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Assume there is an annuity with four $1,000 payments, with the first payment occurring one year...

Assume there is an annuity with four $1,000 payments, with the first payment occurring one year from now. Based on the current interest rate, the PV of the annuity is $3,387.21 and the FV is $4,439.94. What will happen to the PV and FV if the interest rate decreases by half? PV will decrease; FV will decrease PV will increase; FV will increase PV will increase; FV stays the same PV will decrease; FV will stay the same PV will decrease; FV will increase PV will increase; FV will decrease

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Answer #1

By time value of money function,

FV = PV * (1 + r)n

Given this equation, FV of a cash flow is directly proportional to rate of interest, whereas PV is inversely proportional to rate of interest. This implies when interest rates decrease (increase), FV decrease (increase) and PV increase (decrease).

This is also true for a stream of cashflows (since if you consider individual cash flows, this rule will apply to each cash flow).

So for the above question, answer is when interest rates decrease by half - FV decreases, PV increases.

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