FIN-2860 Chapter Notes - Chapter 3: Daily Double, Cash Flow, Investment

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aquamarinewasp815

13 Dec 2020

School

App State

Department

Finance, Banking and Insurance

Course

FIN-2860

Professor

Bryan Bouboulis

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Document Summary

Time value of money: the concept that a dollar received today is worth more than a dollar received in the future, furthermore comparisons between amounts in different time periods cannot be made without adjustments to their values. If you take the interest you earn on investment and reinvest it, you start earning interest on the principal and the reinvested interest. Principal: the face value of the deposit or debt instrument. Present value (pv): the current value, the value in today"s dollars of a future sum of money. Annual interest rate (i/y or r): the rate charged or paid for the use of money on an annual basis. Future value (fv): the value of an investment at some future point. Reinvesting: taking the money you have earned on an investment and plowing it back into that investment. The formula for illustrating the payment of interest is fvn= pv x (1+r)n.

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QUESTION 1 The time value of money refers to the issue of: A. what the value of the stream of future cash flows is today. B. why a dollar received tomorrow is worth more than a dollar received today. C. what the time required to double an amount of money. D. why people prefer to consume things at some time in the future rather than today.

QUESTION 2 The process of converting an amount given at the present time into a future value is called: A. annualizing. B. discounting. C. compounding. D. capital budgeting. 2 points

QUESTION 3 Juan Vinson is planning to buy a house in five years. He is looking to invest $25,000 today in an index mutual fund that will provide him a return of 12 percent annually. How much will he have at the end of five years? (Round to the nearest dollar.) A. $45,000 B. $28,000 C. $44,059 D. $28,530 2 points

QUESTION 4 Which of the following statements is true with respect to the present value of a future amount? A. The higher the discount rate, the higher the present value of a single sum for a given time period. B. The relation between present value and time is exponential. C. The greater the time period, the higher the present value of a single sum for a given interest rate. D. The lower the discount rate, the lower the present value of a single sum for a given time period. 2 points

QUESTION 5 Which of the following statements is true of the rule of 72? A. It can be used to determine the amount of time it takes to double an investment. B. It is fairly accurate for interest rates between 25 and 50 percent. C. It states that the time to double your money (TDM) approximately equals 72/i, where i represents the years it takes to double your investment. D. It can be used to estimate approximate compound interest earned for a period of 72 days. 2 points

QUESTION 6 The present value of future cash flows are computed by multiplying future value with the: A. discounting factor. B. compound factor. C. interest rate. D. number of periods. 2 points

QUESTION 7 The present value of multiple cash flows is: A. greater than the sum of the cash flows. B. equal to the sum of all the cash flows. C. less than the sum of the cash flows. D. higher or lower than the cash flows depending on the interest rate. 2 points

QUESTION 8 Cash flows associated with annuities are considered to be: A. an uneven cash flow stream. B. a constant cash flow stream. C. a mix of constant and uneven cash flow streams. D. a cash flow stream with decreasing trend. 2 points

QUESTION 9 The annuity transformation method is used to transform: A. a present value annuity to a future value annuity. B. a present value annuity to an annuity due. C. an ordinary annuity to an annuity due. D. a perpetuity to an annuity. 2 points

QUESTION 10 The true cost of borrowing is the: A. annual percentage rate. B. effective annual rate. C. quoted interest rate. D. periodic rate.

12. Company HDE is expected to pay an interim dividend of $1.00 six months from now and a final
dividend of $2.10 one year from now. HDE is then expected to repeat the same pattern every year
for the foreseeable future with no growth in dividends. Given that the appropriate effective
discount rate is 7.0% p.a., what is the stock price of HDE closest to today?
A) $30
B) $35
C) $40
D) $45
E) None of the above
13. Which of the following statements is FALSE?
A) The process of moving a value or cash flow forward in time is known as compounding.
B) The effect of earning interest on interest is known as compound interest.
C) It is only possible to compare or combine values at the same point in time.
D) A dollar in the future is worth more than a dollar today.
E) Interest paid only on the principal is simple interest.
14. Consider the following four alternatives:
1. $132 received in two years.
2. $160 received in five years.
3. $200 received in eight years.
4. $220 received in ten years.
The ranking of the four alternatives from most valuable to least valuable if the interest rate is
7% per year would be:
A) 1, 2, 3, 4
B) 4, 3, 2, 1
C) 3, 4, 2, 1
D) 3, 1, 2, 4
E) 3, 1 = 2, 4

Are my answers correct?

Suppose you invest $10,000 in a savings account earning 2% interest (compounded yearly) with no risk. After 7 years, how much will you have?

Principal = $10,000.00

Rate = 2.00%

Year = 7

Amount (Compound interest) = P x (1 + r/n) ^nt

Where P = Principal

r rate of interest

n = number of time interest is calculated in a year

t = time

Amount after 7 years = 10,000 x (1+0.02) ^7 = $11,486.86

Repeat Question #1, but this time there is an inflation rate of 4%. How does this change your overall return on investment? If you had a chance to invest in an account with a long-term expected rate of 5%, with a 50% chance of earning 0% nominal compound interest and a 50% chance of earning 10% nominal compound interest in each year, would you choose this account, or the savings account? Why?

Effects of inflation on PV = 10,000 x (1/(1+0.04)^7) = $7,599.18

FV Adjusted for inflation = 11,486.86 x (1/(1+0.04)^7) = $ 8,729.07

Overall return on investment will decrease by 1,270.93 = 10,000 â 8,729.07

Repeat #1 with inflation:

Amount after 7 years = 10,000 x ((1+0.02)/(1+0.04)) ^7

10,000 x (0.98) ^7 = $8,729.07.

Safe vs. Risky (not including inflation)

If I get 0%, the amount after 7 years = 10,000 x (1+0.00) ^7 = $10,000.00

If I get 10%, the amount after 7 years = 10,000 x (1+0.10) ^7 = $19,487.17

If I get 5% (expected), amount after 7 years = 10,000 x (1+0.05) ^7 = $14,071.00

I would choose the account with the 5% expected rate of return because it has higher effective annual return over the saving account. There is a higher return, but the risk is higher as compared to the savings account, which provides a certain return.

Suppose you will need $50,000 in 4 years to start up a new business you have planned. With a 5% real interest rate, how much do you have to invest now in order to achieve this goal?

This condition clearly says that we need to calculate the present value of the future earnings and it has to be the present value factor and not annuity.

Therefore, to get 50000 is the future value therefore present value of 50000

Amount to be invested today =PVF@5%,4 *Amount

= .82270 * 50000

= $ 41135.12

Repeat Problem #3, but assume you can contribute an equal amount on a yearly basis. How much would you need to put into the account each year?

Amount to invested each year = Amount /FVAF@5%,4 = 11,600.66

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FIN-2860 Chapter Notes - Chapter 3: Daily Double, Cash Flow, Investment

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