Time Value of Money and Annuity

Business & Finance
Tutor: None Selected Time limit: 1 Day

  • create a personal scenario that exemplifies the time value of money that includes the opportunity cost involved.
  • Describe one (1) real-life example that shows the manner in which a person can use an annuity for retirement planning.
May 11th, 2015

A personal scenario: credit and opportunity cost

Suppose I want a car that costs $20,000. If I've borrowed the money at 5% interest per year, compounded annually, and I pay it back over 5 years, the amount I will have spent on the car is $25526 total.

My next best alternative is to save up for 5 years until I have enough money to buy the car outright. Let's say that inflation is approximately 2%. The $20,000 car I could have bought now will cost $22,081 in 5 years. So the opportunity cost of buying the car right away is about $25526 - 22081 = 3445. However, the opportunity cost of not buying the car is having the use of it for 5 years, plus whatever transportation expenses I incur.

A business scenario is: I am considering investing in a retail store that will require a $20,000 up-front investment. I want to keep the investment for about 5 years. Looking at statistics on stores like it, I think there is a 10% chance my investment will triple, a 20% chance my investment will double, a 30% chance I'll break even, and a 40% chance I'll lose the entire amount after 5 years.

In order to determine whether I should make the investment, I must calculate the expected return on investment.

(0.10 * $60000) + (0.20 * $40000) + (0.30 * $20000) + (0.40 * $0) = $20,000

The expected value is exactly the same as my investment. However, that doesn't mean I should make the investment. The other option is for me to put the money into a mutual fund which historically has returned 5% per year. After 5 years, I'd expect to have $25526. Therefore, investing in the mutual fund has a higher expected value over time.


Describe one (1) real-life example that shows the manner in which a person can use an annuity for retirement planning.
You can "fund" an annuity all at once - known as a single premium - or you can pay over time. With an immediate annuity (also called an income annuity), fixed payments begin as soon as the investment is made. If you invest in a deferred annuity, the principal you invest grows for a specific period of time until you begin taking withdrawals - typically during retirement.

May 11th, 2015

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May 11th, 2015
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