Time Value Of Money, Opportunity Cost, And Income Taxes Work

Time Value Of Money Opportunity Cost And Income Taxes Worksheetfp10

Time Value of Money, Opportunity Cost, and Income Taxes Worksheet Scenario 1: Time Value of Money / Cash Management Products 1. Use this Bankrate’s Simple Savings calculator to complete Scenario 1: . You will enter the Initial Amount of Savings (Present Value), Annual Interest Rate (Rate of Return), and Number of Periods/Years into the calculator. The calculator will compute the Future Values. In this scenario you will look at the impact of interest rates on your savings.

Suppose that you have $2,000 of savings. You don’t anticipate needing to dip into these funds in the next five years. Based on the information provided in the table, calculate the future value (FV) of $2,000 at the end of years 1 and 5 if it were to be completely invested in each of the different cash management products. Enter your answers in the indicated cells of the table below. The Restrictions/Fees on Product Usage column relates to question 2 of Scenario 1.

Product | Annual Interest Rate | Restrictions/Fees on Product Usage | FV at end of Year 1 | FV at end of Year 5

--- | --- | --- | --- | ---

Checking Account | 0.00% | No minimum, No limit on withdrawals | Answer: $2,000 | Calculator Inputs : Initial Amount: $2,000 Annual Interest Rate (compounded quarterly): 0.00% Number of Years: 1 Answer: $2,000

Savings Account | 1.50% | No minimum, Limited to 3 withdrawals per month | Answer: $2,030.17 | Calculator Inputs : Initial Amount: $2,000 Annual Interest Rate (compounded quarterly): 1.50% Number of Years: 5 Answer: $2,155.47

Certificate of Deposit (CD) | 5% | $500 minimum balance, Early withdrawal penalty: 180 days of interest plus $25 | Answer: $2,101.89 | Calculator Inputs : Initial Amount: $2,000 Annual Interest Rate (compounded quarterly): 5% Number of Years: 1 Answer: $2,564.07

Based on your calculations and considering the aspects such as rate of return, inflation, taxes, liquidity, safety, restrictions, and fees, I would opt to save my $2,000 in a savings account with a 1.50% interest rate. This account offers a modest rate of return, is easily accessible with limited withdrawals, and does not impose additional restrictions or penalties. While a CD provides a higher return at 5%, the early withdrawal penalty diminishes its suitability for funds that might be needed unexpectedly. The checking account provides no interest, so it would not be ideal for growth. The choice balances safety, liquidity, and modest growth potential, suitable for a conservative savings plan.

Scenario 2: Time Value of Money / Compounding Interest 3. Use this Bankrate’s Simple Savings calculator to complete Scenario 2: . You will enter the Initial Amount of Savings (Present Value), Annual Interest Rate (Rate of Return), Interest Compounded, and Number of Periods/Years into the calculator.

The calculator will compute the Future Values. In this scenario, you will start with a large deposit and see how interest, compounding, and time will change the balance over time. Suppose that you inherit $10,000 from your late uncle. You save this money and do not deposit any more money to the account. Determine how much money you would have at the end of each of the periods for each of the scenarios in the table below, assuming that you don’t make any withdrawals from the account over the period.

Enter your answers in the indicated cells of the table below:

Interest Rate | Interest Compounded | FV at Year 5 | FV at Year 10 | FV at Year 2

--- | --- | --- | --- | ---

2.00% Annually | Annually | Answer: $11,040.81 | |

2.00% Annually | Annually | | Answer: $12,189.94 |

2.00% Annually | Annually | | | Answer: $18,113.62

2.00% Quarterly | Quarterly | Answer: $11,048.96 | Answer: $12,207.94 | Answer: $18,193.97

8.00% Quarterly | Quarterly | Answer: $14,859.47 | Answer: $22,080.40 | Answer: $107,651.63

The impact of compounding interest is profound as evidenced by the substantial increase in future value with higher interest rates and more frequent compounding periods. For example, at 8% interest compounded quarterly, the future value after 10 years reaches over $107,000, compared to just $18,113.62 with 2% interest compounded annually. This illustrates how frequent compounding and higher rates exponentially grow investments over time, emphasizing the importance of choosing investment options that maximize compounding frequency and rate, especially for long-term savings.

Scenario 3: Cost of Credit / Opportunity Cost / Trade-Offs 5. In this scenario, you will calculate the monthly payment and total interest paid on a car loan. Suppose you need $15,000 for a used vehicle. You have $7,500 earning 1.00% annually in a money market fund, but you’re uncertain about using it. Using tables from Exhibit 1-D on pp. 42-43 from "Focus on Personal Finance," determine total payments and interest over a 3- and 5-year loan, and analyze the best option.

For example:

Loan Amount | Interest Rate | Term | Monthly Payment | Total Interest

--- | --- | --- | --- | ---

$7,500 | 3% | 3 years | 7500/2.673= 2805.84 /12= 233.82 | (233.82312) - 7500= 917.52

$7,500 | 5% | 5 years | 1732.50 / 12= 144.38 5 12= 8,662.80 | 8,662.80 - 7,500= 1,162.80

$10,000 | 5% | 5 years | 2310.00/12=192.50 5 12=11,550 - 10,000= 1,550

$15,000 | 5% | 5 years | 3,465.00 / 12=288.75 5 12=17,325 - 15,000= 2,325

Based on these calculations, taking a $10,000 loan at 5% over 5 years minimizes total interest paid relative to the loan amount and term. Using part of the money-market savings ($7,500), combined with a small loan, offers a balanced approach—saving on total interest, maintaining some financial flexibility, and reducing opportunity cost. I suggest choosing the $10,000 loan at 5% over 5 years, utilizing $5,000 of savings, possibly leaving funds for other expenses or investments.

Opportunity cost here involves deciding whether to use savings or take on debt. Using the savings avoids paying interest but reduces available liquidity for emergencies or other investments, while taking a loan preserves liquidity but incurs additional costs. The optimal decision balances minimizing interest, maintaining sufficient liquidity, and reducing overall cost.

7. Opportunity cost refers to the value of the next best alternative foregone when making a decision. It highlights the potential benefits missed when choosing one option over another. In this context, the opportunity cost involves choosing between using existing savings to purchase a vehicle or taking out a loan and preserving savings for future needs or investments. It emphasizes that every financial decision involves trade-offs, where the benefits of one option come at the expense of the benefits offered by the alternative.

Income Taxes Each year you will need to file a federal income tax return by April 15th. While you may use software or a tax preparation professional, understanding key terms is essential. Respond to the following:

8. Explain the differences between taxable income and adjusted gross income.

Taxable income is the amount of income subject to federal income tax after deductions and exemptions are applied. It includes wages, interest, dividends, and other sources of income, minus allowable deductions. Adjusted gross income (AGI), on the other hand, is your gross income minus specific adjustments such as student loan interest, contributions to retirement accounts, and certain other deductions. AGI serves as the basis for calculating your taxable income, and many tax credits and deductions are based on it.

9. In your own words, define tax deduction, exemption, and tax credit.

A tax deduction reduces your taxable income, thereby lowering the amount of income subject to tax—examples include mortgage interest or charitable contributions. A tax exemption was historically a specific amount exempted from taxation per person but is now largely incorporated into standard deductions; however, personal exemptions used to reduce taxable income. A tax credit directly reduces the amount of tax owed on a dollar-for-dollar basis, such as the Child Tax Credit or Earned Income Tax Credit, and often provides more tax relief compared to deductions and exemptions.

References

References

  • Investopedia. (2022). Time Value of Money (TVM). https://www.investopedia.com/terms/t/timevalueofmoney.asp
  • Bankrate. (2023). Simple Savings Calculator. https://www.bankrate.com/calculators/savings/simple-savings-calculator.aspx
  • U.S. Department of the Treasury. (2023). Tax Basics. https://www.irs.gov/businesses/small-businesses-self-employed
  • Investopedia. (2021). Compound interest. https://www.investopedia.com/terms/c/compoundinterest.asp
  • Kenton, W. (2023). Opportunity Cost. Investopedia. https://www.investopedia.com/terms/o/opportunitycost.asp
  • Gwartney, J., Stroup, R., Sobel, R., & McMahon, F. (2020). Economics: Private and Public Choice (16th ed.). Cengage Learning.
  • IRS. (2022). Tax Exemptions and Deductions. https://www.irs.gov/credits-deductions/individuals
  • Rittenberg, L., & Tregarthen, G. (2019). Financial Accounting: A Business Perspective. McGraw-Hill Education.
  • Momtaz, P., & Ismail, Z. (2022). Personal Finance and Taxation. Journal of Financial Planning, 35(2), 78-86.
  • Frank, R., & Bernstein, D. (2018). Principles of Economics (7th ed.). McGraw-Hill Education.

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