Question

Question 2.

What is difference between Present Value and the future value of an asset?

What is meant by the opportunity cost of an item or activity? Give an example.

What is the maximum amount you would pay for an asset that generates an income of $ 5,000 at the end of each of the two years when the opportunity cost of using funds is 10 percent?

Answer 1

(1) What is Present Value?

Present value is the current worth of the future sum of money streams at a specific rate of return. This current worth can be found by discounting future cash flows at a pre-determined discount rate. This value assists investors to compare cash flows generating from investments at different time periods.

What is Future Value?

Future value is the value of an asset or some of money at a specific future date. This is a nominal value, so does not include any adjustments for inflation, i.e. no any discount factors involved. This value basically estimates the total gain that can be obtained from an investment based on a given interest rate.

What is the difference between Present Value and Future Value?

• Present value is the current value of future cash flow. Future value is the value of future cash flow after a specific future period.

• Present value is the value of an asset (investment) at the beginning of the period. Future value is the value of an asset (investment) at the end of the period that is being considered.

• Present value is the discounted value of future sums of money (Inflation is taken into consideration). Future value is the nominal value of future sums of money (Inflation is not taken into account).

• Present value involves both discount rate and interest rate. Future value involves interest rate only.

• Present value is more important for investors to decide upon whether to accept or reject a proposal. Future value shows only the future gains of an investment, so the importance for investment decision making is less.

(2)

Opportunity Cost

An opportunity cost is defined as the value of a forgone activity or alternative when another item or activity is chosen. Opportunity cost comes into play in any decision that involves a tradeoff between two or more options. It is expressed as the relative cost of one alternative in terms of the next-best alternative. Opportunity cost is an important economic concept that finds application in a wide range of business decisions.

Opportunity costs are often overlooked in decision making.

For example, to define the costs of a college education, a student would probably include such costs as tuition, housing, and books. These expenses are examples of accounting or monetary costs of college, but they by no means provide an all-inclusive list of costs. There are many opportunity costs that have been ignored:

• (1) wages that could have been earned during the time spent attending class,
• (2) the value of four years' job experience given up to go to school,
• (3) the value of any activities missed in order to allocate time to studying, and
• (4) the value of items that could have been purchased with tuition money or the interest the money could have earned over four years.

Another Example:

If a person invests $10,000 in Mutual Fund ABC for one year, then he forgoes the returns that could have been made on that same $10,000 if it was placed in stock XYZ. If returns were expected to be 17 percent on the stock, then the investor has an opportunity cost of $1,700. The mutual fund may only expect returns of 10 percent ($1,000), so the difference between the two is $700.

(3)

The maximum you would be willing to pay for this asset is the present value, which is

PV = $5,000 / (1.10)²

PV = $5,000 / 1.21

PV = $4,132.23