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Compound Growth and Present Discounted Value

The document summarizes key concepts related to compound growth and present discounted value. It introduces geometric progressions and their formulas for calculating terms and sums. It then discusses the compound growth formula and how to calculate future values given an initial amount, growth rate, and number of periods. Finally, it covers calculating present discounted values and using logarithms to solve problems related to compound growth.

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Harry Singh
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
46 views

Compound Growth and Present Discounted Value

The document summarizes key concepts related to compound growth and present discounted value. It introduces geometric progressions and their formulas for calculating terms and sums. It then discusses the compound growth formula and how to calculate future values given an initial amount, growth rate, and number of periods. Finally, it covers calculating present discounted values and using logarithms to solve problems related to compound growth.

Uploaded by

Harry Singh
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 26

Chapter 10:

Compound growth and present


discounted value
The Geometric Progression (GP)

A series of form A, AR, AR2, AR3,…,…

with 1st term A, common ratio R.

KEY POINT: you get from 1 term to next by multiplying by a constant, R.

Two formulae:

1. nth term of series is: ARn−1


A(1  R n ) A(R n  1)
2. sum of 1st n terms is:   or  R 1
n 1  R n
Example: Series 1, 2, 4, 8, 16,…,… (A = 1, R = 2)

(a) Find 10th term. Answer: ARn−1 = 1×29 = 512

(b) Find sum of 1st 10 terms. Answer:


A(R n  1) 1(210  1)
  R  1 = 2  1  1023
n
A special case (quite common in economics):

When 0 < R < 1, as n increases Rn gets smaller.

As n → ∞, Rn → 0, so formula for sum becomes:


A(1  R n ) A(1  0) A
  1 R  1 R  1 R

The compound growth formula
Applies to a savings deposit or any other variable that is growing at a
constant compound percentage rate.

y  a(1  r )x
a = "principal" ; r = annual growth rate ; x = number of years.

Example: I deposit €100 in a savings account paying 4% per year, with


interest reinvested. How much after 5 years?

x (completed 0 1 2 3 4 5
years)
100 104 108.16 112.49 116.99 121.67
Growth of a bank deposit or a price index

We can show this graphically

Graph is a step function. Formulay  a(1  r )x describes discontinuous


or discrete growth (that is, growth in jumps).
When interest is added (or growth
occurs) more than once a year
If interest is added n times per year, compound growth formula becomes:

y  a(1  nr )nx

Example: repeat previous example, but with interest added twice per year.

x (completed 0 ½ 1 1½ 2 2½ 3
years)
y  a(1  nr )nx 100 102 104.04 106.12 108.24 110.4 112.61
Nominal and effective interest or growth
rate

When interest added more than once per year, effective interest rate is
higher than nominal rate.

In previous example, nominal interest rate is 4% per year but effective rate
is 4.04% (= actual growth per year).

Effective annual rate (EAR)

EAR  (1  nr )n  1
Check: in previous example, r = 0.04 ; n = 2. So:

EAR  (1  0.04
2
)2
 1  4.04 ; the same as col 4 of table above.
Present discounted value
We use compound growth formula y  a(1  r )x to find y, the future value,
with a, the initial value of the variable, assumed known.

Suppose we have the reverse problem; we know the future value, y, and
want to find the initial value, a.
y
Then by simple algebra: a
(1r )x
Here a is said to be the present discounted value (PV ) of y.
It is what we would need to invest now in order to reach a given value, y, in
x years' time (with r given, of course).
a
Confusing change of notation: y
(1 r )x
Present value and economic behaviour

Concept of PV important in economics, both theoretical and applied.


Underlying idea is that if an individual (or firm or government) can borrow
or lend freely at interest rate r, they will be indifferent between a future
y
sum a and its PV as given by rule a 
(1r )x
Present value of a series of future receipts

This rule relates to just a single receipt of a in x years' time.

By simple extension, PV of a series of receipts, a1, a2, a3,…, an, in years 1,


2, 3,…n is simply the sum of their individual PVs:
a1 a2 a3 an
PV     .... 
(1r )1 (1r )2 (1r )3 (1r )n
Market value of a perpetual bond
A special case of last rule arises when a1 = a2 = a3 =…= an and n goes to
infinity.

Example: some British government bonds (aka Consols) which carry a


fixed annual interest payment and have no redemption date.
a
The PV in the last rule is then the sum of a GP with 1st term A  (1r )
1
and common ratio R  (1 r )
.
A
Using rule above,  
n 1 R
the sum is then
A
PV  1R  a
r
Note this means PV (=market value) of bond varies inversely with r. (see
figure in the next slide)
Relation between the price of a
perpetual bond and the market rate of interest, given the
‘coupon’, a
Calculating loan repayments
When you borrow money to buy a car or flat, both borrower and lender
normally prefer repayment in equal instalments, each comprising a mix of
interest and capital.
Calculating the required instalment is not easy because the interest
component diminishes as the loan is repaid.

The formula is: P1  K  r x 


 (1r ) 1

where P1 = capital repaid in first instalment; K = amount borrowed; 100r =


percentage interest rate per period; x = number of repayment periods
(years or months)
The size each equal repayment is then given by P1 + rK
Instalment structure

The figure below shows how mix of interest and principal varies from one
instalment to next.
Chapter 11:
The exponential and
logarithmic functions

14
Preliminary: revision of the inverse
function

Example: given y  3x  4 , the inverse function is x  13 y  43


Key point is that the relationship between x and y is the same in both the
function and its inverse, therefore:

• Any pair of values, x0, y0, that satisfies one function automatically
satisfies the other.

• They have the same graph (fig 11.1, next slide)

15
Figure 11.1: Inverse functions (not to
scale)

16
The exponential function y  10 x
Key feature is a constant base (in this case, 10) raised to a power that is a
function of x (in this case, x)

What will graph look like?

When x = 0, y  10  1 . So y intercept is 1.
0

When x increases from 1 to 2, y increases from 10  10 to 10  100 ;


1 2

so graph turns up very steeply

When x < 0, say, x = −1, y  101  10


1 ; so y always > 0

See fig 11.2a (next slide)

17
Figure 11.2: Graphs of y = 10x and x = log10y
(not to scale)

18
The function inverse to y  10 x
In example above, y  3x  4 , we found the inverse by elementary
algebra. But this won't work with y  10 x (Why not?)

Instead, we have to define a new term, a logarithm. Given y  10 x , we say


that "x is the logarithm, to base 10, of y ".

This definition is written compactly as: x  log10 y


This defines the function inverse to y  10 x (rule 11.1)
What will its graph look like? It is simply y  10 x , with axes interchanged
(since x now the dependent variable). See fig 11.2b (previous slide)

19
Key features of graph of x  log10 y
• when y = 1, x = 0 (because 100 = 1)

• when 0 < y < 1, x < 0 (because e.g.101  1 )


10
• when y < 0, no corresponding x. So logs of negative numbers do not
exist.

We get graph of by swapping x and y (fig 11.3)

20
Figure 11.3: Graph of y = log10x (x-axis
not to scale)

21
Demystifying logs
• Figs 11.2a and 11.2b both convey exactly the same information,
presented slightly differently.

• Example: log10 100  2 and 102  100


Logs on your calculator

• Press log/100/= with result 2

• To reverse this, press shift or inv (depending on calculator), followed by


log/2/= with result 100.
(Note you are really finding 102)

• Note: log10 x usually written more compactly as log x

22
Rules for manipulating logs (rule 11.2)
1. If A  B, then log A  log B
2. log( AB )  log A  log B KEY RULE
3. From 2, if A = B, log( A2 )  log A  log A  2(log A)
Generalizing, log( An )  n(log A)
4. log( BA )  log A  log B (reverses rule 2)
5. From 4, if A = B, log( AA )  log A  log A  0 ; so log(1)  0
6. log(10) = 1 (because 101 = 10)

23
Using logs to solve problems

Example: If the price index rises at 5% per year, how long before the price
level doubles?
Solution: y  a(1  r )x with a = 100, r = 0.05, y = 200, x to be found.
Thus 200  100(1.05)x  2  (1.05)x
 log(2)  log[(1.05)x ]  x log[1.05] (rules 1, 3)
(years)
 x  log[1.05]  0.02119  14.2
log(2) 0.3010

(This assumes price index increases in annual jumps)

24
Natural logarithms

1. Revision: from sec 11.1 – 11.6:


x  log10 y is the function inverse to y  10 x (rule 11.1)
so they have same graph (fig 11.2)

But we re-label as y  log10 x so that dep. var. is y


2. Similarly:
x  loge y is function inverse to y  e x (rule 12.3)
so they have the same graph (figs 12.2 and 12.7)

But we re-label as y  loge x so that dep. var. is y (fig 12.8)

25
Figure 11.2 and 12.8

Figure 11.2: Graphs of y = 10x Figure 12.8: Graph of y  log e x


and x = log10y (not to scale) = (x-axis not to scale)

26

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