Investment and Opportunity Cost
Question
Chapter 4
(4-2)What is an opportunity cost rate? How is this rate used in discounted cash flow analysis, and where is it shown on a time line? Is this opportunity rate a single number that is used to evaluate all potential investment?
The rate of return you would earn on an alternative investment of small risk if you don’t invest in the security under consideration.
An opportunity cost is the difference in return between an investment that has chosen for investment and one that is inevitably gave up. For example, if a person invests in equity and get 3% return over a period of time then by investing his/her money on stock that person gave up the opportunity of another investment.
Opportunity cost rate is used as an interest rate (discounting factor) to calculate present value of future cash flow. To compute present value, future value is divided by (1 + r) in each year. Therefore, in time line opportunity cost is shown in between two cash flows.
No the opportunity cost is not the single number that is used in all situation. As per the risk associated with investment the alternatives as well as opportunity cost will be different.
(4-4) If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain?
FV=PV(1+I)n
N=10 PV=$1 FV=$2 I=7%
The above statement is true because annual growth rate is 7%
(4-5) Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain?
I would rather have a saving account that pays 5% interest compounded daily than compounded semiannually because effective rate of semiannual interest rate is 5.063% while effective rate of daily compounding is 5.13%.
Interest compounded semiannually
= (1+ I )n - 1
= (1 + 0.05/2)2 - 1
= 5.063%
Interest compounded daily
= (1+ I )n - 1
= (1 + 0.05/365)365 - 1
= 5.13%
Problems
Chapter 4
(4-2)What is an opportunity cost rate? How is this rate used in discounted cash flow analysis, and where is it shown on a time line? Is this opportunity rate a single number that is used to evaluate all potential investment?
The rate of return you would earn on an alternative investment of small risk if you don’t invest in the security under consideration.
An opportunity cost is the difference in return between an investment that has chosen for investment and one that is inevitably gave up. For example, if a person invests in equity and get 3% return over a period of time then by investing his/her money on stock that person gave up the opportunity of another investment.
Opportunity cost rate is used as an interest rate (discounting factor) to calculate present value of future cash flow. To compute present value, future value is divided by (1 + r) in each year. Therefore, in time line opportunity cost is shown in between two cash flows.
No the opportunity cost is not the single number that is used in all situation. As per the risk associated with investment the alternatives as well as opportunity cost will be different.
(4-4) If a firm’s earnings per share grew from $1 to $2 over a 10-year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain?
FV=PV(1+I)n
N=10 PV=$1 FV=$2 I=7%
The above statement is true because annual growth rate is 7%
(4-5) Would you rather have a savings account that pays 5% interest compounded semiannually or one that pays 5% interest compounded daily? Explain?
I would rather have a saving account that pays 5% interest compounded daily than compounded semiannually because effective rate of semiannual interest rate is 5.063% while effective rate of daily compounding is 5.13%.
Interest compounded semiannually
= (1+ I )n - 1
= (1 + 0.05/2)2 - 1
= 5.063%
Interest compounded daily
= (1+ I )n - 1
= (1 + 0.05/365)365 - 1
= 5.13%
Problems