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Name:

FISV 2010 Finance

Spring Term 2014

Exam 3- Due as hard-copy in class Thursday May 1, 2014

Instructions

  1. Please type answers into this word document
  2. You may use your textbook to answer these questions.
  3. You may not collaborate/co-author with another student or any other individual to write answers for this exam.This assignment is for a grade and must be the student’s individual work. Evidence of collaboration/co-authoring will be considered ‘cheating’. Please consult my syllabus for consequences of cheating.
  4. NO LATE ASSIGNMENTS WILL BE ACCEPTED. This exam will be collected at the start of class with calling the roster. In cases of extreme emergency, students who must be absent must email me prior to 3:00 pm on the due date to receive permission to email the assignment prior to 3:50 pm May 1, 2014 when it is due. I will not accept emailed submissions that do not have my approval or that arrive after the due date/time.
  1. Explain the phrase “a dollar today is worth more than a dollar tomorrow.”

The implication is that if one was to receive a dollar today instead of in the future the dollar could be invested and will be worth more than a dollar tomorrow because of the interest earned during that one day. This makes it more valuable than receiving a dollar tomorrow.

  1. Explain the importance of a timeline.

Time lines are important tools used to analyze investments that involve cash flow

streams over a period of time. They are horizontal lines that start at time zero (today) and show cash flows as they occur over time. Because of time value of money it is crucial to keep track of not only the size, but also the timing of the cash flows.

  1. What are the two factors to be considered in time value of money?

The factors that are critical in time value of money are the size of the cash flows and the timing of the cash flows.

  1. Differentiate future value from present value.

Future value measures what one or more cash flows are worth at the end of a specified period while present value measures what one or more cash flows that are to be received in the future will be worth today (at t = 0).

  1. Differentiate between compounding and discounting.

The process of converting an amount given at the present time into a future value is called compounding. It is the process of earning interest over time. Discoun--ting is

the process of converting future cash flows to what its present value is. In other words present value is the current value of the future cash flows that are discounted at an appropriate interest rate.

  1. Explain how compound interest differs from simple interest.

Suppose I invest $100 for three years at a rate of 10 percent. Simple interest would imply that I will earn $10 for each of the three years for a total of $30 interest. At the end of three years I would have $130. Compound interest recognizes that the interest earned in years 1 and 2 will also earn interest over the remaining period. Thus the $10 earned in the first year would earn interest at 10 percent for the next two years, and the $10 earned in the second year would earn interest for the third year. Thus the total amount that I would have at the end of three years would be: . By compounding, I have earned an additional interest of $3.10. The total interest or compound interest is the $33.10 earned on the $100 invested, while the simple interest earned is equal to $30.

  1. If you were given a choice of investing in an account that paid quarterly interest and one that paid monthly interest, which one should you choose if they both offer the same stated interest rate and why?

The impact of compounding really dictates that one should pick the account that pays interest more frequently (as long as the interest rates are the same). This allows for the interest earned in the earlier periods to earn interest and the investment to grow more.

  1. Compound growth rates are exponential over time. Explain.

Growth rates, as well as interest rates, are not linear, but rather exponential over time. In other words, the growth rate of the invested funds is accelerated by the compounding of interest. Over time, the principal amount you receive interest on will get larger with compounding, thus generating higher interest payments.

  1. What is the rule of 72?

This is a rule of thumb to determine how fast an investment can double. It is a rule that allows you to closely approximate the time that it would take to double yourmoney. It works well with interest rates between 5 and 20 percent but varies more with higher rates. The Rule of 72 says that the time to double your money (TDM) approxi--mately equals 72/i, where i is expressed as a percentage.

  1. You are planning to take a spring break trip to Cancun your senior year. The trip is exactly two years away, but you want to be prepared and have enough money when the time comes. Explain how you would determine the amount of money you will have to save in order to pay for the trip.

First, determine how much money you will need for the trip. Second, check how much you already have and how it translates into future value cash how much it will be worth in two years. Next, determine how much you will have to deposit today, given the bank's offered interest rate, to ensure that you will have saved up the difference when the time for your senior spring break comes.