Question

1. You were promised a payment of $400 for each of the next four years to be received at the end of the year. What is the fair value of these payments if the interest rate is 6%?

2. Which of the following is a reason why a dollar today is worth more than a dollar two years from now?

a) A dollar today can be put in the bank and charged interest.

b) Individual people generally value

c) consumption today more than consumption two years from now.

c) both a) and b) are correct.

d) neither a) nor b) are correct.

Answer 1

Answer(1):

PV of Annuity = P [ 1- (1+r) ^-n] / r

P= periodic payments, r = rate per period, n = number of periods

P = $400, n = 4, r = 6%

Putting the above values in the formula, we get:

PV of annuity = 400 [1-(1+.06) ^-4] / .06

PV of annuity = $1386.04

Answer(2): a) A dollar today can be put in the bank and charged interest.

Time value of money is that dollar today is worth more than dollar after 2 years or so. If money is put today into the bank, bank will give interest and money will increase its value. Dollar loses its value (purchasing power) as the time passes