Week 6 Homework

1. What term does the textbook use to describe the value of an investment after one or more

periods?

Solution: The textbook uses the term "Future Value" to describe the Value of an investment

after one or more periods. It represents the expected worth of an investment at a specified future

date, considering the initial investment amount, periodic contributions or withdrawals, and the

expected rate of return. Future Value serves as a critical concept in financial planning and

investment analysis, helping individuals assess the growth potential of their investments over

time.

2. What term does the textbook use to describe the amount a future cash flow is worth today?

Solution: The textbook uses the term "Present Value" to describe the amount a future cash flow

is worth today. Present Value represents the current monetary worth of a future sum of money,

discounted to reflect its current Value, accounting for factors such as the time value of money

and the expected rate of return. It is a fundamental concept in finance and investment analysis,

enabling individuals to evaluate the attractiveness of investment opportunities, assess the cost-

effectiveness of projects, and make informed decisions regarding resource allocation and

financial planning. Present Value calculations help individuals determine the current worth of

future cash flows, aiding in decision-making processes.

3. What term does the textbook use to describe a graphical representation showing the size and

timing of cash flows through time.

Solution: The textbook uses the term "Cash Flow Timeline" to describe a graphical

representation showing the size and timing of cash flows through time. A Cash Flow Timeline

typically consists of a horizontal axis representing periods, such as years or months, and a
vertical axis representing the magnitude of cash flows. It visually depicts the timing and amount

of cash inflows and outflows associated with a particular financial investment or project. Cash

Flow Timelines are essential tools in financial analysis, enabling individuals to visualize and

understand the cash flow dynamics of an investment over its lifespan, aiding in decision-making

and financial planning processes.

4. What is the rule of 72?

Solution: The rule of 72 is a simple mathematical formula used to estimate the time it takes for

an investment to double in value, given a fixed annual rate of return. It states that by dividing 72

by the annual rate of return (expressed as a percentage), one can approximate the number of

years required for the investment to double. For example, if an investment has an annual return

rate of 8%, applying the rule of 72 suggests that it would take approximately 9 years (72 divided

by 8) for the investment to double in value. The rule serves as a quick and handy tool for

assessing the growth potential of investments.

5. According to the lecture, when we hear people speak of the time value of money, what are

they really saying?

Solution:

When people speak of the time value of money, they are referring to the concept that a dollar

today is worth more than a dollar in the future due to its potential earning capacity. Essentially,

it recognizes that money has a time-based value, and the timing of cash flows matters in

financial decision-making. This principle acknowledges the opportunity cost associated with

money over time, emphasizing the importance of factors like interest rates, inflation, and the
risk associated with investments. Understanding the time value of money enables individuals

and businesses to make informed decisions regarding investments, loans, and financial planning

strategies.

6. According to the textbook, Albert Einstein is supposed to have identified the most powerful

force in the universe as what?

Solution: According to the textbook, Albert Einstein is reputed to have identified compound

interest as the most potent force in the universe. This statement underscores the profound impact

of compounding on financial growth over time. Compound interest allows investments to grow

exponentially by earning interest on both the initial principal and the accumulated interest. As

time progresses, the effect of compounding becomes increasingly significant, leading to

substantial wealth accumulation. Einstein's recognition of compound interest as a formidable

force highlights its transformative potential in financial planning and underscores the importance

of harnessing it to achieve long-term financial goals.

7. Explain how compounding can create wealth over time.

Solution: Compounding is a powerful wealth-building concept that involves earning returns not

just on the initial investment but also on the accumulated interest or returns. Over time,

reinvesting earnings generates additional income, accelerating wealth accumulation. The

compounding effect snowballs as the investment grows, leading to exponential growth over time.

Even modest returns can yield significant wealth when compounded over long periods due to the

principle of exponential growth. By allowing investments to grow organically and exponentially,

compounding enables individuals to build substantial wealth over time and achieve their

financial objectives.

8. What is an amortization schedule?

Solution: An amortization schedule is a detailed table that outlines the repayment of a loan over

time. It breaks down each periodic payment into its principal and interest components, showing

how much of each payment goes towards reducing the loan balance (principal) and how much is

attributed to interest charges. The schedule typically spans the entire loan term, providing a clear

overview of the loan's repayment progression. Amortization schedules are commonly used for

mortgages, car loans, and other installment loans, helping borrowers understand their repayment

obligations and track the reduction of their debt over time.

Calculations

9. What is the present value of $100,000 to be received in 15 years? Your required rate of return

is 9% per year.

Solution:

To calculate the present value of $100,000 to be received in 15 years with a required rate of

return of 9% per year, we use the present value formula:

PV= FV/ (1+r)n

Where:

 PV = Present Value

 FV = Future Value ($100,000)

 r = Required Rate of Return (9% or 0.09)

 n = Number of periods (15 years)

Substituting the values into the formula:

PV= 100,000/ (1+0.09)15

PV= 100,000/ (1.09)15

Using a calculator:

PV= 100,000/(2.367)]

PV≈42317.076

Therefore, the present value of $100,000 to be received in 15 years with a required rate of return

of 9% per year is approximately $42,317.08.

10. If you buy a 3 year 4% Certificate of Deposit (CD) for 25,000, how much is it worth at

maturity?

Solution:

The Certificate of Deposit (CD) we purchase for $25,000 at a 4% interest rate compounded

annually will be worth approximately $28,121.60 at maturity after 3 years.

11. Given the same information in #10, what is the total interest paid on the CD at maturity?

Solution:

To find the total interest paid on the Certificate of Deposit (CD) at maturity, we need to subtract

the principal amount (the initial investment) from the total amount accumulated at maturity.

We've already calculated that the total amount accumulated (A) at maturity is approximately

$28,121.60.

The principal amount (P) is $25,000.

So, the total interest paid (I) can be calculated as:

I=A−P

I=28,121.60−25,000

I≈3,121.60

Therefore, the total interest paid on the CD at maturity is approximately $3,121.60.

12. If you invest $1,000 a year for 20 years at 6% annual interest, how much will you have at

the end of the 20th year?

Solution:

If we invest $1,000 a year for 20 years at an annual interest rate of 6%, we will have

approximately $36,785.59 at the end of the 20th year.

13. How many years will it take to double your investment of $20,000 at an interest rate of 9%

Solution:

It will take approximately 8 years to double your investment of $20,000 at an annual interest rate

of 9%.

14. If you make a $5,000 investment in stock today, and hold the investment for 10 years and

decide to sell the entire investment, how much money (before tax) will you receive. Interest

earned on this investment has been 8% per year.

Solution:

After holding a $5,000 investment for 10 years at an annual interest rate of 8%, we will receive

approximately $10,794.62 before tax when we decide to sell the entire investment.

15. What is the annual interest rate required for 40,000 to grow into 80,000 in 15 years?

Solution:

The annual interest rate required for an initial investment of $40,000 to grow to $80,000 in 15

years is approximately 4.73%.