Chapter 4

CHAPTER 4 – TIME VALUE OF MONEY 1: ANALYZING SINGLE CASH FLOWS

Questions

LG1 1. List and describe the purpose of each part of a time line with an initial cash inflow and a future cash outflow. Which cash flows should be negative and which positive? Why?

The cash flow timeline is a visual depiction of inflows and outflows relative to the period under consideration. Cash flows are illustrated above the cash flow line with the corresponding periods that apply appearing under the cash flow diagram. Inflows are represented by positive numbers and outflows by negative numbers.

LG2 2. How are the present value and future value related?

The measure that relates present values to future values is the interest rate i. A present value can be moved forward in time with interest to arrive at the future value ( ). A future value can be discounted back to the present by rearranging the equation so that the FV is divided by the interest factor.

LG3 3. Would you prefer to have an investment earning 5 percent for 40 years or an investment earning 10 percent for 20 years? Explain.

Investments of $1 will grow to $7.04 in 40 years (= $1.0540) and $1 will grow to $6.73 in 20 years (= $1.1020). The 5 percent investment for 40 years is worth more. This example illustrates the importance of time in building wealth.

LG4 4. How are present values affected by changes in interest rates?

Interest rates have an inverse relationship to present values. Increases in expected interest rates result in lower present values because future values are discounted at a high rate to become smaller present values. Decreases in expected interest rates result in higher present values because future values are discounted at a lower rate.

LG5 5. What do you think about the following statement. “I am going to receive $100 two years from now and $200 three years from now, so I am getting a $300 future value.” How could the two cash flows be compared or combined?...