in principle so
the interest paid is 1258.80 − 1000 = 258.80. (See the note on interest paid for further details)
The outstanding balance on the loan after four years is the present value of the remaining payments
(since they should cover the remaining amount owing). Thus n = 2 since there are two years remaining.
 
1 1
P VYear 3 = 209.80 − = 379.32
0.07 0.07(1.07)2
Therefore the outstanding loan balance after three years is $379.32.
4. You borrowed $1000 dollars at a rate of 6% compounded yearly. You make yearly payments of $161.04
to pay off the loan beginning at the end of the year. You pay $288.29 in interest over the life of the
loan. How many years will it take you to pay off the loan? What is the outstanding balance on the
loan after six years?
Over the term of the loan, we pay a total of n ∗ 161.04. Over the term of the loan, we pay back $1000
in principal (PV of the loan). Any additional above the principal paid back is the interest paid. So
term of loan is:

n ∗ 161.04 = $288.29 + 1000

 
1288.29
n= = 8 years
161.04
The outstanding balance on the loan after six years will be the present value of the loan at Year 6. We
bring back the annuity 2 years to find P VY ear6 .

1 − (1.06)−2
 
P VYear 6 = 161.04 = 295.24
0.06
Thus, the outstanding balance on the loan after six years is $295.24.
5. You managed to negotiate a price of $45,000 on your dream car. You need to make monthly payments
for five years at an APR of 5%. The residual value of the car is $11,000. What are your monthly
payments for this car?

AP R 0.05
r= = = 0.004166666667, n = 5 years · 12 payments = 60, F Vresidual = 11000
12 12

P Vlease = P VAD + P VSA

1 − (1.004166666667)−60
 
11000
45000 = P M T +
0.004166666667 (1.004166666667)60
1 − (1.004166666667)−60
 
11000
45000 − = PMT
(1.004166666667)60 0.004166666667
36, 428.74 = P M T (52.9907063234)
P M T = 687.46
Therefore you should expect to pay $687.46 per month for this car.

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

5.3 Wednesday
1. You and your parents have decided to purchase a house in Waterloo that you can live in for the next
three years and then rent to students. The house you purchase is $265,000 and you make a down
payment of $35,000. You arrange a 5 year mortgage with a 6.50% interest rate compounded semi-
annually. The mortgage has an amortization period of 25 years. What is the size of your monthly
mortgage payment (assuming you begin payments at the end of this month)?
Amount owing today: 265, 000 − 35, 000 = 230, 000; rnom = 6.50%; m = 2; p = 12
 2
0.065 12
Use the effective rate formula: EIR = 1 + − 1 = 0.005344740075
2
n = 25 · 12 = 300; P M T =?; P VOA = 230, 000
Plug it all in:
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
230000 = P M T −
0.005344740075 0.005344740075(1.005344740075)300
230000 = P M T (149.2929963018)
230000
PMT =
149.2929963018
P M T = 1, 540.59

Therefore the monthly mortgage payment will be $1,540.59.

2. A friend negotiates a loan to borrow $55,000 at a rate of 9% compounded quarterly. Your friend has
agreed to pay $499.08 dollars per month to pay off the loan. How many years will it take for him to
pay off his loan, assuming his first payment is at the end of the month?
 4/12
0.09
rnom = 0.09; m = 4; p = 12; EIR = 1+ − 1 = 0.007444442749
4
P M T = 499.08; P VOA = 55000
 
1 1
P VOA = P M T −
r r(1 + r)n
 
1 1
55000 = 499.08 −
0.007444442749 0.007444442749(1.007444442749)n
1 1
122.4726106707 − =−
0.007444442749 0.007444442749(1.007444442749)n
(−11.855778131)(−0.007444442749) = (1.007444442749)−n
0.08825966154 = (1.007444442749)−n
ln(0.08825966154) = −n ln(1.007444442749)
ln(0.08825966154)
n=−
ln(1.007444442749)
n = 327.290653094 = 328 months

But n is in months, so to convert to years we divide by 12 to get 328/12 = 27.33 years or 27 years and
4 months. (Note we round up to the next compounding period which in this case is months, not years)

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Time Value of Money: Challenge Questions BU 111 - Fall 2018

3. You borrowed $1000 dollars at a rate of 9% compounded yearly. You make yearly payments of $308.67
for 4 years to pay off the loan beginning at the end of the year. How much interest do you pay in total
over the term of the loan? What is the outstanding balance on the loan after two years?

r = 0.09; n = 5; P M T = 308.67; P VOA = 1000

Over the term of the loan we pay a total of 4 · 308.67 = 1234.68. We pay back $1000 in principle so
the interest paid is 1234.68 − 1000 = 234.68. (See the note on interest paid for further details)
The outstanding balance on the loan after two years is the present value of the remaining payments
(since they should cover the remaining amount owing). Thus n = 2 since there are two years remaining.
 
1 1
P VYear 3 = 308.67 − = 542.98
0.09 0.09(1.09)2

Therefore the outstanding loan balance after three years is $542.98.

4. You borrowed money at a rate of 11% compounded yearly. You make yearly payments of $236.38 for
6 years to pay off the loan beginning at the end of the year. You pay 418.28 in interest over the life of
the loan. How much did you borrow? What is the outstanding balance on the loan after four years?
Over the term of the loan, we pay a total of 6 ∗ 236.38 = 1418.28. Over the term of the loan, we pay
418.28 in interest. Since any additional paid above the principal paid back is the interest paid, the
principle is:

1418.28 − 418.28 = 1000 = P VY ear0

The outstanding balance on the loan after six years will be the present value of the loan at Year 4. We
bring back the annuity 2 years to find P VY ear4 .

1 − (1.11)−2
 
P VYear 4 = 236.38 = 404.81
0.11

Thus, the outstanding balance on the loan after six years is $404.81.
5. You managed to negotiate a price of $40,000 on your dream car. You need to make monthly payments
for five years at an APR of 7%. The residual value of the car is $11,000. What are your monthly
payments for this car?

AP R 0.07
r= = = 0.005833333333, n = 5 years · 12 payments = 60, F Vresidual = 11000
12 12

P Vlease = P VAD + P VSA

1 − (1.005833333333)−60
 
11000
40000 = P M T +
0.005833333333 (1.005833333333)60
1 − (1.005833333333)−60
 
11000
40000 − = PMT
(1.005833333333)60 0.005833333333
32, 240.54 = P M T (50.5019935016)
P M T = 638.40

Therefore you should expect to pay $638.40 per month for this car.

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