Chapter 2

Time Value of Money

Answers to Think It Over (p.43)

1 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.

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Check Your Progress

Q1 (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. 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. 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. Less than $200,000
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Q2

Q3

Q4

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Q5

$5,000 (1 + 8%)4$5,000 = $6,802.4$5,000 = $1,802.4 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. 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. (a) FV = $5,000 (1 + 6%)4 = $5,000 1.262 = $6,310 (b) FV = $1,000 (1 + 4%)3 = $1,000 1.125 = $1,125

Q6

Q7

Q8

Q9

The lump sum received after three years = $1,000 (1 + 5%)3 = $1,000 1.158 = $1,158

Q10 (a) PV = $6,000 (1 + 10%)5 = $6,000 1.611 = $3,724 (b) PV = $2,000 (1 + 7%)6 = $2,000 1.501 = $1,332 Q11 The money Cheryl needs to deposit now = $20,000 (1 + 5%)3 = $20,000 1.158 = $17,271 Q12 Assume n is the number of years that he should keep the money in the bank. PV = FV PVIFi,n $5,000 = $7,500 PVIF10%, n PVIF10%, n = 0.667
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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) FVA = $2,000 FVIFA10%, 10 = $2,000 15.937 = $31,874 FVA = $1,500 FVIFA8%, 15 = $1,500 27.152 = $40,728 PVA = $4,000 PVIFA6%, 10 = $4,000 7.360 = $29,440 PVA = $2,500 PVIFA8%, 3 = $2,500 2.577 = $6,442.5

(b)

Q14 (a)

(b)

Q15 PV of the $15,000 received five years later = $15,000 1.085 = $10,208.7 NPV = $10,208.7$10,000 = $208.7 Since the NPV of the investment is positive, I will invest in it. Q16 They will find the NPV of an investment by comparing the PV of future cash inflows of the investment with its initial outlay. If the NPV is positive, managers will invest in the project. If the NPV is negative, they will reject the investment. If the NPV is equal to zero, the firm is indifferent about investing in the project or not. In this case, managers should make the decision based on other criteria. Q17 A negative NPV means that the PV of future cash inflows of a project is smaller than the initial cost of the project. In this case, the firm will suffer a loss.
i ) 1 Q18 The ERR for plan a = ( 1 + m m

= (1 +

0.12 12 12

= 1.127 1
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= 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*
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B $10,100

C $10,200

D $10,500

10,000 (1 + 5%/12) = $10,511.6 As the final amount of investment A is the highest, this is the best investment choice. 9 D NPV = PVInitial outlay $200,000 = PV$50,000 PV = $250,000

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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.

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Short Questions
13 Value of the apartment after 10 years = $3,000,000 (1 + 6%)10 = $3,000,000 1.791 = $5,373,000 The amount at the end of Year 5 = $1,000 (1 + 10%)5 = $1,000 1.611 = $1,611 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. PV = FV (1 + i)n = $2,205 (1 + 5%)2 = $2,000 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. PVA = Pmt PVIFAi, n
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$50,000 = Pmt PVIFA10%, 5 $50,000 = Pmt 3.791 Pmt = $13,189 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 (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. New NPV = $47,107$45,000 = $2,107 Since the NPV is positive, the financial benefit of buying the system outweighs its cost. Mavis should buy the system. The total PV of annual cash inflows = $25,000 (1.1)3 + $25,000 (1.1)2 + $25,000 (1.1) = $62,171 PV of Excellent at the end of year 3 = $20,000 (1.1)3 = $15,026 Total PVs = $62,171 + $15,026 = $77,197 NPV = $77,197$80,000 = -$2,803 Since the NPV of Speedy ($2,107) is higher than that of Excellent (-$2,803), Mavis should buy Speedy. 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. Bank A: $50,000 (1 + 5%) = $52,500
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(b)

(c)

(d)

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(a)

(b)

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(c)

Bank B: $50,000 (1 + 6%) = $53,000 Bank C: $50,000 (1 + 6.5%) = $53,250 Bank A: $50,000 (1 + 1.375%)4 = $52,807 Bank B: $50,000 (1 + 3%)2 = $53,045 Since the return of Bank C is still the highest, she should choose Bank C. FV = $5,000 (1 + 12%)3 = $5,000 1.405 = $7,025 (i) FV = $5,000 (1 + 6%)6 = $5,000 1.419 = $7,095 (ii) FV = $5,000 (1 + 3%)12 = $5,000 1.426 = $7,130

(d) 22 (a)

(b)

(c)

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.

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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)

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Pmt

$145,800 7.523

= $19,380.6

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