Question

a. Compute the future value at the end of 4 years of $900 invested today at an interest rate of 6 per cent and describe two business uses for this specific type of computation.

b. Compute the future value at the end of 4 years of $900 put away in a savings account each of four years at an interest rate of 6 per cent and describe two business uses for this specific type of computation.

c. Explain the time value of money concept and the role of compound interest and opportunity cost in time value of money concept as it relates to business planning.

Answer 1

Future value is given by

a.

Thus, using this

If today you were to invest $900.00 at a rate of 6.00%, you would have $1,136.23 at the end of 4 time periods (e.g. weeks, months, or years). In other words, a future value of $1,136.23 is equal to a present value of only $900.00.

What does this mean to you? Well, if you had a choice between taking an amount higher than the $900.00 today and taking the $1,136.23 at the end of 4 time periods, you should take the money today. By doing so, you would be able to invest the higher amount at 6.00% for 4 equal time periods, which would end up giving you more than $1,136.23.

b.

A savings account provides simple interest

Thus, $900 put in savings account for 4 years will provide a future value of

c. Time value of money is based on the idea that money can be put to work over a period of time and that the value of one dollar today will not be the same after one year because of many factors including the earning potential of the money as well as inflation.

The time value of money draws from the idea that rational investors prefer to receive money today rather than the same amount of money in the future because of money's potential to grow in value over a given period of time.

The role of compound interest in business planning is so crucial that some have even called it as the eighth wonder. The idea is to reinvest investment earnings rather than spend them. It is an exponential function and thus, as time passes, the money grows faster and faster.

Opportunity cost is the cost of a missed opportunity. It is related to the risk-reward tradeoff implied in entrepreneurship. Higher the risk, higher the potential reward. Businesses have different opportunity costs when determining whether to launch new products, services, etc. Identifying the opportunity costs, analyzing them, and then making the optimum decisions is a part of business planning.