Time Value of Money, Opportunity Cost, and Income Taxes Worksheet
Scenario 1: Time Value of Money / Cash Management Products
1. Use this Bankrate’s Simple Savings calculator to complete Scenario 1: http://www.bankrate.com/calculators/savings/simple-savings-calculator.aspx. You will enter the Initial Amount of Savings (Present Value), Annual Interest Rate (Rate of Return), and Number of Periods/Years into the calculator. The calculator will compute the Future Values.
In this scenario, you will look at the impact of interest rates on your savings. Suppose that you have $2,000 of savings. You don’t anticipate needing to dip into these funds in the next five years. Based on the information provided in the table, calculate the future value (FV) of $2,000 at the end of years 1 and 5 if it were to be completely invested in each of the different cash management products.
Enter your answers in the indicated cells of the table below. The Restrictions/Fees on Product Usage column relates to question 2 of Scenario 1.
Product
Annual Interest Rate
Restrictions/Fees on Product Usage
FV at end of Year 1
FV at end of Year 5
Checking Account
0.00%
No minimum
No limit on withdrawals
Answer: $2,000
Inputs:
Interest Rate per Time Period: 0% per year
Number of Time Periods: 1 Years
Present Value: $2,000
Answer: $2,000
Inputs:
Interest Rate per Time Period: 0% per year
Number of Time Periods: 5
Present Value: $2,000
Savings Account
1.50%
No minimum
Limited to 3 withdrawals per month
Answer: $2,030.21
Inputs:
Interest Rate per Time Period: 1.5% per year
Number of Time Periods: 1
Present Value: $2,030.21
Answer: $
Inputs:
Interest Rate per Time Period: 1.5% per year
Number of Time Periods: 5
Present Value: $2,155.67
Certificate of Deposit (CD)
5%
$500 minimum balance
Early withdrawal penalty: 180 days of interest plus $25
Answer: $2,100
Inputs:
Interest Rate per Time Period: 5% per year
Number of Time Periods: 1
Present Value: $2,100
Answer: $2,552.56
Inputs:
Interest Rate per Time Period: 5% per year
Number of Time Periods: 5
Present Value: $2,552.56
2. Based on your calculations and on all you have learned this week, how would you choose to save your $2,000? Consider things such as rate of return, inflation, taxes, liquidity, safety, restrictions, and fees, and explain the rationale for your decision. Respond in at least 50 words.
The rationale for selecting a savings strategy would depend primarily on the rate of return since I do not anticipate dipping into the funds for the next five years. Therefore, even with the restrictions placed on the Certificate of Deposit (CD) account, this account provides maximum returns on my investment while also imposing limits that reduce my willingness to withdraw funds before the set time.
Scenario 2: Time Value of Money / Compounding Interest
3. Use this Bankrate’s Simple Savings calculator to complete Scenario 2: http://www.bankrate.com/calculators/savings/simple-savings-calculator.aspx. You will enter the Initial Amount of Savings (Present Value), Annual Interest Rate (Rate of Return), Interest Compounded, and Number of Periods/Years into the calculator. The calculator will compute the Future Values.
In this scenario you will start with a big deposit and see how interest, compounding, and time will change the balance over time. Suppose that you inherit $10,000 from your late uncle. You save this money and do not deposit any more money to the account. Determine how much money you would have at the end of each of the periods for each of the scenarios in the table below, assuming that you don’t make any withdrawals from the account over the period.
Enter your answers in the indicated cells of the table below:
Annual Interest Rate
Interest Compounded
FV at the end of Year 5
FV at the end of Year 10
FV at the end of Year 30
2.00%
Annually
Answer:
$11,040.81
Answer:
$12,189.94
Answer:
$18,133.62
2.00%
Quarterly
Answer:
$11,048.96
Answer:
$12,207.94
Answer:
$18,193.97
8.00%
Annually
Answer:
$14,693.28
Answer:
$21,589.25
Answer:
$100,626.57
8.00%
Quarterly
Answer:
$14,859.47
Answer:
$22,080.40
Answer:
$107,651.63
4. Based on your calculations above, explain in your own words the impact of compounding interest.
Compounding interest adds the interest to the deposit and then considers this cumulative amount as the deposit on which to calculate the next interest payment.
Scenario 3: Cost of Credit / Opportunity Cost / Trade-Offs
5. In this scenario
you will calculate the monthly payment and total interest paid on a car loan. Suppose that you need $15,000 to buy a used vehicle to get back and forth to work and school. You have $7,500 in a money market fund earning 1.00% per year, but you are not sure you want to use any or all of that money.
Using the tables in Exhibit 1-D, located on pp. 42-43 in the Ch. 1 Appendix of Focus on Personal Finance, determine the total amount of payment due at the end of each year, and divide by 12 to estimate the monthly payment for each of the following loan scenarios. Also, calculate the total amount of interest you would pay over the life of each loan. Be sure to show your work for opportunities to earn partial credit, where applicable.
For example, if you have the correct formula but put a decimal in the wrong spot you could earn partial credit. The first row in the table has been completed to demonstrate you how work can be shown.
Loan Amount
Interest Rate
Term
Monthly Loan Payment = Amount Borrowed divided by “Table Factor in Exhibit 1-D” divided by 12
Total Amount of Interest = (Monthly Loan Payment * Term * 12) - Loan Amount
$7,500
6%
3 years
Example:
7500/2.673=2,805.84
2,805.84/12= 233.82
Example:
(233.82*3*12) - 7,500= 917.52
$7,500
6%
5 years
7,500/4.212=1,780.63
1,780.63/12=148.39
(148.39*5*12) - 7,500= 1,403.4
$10,000
6%
5 years
10,000/4.212=2,374.17
2,374.17/12=197.85
(197.85*5*12) – 10,000=1,871
$15,000
6%
5 years
15,000/4.212=3,561.25
3,561.25/12=296.77
(296.77*5*12) – 15,000=2,806.2
6. Based on the above calculations, the price of the car, and the money available in a money market fund, which loan option would you suggest to someone purchasing a vehicle? Please explain the rationale and considerations for your decision.
For someone looking for a car loan, I would recommend the $7,500 5-year loan due to the minimal amount of interest payable for this loan. This is because when compared to the amount of interest for the other loans, this option requires minimal monthly payments and accrues to the second lowest interest rate charge.
7. In your own words, how would you summarize “opportunity cost”? How does the concept of opportunity cost apply to this decision? Explain in a brief paragraph.
Opportunity cost represents the loss of alternatives that one incurs when selecting one of the available options. The concept applies in this case since selecting one of the loan options also means foregoing any of the others as well as the potential benefits and pitfalls associated with each of these options.
Income Taxes
Each year you will need to file a federal income tax return by April 15th. While you may use software or a tax preparation professional to help you complete your return, there are still some terms of which you should have a basic understanding. Respond to the following to demonstrate your understanding. Each response should be at least 50 words.
8. Explain the differences between taxable income and adjusted gross income.
Adjusted gross income refers to the total gross income that an individual gets when specific deductions are made on the income. On the other hand, taxable income is the amount left after allowances such as itemized deductions and other personal exemptions, with adjusted gross income having greater relevance than gross income for these calculations.
9. In your own words, define tax deduction, exemption, and tax credit.
A tax deductions occur when an individual’s tax is lowered to compensate for specific expenses that the person incurs as a taxpayer. On the other hand, tax exemptions refer to the tax relief that a person gets for having dependents such as spouses and children. Tax credits describe the amount that is directly excluded from a person’s tax liability after making all other deductions.
