Question

3. Present value 

Finding a present value is the reverse of finding a future value. 

_______  is the process of calculating the present value of a cash flow or a series of cash flows to be received in the future. 

Which of the following investments that pay will $15,000 in three years will have a lower price today? 

The security that earns an interest rate of 21.75% 

The security that carns an interest rate of 14.50% 

Eric wants to invest in government securities that promise to pay $1,000 at maturity. The opportunity cost interest rate) of holding the security is 4.00%. Assuming that both investments have equal risk and Eric's investment time horizon is flexible, which of the following investment options will exhibit the lower price? 

An Investment that matures in seven years 

An investment that matures in six years 

Which of the following is true about present value calculations? 

Other things remaining equal, the present value of a future cash flow decreases if the investment time period increases. 

other things remaining equal, the present value of a future cash flow increases if the investment time period Increases.

Answer 1

1. Discounting is the process of calculating the present values of cash flow/ series of cash flows. Discounting factor is used to bring the future values to the present.

2. An Instrument with high interest rate will be lower in price today to yield the same amount in future. Thus in given Case investment paying 21.75% will be lower in price.

For E.g. Security A with 21.75% interest rate paying $15000 3 years from now will cost at $ 8,311 (Using PV Formula in Excel - PV(Rate= 0.2175, nper= 3year, pmt=0, FV=15000,0)

And Security B with 14.50% interest paying $15000 in 3 years from now will cost 9992.51 (Similarly)

3. When Interest rate and maturity value is same, The investment that matures later will be cheaper in price. (This can be validated using PV formula as above) FV- 1000, Nper= 6/7, Rate 0.04.

An instrument with 6 years to maturity will cost ~$790 whereas Investment with 7 years to maturity will cost ~$759

4. Difference between the present value and future value is time value of money. Higher the time period,higher will be the difference between the two. Thus, the following statement is true:

Other things remaining equal, the present value of future cash flow decreases if the investment time period increases