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Questions and Answers
A company is evaluating two investment options with identical future payoffs. Option A guarantees the payoff in one year, while Option B guarantees it in two years. Assuming all other factors are constant, which option should the company prefer based solely on the time value of money principle?
A company is evaluating two investment options with identical future payoffs. Option A guarantees the payoff in one year, while Option B guarantees it in two years. Assuming all other factors are constant, which option should the company prefer based solely on the time value of money principle?
- The company should be indifferent between Option A and Option B, as the future payoffs are identical.
- Option B, as the additional time allows for greater potential compounding of returns, increasing the overall value.
- The preference between Option A and B depends on the risk associated with each option, not the time value of money.
- Option A, because receiving money sooner is always more valuable due to the preference for immediate consumption. (correct)
An investor is considering an investment that promises a 10% nominal return. However, the inflation rate is expected to be 4%. What is the approximate real rate of return for this investment, and what does it signify?
An investor is considering an investment that promises a 10% nominal return. However, the inflation rate is expected to be 4%. What is the approximate real rate of return for this investment, and what does it signify?
- 14%; indicating the actual increase in purchasing power after accounting for inflation.
- 6%; representing the increase in purchasing power after adjusting for the effects of inflation. (correct)
- 40%; reflecting the compounded effect of nominal return and inflation on the investment.
- 2.5%; showing the proportional decrease in the investment's value due to inflationary pressures.
An individual deposits $5,000 into a savings account with an annual interest rate of 8%, compounded annually. If inflation is expected to remain constant at 3% per year, what is the approximate real value of the investment after 3 years, adjusted for inflation?
An individual deposits $5,000 into a savings account with an annual interest rate of 8%, compounded annually. If inflation is expected to remain constant at 3% per year, what is the approximate real value of the investment after 3 years, adjusted for inflation?
- $5,815.14; showing the inflation-adjusted value of the investment, providing insight into the real return on investment. (correct)
- $5,773.24; indicating the adjusted present value of the investment after accounting for the reduction in purchasing power due to inflation.
- $6,298.56; reflecting the nominal value of the investment after 3 years, without adjusting for inflation.
- $6,050.00; representing the future value of the investment, considering both the interest earned and the increased costs due to inflation.
Consider two scenarios: In Scenario A, you receive $1,000 today. In Scenario B, you receive $1,100 one year from today. If the annual inflation rate is expected to be 5% and the nominal interest rate is 12%, which scenario provides a higher real return in terms of today's purchasing power?
Consider two scenarios: In Scenario A, you receive $1,000 today. In Scenario B, you receive $1,100 one year from today. If the annual inflation rate is expected to be 5% and the nominal interest rate is 12%, which scenario provides a higher real return in terms of today's purchasing power?
How does understanding the time value of money impact decisions related to long-term investments, such as retirement savings or funding a child's education, especially in the context of varying inflation rates and market returns?
How does understanding the time value of money impact decisions related to long-term investments, such as retirement savings or funding a child's education, especially in the context of varying inflation rates and market returns?
Consider a scenario where a government offers its citizens a choice between receiving a lump-sum payment of $10,000 today or $12,000 three years from now. The current annual inflation rate is 4%, and the nominal interest rate on comparable investments is 7%. Evaluate which option is more economically advantageous for the citizens, considering the time value of money.
Consider a scenario where a government offers its citizens a choice between receiving a lump-sum payment of $10,000 today or $12,000 three years from now. The current annual inflation rate is 4%, and the nominal interest rate on comparable investments is 7%. Evaluate which option is more economically advantageous for the citizens, considering the time value of money.
An investor is comparing two investment opportunities with different risk profiles. Investment A is low-risk, offering a guaranteed nominal return of 5%, whereas Investment B is high-risk, projecting a potential nominal return of 15%. If the current inflation rate is 3%, how should the investor factor in the time value of money and risk to make a sound investment decision?
An investor is comparing two investment opportunities with different risk profiles. Investment A is low-risk, offering a guaranteed nominal return of 5%, whereas Investment B is high-risk, projecting a potential nominal return of 15%. If the current inflation rate is 3%, how should the investor factor in the time value of money and risk to make a sound investment decision?
Suppose a project requires an initial investment of $50,000 and is expected to generate cash inflows of $20,000 per year for the next three years. If the discount rate is 8%, what is the project's net present value (NPV), and what does it indicate about the project's viability?
Suppose a project requires an initial investment of $50,000 and is expected to generate cash inflows of $20,000 per year for the next three years. If the discount rate is 8%, what is the project's net present value (NPV), and what does it indicate about the project's viability?
A company can invest in one of two projects: Project A requires investing $1,000 today and returns $1,200 next year. Project B requires investing $1,000 today and returns $500 next year and $800 in two years. The company's cost of capital is 10%. Which project has a higher Net Present Value (NPV)?
A company can invest in one of two projects: Project A requires investing $1,000 today and returns $1,200 next year. Project B requires investing $1,000 today and returns $500 next year and $800 in two years. The company's cost of capital is 10%. Which project has a higher Net Present Value (NPV)?
Suppose a firm is considering changing its payment terms. Currently, the firm gets paid $1,000,000 at the end of the year. One potential modification is to get paid $500,000 today, and $500,000 at the end of the year. Assuming a discount rate of 10%, what is the value of this new arrangement?
Suppose a firm is considering changing its payment terms. Currently, the firm gets paid $1,000,000 at the end of the year. One potential modification is to get paid $500,000 today, and $500,000 at the end of the year. Assuming a discount rate of 10%, what is the value of this new arrangement?
Flashcards
Time value of money
Time value of money
Money is worth more now than in the future due to factors like preference for immediate consumption and inflation.
Inflation
Inflation
A general increase in prices, reducing the purchasing power of money.
Nominal interest rate
Nominal interest rate
The interest rate before taking inflation into account.
Real interest rate
Real interest rate
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Calculating Real Interest Rate (approx.)
Calculating Real Interest Rate (approx.)
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Study Notes
- Money possesses varying values across different time periods
- The present value of money is higher than its future value
Investments and Liabilities
- Companies fund investments by raising capital and incurring liabilities
- This includes borrowing from banks with a promise to repay with interest
Time Value of Money
- The value of a specific amount of money changes over time
- For example, €100 today is worth more than €100 a year from now
Reasons for Time Value
- People prefer immediate consumption over delayed consumption
- Inflation reduces purchasing power over time
- Present value is certain, while future cash inflow is less certain
Inflation
- Inflation describes a general increase in prices
- With a 5% annual inflation rate, goods costing $1.00 last year would cost $1.05 this year
- Inflation erodes the purchasing power of money
Real vs Nominal Interest Rate
- Depositing $1,000 at a 6% EAR results in $1,060 at year-end
- If inflation is also 6%, there is no real gain in purchasing power
- In this case, the nominal interest rate is 6%, but the real interest rate is zero
Calculating Real Interest Rate
- The formula for real interest rate: 1 + real interest rate = (1 + nominal interest rate) / (1 + inflation rate)
- Approximation when rates are near zero: real interest rate ≈ nominal interest rate − inflation rate
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