Module 2 - Time Value of Money

Question 1

The time value of money concept is often stated as…

Answer 1

“a dollar received today is worth more than a dollar received tomorrow” - implying that the dollar received today will be invested to grow to a greater amount.

Question 2

What else makes the time value of money statement true apart from investing?

Answer 2

Inflation - Usually in the economy, we will experience inflation. Meaning the price of goods and services generally increase so $1 you have today will not buy you the same thing in 10 years time.

Question 3

Why is it that
$1k (in the first year)+ $1k (in the second year)+ $1k (in the third year) ≠ $3k
under the time value of money concept

Answer 3

Mathematically speaking, that is correct but that’s not the actual value of today. The value of the three $1k, even though they are the same $1k, but receiving it in different time will have different value to it in today’s term.

Question 4

What are the two types of investments that are relatively risk-free?

Answer 4

1) Time deposits - term deposits that you put in your savings account
2) Government debt - Government can also borrow money from the public and the public can earn interest on the lent money

Question 5

What are the two higher-risk returns when investing?

Answer 5

1) Debenture investments - where the general public lends money to the company and in return, they receive interest return
2) Share market investments - the returns that the shareholders get are either in the form of market capitalisation and/or dividends. This is highly risky because the board of the company may decide to not issue out dividends and there is risk involved in the share prices going down which will affect the market capitalisation.

Question 6

What is the relationship between risk and return?

Answer 6

Positive relationship - if the investment has a higher risk, then the individual investors should demand a higher return to compensate for the extra risk.

Question 7

Which interest that is earned on the original interest will also earn interest?

Answer 7

Compounded interest

Question 8

Which interest will only allow you to earn interest on the original interest?

Answer 8

Simple interest

Question 9

What interest is this an example of?
original invested amount = $2
interest per year = 4%
after 10 years, 
return = $2 + (2x0.04) x 10 = $2.80

Answer 9

Simple interest

Question 10

What interest is this an example of?
original invested amount = $2
interest per year = 4%
after 10 years, 
return = $2 x (1+0.04)^10 = $2.96

Answer 10

Compound interest

Question 11

The formula for compound interest

Answer 11

[FV = PV x (1 + r)^n]
where
FV= future value
PV= present value
r= rate of return
n= number of periods

Question 12

The formula for simple interest

Answer 12

[FV = PV( 1 + rn)]
FV= future value
PV= present value
r= rate of return
n= number of periods

Question 13

The return in today’s value is what we refer to as …

Answer 13

Present value

Question 14

‘Table A Factor’ is also known as…

Answer 14

The discount factor

Question 15

What is the relationship between the discount factor and interest rate/number of periods?

Answer 15

The discount factor gets smaller as we increase the (r)/(n)

Question 16

Through which process will you know how much return you’ll receive after certain periods when you put inside your savings account today? (Compounding or Discounting)

Answer 16

Compounding

Question 17

Through which process will you work out what it is worth in today’s value if you know how much you receive in certain periods? (Compounding or Discounting)

Answer 17

Discounting

Question 18

When can we use the ‘Table B factor’?

Answer 18

Table B may be used if the multiple future amounts follow at least one of the following:

1) The same dollar amount each period
2) Equally spaced periods (n)
3) Same rate (r) per period

Question 19

The PV of an annuity formula

Answer 19

[PV(annuity) = Annuity x (Table B factor)]