1
Time Value of Money
(More Fun Applications)
1.
First City Bank pays 4% simple interest on its savings account balances.
Second City
Bank pays 4% interest, compounded quarterly.
If you deposit $10,000 in each account,
how much will you have in each after 10 years?
First City Bank – simple interest
$10,000 x .04 = $400 interest per year.
Interest is paid only on the original amount
deposited, so over 10 years the interest earned is $400 per year times 10 years =
$4,000.
After 10 years you have $10,000 deposit + $4,000 interest = $14,000.
Second City Bank – compound interest, with quarterly compounding
P/Y = 4 for quarterly compounding
I = 4
N = 40
PV = -10,000
Solve:
FV = $14,888.64
Or, try this – you earn 4% per year, or 1% per quarter.
So you would have:
10,000 (1.01)(1.01)(1.01)
(do this 40 times)
or
10,000 (1.01)
40
= $14,888.64
2.
Near the end of 2005, baseball player A. J. Burnett signed what was reported to be a
$55 million contract with the Toronto Blue Jays.
It consisted of a $6 million signing
bonus, a $1 million salary for 2006, and a $12 million salary for years 2007 through
2010.
Did he really get $55 million?
Estimate the value of his contract.
Since the
payoffs are not considered high risk, use a discount rate of 5 percent.
Timeline:
0
6,000,000
1
1,000,000
2
12,000,000
3
12,000,000
4
12,000,000
5
12,000,000