Different Types of TVOM

Practice

To solve each problem follow these steps:

  1. Create a time line
  2. Identify type of cash flows and
  3. Identify the appropriate equation needed to solve a problem.

Note: The solution to each problem is given.

Practice Question 1:

Tyler won a lottery. The commission asked him to choose between $10,000 today and $20,000 three years from today. Which option should Tyler take if his investment opportunity is 10% annually compounding?

Solution:

$10,000 is today's value while $20,000 is the value three years from today. In order to choose between these two options, you need to convert $20,000 to be today's value so that it can be compared to $10,000.

Step 1- Create a Timeline:

Timeline labeled with r equals 10%, P V equals question mark at zero and 20,000 at 3.

Step 2- Identify the type of cash flow: Since $20,000 is only one cash flow amount on the time line, the type of cash flow is lump sum.

Step 3- Select the appropriate equation: We can also see that the present value of $20,000 is needed. The equation for the problem is present value of lump sum:

P V equals numerator F V denominator left parens 1 plus r right parens sup t base

Step 4- Enter the variables in the equation and solve: FV = $20,000 (value at the end); r = 10% (investment opportunity); t = 3 (compounding periods)

P V equals numerator 20000 denominator left parens 1 point 1 right parens sup 3 base