TVM Question

aditi.kaushal
Posts: 1
Joined: Thu Jun 01, 2017 6:03 am

TVM Question

Postby aditi.kaushal » Mon Jul 24, 2017 10:24 am

Eric Keener's father has promised to give him $1,000 each year for the next three years. A bank deposit pays 5 percent compounded semi-annually. How much money will Eric have at the end of three years if he invests in the bank? Assume the money (the $1,000 from his father) will be received at the end of each year.
a. $3,154.43
b. $2,859.41
c. $4,000.00
d. $2,723.24
e. None of the above is within $1.00 of the correct answer.

I m trying with two methods-

Method 1- PMT=1000, I/Y=5%/2, N=3*2, CPT FV
Method 2- convert 5% nominal rate to effective rate 5.06% and then PMT=1000, I/Y=5.06%, N=3, CPT FV

There are examples where we used method 1 i.e. divide the interest rate with compounding that is 5%/2=2.5% and multiply the compounding with N that is N=3*2=6. This is giving me incorrect answer
If I use method 2 I am getting correct answer.

I am confused in what scenario we use method1 and in what scenario we can use method 2???

edupristine
Finance Junkie
Posts: 871
Joined: Wed Apr 09, 2014 6:28 am

Re: TVM Question

Postby edupristine » Tue Jul 25, 2017 8:12 am

Hi,

In the first method, it is more of use when you have semi-annual payments and annual interest rates. Here, you need to calculate the effective rate. Solution:-

A, Two steps with the key being to use the effective rate rather than the nominal rate, 1) find the effective rate using 5% nominal with 2 periods per year, 2) then find FV, based on PV=0, I=step 1 answer, N=3, PMT=1000, and compute FV.


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