Question

1. Please explain why money has a time value. Please interpret the present and future value of a series of future cash flows.   What is the effective rate of return? Would you prefer more frequent compounding or less and why?

Answer 1

Money has the time value due to inflationary factors and the opportunity cost of money. A dollar today is worth more than a dollar received in the future. This is because money received today can buy more things immediately than the money received in future. Also it can be invested to earn a certain rate of interest.

In a series of cash flows such as 0,100,100,100, assuming a 10% rate of interest, present value will be

0+100/1.1^1+100/1.1^2+100/1.1^3

=248.69

Future value will be 0+100*1.1^2+100*1.1^1+100 = $331

Present value is that today’s value of the series of cash flows while future value is the value at the end of the period.

The effective rate of return is the rate of return or and considering the number of compounding sin a certain period. For example a 10% rate of interest compounded semiannually will be equal to an effective rate of (1+10%/2)^2-1=10.25%

Greater compounding frequency is preferred because higher the compounding, greater will be the effective rate and hence the future value will be higher.