Recognizing the Different Types of Time
Value of Money Problems.
Sometimes students feel overwhelmed when facing a time value of money word
problem. Actually, solving a word problem is not as hard as you might think. If
you follow the following steps, you will discover that solving a word problem is
as easy as 1-2-3!
- Read the problem and find out what it is that the problem is asking you to
solve. This is called the unknown. It is usually the item that follows the
"how" or "what" in the question. Common "how"
questions are "how much . . .", "how long . . .", or
"how many . . . ." Most "what" questions have the form
"what is the . . ."
- Identify all of the different types of information that is given.
Simply enter the given information into the calculator and solve of the
|The payments per year (or the compounding period) is always given (or
may be assumed to be annual if no period is mentioned.) Look for the
words annually (1 P/YR), semi-annually (2 P/YR), quarterly
(4 P/YR), bi-monthly (6 P/YR), monthly (12 P/YR), bi-weekly
(26 P/YR), weekly (52 P/YR), or daily (365 P/YR). If more
than one of these words is used in the problem, the payments per year is
usually the largest number of payments per year.|
|The number of years is usually easily recognized unless it the unknown
sought in the problem.|
|The present value (PV) will be that value which is the earliest in
time. Sometimes it is easy to think that a reference to
"today" suggests a present value. However, that is not always
reliable. Consider the following problem: "If you purchased a lot
for $ 24,509 eleven years ago, what is your expected annual rate of
return if you can sell the lot for $ 90,558 today and you assume
bimonthly compounding?" In this problem, $24,509 is the present
value since it occurred the earliest in time.|
|The amount of the payment (PMT) is an amount which is repeated every
period. (Remember that another name for this reoccurring payment is an
annuity.) This means any payment amount must occur more than once in the
problem. Just because you see the word "pay", you cannot
assume that it refers to a payment unless it occurs more than once. For
example, if the problem says "pay each month", this would be a
payment. However, if it simply says "you pay $10,000 for an
investment that . . .", the $10,000 would not be a payment since it
the problem implies that there is only one $10,000 payment.|
|The future value (FV) will be that value which is the latest in time.
Sometimes it is easy to think that a reference to "today"
suggests a present value. However, that is not always reliable. Consider
the problem cited above: "If you purchased a lot for $ 24,509
eleven years ago, what is your expected annual rate of return if you can
sell the lot for $ 90,558 today and you assume bimonthly
compounding?" In this problem, $90,558 is the future value since it
occurred the latest in time.|
|Finally the interest rate per year (I/YR) must be on an annual basis.
If the problem specifies an interest rate on other than an annual basis,
you would need to convert the rate to an annual rate. For example, if
the problem said "1% monthly interest", this would be entered
as 12% annual interest.|
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Let's try our 1-2-3 procedure on a few word problems.
First let's consider the problem mentioned above: "If you purchased a
lot for $ 24,509 eleven years ago, what is your expected annual rate of return
if you can sell the lot for $ 90,558 today and you assume bimonthly
- What is the problem is asking you to solve? Look for the "what
is" in the problem. It asked, "what is your expected annual rate
of return." Therefore, the problem is asking for an interest rate per
year. You will be solving for I/YR.
- Next, identify what you know.
Now enter the data and solve for the unknown.
|You are given an amount of $24,509. This amount occurred first, so it
is a present value (PV).|
|You are given the number of years ("eleven years ago") as
|You are given an amount of $ 90,558. This amount occurred last so it
is a future value (FV).|
|Finally, you are told the compounding period (P/YR). In this case the
problem says "bi-monthly" so your payments per year is 6.
(Note that the problem mentions both the words annual and bi-monthly.
Using the general rule suggested above, you would use the largest number
of payments per year as the correct entry.)|
|Remember you must always begin by entering the payments per year. You
would do this by pressing 6, the cream colored key
and then the P/YR
|Now enter the number of years by pressing 11, the cream colored key
and then the xP/YR
|The present value is entered by pressing 24509, the change sign
key, and then the PV
key. The sign is changed to indicate that this cash flow was paid rather
|The future value is entered by pressing 90558 and then the FV
|Finally, you solve for the unknown, the annual rate, by pressing the
I/YR key. The display
show 12. This means that you would have earned 12% per year on your
Would you like to
test your skill at recognizing the parts in a time value of money word
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Dr. Jerry Belloit with questions or comments about this web site.
Copyright © 2006 Dr. Jerry D. Belloit