2. Since the construction industry is notorious for having slumps in the course of business where operational cash flow is constrained, Ms. Sims has decided to put aside $15,000 a month from profits for the next five years as a safety net for recessionary periods. The money will be set aside in a separate account which pays 3.25% annual interest compounded monthly. The first $15,000 is placed in the account today.
At=Ao x (1+r/n)^nt
A0 : principal amount, or initial investment – 15,000
At : amount after time t
r : interest rate – 3.25%
n : number of compounding periods, usually expressed in years – 12 (monthly)
Activity: Compute how much this account will contain after 5 years.
You know that the board of directors will have questions for Sue to answer and to place this in context of Sue’s recommendations and potential impact to the company you should prepare answers for her based on your research and conversations with Sue. Here are some of the questions the board may ask:
Isn’t this money an opportunity cost to the company?
Would you recommend using company profits in this manner? Are there better options here to manage the volatility of sales?
Explain and support your answers since Sue is counting on you to prepare her for this board meeting.
Concept check: In every managerial decision concerning company assets we have to keep in mind the time value of money as well as unseen opportunity costs. Every action has an impact on the overall health of the business and the long-term as well as short-term cash flow needs. One option is always to do nothing.
Helpful Hint: Compound interest is the interest earned on the interest you have received in the past. You cannot just multiply a dollar amount by the interest rate and then by the number of years it is invested or you will miss the compounding effect. Be careful with the number of time periods and the periodic interest rate involved with compounding.
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P = $15,000
Months = 5*12 = 60 Months
Rate = 3.25%/12 = 0.270833%...
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