Question

1. hy does money have a time value?

2. What is an ordinary annuity? An annuity due? And a deferred annuity? Be sure to discuss when the stream of payments will occur.

3. What are three (3) different financial applications of the time value of money?

4. As an investor, if you had a choice of daily, monthly, or quarterly compounding, which would you choose? Why?

5. How are present values affected by changes in interest rates?

6. The interest on your home mortgage is tax deductible. Why are the early years of the mortgage more helpful in reducing taxes than in the later years?

Answer 1

1. Time Value of Money means that the money available presently is worth more than the same amount in the future, due to its potential earning capacity.
A rupee today represents a greater real purchasing power than a dollar a year, due to inflation.
Receiving a dollar a year hence is uncertain, so the risk is involved.

2. An Annuity represents a series of equal payments or receipts occurring over a specified no. of equidistant periods.
Ordinary annuity- In this, payments or receipts occur at the end of the period.
Annuity Due- In this, payments or receipts occur at the beginning of the period.
Deferred Annuity- It is an annuity in which the payments are made to received only after a passage of some specified time.

3. Applications of Time Value of Money (TVM)
a. Finding out the Intrinsic Value of Firm, Shares or Bonds or any other financial instrument
b. Finding out Compounded Annual Growth rate
c. Finding Net Present Value

4. Daily Compounding, as it would maximize return.
example- $1000 @5% would yield
Compounded quarterly = $50.95
Compounded monthly= $51.16
Compounded daily = $51.27

5. Present Value is the current value of the future cash flow or sum of money evaluated at a given interest rate. The process of determining the present value of a series of cash flow is known as Discounting.
Present Value and interest rate are inversely related. Thus, higher the interest rate, lower the present value because higher interest rate means you would invest less today to earn a specied amount in future.