The Time Value of Money

Questions

1) What is the difference between an ordinary annuity and an annuity due?

ANSWER:  An ordinary annuity has the payments at the end of the period and an annuity due has

the payment due at the start of the period.

2) What does the amortization schedule tell you about a loan repayment?

ANSWER: An amortization schedule tells you the amount of each payment that is applied against the interest expense, the amount applied against the principal and the principal balance after the payment at each scheduled payment.

3) If you increase the number of payments on an amortized loan, does the payment

increase or decrease? Why or why not?

ANSWER: Increasing the number of payments (all else held constant) decreases the size of each

payment. Reverse logic provides the rationale for the answer. If the payment was

increased with the same interest payment, the loan would be paid off sooner with the

higher payments. Therefore in creasing the time to pay off the loan means the payments

have been lowered. As the amount applied to the interest is the same but the amount

applied to the principal is lower so it takes more payments to eliminate the principal.

4) If you increase the interest rate on an amortized loan, does the payment increase or decrease? Why or why not?

ANSWER: The payment increases with a rise in interest rates all else held constant. The reason is

that more of the payment is applied to the interest and so to reduce the principal at the same pace as before a higher payment is needed.

5) If you won the lottery and had the choice of the lumpsum payoff or the annuity payoff, what factors would you consider besides the implied interest rate (indifference interest rate) in selec ting the payoff style?

ANSWER:  Factors such as your current wealth or debts could influence your decision. If you have a large amount of debt and want to be debt free you might elect the lump sum option. If you are terrible at budgeting money and know you would pr obably squander the money you might elect a slower payment method, i.e. the annuity. If you wanted to be philanthropic you might want to take the lump sum to give more money away to important causes. These are just a few of the potential non financial impacts that could influence your decision on the payout style.