HW Set 2: Chapter 5 Concepts Review and Critical Thinking Questions
2. What is Compounding? What is Discounting?
Compounding is a method of gathering interest on an investment as time goes by so you can earn more interest later on. In other words, compounding interest earns interest on interest. If you let time pass as your money sits on an investment, you will be able to reinvest the interest from your payments. Earning interest on previous periods as well as when you first invest is called compound interest. Discounting is the opposite of compounding and by that, I mean instead of compounding the money for future value, we discount it back to the present value. Present value is what the money is currently valued at but discounted at a reasonable amount.
3. As you increase the length of time involved, what happens to future values, what happens to present values?
As you increase the length of time involved, the future values increase because of payments and interest. The longer the amount of time, the higher the future value. The present values will decrease because the of the interest.
4. What happens to a future value if you increase the rate r? what happens to a present value?
Future value increases based on an increase in the rate r which in turn, would decrease present value.
8. Would you be willing to pay $24,099 today in exchange for $100,000 in 30 years? What would be the key considerations in answering yes or no? would your answer depend on who is making the promise to repay?
Yes, I would be willing to pay $24,099 today in exchange for $100,000 in thirty years if I knew that the $100,000 would help me reach my goals and if the $24,099 is worth $100,000 at that point in the future. I also have to consider the time value of money, as discussed earlier in the chapter. It states that money today is worth more than the same amount in the future. The interest accumulated on the $24,099 quite possibly will be worth $100,000 or more. That being said, the rate of return would be one thing to consider when answering yes or no. There is also always a risk that comes with investing that much money. I would fully consider it based on the reasons listed above but it would be really hard for me to wait 30 years because that is basically half of my working career. The person promising to repay me would have to be very reliable.