Saving for the Future Coursework Example | Topics and Well Written Essays - 1000 words

Saving for the Future - Coursework Example However, owing to the notion of time value of money, the buyer would be required to save an amount different from that of $25,000. Taking the 5 year interest rate of 0.78% (U.S Department of The Treasury, 2012), the saving required annually amounts to the future value of an annuity (ordinary) assuming that $125,000 will be required after 5 years. This amounts to: 125,000= C* {(1.0078^5)-1/0.0078} = $24,613.03 Where: C= unknown i= 0.78% n=5 This is based on the following formula: FV (annuity) = C * {[(1+i) ^n – 1] / i} (Brigham & Houston, 2011) Where: C = Cash flow per period i = interest rate n = number of payments Two factors highly influence the future value of the cash flows calculated today; firstly, the periods for which they are calculated and, secondly, the rates at which they are calculated (Brigham & Houston, 2011). In both cases, the future value of the savings today is directly related to the interest rate and period. Higher the interest rate or period at which cash flows are calculated, greater the amount of future value of the investments made at T=0 (Brigham & Houston, 2011). Furthermore, the fact that whether savings are made at the beginning or end of a particular period, as well as the number of compounding periods also matters (Brigham & Houston, 2011). ... However, if changes are made to the number of compounding periods such that the number of compounding periods is 12 instead of 1, the resultant savings would then be: (125,000 / 76.213)= $1,640.134 which is approximately $1,640 The total annual investment/savings would translate to: $24,613 x 5= $123,065 if compounded annually On the other hand, the net investment/savings for five years would be: $98,400 (1,640 x 12 x 5) if calculated using monthly compounding. The savings bear an annual opportunity cost of $24,665 Furthermore, it has been observed that the rate of interest is apparently low owing to the riskless nature of Treasury Bills (Brigham & Houston, 2011). This is based on the simple rule underlying financial theories that the rate of return is positively associated with the level of risk (Brigham & Houston, 2011). A higher risk translates to higher return and vice versa. As opposed to T-bills, if the savings are channelized into corporate bonds, they will reap a higher rate of return compared to T-bills because these bonds are riskier compared to T-bills both in terms of riskiness of principal and interest payment. If the investment in these corporate bonds was made on a rate that is compounded annually, the savings required in order to obtain $125,000 towards the end would be lower than the amount shown in initial calculations. Thus, the net effect would be that the investor will lose money by investing in T-bills rather than corporate bonds representing an opportunity cost. To sum up, there are two alternatives available to an individual investor in order to accumulate $125,000 at the end of the year: to invest in corporate bonds or to invest in T-bills. The option that investor chooses entirely depends on his/her attitudes towards risk (