ASI 202 LO

Lecture 02 tfirsthalf
Time value of money

Money has different value over time, which is

captured by an interest rate. This lecture describes
two introductory concepts involving the time value
of money: interest and cash flow equivalence.

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1. Time value of money

 Money has different value over time.
• This is one of the most important concepts in financial economics.
 Would you receive $1,000 today or $1,000 a year from now?
• Of course, today! Why?
• Inflation can be a factor, but you will prefer today’s money even without inflation.
• You could invest $1,000 today (e.g., stock, real estates) to make money for a year.
• You could buy stuffs today (e.g., smartphone, bicycle), and enjoy them for a year.
• Risk of default: Who knows what will happen during the next year?
 Now, would you receive $1,000 today, or $1,200 a year from now?
• Well… It depends on people’s preference!

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 1.1. Interest rate
 Suppose you want to borrow $1,000 from a friend for a year.
• Will she lend you $1,000 if you pay back the same $1,000 a year from now?
• She gives up using $1,000 for a year, so you need to give compensation to her.
 Interest: The compensation for giving up the present use of money
• When you rent an apartment, you pay monthly rent. At the end of the contract,
you return the apartment to the owner.
• When you borrow money, you pay interest. At the end of the contract, you return
the principal to the lender.
 Interest rate: The rate to calculate the size of compensation
• An interest rate represents the cost of borrowing money.
• The stated interest rate is an annual rate, unless otherwise stated.
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1.1. How is interest rate determined?

 In theory, interest rate is determined by supply and demand for money.
 In practice, Bank of Canada (or central bank) determines interest rates.
• Policy interest rate (overnight rate): It is the interest rate that major Canadian
banks charge each other for overnight loans.
• The Bank of Canada sets the policy interest rate to keep inflation stable and low.
 What is the prime interest rate?
• It is the interest rate that commercial banks charge their most creditworthy
customers, often large corporations.
• The policy interest rate serves as the basis of the prime interest rate.
• Likewise, the prime rate forms the basis for most other interest rates, e.g., credit
card loans, mortgage, small business loans, etc.
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 1.1. Canada prime and policy rates (1970 – 2023)
Source: https://wowa.ca/banks/prime-rates-canada
25
Prime rate BoC policy rate rate
instantintent

I
20

15 0

10 I
5

0
1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

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1.1. Terminology: interest rate vs. rate of return

 Interest rate vs. rate of return: They are the same concept.
• Borrower’s perspective: interest rate paid to bank
• Lender’s (or investor's) perspective: rate of return earned from stock or bond

Interest paid Interest earned

Interest rate Rate of return
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 Toobasic we
onlyuse compound interestrate

1.2. Simple vs. compound interest

I Simple interest: The interest is computed only on the original sum.
• Total interest amount = P (principal) × i (interest rate) × n (years)
• If you lend $1,000 for 5 years at a simple interest rate of 10% per year, the total
amount of interest is $500 (= $1,000  0.1  5 years).
• From now on, you can forget the simple interest: No lenders (banks, financial
institutions) use this method.
 Compound interest: The interest is computed on accumulated amount.
• Total value with interest = P(1 + i)n Memorisethis formula
• If you lend $1,000 for 5 years at a compound interest rate of 10% per year, the
total amount of interest is $610 (= 1,000(1 + 0.1)5 – 1,000).
• You always assume a compound interest rate for any loans or financial deals.

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Ex 1-1. Value of the Manhattan island

 Purchase of Manhattan island (New York City)
• Peter Minuit was the director general of New Netherland
(now New York) during 1626 – 1633.
• He purchased the island of Manhattan from Native Americans
on May 24, 1626 for $24-worth of bead trinkets.
 At 6% interest rate, what is the worth of Manhattan in 2023 (397 years
later), in terms of simple interest and compound interest?
simple 24 24 x 61 x 397 596
compound P I it 24 i 0.06137 2676in
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 Ex 1-2. Budget buster
 In April 1993, a couple in Nevada in the United States presented the
state government with a $1,000 bond issued by the state in 1865.
• The bond carried an annual interest rate of 24%, and they claimed the bond was
worth several trillion dollars in 1993.
• The Wilsons, the owner of the bond, were willing to settle for only $54 million!
(Newsweek, 1993, “Budget Buster”).
 What would be the worth of the bond in 1993 (127 years later)?
simple 1000 1000 244 127 31480
1000 11 0.241127 817327
02
Compound

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1.2. Wonder of compound interest

 Who said these?
• “The most powerful force in the universe is compound interest.”
• “Compound interest is the eighth wonder of the world. He who
understands it, earns it; he who doesn't, pays it.”
• “My wealth has come from a combination of living in America,
some lucky genes, and compound interest.”
 Value of practicing every day
• If you made a 1% improvement in your knowledge each day, your knowledge will
be improved by 2.7 times after 100 days (= 1.01100).
• A 1% decline everyday will result in 0.36 of your starting level (= 0.99100).
• Listen to your instructors and practice every day!

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 2. Equivalence and interest rate
 If you owe some money, how do you pay back the debt?
• You can pay back in different structures: lump-sum at the end of the term; equal
annual payment; interest only till the last period, etc.
• If you are indifferent to each payment structure, they are called equivalent.
 Equivalence
• We can convert different cash flows at different times to an equivalent value at a
common reference point (called discount cash flow, DCF).
o If you invest $100 now, how much will you have 5 years later?
o If I buy a Honda Civic for $20,000, what is the monthly payment?
o If I save $200 every month, how much will I have 40 years later?
• Equivalence and conversion of cash flows depend on the interest rate.

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2.1. Equivalence: Repaying a debt

diffident  Suppose you borrow $5,000 now and have to pay the debt in 5 years,
with 8% interest rate. How do you pay?
 Plan 1: Pay ($1,000 + interest) at the end of each year.
• $1,400; $1,320; $1,240; $1,160; $1,080, with a total of $6,200.
 Plan 2: Pay only interest each year, and the principal at the end of 5 year.
• $400; $400; $400; $400; $5,400, with a total of $7,000.
 Plan 3: Pay in 5 equal payment each year yMontpaywent
• $1,252; $1,252; $1,252; $1,252; $1,252, with a total of $6,260.
 Plan 4: Pay all (principal and interests) at the end of 5 year, with $7,347.
 While the total payments are different, they are all equivalent.

r
12
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12

effusive It's called equivalence

5000 at the end
became
to dwn payingback
notparty of 5year
we interest
6
the
 2.2. Cash flow in project
 Most engineering projects involve money which comes at different
times with different sizes.
• Investment cost (First cost): One time cost at the start of a project
• Annual tax; Monthly insurance; Bi-weekly wage
• Salvage value: Receipt at project termination
• Overhaul cost: Expenditure occurred during the asset’s life
 We can summarize them with a cash flow diagram.
• It illustrates the size, sign, and timing of individual cash flows.
• Cash receipts (benefit or revenue): positive cash flows
• Cash disbursements (cost or expense): negative cash flows

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2.2. Cash flow diagram

 Cash flow diagram
• We evaluate the values at date zero. ‘Today’ or ‘Now’ is at date zero.
• Most payments are made at the end of the year.
• End of period t = Beginning of period t + 1
• All factor formulas are based on these assumptions of timing.
Revenue at the end
of period 1 $100 $100 End of period 3 =

y
beginning of period 4

0 1 2 3 4
Time 0 $50
canbe
I anyperiod G Dec31 Jm I
(‘Today’)
$200

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 2.2. Cash flow conversions
 We will study a series of interest factors which convert cash flows to
different point of time, with the concept of equivalence.
 Compounding process
• If the present worth (P) is known, what is the future worth (F), given interest rate
i and number of periods n?
• F = P(1 + i)n or F = P(F/P, i, n)
where (F/P, i, n) = (1 + i)n

to
 Discounting process

ÉÉ • If F is known, what is P, given i and n?

• P = F/(1 + i)n or P = F(P/F, i, n)
where (P/F, i, n) = 1/(1 + i)n

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Ex 2-1. Single payment cash flow

 If you deposit $20,000 in a bank now, how much would you have 10
years later, if the interest rate is 12%?
F 20000 I t o 12710 20000 Fp 12 10

LEE EEE
20000
 The price of Honda Civic EX is $25,000. If you plan to buy the car 5 years
later (assuming the price will be the same), how much should you put
into the bank now, given a 6% interest rate?
P 3,5
9 5 25000 PIF 6 5 25000 0.7473

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 2.3. Calculation of a factor
 How to calculate the interest factors, such as (1 + 0.12)10 or 1/ (1 + 0.06)5?
 Method 1: You can use the formula directly.
 Method 2: You can use the factor table: For (P/F, 6%, 5), 2
Eiffel
thistable
on theRind

 Method 3: You can use Excel with its built-in functions.

• (P/F, i, n): PV(i, n, 0, -1)  “=PV(0.06, 5, 0, -1)”  0.7473
• (F/P, i, n): FV(i, n, 0, -1)  “=FV(0.12, 10, 0, -1)”  3.106
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Use excel on assignment
2 on LEARN

2.3. Example: Different factor formulas

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 2.4. Compounding period
 This loan comes with a “6% interest rate.” period it n
about
• If there is no stated time period, it is an annual interest rate of 6%.
• If nothing is mentioned, it is compounded as the interest rate period, annually.interfile
 This loan comes with a “6% interest rate, compounded monthly.”
• Without a stated time period, it is an annual interest rate of 6%.
• However, it is compounded monthly, by 0.5% (= 6%/12) each month.
 This loan comes with a “6% monthly interest rate.” compounded
This is interest
• As stated, it is a monthly interest rate of 6%. 2 month and
• It is compounded monthly, same as the interest rate period. rateis
monthly
• It is equivalent to “6% monthly interest rate, compounded monthly.”

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Ex 2-2. Compounding period

 If you deposit $20,000 now and the bank pays “12% interest rate,
compounded quarterly,” how much would you have at the end of 10
years?
FromTable
Annual Compounding Ex2 1
1
10 20000 3.1067 62120
F 20000 FIP 121
Quarterly

FIP31 40 20000 3.262 65240

F 20000
Monthly
20000 3.300 66007
F 20000 FIP I l
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 Ex 2-3. Berkshire Hathaway stock return
 The stock price of Warren Buffett’s Berkshire Hathaway Company was
$19 in 1964, and $290,696 in May 2018. What is the firm’s annual rate of
return over the last 53 years?

F P Iti 200697 194 1753 1 0.1993 201

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3. Effective interest rate

 Interest rates are stated in many ways, creating some confusion.
• The way to state an interest rate may be the result of tradition or legislation.
 Suppose you borrow $10,000 with a “6% interest rate, compounded
monthly.” How much interest do you pay per year? Idea ofthe
• You pay 0.5% (= 6%/12) every month: 10,000(F/P, 0.5%, 12) = 10,617  $617 effector
• This is equivalent to a loan with “6.17% interest rate, compounded annually.” d internist

 Nominal vs. effective interest rate

• The 6% is called a stated or nominal interest rate (without the compounding effect).
• The 6.17% is called an effective interest rate, the rate you actually pay.
• It is your job to calculate the effective interest rate in making a decision.

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 3.1. Example: Annual percentage rate (APR)
 Canadian government requires that lenders (credit card, car loan, etc.)
must disclose an APR (or nominal rate) on all loans.
• However, lenders are free to choose the compounding period.
• Lenders have a strong incentive to have frequent compounding periods, and
borrowers are often misled due to different compounding periods.

compounding
Daily

1
ratel

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3.1. Effective interest rate

 The effective interest rate is calculated as
ie = (1 + i/m)m – 1 = (1 + is)m – 1
• i: Annual nominal interest
• is: Sub-period interest rate per compounding period (is = i/m)
• m: Number of compounding periods per year

 Example: A credit card company charges an APR of 24% on overdue

accounts, compounded daily. What is the effective interest rate?

ie it 8575 1 2711
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 Ex 3-1. Credit card rates
 Three credit card companies charge different interests on an overdue
account.
• The Vic Visa card charges 20% compounded daily.
• The Mag Master card charges 21% compounded semiannually.
• The Am Ex card charges 22% compounded quarterly.
 Which card has the best deal?
I v it 951365 1 22 131
im I 9112 1 22.11
I A I t 02,1 1 23.881

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Ex 3-2. Payday loan rate (1)

 What is payday loan?
• It is a small, short term loan until the borrower’s next payday.
• People don’t (or can’t) borrow a few hundred dollars from a bank.
• Typical loan amount is less than $500, due in two weeks.
• The fee is usually $15 – 20 for each $100: that is, 15% - 20% of interest rate for
two weeks!
• Have you heard a “loan shark”?

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 Ex 3-2. Payday loan rate (2)
 Suppose Sam writes a check of $550 to a loan shark to borrow $500 for
two weeks. What is the nominal annual interest rate (with a simple
interest rate)?
I 104 26 2601
gourmetm451 somethinglike
I
this
 What is the effective (annual) interest rate of this loan?
be it 0.1726 i 1091 l
10.918
 If the fee is $100 for two weeks, what is the effective interest rate?

ie I 0.2120 1 113,475 7113471

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3.2. Effective interest rate and time period

 In most cases, we consider an annual effective rate.
• However, it can be shorter or longer than one year.
 Example: Suppose there are two offers of financing.
• Offer 1: 12% interest rate, compounded quarterly.
• Offer 2: 12% interest rate, compounded monthly.
• Determine the “semiannual” effective interest rate and the “5-year” effective
interest rate for each bid.
semi 5 year
op 1 1 0.03 1 6.091 1 0.03720 1 80.611
op2 1 0.0116 1 6.151 it0.017 1 81.671
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 3.2. Continuous compounding
 Continuous compounding
m
 i 
ie = lim  1+   1 = e i  1
m 
 m
• This is a theoretical concept, indicating the most frequent compounding.
• In some financial markets (stock, mutual funds, etc.), the transaction occurs
several times a day. Nearly continuous!

 If a new investment returns a nominal interest of 30%, compounded

continuously, what is the effective interest rate?

ie co3 1 34.911
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3.3. Nominal vs. effective interest rate

Nominal
Semi-Annual Quarterly Monthly Daily Continuous
rate
1% 1.00% 1.00% 1.01% 1.01% 1.01%
5% 5.06% 5.10% 5.12% 5.13% 5.13%
10% 10.25% 10.38% 10.47% 10.52% 10.52%
15% 15.56% 15.87% 16.08% 16.18% 16.18%
20% 21.00% 21.55% 21.94% 22.13% 22.14%
30% 32.25% 33.55% 34.49% 34.97% 34.99%
40% 44.00% 46.41% 48.21% 49.15% 49.18%
50% 56.25% 60.18% 63.21% 64.82% 64.87%
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 Summary of Lecture 02
 Time value of money
• Definition of interest and interest rate
• Compound interest vs. simple interest
• Compounding period
 Compounding vs. discounting series: P/F vs. F/P
 Nominal vs. effective interest rate

 Selective end-of-chapter problems

• Newnan Ch03: 15, 17, 24, 28, 35, 39, 45, 51, 62

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