Author Question: Compare and contrast the discount rate with the compound (or growth) rate. What will be an ideal ... (Read 45 times)

kellyjaisingh · **on:** Jul 10, 2018

Compare and contrast the discount rate with the compound (or growth) rate.

What will be an ideal response?

Question 2

Harold's parents have offered him a 10,000 high school graduation gift with an option for another 20,000 upon graduation from college in four years.

His friends tell him this is a 30,000 gift from his parents, but Harold already knows something about the time value of money. If the expected inflation rate over the next four years is expected to be 4 per year, what does Harold think the gift is worth in today's dollars? How should he explain his thinking to his friends?
What will be an ideal response?

duy1981999 · **Reply #1 on:** Jul 10, 2018

Answer to Question 1

Answer: These rates are actually the same value in the TVM equation, but they take on different names when used for different purposes. In the equation FV = PV (1 + r)n, the r is referred to as the growth rate or compound rate because it represents the rate at which the initial PV is growing to the future value. In the equation PV = FV , the r represents the discount rate or the rate at which the FV is reduced to represent the current or present value.

Answer to Question 2

Answer: First, Harold must calculate the PV of his gifts. He calculates a value equal to 10,000 + = 27,096.08. Harold should explain to his friends that a dollar today has a different value than a dollar in the future due to opportunities and purchasing power. The promise of 20,000 in four years, while generous, is worth less than 20,000 today because you must forego consumption for a period of time. When you are able to use the money in the future, goods will cost more than they do now. Thus, you will be able to consume fewer goods. In addition, if you had the money now you would have the opportunity to invest it, so that in four years the value could exceed 20,000.