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Unformatted text preview: Chapter 04 - Introduction to Valuation: The Time Value of Money CHAPTER 4 INTRODUCTION TO VALUATION: THE TIME VALUE OF MONEY Answers to Concepts Review and Critical Thinking Questions 1. Compounding refers to the growth of a dollar amount through time via reinvestment of interest earned. It is also the process of determining the future value of an investment. Discounting is the process of determining the value today of an amount to be received in the future. 2. Future values grow (assuming a positive rate of return); present values shrink. 3. The future value rises (assuming a positive rate of return); the present value falls. 4. It depends. The large deposit will have a larger future value for some period, but after time, the smaller deposit with the larger interest rate will eventually become larger. The length of time for the smaller deposit to overtake the larger deposit depends on the amount deposited in each account and the interest rates. 5. It would appear to be both deceptive and unethical to run such an ad without a disclaimer or explanation. 6. Its a reflection of the time value of money. TMCC gets to use the $24,099. If TMCC uses it wisely, it will be worth more than $100,000 in thirty years. 7. This will probably make the security less desirable. TMCC will only repurchase the security prior to maturity if it to its advantage, i.e. interest rates decline. Given the drop in interest rates needed to make this viable for TMCC, it is unlikely the company will repurchase the security. This is an example of a call feature. Such features are discussed at length in a later chapter. 8. The key considerations would be: (1) Is the rate of return implicit in the offer attractive relative to other, similar risk investments? and (2) How risky is the investment; i.e., how certain are we that we will actually get the $100,000? Thus, our answer does depend on who is making the promise to repay. 9. The Treasury security would have a somewhat higher price because the Treasury is the strongest of all borrowers. 10. The price would be higher because, as time passes, the price of the security will tend to rise toward $100,000. This rise is just a reflection of the time value of money. As time passes, the time until receipt of the $100,000 grows shorter, and the present value rises. In 2018, the price will probably be higher for the same reason. We cannot be sure, however, because interest rates could be much higher, or TMCCs financial position could deteriorate. Either event would tend to depress the securitys price. 4-1 Solutions to Questions and Problems NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability constraints, when these intermediate steps are included in this solutions manual, rounding may appear to have occurred. However, the final answer for each problem is found without rounding during any step in the problem....
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