The Time value of Money
Q1) Identify the steps involved in computing future value of multiple cash flows?
When there are multiple cash flows, their values are determined by finding the future value of each cash flow and then adding all the values to ascertain total future value of the multiple cash flows.
Step 1: Ascertain appropriate discount rate to discount cash flows.
Step 2: Finding Future Value for each cash flow using a discount rate ascertained in Step 1.
Step 3: Add up all the values which will be the future value of multiple cash flows.
Q2)Which economic principle is involved in finding the present and future value of multiple cash flows?
The economic principle involved in finding the present and future value of multiple cash flows is The Time Value of Money, which states that the value of money received today is more than same amount of money received tomorrow or in any future date.
Q3) What is the difference between annuity and perpetuity?
An annuity is a stream of equal cash flows that occur at equal intervals for a fixed period of time. For Instance, receiving $1000 per year at the end of each of the next eight years is an example fo an annuity. In contrast, a perpetuity is a financial instrument that promises to pay a fixed amount every agreed time period for an infinite period. For Instance, British Consul Bonds and Preferred Stocks are examples of perpetuity, since they promise fixed interest or dividend payments forever.
Q4) Define annuity due? Would the value of an investment be more if it were an ordinary annuity or an annuity due?
An annuity, where the payments or receipts occur at the beginning of each period is known as annuity due. Since, in an annuity due, all the cash flows are shifted back by one period, the value of an annuity due will be greater than the ordinary annuity. In other words, the future value of an annuity due is larger as since all the payments are made earlier there is additional time available for more compounding and thus, an annuity due have a large value.
Q5) Which of the following statement is correct?
Statement ‘C’ is correct as under an annuity due, both present value and the future value will be greater than the ordinary due.
Q6) Which of the following investments will have highest future value?
The value of an investment will be highest under option ‘C’ when $1000 is received at the beginning of each period.
Q7) Explain whether or not the following statements are correct?
1)Correct, a 15 year mortgage loan will indeed have higher monthly payments as more of the principal amount is intended to be included in the loan payments as compared to mortgage loan of 30 years.
2)False, Effective Annual Rate is always higher than the given rate
Q8) When will be Annual Percentage Rate(APR) be the same as Effective Annual Rate(EAR)?
Annual Percentage Rate(APR) will be same as to Effective Annual Rate(EAR) when compounding occurs annually.
Q9) Why is EAR superior to APR in measuring the economic cost or return?
Although, most of the debts are expressed in the Annual Percentage Rates(APR), but this is just intended to make easy comparison of the loan options. However, it is the Effective Annual Rate(EAR) which the borrowers pays on his debt. Moreover, since EAR takes into the account the effect of the time value of money it shows a real economic picture and hence it is superior to APR in measuring the true economic cost or return.
Q10) A higher discount rate will tend to favor:
The investment with large cash flows early.
Works Cited
Meritt, Cam. The Difference Between Perpetuity & Ordinary Annuities. 17 February 2014 <http://budgeting.thenest.com/difference-between-perpetuity-ordinary-annuities-22186.html>.
