Question

1. Which of the following securities present a better investment? Assume that the investment amount is flexible and you may choose to purchase more than one of each security. A. A security that costs you $1000/contract now and will give you $2800/contract back in 10 years B. An investment account that pays 10% annual interest 2. Edward took out a loan of $5,000 today at monthly interest rate of 1.25%. If he pays off this loan with one single payment in 5 years, what is the dollar amount of interest he needs to pay then? A. $5,536 B. $9,196 C. $10,536 D. $14,196 Short-answer question (2 questions, 0.5 points/question, total 1 points) 1. How would the present value of a single future sum change in response to each of the following changes: a) a higher interest rate is used b) the future amount is further into the future 2. What is the difference between compound interest and simple interest?

Answer 1

1 ) We know that Future Value (FV) = Present Value (PV) *(1+interest rate)^no of periods ------>(1)

or, 1000(1+r)^10 =2800    or, (1+r)^10 =2.8   or, (1+r) = 1.108449

or, r =0.108449   or, r = 10.8449%

Since in case A the interest rate is 10.8449% which is greater than 10% offered in case B . Case A presents a better investment.

2) As 1.25% is monthly interest rate hence for period of 5 years there will be 5*12 (60 periods)

Thus dollar amount of interest to be paid = 5000*(1+1.25%)^60 =$10536

II)

1 a)

We can write down equation 1 as PV = FV/(1+interest rate)^no.of periods

Thus for a given future value if interest rate increases then Present Value falls down.

b)

If future amount is further into the future then no of periods in the above equation will go up resulting into Present Value falling down.

2) Simple Interest is calculated on the basis of principal amount of a loan. Thus if interest rate remains constant simple interest also remains constant for a particular period of time. However Compound interest is based not only on principal amount but also on the interest that accumulates on it on every period.