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Assumptions of the TVM Model (graded)

I really enjoy class Discussions and think they are a great way to learn the material in our courses. But one thing that kind of bothers me is that we all start off with the same discussion prompt. So even a question like What is the meaning of life? can get kind of boring after we’ve read thirty answers to the question. That’s even true if all the answers are great.

What I am going to try to do in our Discussion is add some options. If you see one of my posts labeled OPTION, that’s the signal that we can start a new discussion thread there. You should choose one or more of the options to post to. You don’t have to post in all of them. In fact, you don’t even need to read all of them. However, some of the options may be related to questions on the final exam, so….

Please place your posts as a response either to my OPTION post or to one of the posts in the response chain below it. Also, you are able to change the subject line, so please do so as appropriate.

Collapse Mark as Read OPTION: Assumptions behind the TVM model. Professor Author 10/31/2015 7:58:34 AM

What are some of the assumptions behind the TVM calculations? How do these assumptions limit our application of these calculations? Some of the assumptions are discussed beginning on about page 98 of the text. There are also other assumptions.

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Emily Email this Author 11/3/2015 7:43:02 AM

Some of the assumptions are that the value of a dollar stays the same throughout all periods, so if you gain 10% interest on your 401k for 10 years, that tenth year is not worth the same 10% as the first year. Another one is benefits down the road are already known by calculations.

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(an instructor response)

Collapse Mark as Read Some of the assumptions are that the value of a dollar stays the same throughout all periods Professor mail this Author 11/3/2015 8:33:41 AM

Emily,

Things are bringing in that assumption. That is one of the assumptions of the TVM model, but I'm not quite sure about the explanation. Could you expand on that, or could someone help Emily out with the explanation?

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Maxwell Email this Author 11/3/2015 11:27:48 AM

There are several assumptions behind TVM calculations. One assumption is that cash flow over the period under evaluation will offset the inflation impact and real value will remain same. And another assumption is that cash flow can be estimated with reasonable accuracy and certainty. Please keep in mind that the future is always uncertain and nobody can predict the future accordingly some assumption has to be made in the analysis of project and in spite of these assumption TVM is considered to the best and reliable technique to analyze any project.

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Stephen 11/3/2015 12:34:51 PM

One of the most unpredictable assumptions of the TVM is that the money and interest rate will remain the same over the given period of time. Many loans and investments use floating rates or rates set to prime at a given point. As the prime rate fluctuates up and down it would change the return on investment which would also change the present and future values of the investment in real time.

Beyond this, the model makes the it equates all of the cash flows to the same interest rate. In the real world you may have to evaluate many different projects, with different levels of investment, different interest and ending rates. The only way you can bring them to a point of equilibrium is finding their present value in relationship to the present expenditure needed. With that information you can look and see which has the more positive net present value percentage and go with that.

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Joe 11/3/2015 4:01:18 PM

Assumptions are the values must be compared at the same point in time. Another assumption is that compounding must be used in order to move a cash flow forward ( Berk 99). Additionally, the time periods must be of equal duration and the interest rate must be constant.

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Suzanne 11/3/2015 6:59:42 PM

TVM is based on the concept that a dollar that you have today is worth more than the promise that you will receive a dollar in the future. Money that you hold today is worth more because you can invest it and earn interest. After all, you should receive some compensation for not spending all your money. For instance, you can invest your dollar for one year at a 6% annual interest rate and accumulate $1.06 at the end of the year. You can say that the future value of the dollar is $1.06 given a 6% interest rate and a one-year period. It follows that the present value of the $1.06 you expect to receive in one year is only $1.

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Collapse Mark as Read RE: OPTION: Assumptions behind the TVM model. Bozic r 11/3/2015 8:48:06 PM

Important assumption are that interest rates are equal through the term and short term interest rates are equal to long term interest rates and this is not realistic.

Also in many examples we start with the assumption that risk free interest rate will be constant for a given period of time which is almost impossible to predict for any longer time period.

In order for cash flow calculations to be meaningful, discounting and/or compound interest calculations have to be performed first since dollar today and dollar tomorrow should not be directly compared. TVM analysis is not neceserly considering cash flow calculations.

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Collapse Mark as Read OPTION: I need some investment advice. Professor 10/31/2015 7:59:18 AM

This discussion brings to mind an investment decision I've been thinking about. There are some bonds of a major American corporation that have a YTM of 5%. These bonds have a maturity of way beyond any point where I might reasonably expect to survive. Despite the fact that my wife thinks she will live forever, she will probably depart Earth at about the same time I do. We do not have any children. A five percent yield on anything right now is pretty good. Don't worry too much about yield to maturity (YTM). We will learn all about that in a few weeks. For now, just think of it as the i in a TVM calculation.

Anyway, I have been thinking about buying enough for these bonds that the 5% YTM would provide sufficient income for me to live on in my retirement. My plan would be to use these as a backstop to keep me off the street in case the stock market went to pot or something. But I have some nagging concerns.

One concern is what would happen to my income if the current ridiculously low market interest rates jumped up to 10 or 12% or even more, like in the 1970s? This does not seem unreasonable to me given that our government is spending money like a drunken sailor. (I mean no offense to any of you who are drunks or sailors.)

How would an increase in interest rates affect my plan? Or would it affect me at all?

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Collapse Mark as Read RE: OPTION: I need some investment advice. Chris 11/3/2015 6:14:30 PM

Modified:11/3/2015 6:31 PM

First, even drunken sailors know when they have run out of money; however, our government does not. I remember as a kid getting 6% on my savings account in the 80's and still hanging on for the good old days to come back, but luckily I didn't have a mortgage rate in the teens back then either. When I think of your problem as a TVM calculation your 5% bond will keep you locked in for x amount of years or months. So lets say you lock in at 5% for 7 years you are stuck at that rate for term of the bond, dramatically affecting your FV if the rates jump up to 10%. An investment in TVM terms of $5000 at 5% for 7 years would result in $7035.50. Now if you had the courage to hold out for 10% interest rate and invested $5000 for 7 years you would have $9743.58 more than doubling the interest you would have made. Now I can only hope you weren't thinking about a perpetual bond.

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Collapse Mark as Read RE:OPTION: I need some investment advice. Rosalie 11/3/2015 8:05:59 PM

When it comes to bonds, the only thing that changes with the rise and fall of interest rates is the market price. The market price and interest rates act inversely, so when interest rates rise then the market price will fall.

Let's apply some numbers to your example. If you were to invest $100,000 in bonds at the 5% yield, the annual income would be $5,000. Now when another bond issues at a higher interest rate, the market value of your bond will decline. But that is only if you attempt to sell your bond.

Now hopefully you've diversified your investments. Especially because this is for current or soon to be retirement income. If so, then you should hold the bond. You'll continue to earn your annual income of 5%, and you could wait until the interest rates come down and you can improve your market value.

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Collapse Mark as Read RE: OPTION: I need some investment advice. Slavica 11/3/2015 9:26:18 PM

Future interest rate will not affect your investment. When making investment decision you cannot compare cost and benefits that occur in different points of time.

If we can look into future and predict how market will behave that would definitely help us to make better decisions, but as best as we can do today is evaluate between multiple opportunities using NPV and select alternative with the highest NPV.

If you had a crystal ball that will tell you that interest rates in 2018 are going up to 10% then it would be worth while waiting to invest at that time and not locking your money with 5% investment today, but that would be decision based on your assumptions and not on viable data. I am sure that you did perform such analysis for this investment and it met your criteria. How other investment options perform in the future has no effect on your current investment

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(an instructor response)

Collapse Mark as Read OPTION: Arbitrage Professor Author 10/31/2015 7:59:48 AM

What is arbitrage and how does it fit into the TVM model and what does it have to do with grapefruit?

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Collapse Mark as Read RE: OPTION: Arbitrage 11/1/2015 1:43:11 AM

The concept of time value of money is that a dollar today is worth more than a dollar in the future because you can invest the money you have now and make interest than a future expectation.

Arbitrage is the practice of continuous purchase and sales of equivalent goods in different markets to take advantage of the difference in prices. This happen mostly in financial market, stock market, FOREX in which a broker buys at a cheaper rate and sells immediately at a higher rate. This is an opportunity for the investors to have a positive NPV base on immediate investment.

f;rBerk, Jonathan, Peter DeMarzo. Corporate Finance, 3rd Edition. Pearson Learning Solutions, 02/2013. VitalBook file.

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Collapse Mark as Read How does arbitrage fit into the TVM model and what does it have to do with grapefruit Professor Email this Author 11/3/2015 8:26:09 AM

How does arbitrage fit into the TVM model and what does it have to do with grapefruit

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Collapse Mark as Read RE: How does arbitrage fit into the TVM model and what does it have to do with grapefruit Ja-eun 11/3/2015 2:17:52 PM

Modified:11/3/2015 2:21 PM

According to our lecture, arbitrage is buying something in one market and selling it at a higher price in another market. TVM is the idea that the money today is worth more than the same amount of money in the future. So I'm thinking For arbitrage, different market is the key point and for TVM, different time is the point.

Assuming all the grapefruits are have the same quality, if you can buy them at a low price and sell them at a higher price at a different market, you will make a profit. Say I buy 100 boxes of grapefruit at $300 in Florida then I go to Alaska and sell those 100 boxes for $600. Did I make $300 profit? I need to think about what took me to bring those 100 boxes all the way to Alaska to be able to say whether I made a profit or not.

For TVM, I will use something other than grapefruit because grapefruits go bad over time. Someone mentioned about buying an American doll which price goes up quite a bit in the other discussion. So I buy a doll at $200 hoping that the price will go up and I can make a profit. Say 10 years later, I wanted to sell it and it was $300. Did I make $100 profit? When thinking about TVM, We can't say we made $100 profit because the money was worth more 10 years ago. So I need to calculate the present value to really compare to see if I made a profit by waiting 10 years to sell it or if we actually lost money by inflation.

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Collapse Mark as Read RE: OPTION: Arbitrage Leonard 11/2/2015 9:13:07 AM

Arbitrage is the simultaneous purchase and sales of an asset in order to maximize profit as a result of the difference in price. It exploits price difference of identical or similar financial instruments, on different markets or in different forms. I think it fits into the TVM model on the assumption of the core principle of finance; that holds that since money can be invested, any amount of money is worth more the sooner it is received. Arbitrage is relate to the grapefruit concept in that it relates to the issue of buying grapefruit in one market and selling it in another market , even when the profit maybe small. for example grapefruit in Florida will be sold at a different price than in California, or even at the local farmer market. Buying grapefruit in one market and selling it in another market simultaneously at a higher price is called arbitrage. The price of grapefruit varies depending on who and where you are making your purchase. Arbitrage is what makes the Law of One Price works in finance because these assets are typically exchange electronically or by mail( eliminating the worry of transportation cost etc, when buying and selling grapefruit). The Arbitrage market is what keeps all of the financial markets in sync, the logic of the law of one price is that all buyers and sellers of financial assets faces the same price at any given time.

reference:(www.coursehero .com)

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Collapse Mark as Read Reference Professor Email this Author 11/3/2015 8:32:10 AM

We always need complete references for sources. Coursehero is a very large site. In cases where a document may be difficult to find, a complete URL should be provided in the reference.

I would suggest that you might want to consider whether you even want to use coursehero for source, especially given that the information is given in the text and lecture.

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Collapse Mark as Read RE: OPTION: Arbitrage Lynnze 11/3/2015 4:35:03 PM

What is arbitrage and how does it fit into the TVM model and what does it have to do with grapefruit?

“Arbitrage is the practice of buying and selling goods in different markets to take advantage of a price difference. An arbitrage opportunity occurs when it is possible to make a profit without taking any risk or making any investment,” (PPT slides).

As stated in the week 2 lecture, I believe the grapefruit reference is an example of how one has the option to purchase and sell an asset by the way of making the best decision. The example of the grapefruit makes it easy to understand that price and location make a difference.

If one is buying a large sum of grapefruit from grocery store XYZ and turning around to sell to individuals on the roadside, will they earn a profit? What will be the cost to purchase the grapefruit and will there be other expenses incurred?

In order to sell the grapefruit in a different market, there would be a “need” for the commodity on hand. With this demand, the seller could markup the cost of the grapefruit to cover their initial cost and any expenses incurred and still make somewhat of a profit.

Am I on the right track here? This terminology is all new to me and I am having a tough time understanding it, although the example in the lecture seemed pretty easy to understand. I just did not want to repeat here.

Week 2 Lecture – Time Value of Money

Week 2 iConnect Live Lecture – Power Point Slides

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Collapse Mark as Read RE: OPTION: Arbitrage Zeena 11/3/2015 5:47:27 PM

Arbitrage is when a product is purchased for one price and sold for a profit. A grapefruit is the example used in the textbook that I felt was a great example of understanding the definition of arbitrage. For those that need a visual of arbitrage may I suggest watching the moving Trading Places with Dan Aykroyd and Eddie Murphy. The movie talks about how stocks were purchased at a low price then the same stock was then sold at a higher pricing making Dan and Eddie's characters extremely rick.

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Collapse Mark as Read RE: OPTION: Arbitrage Kyia 11/3/2015 7:43:17 PM

As the text outlines arbitrage as it refers to buying a product in a market and selling it for a higher price in another market. The lecture provides us with an example of a truckload of grapefruit from a Florida farmer driving them to Chicago to sell the grapefruit at the markup price to make a profit.

When we are talking about financial assets, the Law of one Price (LOP) becomes a little easier to understand. You don't have to worry about transportation or location because financial assets are typically exchanged electronically or, in the worst case, by mail. Financial assets typically do not spoil something like grapefruit. Because of arbitrage, speculators are constantly looking for a chance to buy financial assets in one market and sell them in a different market for even the smallest of profit. The arbitrage market is what keeps all of the financial markets in sync.

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Collapse Mark as Read RE: OPTION: Arbitrage Pamela 11/3/2015 9:39:19 PM

The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, on different markets or in different forms. Time Value of Money is a central concept of finance theory that gives different value to the same nominal cash flow, depending on a pay-off date. In another words, one dollar has bigger value if received now as opposed to some future point of time. Hence, the difference in these valuations is a function of time passed between some present and future date. The existence of TVM drives a good deal of the financial decision making when it comes to fruit pricing and buying.

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