Unit 2 of 5
Study guide for DSST DSST Principles of Finance — Unit 2: Time Value of Money. Practice questions, key concepts, and exam tips.
42
Practice Questions
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Key Topics
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Tom has $1,000 to invest for 5 years. He can invest it in a savings account that earns a 2% annual interest rate, compounded annually. Alternatively, he can invest it in a certificate of deposit (CD) that earns a 5% annual interest rate, compounded annually, but has a 5-year term. Which investment will give Tom the most money after 5 years?
Answer: A — The correct answer is A because the CD earns a higher interest rate than the savings account. Although both accounts compound annually, the higher interest rate of the CD will result in more money after 5 years. The savings account will earn approximately $104 in interest over 5 years, while the CD will earn approximately $283 in interest over 5 years. Therefore, options B, C, and D are incorrect.
Tom has been offered two investment opportunities: Investment A, which offers a 5% annual return for 5 years, and Investment B, which offers a 10% annual return for 3 years. If Tom invests $1,000 in each investment, which one will have a higher future value at the end of the investment period, assuming compound interest is applied annually?
Answer: C — Correct answer C is correct because the time value of money and compound interest will have a greater impact over the longer investment period, resulting in a higher future value for Investment A. Option A is incorrect because while the longer investment period does contribute to the higher future value, it is not the only factor. Option B is incorrect because the higher annual return of Investment B is offset by its shorter investment period. Option D is incorrect because the difference in annual returns is not exactly offset by the difference in investment periods, resulting in different future values.
Tom has been offered two investment opportunities: Investment A, which offers a 5% annual return for 5 years, and Investment B, which offers a 4% annual return for 10 years. If Tom invests $1,000 in each investment, which one will have a higher future value at the end of the investment period, assuming compound interest is applied annually?
Answer: D — Investment B will have a higher future value because the longer investment period allows for more time to compound interest, even with a lower annual return. Although Investment A has a higher annual return, the shorter investment period limits the time for interest to compound. In contrast, Investment B's longer investment period provides more opportunities for interest to compound, resulting in a higher future value. Options A and C are incorrect because they do not accurately consider the impact of the investment period on the compounding of interest. Option B is partially correct but does not fully explain why Investment B has a higher future value.
Tom has $1,000 to invest for 5 years. He can choose between two investment options: a 5-year bond with a 4% annual interest rate compounded annually, or a 5-year bond with a 3% annual interest rate compounded quarterly. Which investment option will give Tom the highest future value at the end of 5 years?
Answer: B — The correct answer is B because the 3% annual interest rate compounded quarterly will give Tom a higher future value due to the power of compounding. Compounding quarterly results in more frequent interest payments, which increases the total amount of interest earned over time. Option A is incorrect because the 4% annual interest rate compounded annually will result in less interest earned compared to the quarterly compounding option. Option C is incorrect because the two options will not give Tom the same future value. Option D is incorrect because the present value of the bond is given as $1,000, so the future value can be determined.
Tom has been offered two investment opportunities. Investment A offers a lump sum of $10,000 today, while Investment B offers $12,000 in 2 years. Assuming an annual interest rate of 5% compounded annually, which investment is more valuable to Tom today?
Answer: D — The correct answer is D because the present value of Investment B can be calculated as $12,000 / (1 + 0.05)^2 = $10,953.49, which is less than the $10,000 offered by Investment A today, making Investment A more valuable by $1,946.19 ($12,000 - $10,053.81). The other options are incorrect because they do not accurately calculate the present value of Investment B and compare it to the value of Investment A.
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