Question

1. What are the differences between simple interest and compound interest

2. With regards to money: What are the differences between future value and present value?

3. What considerations do you need to take when considering "time value of money"?

4. Why is the following statement true? "A dollar today is worth more than a dollar tomorrow."

Answer 1

1. What are the differences between simple interest and compound interest?

Answer:

BASIS FOR COMPARISON	SIMPLE INTEREST	COMPOUND INTEREST
Meaning	Simple Interest refers to an interest that is calculated as a percentage of the principal amount.	Compound Interest refers to an interest which is calculated as a percentage of the principal and accrued interest.
Return	Less	Comparatively high
Principal	Constant	Goes on changing during the entire borrowing period.
Growth	Remains uniform	Increases rapidly
Interest charged on	Principal	Principal + Accumulated Interest
Formula	Simple Interest = P*r*n	Compound Interest = P*(1 + r)^nk

2. With regards to money: What are the differences between future value and present value?

Answer:

Basis		Present Value		Future Value
Meaning		Present value is defined as the current value of the cash flow in the future. It is basically the amount of cash in hand on today’s date.		It is defined as the value of the future cash flow after a certain future period. This is the amount of cash which will be received at a specified future date.
Time Frame		It is the current value of an asset or investment at the starting of a particular time period.		It is that value of the asset or investment at the end of a particular time period.
Inflation Effect		For the present value, inflation is considered.		For future value, inflation is not considered.
Rates Applicable		While calculating present value both the discount rate and interest rate are taken into account.		While calculating future value only interest rate is taken into account.
Decision Making		Present value is very much important for the investors as it helps to decide whether to invest or not.		Since this reflects the future profits from an investment it has lesser importance in decision making regarding investments.
Calculation Method		While calculating present value discounting is applied to find out the present value of every cash flow and then all these values are added up to find the investment’s value on today’s date.		Future value calculation uses the compounding technique to arrive at the future value of every cash flow after a certain time period and then all these values are added up to get the investment’s future value.
Nature		Present value is that amount which is required to obtain the future value.		Future value is that amount which an individual will get from cash on hand.

3. What considerations do you need to take when considering "time value of money"?

Answer:

The present or future value of cash flows is calculated using a discount rate (also known as the cost of capital, WACC and required rate of return) that is determined on the basis of several factors such as:

●   Rate of inflation	Higher the rate of inflation, higher the return that investors would require on their investment.
●   Interest Rates	Higher the interest rates on deposits and debt securities, greater the loss of interest income on future cash inflows causing investors to demand a higher return on investment.
●   Risk Premium	Greater the risk associated with future cash flows of an investment, higher the rate of return required by investors to compensate for the additional risk.

4. Why is the following statement true? "A dollar today is worth more than a dollar tomorrow."

Answer:

The time value of money is an idea that a dollar today is worth more than a dollar tomorrow due to inflation or its buying capacity. The value of a dollar changes dramatically depending upon when you get it and what you do with it.

Say you have $100 today. If you keep it in your house for a year, you will still have $100 at the end of the year. But if inflation during that year is 3 percent, the $100 item that you wanted to buy a year ago will have increased 3 percent and now costs $103. Your $100 will have lost value because you now need $3 more to buy the same item. In this case, a dollar today is worth more than the same dollar next year.

But if you put the $100 in a bank savings account and you earn 3 percent, then at the end of the year, your $100 is now worth $103. The item you want to buy now costs $103 so your account has kept up with inflation.