Simple Interest

Simple interest is interest that is incurred only on the amount of principal that is outstanding.
Unpaid interest is not added to the principal, and interest is not charged on unpaid interest.

Simple interest for any amount of time can be calculated with this formula:

I = P × IR X (DO ÷ DY)

Where: I = Simple interest incurred

P = Principal outstanding
IR = Interest rate per year (per annum), in decimal form
DY = Number of days in year (usually 360, but may be 365)
DO = Number of days principal is outstanding

Compound Interest

Usually, interest is compounded at regular intervals. Interest that has accrued (incurred) and has
not been paid by the borrower is added to the outstanding principal at the end of each stated
period. Then the interest incurred for the next period is calculated based on the increased
principal balance that consists of the previous principal plus the compounded (added)
interest. The amount of interest calculated using this procedure is called compound interest.

TIME VALUE OF MONEY

The time value of money refers to the observation that it is better to receive money sooner than
later. Money that you have in hand today can be invested to earn a positive rate of return,
producing more money tomorrow. For that reason, a dollar today is worth more than a dollar in the
future
BASIC PATTERNS OF CASH FLOW

1.) Single amount: A lump-sum amount either currently held or expected at some future date.
Examples include $1,000 today and $650 to be received at the end of 10 years.

2.)Annuity: A level periodic stream of cash flow. For our purposes, we’ll work primarily with
annual cash flows. Examples include either paying out or receiving $800 at the end of each of the
next 7 years.

3.)Mixed stream: A stream of cash flow that is not an annuity; a stream of unequal periodic cash
flows that reflect no particular pattern. Examples include the following two cash flow streams A
and B.

FUTURE VALUE:

The value at a given future date of an amount placed on deposit today and earning interest at a
specified rate. Found by applying compound interest over a specified period of time. The future
value depends on the rate of interest earned and the length of time the money is left on deposit

Let

FVn = future value at the end of period n

PVn = initial principal, or present value

r = annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this
rate.)

n = number of periods (typically years) that the money is left on deposit

The general equation for the future value at the end of period n is
PRESENT VALUE :

Present value is the current dollar value of a future amount—the amount of money that would
have to be invested today at a given interest rate over a specified period to equal the future
amount. Like future value, the present value depends largely on the interest rate and the point in
time at which the amount is to be received

Discounting cash flows

The process of finding present values; the inverse of compounding interest.

Let

FVn = future value at the end of period n

PVn = initial principal, or present value

r = annual rate of interest paid. (Note: On financial calculators, I is typically used to represent this
rate.)

n = number of periods (typically years) that the money is left on deposit

The present value, PV, of some future amount, FVn, to be received n periods from now, assuming an
interest rate (or opportunity cost) of r, is calculated as follows

ANNUITY

A stream of equal periodic cash flows over a specified time period. These cash flows can be inflows
of returns earned on investments or outflows of funds invested to earn future returns.

We can use the present value/future value of an annuity factor to calculate the present value/
future value of an annuity if and only if:

• the amount to be received or paid is a constant amount for each and every payment;

• the amount to be received or paid will be received or paid at the same point in every period; and

• the interest will be compounded once each period.

There are two basic types of annuities.

Ordinary annuity is an annuity with payments made or received at the end of each period (for
example, December 31).
Annuity due is an annuity with payments made or received at the beginning of each period (for
example, January 1).

Future Value of Ordinary Annuity

CF = Annual Cash Flow

Present Value Formulas

* R / CF = Annual Cash Flow

Shortcut: To Adjust a Present Value of an Ordinary Annuity Factor for Use as a Present Value
of an Annuity Due Factor

There are two ways to adjust a Present Value of an Ordinary $1 Annuity for use as a Present Value
of a $1 Annuity Due factor.

1) Use the PV of an ordinary annuity factor for

the interest rate and one period less than the 1+
number of periods needed and add 1.000 to it;
or
2) Multiply the PV of an ordinary annuity factor
for the discount rate and number of periods
needed by 1 + the interest rate.
Perpetuity

A perpetuity is an annuity with an infinite life—in other words, an annuity that never stops
providing its holder with a cash flow at the end of each year (for example, the right to receive $500
at the end of each year forever).

Perpetuity = CF / r

Nominal and Effective Annual Rate

Nominal (stated) annual rate

Contractual annual rate of interest charged by a lender or promised by a borrower.

Effective (true) annual rate

The annual rate of interest actually paid or earned. The effective annual rate reflects the effects of
compounding frequency, whereas the nominal annual rate does not.

Effective Annual Rate Formula

m = the number of times per year interest is compounded

These values demonstrate two important points:

1.) Nominal and effective annual rates are equivalent for annual compounding.

2.) The effective annual rate increases with increasing compounding frequency, up to a limit
that occurs with continuous compounding.

Note: For a stated interest rate and a stated period,

1.) Compound interest is greater than simple interest, because interest is earned on interest; and

2.) The more frequently interest is compounded, all other things being equal, the greater will be the
amount of interest earned.
Case Problems

1.) Present Value of Ordinary Annuity

What is the present value of a 5-year ordinary annuity with annual payments of $200, evaluated at
a 15 percent interest rate?

$ 200 X 1- 1.15 ( raised to negative 5 ) = $ 670.43

0.15

2.) Perpetuity
You have the opportunity to buy a perpetuity that pays $1,000 annually. Your required rate of
return on this investment is 15 percent. You should be essentially indifferent to buying or not
buying the investment if it were offered at a price of

$1,000 / 0.15 = $ 6,666.66

3.) Present Value of a mixed stream

A real estate investment has the following expected cash flows:

Year Cash Flows
1 $10,000
2 25,000
3 50,000
4 35,000
The discount rate is 8 percent. What is the investment’s present value?

1 $10,000 X 1.08 ( raised to negative 1 ) = $ 9,259.3

2 25,000 X 1.08 ( raised to negative 2 ) = 21,433.4
3 50,000 X 1.08 ( raised to negative 3 ) = 39,691.6
4 35,000 X 1.08 ( raised to negative 4 ) = 25,726
= 96,110.3

4.) Future Value with Effective Annual Interest Method

If $100 is placed in an account that earns a nominal 4 percent, compounded quarterly, what will it
be worth in 5 years?

Step 1 : Divide 4 % into 4 quarters = 1 %

Step 2 : Multiply 5 years X 4 quarters = 20 periods

$ 100 X 1.01 ( raised to 20 ) = $ 122.02

Or , find the effective annual rate

(1.01) ( raised to negative 4 ) = 4.06% effective rate

$100 X 1.0406 ( raised to 5 ) = $ 122.02

Case Problems to be discussed during synchronous session

Deriving Present Value to find Future Value

1.) If a 5-year ordinary annuity has a present value of $1,000, and if the interest rate is 10 percent,
what is the amount of each annuity payment? 263.80

Effective Annual Rate Method

2.) An investment pays you 9 percent interest compounded semiannually. A second investment of
equal risk, pays interest compounded quarterly. What nominal rate of interest would you have to
receive on the second investment in order to make you indifferent between the two investments?
9.31%

Annuity due – Future Value

3.) You are contributing money to an investment account so that you can purchase a house in five
years. You plan to contribute six payments of $3,000 a year. The first payment will be made today (t
= 0) and the final payment will be made five years from now (t = 5). If you earn 11 percent in your
investment account, how much money will you have in the account five years from now (at t = 5)?
23,739