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CH 2 Time Value of Money
CH 2 Time Value of Money
This is because Nancy started saving 10 years earlier than Justin. When she stopped saving at
20 years of age, she left the accumulated sum (principal + interest earned) in the bank for
another 10 years. During those 10 years, she kept earning interest on the sum at a rate of 5%
per year compounded annually. By the time both Nancy and Justin were 30 years old, Nancy
had invested $10,000 for 20 years while Justin had only invested for 10 years. The difference
between the sums accumulated by Nancy and Justin illustrates the power of the time value of
money.
Losing the opportunity of saving red packet money and earning interest on savings.
If I were Justin, I would reduce my video game expenses and deposit the remaining red packet
money in the bank in his earlier years. Then I can take advantage of the time value of money
and the effect of compounding. For example, I would deposit half of my red packet money
(i.e., $500) every year from the age of 11 onwards. When I was 21 years old, I would deposit
$1,000 in the bank each year.
(a) Jacky will choose watching a movie because it is his first priority.
(b) Singing karaoke
(c) He will then choose singing karaoke and his opportunity cost is playing badminton.
Q2
Using the scenario in Q1 as an example, the cost of watching a movie is not both of the other
two alternatives forgone. This is because even if Jacky does not choose to watch a movie, he
can either choose to sing karaoke or play badminton. He cannot participate in both activities
as he does not have enough time. Therefore only the highest-valued alternative forgone (i.e.,
sing karaoke) is the opportunity cost.
Q3
In personal finance, the opportunity cost of doing something is usually measured as the
income that we cannot earn from the highest-paid alternative. Thus the higher the income
forgone, the higher the opportunity cost of a persons time. Consequently, opportunity cost
and the value of time tend to be equal.
Q4
Q5
Q6
The time value of money means that a dollar received today is worth more than a dollar
received in the future. This is because a dollar received today can be invested and earn
interest.
Q7
Compounding means that the profit earned on an investment is reinvested to make even more
profit. It is the process of finding future values. Discounting is the reverse of compounding. It
is the process of finding the present value.
Q8
Q9
PVIF10%, n = 0.667
From the table on p.54, when n = 4, the PVIF is 0.683; when n = 5, the PVIF is 0.621. Since
0.621 < 0.667 < 0.683, the time needed to save the required amount would be four to five
years. In practice, Eric should keep the money in the bank for five years.
Q13 (a)
(b)
Q14 (a)
(b)
i m
m
0.12 12
12
1
Pearson Education Asia Limited 2009
14
= 1.127 1
= 0.127
= 12.7%
The ERR for plan b = 1
0.14 2
2
= 1.145 1
= 0.145
= 14.5%
Since the ERR for plan b is greater than that for plan a, plan b is preferable.
Q19 The frequency of compounding accounts for the difference between the nominal rate of return
and the effective rate of return. The more frequently interest is compounded, the larger the
sum received at the end of the period because the interest grows faster.
Q20 When interest is compounded more frequently, it grows faster. This is because the interest is
earned more frequently and the amount earned will generate new interest. This compounding
effect of interest leads to a larger final amount.
Assessment
MCQ
1
2
3
4
5
6
7
8
A
C
D
B
C
B
B
A
The final amount obtained from the four investment choices:
A
$10,511.6
$10,100
$10,200
$10,500
10
11
PV = FV PVIF
= $2,000 0.5
= $1,000
PV = FV PVIFi%, n
$1,000 = $2,000 PVIFi%, 9
0.5 = PVIFi%, 9
Refer to Appendix 3, you can find that at the row of n = 9, the interest factor at 8% is
equal to 0.500.
12
Short Questions
13
14
15
Sometimes opportunity cost is measured in tangible terms such as dollars (e.g., the income you
have to give up by not working as a tutor). In other situations, it can be very abstract and
intangible, such as the happiness that you lose by not purchasing a mobile phone. Given the
same set of alternatives, the opportunity cost can vary from one person to another.
16
PV = FV (1 + i)n
= $2,205 (1 + 5%)2
= $2,000
17
PV of choice 1 = $2,000
PV of choice 2 = FV (1 + i)n
= $2,100 (1 + 6%)
= $1,981
Therefore choice 1 is better.
= Pmt PVIFAi, n
= Pmt PVIFA10%, 5
= Pmt 3.791
= $13,189
18
PVA
$50,000
$50,000
Pmt
19
PV
= FV PVIFi, n
$2,000 = $2,677.4 PVIF? %, 5
PVIF? %,5 = 0.747
Check Appendix 3 on p.187, look across the row for n = 5 years, and you will find that under
the 6% column, the PVIF is 0.747. Thus, the answer is 6%.
Application Problems
20
21
(a)
The total PV of annual cash inflows = $20,000 (1.1)2 + $20,000 1.1 = $34,710
PV of the computer system at the end of year 2 = $15,000 (1.1)2 = $12,397
Total PVs = $34,710 + $12,397 = $47,107
NPV = Total PVsCost
= $47,107$50,000
= -$2,893
Since the NPV is negative, Mavis should not buy the computer system.
(b)
(c)
(d)
Since the NPV of Speedy ($2,107) is higher than that of Excellent (-$2,803), Mavis
should buy Speedy.
(a)
The banking sector acts as a financial intermediary, channelling savings into investment
by receiving deposits from the public and then lending the money to borrowers.
(b)
(c)
22
(d)
Since the return of Bank C is still the highest, she should choose Bank C.
(a)
FV = $5,000 (1 + 12%)3
= $5,000 1.405
= $7,025
(b)
(c)
23
This is the result of a difference in the frequency of compounding. The more frequently
interest is compounded, the larger the final amount will be. Since the money in (b)(ii) is
compounded most frequently, the final amount is the largest.
First, we need to calculate the amount that Tom needs to save for tuition fees (i.e., the present
value of the four-year tuition fee).
Present value of annuity of the tuition fee of $45,000 per year:
PVA = Pmt PVIFAi, n
= $45,000 PVIFA9%, 4
= $45,000 3.240 (see Appendix 5 on p.189)
= $145,800
Then, we can calculate the annual savings for the next six years so that Tom will have
$145,800 in six years.
Annual savings for the next six years:
FVA
= Pmt FVIFAi, n
$145,800 = Pmt FVIFA9%, 6
$145,800 = Pmt 7.523 (see Appendix 4 on p.188)
Pmt
$145,800
7.523
= $19,380.6