[ CITATION Bar \l 1033 ]

1. What is an opportunity cost? How is this concept used in TVM analysis? Explain.

The time value of money rests upon the understanding that money received in the present
is more valuable than the same sum in in the future for the reason that it has the potential
to be invested and earn interest.

The time value of money analysis on the other hand, is an analysis which is done to
understand the change in value of money with time. With the help of this analysis, it is
determined that whether the value of money is increased or decreased with time.
[ CITATION Bar \l 1033 ]

Investors make decisions depending on their financial situation and are often faced with a
set potential outcomes.That’s where opportunity cost comes in. Opportunity cost is the
difference between the value of one option that is given up for another option. It can be
used to compare two or more financial outcomes.

It is an important factor in TVM analysis as it helps investors weigh options and make
better decisions that help them in earning more value of money in the future.

For example, if a close friend of mine whom recently borrowed ₱40,000 from me have
given me options whether to repay me 40,100 today or 41,000 next month; in this
situation I must consider if the potential gain of my money till next month through
investment will amount more than the gain that I will receive from my friend if I delay
receiving the payment.

2. Would you rather have a savings account that pays 5% interest compounded semi-
annually or one that pays 5% interest compounded quarterly? Explain.

The savings account that pays 5% interest compounded quarterly is a more reasonable
choice. In compound interest accounts, interest is reinvested and earns interest for the
remainder of the term and the more times compounding takes place, the more interest the
investor earns.
To illustrate, let’s say I am to deposit ₱35,000 to the savings account, here are the
possible earnings in each option.

On the first option the interest is compounded semi-annually so the 5% is divided into
two equal parts. The first 2.5% is paid after 6 months and the second 2.5% at the end of
the year. The total amount at the end of the year equals ₱35,000(1.025)(1.025) or
₱36,771.88.

On the second option, the interest is paid in 4 installments. We divide the 5% into 4 equal
parts of 1.25% each. The total amount is now ₱35,000(1.0125)4 = ₱36,783.09. This is
₱11.21 more than the first option.
 Having a savings account that pays 5% interest compounded quarterly will yield more
earnings than the one that is compounded semi-annually. The higher the compounding
frequency, the higher the effective annual rate.

3. Give at least two different financial applications of the time value of money. Discuss
how such may be used in a real-world setting.

The rate at which compound interest accrues depends on the frequency of

compounding, such that the higher the number of compounding periods, the greater
the compound interest.
This can be useful for decision making in investing in banks if you are to invest in a
bank and you are faced with options on whether to invest though they have same
interest rate, but having the knowledge, you will know that the frequency.
For example, if you are uncertain where to invest when they have the same interest
rate which is 10% but one is compounded annually and the other is compounded
semi-annually and you have ₱100,000. Knowing the fact that higher number of
compounding periods yields greater amount of compound interest you’ll know that
the amount of compound interest accrued on ₱100,000 compounded at 10% annually
will be lower than that on ₱100,000 compounded at 5% semi-annually over the same
time period.

In establishing golas on retirement savings, mortage loans,

Net Present value
When you are bought a furniture for your house for example and the dealer gives you
an option if you either pay 38,000 now or opt for installment of 2,000 per month for
the next two years.
The first one is pretty simple, right? You can just pay off Rs. 3,00,000 this instant, but
this amount can cause a huge dent in your savings, depending on your income and
financial status.

Now, for the second one, if you pay Rs. 1,00,000 at the end of each year for three
years, it might cause you a bigger dent in your savings because as we’ve learned, the
value of money keeps increasing over time.

Therefore, it is clear that even if we are paying three installments of Rs. 1,00,000
each, the effective value of these installments can be much higher in the future.
This technique is relevant for any loan – from a home loan to a simple EMI-system
purchase of home appliances. You can read about calculating EMIs in an easy
way, here.