Assignment 2 257

TIME VALUE OF MONEY

JeffWarren is an entrepreneur with a great idea of developing a newcomputer software product that will help users communicate using thenext-generation magnet. After consulting with some PhD students and hisFinancial Advisor, Jeff decided to register his software company as Scorporation, which is a special designation that allows small businessesto be taxed as if they were a sole proprietorship or a partnershiprather than as a corporation whilst at the same time enjoying limitedliability of a corporation. Jeff is satisfied with this choice becausehe is aware that one of the disadvantages of a corporation is the doubletaxation of corporate earnings.

Jeffis determined to make sure his business succeeds and has a long-termplan of expanding his business to some emerging countries. He has beenreading some articles in finance journals about time value of money andhow he can apply the concept to manage his finances and expansionplans. The time value of money holds that it is better to receive moneysooner than later. Money that is available today is worth more thanmoney to be received in the future. This is so because money in handtoday can be invested to earn a positive rate of return, therebyproducing more money tomorrow. On his google search he came across thisarticle:

Schmidt,C. E. (2016). A journey through time: From the present value to thefuture value and back or: retirement planning: A comprehensibleapplication of time value of money concept. American Journal of Business Education, 9(3), 137 – 143.

Thearticle discusses a contemporary financial planning problem ofcorrectly solving time value of money problems and identifying the cashflows and timing necessary for financial and investment decisions.Schmidt (2016) explains with practical examples the applications of theconcept of time value of money to retirement planning, valuing stocksand bonds, setting up loan amortization schedules, and making capitalbudgeting decisions. Jeff does not fully understand some of the financeterms such as future value of compounding, present value anddiscounting, perpetuity and annuities etc. that the article discussed.He believes that once he grasps these time value of money concepts, hewill be able to make sound financial and investment decisions. His majorconcern is that these concepts require application of some basicquantitative techniques which he tried to avoid at the graduate schooltwo years ago.

Jeff has approached you for help in answering the following questions:

a.Suppose Jeff has $85,000 to invest in an IRA at an interest rate of 10%per year for his retirement in 10 years. How much money can heaccumulate at the end of the time period?

b.Jeff wants to send his daughter to college in 18 years. He has assumedthat he would need $100,000 at the time in order to pay for her tuition,room and board, school supplies etc. If he can earn an average of 8%per year, how much money does he need to invest today as a lump sum toachieve that goal?

c.Jeff wants to move $50,000 from his checking accounts and invests it inmoney market securities for 3 years. The money market earns 7% interestcompounded annually. How much can this investment grow at the end ofthe investment period?

d.Jeff wants to find the present value of the following uneven cash flowshe expects to receive in the next 3 years from his business.

Year

Cash Flows

1

$25,000

2

$20,000

3

$15,000

What is the present value of the cash flows assuming the discount rate is 7%?

e.Jeff wants to invest in preferred stocks issued by Camden Company. Thecompany paid $3 dividend per share on its stock last year. The dividendis expected to grow at a constant rate of 10% per year indefinitely. IfJeff requires a rate of return of 15% on the stock, what is the(estimated) current price of Camden stock?

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