3-0

Chapter Three
The Time Value of Finance
Corporate
Ross Westerfield Jaffe
Money and Discounted • •
3
Sixth Edition

Cashflow Model

Instructor: Pham Ha
3-1

Chapter Outline

• The One-Period Case

• The Multiperiod Case
• Compounding Periods
• Simplifications
• What Is a Firm Worth?
• Summary and Conclusions
3-2

Chapter Outline

• Be able to compute the future value of

multiple cash flows
• Be able to compute the present value of
multiple cash flows
• Be able to compute loan payments
• Be able to find the interest rate on a loan
• Understand how loans are amortised or paid
off
• Understand how interest rates are quoted
3-3

3.1 The One-Period Case: Future Value

• If you were to invest $10,000 at 5-percent interest for
one year, your investment would grow to $10,500

$500 would be interest ($10,000 × .05)

$10,000 is the principal repayment ($10,000 × 1)
$10,500 is the total due. It can be calculated as:

$10,500 = $10,000×(1.05).

The total amount due at the end of the investment is

called the Future Value (FV).
3-4

3.1 The One-Period Case: Future Value

• In the one-period case, the formula for FV can
be written as:
FV = C0×(1 + r)

Where C0 is cash flow at date 0 and r is the

appropriate interest rate.
C0×(1 + r)
C0 = $10,000 FV = $10,500
$10,000  1.05

Year 0 1
3-5

3.1 The One-Period Case: Present Value

• If you were to be promised $10,000 due in one year

when interest rates are at 5-percent, your investment
would be worth $9,523.81 in today’s dollars.
$10,000
$9,523.81 =
1.05
The amount that a borrower would need to set aside
today to be able to meet the promised payment of
$10,000 in one year is call the Present Value (PV) of
$10,000.
Note that $10,000 = $9,523.81×(1.05).
3-6

3.1 The One-Period Case: Present Value

• In the one-period case, the formula for PV can
be written as:
C1 present

PV =
value

1+ r
Where C1 is cash flow at date 1 and r is
the appropriate interest rate.

C1/(1 + r)
PV = $9,523.81 C1 = $10,000
$10,000/1.05

Year 0 1
3-7

3.1 The One-Period Case: Net Present Value

• The Net Present Value (NPV) of an investment
is the present value of the expected cash flows,
less the cost of the investment.
• Suppose an investment that promises to pay
$10,000 in one year is offered for sale for
$9,500. Your interest rate is 5%. Should you
buy? $10,000
NPV = −$9,500 +
1.05
NPV = −$9,500 + $9,523.81
NPV = $23.81 Yes!
3-8

3.1 The One-Period Case: Net Present Value

In the one-period case, the formula for NPV can be
written as:
NPV = −Cost + PV
If we had not undertaken the positive NPV project
considered on the last slide, and instead invested our
$9,500 elsewhere at 5-percent, our FV would be less
than the $10,000 the investment promised and we
would be unambiguously worse off in FV terms as
well:
$9,500×(1.05) = $9,975 < $10,000.
3-9

3.2 The Multiperiod Case: Future Value

• The general formula for the future value of an

investment over many periods can be written
as:
FV = C0×(1 + r)T
Where
C0 is cash flow at date 0,
r is the appropriate interest rate, and
T is the number of periods over which the cash is
invested.
3-10

3.2 The Multiperiod Case: Future Value

• Suppose that Jay Ritter invested in the initial

public offering of the Modigliani company.
Modigliani pays a current dividend of $1.10,
which is expected to grow at 40-percent per
year for the next five years.
• What will the dividend be in five years?

FV = C0×(1 + r)T

$5.92 = $1.10×(1.40)5
3-11

Future Value and Compounding

• Notice that the dividend in year five, $5.92, is

considerably higher than the sum of the
original dividend plus five increases of 40-
percent on the original $1.10 dividend:

$5.92 > $1.10 + 5×[$1.10×.40] = $3.30

This is due to compounding.

3-12

Future Value and Compounding

$1.10  (1.40) 5

$1.10  (1.40) 4
$1.10  (1.40) 3
$1.10  (1.40) 2
$1.10  (1.40)

$1.10 $1.54 $2.16 $3.02 $4.23 $5.92

0 1 2 3 4 5
3-13

Present Value and Compounding

• How much would an investor have to set

aside today in order to have $20,000 five
years from now if the current rate is 15%?

PV $20,000

0 1 2 3 4 5
$20,000
$9,943.53 =
(1.15) 5
3-14
How Long is the Wait?

If we deposit $5,000 today in an account paying 10%,

how long does it take to grow to $10,000?

FV = C 0  (1 + r )T $10,000 = $5,000  (1.10)T

$10,000
(1.10) = T
=2
$5,000
ln( 1.10) = ln 2
T

ln 2 0.6931
T= = = 7.27 years
ln( 1.10) 0.0953
3-15
What Rate Is Enough?
Assume the total cost of a university education will be
$50,000 when your child enters university in 12 years.
You have $5,000 to invest today. What rate of interest
must you earn on your investment to cover the cost of
your child’s education? About 21.15%.
FV = C 0  (1 + r ) T
$50,000 = $5,000  (1 + r ) 12

$50,000
(1 + r ) =
12
= 10 (1 + r ) = 101 12
$5,000

r = 10
1 12
− 1 = 1.2115 − 1 = .2115
3-16

3.3 Compounding Periods

Compounding an investment m times a year for
T years provides for future value of wealth:
mT
 r
FV = C0  1 + 
 m
For example, if you invest $50 for 3 years at
12% compounded semi-annually, your
investment will grow to
23
 .12 
FV = $50  1 +  = $50  (1.06) = $70.93
6

 2 
3-17

Effective Annual Interest Rates

A reasonable question to ask in the above
example is what is the effective annual rate of
interest on that investment?
.12 23
FV = $50  (1 + ) = $50  (1.06) 6 = $70.93
2
The Effective Annual Interest Rate (EAR) is the
annual rate that would give us the same end-of-
investment wealth after 3 years:
$50  (1 + EAR ) 3 = $70.93
3-18

Effective Annual Interest Rates (continued)

FV = $50  (1 + EAR ) 3 = $70.93

$70.93
(1 + EAR) =
3

$50
13
 $70.93 
EAR =   − 1 = .1236
 $50 
So, investing at 12.36% compounded annually
is the same as investing at 12% compounded
semiannually.
3-19

Continuous Compounding (Advanced)

• The general formula for the future value of an
investment compounded continuously over many
periods can be written as:
FV = C0×erT
Where
C0 is cash flow at date 0,
r is the stated annual interest rate,
T is the number of periods over which the cash is
invested, and
e is a transcendental number approximately equal
to 2.718. ex is a key on your calculator.
3-20

3.4 Simplifications

• Perpetuity
– A constant stream of cash flows that lasts forever.
• Growing perpetuity
– A stream of cash flows that grows at a constant rate
forever.
• Annuity
– A stream of constant cash flows that lasts for a fixed
number of periods.
• Growing annuity
– A stream of cash flows that grows at a constant rate for a
fixed number of periods.
3-21

Perpetuity
A constant stream of cash flows that lasts forever.
C C C
…
0 1 2 3
C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3

The formula for the present value of a perpetuity is:

C
PV =
r
3-22

Perpetuity: Example
What is the value of a British consol that promises to
pay £15 each year, every year until the sun turns
into a red giant and burns the planet to a crisp?
The interest rate is 10-percent.

£15 £15 £15

…
0 1 2 3

£15
PV = = £150
.10
3-23

Growing Perpetuity
A growing stream of cash flows that lasts forever.
C C×(1+g) C ×(1+g)2
…
0 1 2 3
C C  (1 + g ) C  (1 + g ) 2
PV = + + +
(1 + r ) (1 + r ) 2
(1 + r ) 3

The formula for the present value of a growing perpetuity is:

C
PV =
r−g
3-24

Growing Perpetuity: Example

The expected dividend next year is $1.30 and
dividends are expected to grow at 5% forever.
If the discount rate is 10%, what is the value of this
promised dividend stream?
$1.30 $1.30×(1.05) $1.30 ×(1.05)2
…
0 1 2 3

$1.30
PV = = $26.00
.10 − .05
3-25

Annuity
A constant stream of cash flows with a fixed maturity.
C C C C

0 1 2 3 T

C C C C
PV = + + +
(1 + r ) (1 + r ) (1 + r )
2 3
(1 + r )T
The formula for the present value of an annuity is:

C 1 
PV = 1 − T 
r  (1 + r ) 
3-26

Annuity: Example
If you can afford a $400 monthly car payment, how
much car can you afford if interest rates are 7% on
36-month loans?
$400 $400 $400 $400

0 1 2 3 36

$400  1 
PV = 1 − 36 
= $12,954.59
.07 / 12  (1 + .07 12) 
3-27

Annuity: Canadian Mortgages

What is special about Canadian Mortgages?

• Canadian banks quote the annual interest

compounded semi-annually for mortgages, although
interest is calculated (compounded) every month.

• The terms of the mortgage are usually renegotiated

during the term of the mortgage. For example, the
interest of a 25-year mortgage can be negotiated 5
years after the initiation of the mortgage.
3-28

Canadian Mortgages: Example

You have negotiated a 25-year, $100,000 mortgage at a
rate of 7.4% per year compounded semi-annually with
the Toronto-Dominion Bank. What is your monthly
payment?

To answer this question, we first have to convert the

quoted mortgage rate, to the effective interest rate
charged each month.

We have: 2
 0.074 
EAR = 1 +  − 1 = .075369 = 7.5369%
 2 
3-29

Canadian Mortgages: Example (Continued)

The effective interest rate charged each month is
given by:

(1 + 0.075369 )
1
12 − 1 = .00607369 = .607369 %
We use the present value of annuity formula to find
the monthly payment (PMT):

PMT  1 
100,000 = 1− 300 
.00607369  (1 + .00607369) 

PMT = $725.28
3-30

Growing Annuity
A growing stream of cash flows with a fixed maturity.
C C×(1+g) C ×(1+g)2 C×(1+g)T-1

0 1 2 3 T
C C  (1 + g ) C  (1 + g )T −1
PV = + ++
(1 + r ) (1 + r ) 2
(1 + r )T
The formula for the present value of a growing annuity:

C   1+ g  
T

PV = 1 −   
r − g   (1 + r )  
 
3-31

Growing Annuity
A retirement plan offers to pay $20,000 per year for
40 years and increase the annual payment by 3-
percent each year. What is the present value at
retirement if the discount rate is 10-percent?

$20,000 $20,000×(1.03) $20,000×(1.03)39


0 1 2 40

$20,000   1.03  
40

PV = 1 −    = $265,121.57
.10 − .03   1.10  
3-32

3.5 What Is a Firm Worth?

• Conceptually, a firm should be worth the

present value of the firm’s cash flows.

• The tricky part is determining the size,

timing, and risk of those cash flows.
3-33

3.6 Summary and Conclusions

• Two basic concepts, future value and present value

are introduced in this chapter.
• Interest rates are commonly expressed on an annual
basis, but semi-annual, quarterly, monthly and even
continuously compounded interest rate
arrangements exist.
• The formula for the net present value of an
investment that pays $C for N periods is:
N
C C C C
NPV = −C0 + + ++ = −C 0 + 
(1 + r ) (1 + r ) 2
(1 + r ) N
t =1 (1 + r ) t
3-34

3.6 Summary and Conclusions (continued)

• We presented four simplifying formulae:
C
Perpetuity : PV =
r
C
Growing Perpetuity : PV =
r−g
C 1 
Annuity : PV = 1 − T 
r  (1 + r ) 

C   1+ g  
T

Growing Annuity : PV = 1 −   
r − g   (1 + r )  
 
3-35

How do you get to Bay Street?

• Practice, practice, practice.

• It’s easy to watch Olympic gymnasts and
convince yourself that you are a leotard
purchase away from a triple back flip.
• It’s also easy to watch your finance professor
do time value of money problems and
convince yourself that you can do them too.
• There is no substitute for getting out the
calculator and flogging the keys until you can
do these correctly and quickly.
3-36

Multiple Cash Flows – FV Example 1

• Suppose you invest $500 in a investment

fund today and $600 in one year. If the fund
pays 9% annually, how much will you have
in two years?
– FV = 500(1.09)2 + 600(1.09) = $1248.05
3-37

Example 2 Continued

• How much will you have in 5 years if you

make no further deposits?
• First way:
– FV = 500(1.09)5 + 600(1.09)4 = $1616.26
• Second way – use value at year 2:
– FV = 1248.05(1.09)3 = $1616.26
3-38

Multiple Cash Flows – FV Example 2

• Suppose you plan to deposit $100 into an

account in one year and $300 into the
account in three years. How much will be in
the account in five years if the interest rate is
8%?
– FV = 100(1.08)4 + 300(1.08)2 = 136.05 + 349.92
= $485.97
3-39

Example 2 Timeline

0 1 2 3 4 5

100 300

136.05

349.92

$485.97
3-40

Multiple Cash Flows – PV Another Example

• You are considering an investment that will

pay you $1000 in one year, $2000 in two
years and $3000 in three years. If you want to
earn 10% on your money, how much would
you be willing to pay?
– PV = 1000 / (1.1)1 = $909.09
– PV = 2000 / (1.1)2 = $1652.89
– PV = 3000 / (1.1)3 = $2253.94
– PV = 909.09 + 1652.89 + 2253.94 = $4815.93
3-41
Example: Spreadsheet Strategies

• You can use the PV or FV functions in Excel

to find the present value or future value of a
set of cash flows
• Setting the data up is half the battle – if it is
set up properly, then you can just copy the
formulas
3-42

Decisions, Decisions
• Your broker calls you and tells you that he has this great investment
opportunity. If you invest $100 today, you will receive $40 in one year
and $75 in two years. If you require a 15% return on investments of this
risk, should you take the investment?
– Use the CF keys to compute the value of the
investment
• CF; CF0 = 0; C01 = 40; F01 = 1; C02 = 75; F02 = 1
• NPV; I = 15; CPT NPV = $91.49

– No – the broker is charging more than you would

be willing to pay
3-43

Saving for Retirement

• You are offered the opportunity to put some

money away for retirement. You will receive
five annual payments of $25,000 each
beginning in 40 years. How much would you
be willing to invest today if you desire an
interest rate of 12%?
– Use cash flow keys:
• CF; CF0 = 0; C01 = 0; F01 = 39; C02 = 25000; F02 =
5; NPV; I = 12; CPT NPV = $1084.71
3-44

Saving for Retirement Timeline

0 1 2 … 39 40 41 42 43 44

0 0 0 … 0 25K 25K 25K 25K 25K

Notice that the year 0 cash flow = 0 (CF0 = 0)
The cash flows years 1 – 39 are 0 (C01 = 0; F01
= 39
The cash flows years 40 – 44 are 25,000 (C02 =
25,000; F02 = 5)
3-45

Quick Quiz: Part 1

• Suppose you are looking at the following

possible cash flows: Year 1 CF = $100;
Years 2 and 3 CFs = $200; Years 4 and 5 CFs
= $300. The required discount rate is 7%
• What is the value of the cash flows at year 5?
• What is the value of the cash flows today?
• What is the value of the cash flows at year 3?
3-46

Annuities and Perpetuities Defined

• Annuity – finite series of equal payments that

occur at regular intervals
– If the first payment occurs at the end of the
period, it is called an ordinary annuity
– If the first payment occurs at the beginning of the
period, it is called an annuity due
• Perpetuity – infinite series of equal payments
3-47

Annuities and Perpetuities – Basic Formulas

• Perpetuity: PV = C/r
• Annuities:

 1 
1 − 
(1 + r ) t
PV = C  
 r 

 

 (1 + r ) t − 1 
FV = C  
 r 
3-48

Annuities and the Calculator

• You can use the PMT key on the calculator

for the equal payment
• The sign convention still holds
• Ordinary annuity versus annuity due
– You can switch your calculator between the two
types by using the 2nd BGN 2nd Set on the TI BA-
II Plus
– If you see “BGN” or “Begin” in the display of
your calculator, you have it set for an annuity due
– Most problems are ordinary annuities
3-49

Annuity – Sweepstakes Example

• Suppose you win the Publishers

Clearinghouse $10 million sweepstakes. The
money is paid in equal annual instalments of
$333,333.33 over 30 years. If the appropriate
discount rate is 5%, how much is the
sweepstakes actually worth today?
– PV = 333,333.33[1 – 1/1.0530] / .05 =
$5,124,150.29
3-50

Buying a House

• You are ready to buy a house and you have a

$20,000 deposit and legal fees. Legal fees are
estimated to be 4% of the loan value. You have an
annual salary of $36,000 and the bank is willing to
allow your monthly mortgage payment to be equal
to 28% of your monthly income. The interest rate
on the loan is 6% per year with monthly
compounding (.5% per month) for a 30-year fixed
rate loan. How much money will the bank loan you?
How much can you offer for the house?
3-51

Buying a House – Continued

• Bank loan
– Monthly income = 36,000 / 12 = $3,000
– Maximum payment = .28(3,000) = $840
– PV = 840[1 – 1/1.005360] / .005 = $140,105
• Total Price
– Legal fees = .04(140,105) = $5,604
– Deposit = 20,000 – 5604 = $14,396
– Total Price = 140,105 + 14,396 = $154,501
3-52

Example: Spreadsheet Strategies – Annuity PV

• The present value and future value formulas

in a spreadsheet include a place for annuity
payments
3-53

Quick Quiz: Part 2

• You know the payment amount for a loan and

you want to know how much was borrowed.
Do you compute a present value or a future
value?
• You want to receive $5000 per month in
retirement. If you can earn .75% per month
and you expect to need the income for 25
years, how much do you need to have in your
account at retirement?
3-54

Finding the Payment

• Suppose you want to borrow $20,000 for a

new car. You can borrow at 8% per year,
compounded monthly (8/12 = .66667% per
month). If you take a 4 year loan, what is
your monthly payment?
– 20,000 = C[1 – 1 / 1.006666748] / .0066667
– C = $488.26
3-55
Example: Spreadsheet Strategies – Annuity Payment

• Another TVM formula that can be found in a

spreadsheet is the payment formula
– PMT(rate,nper,pv,fv)
– The same sign convention holds as for the PV
and FV formulas
3-56

Finding the Number of Payments –

• Suppose you borrow $2000 at 5% and you

are going to make annual payments of
$734.42. How long before you pay off the
loan?
– 2000 = 734.42(1 – 1/1.05t) / .05
– .136161869 = 1 – 1/1.05t
– 1/1.05t = .863838131
– 1.157624287 = 1.05t
– t = ln(1.157624287)/ln(1.05) = 3 years
3-57

Finding the Rate

• Suppose you borrow $10,000 from your

parents to buy a car. You agree to pay
$207.58 per month for 60 months. What is
the monthly interest rate?
– Sign convention matters!!!
– 60 N
– 10,000 PV
– -207.58 PMT
– CPT I/Y = .75%
3-58
Annuity – Finding the Rate Without a Financial Calculator

• Trial and Error Process

– Choose an interest rate and compute the PV of
the payments based on this rate
– Compare the computed PV with the actual loan
amount
– If the computed PV > loan amount, then the
interest rate is too low
– If the computed PV < loan amount, then the
interest rate is too high
– Adjust the rate and repeat the process until the
computed PV and the loan amount are equal
3-59

Quick Quiz: Part 3

• You want to receive $5000 per month for the next 5

years. How much would you need to deposit today
if you can earn .75% per month?
• What monthly rate would you need to earn if you
only have $200,000 to deposit?
• Suppose you have $200,000 to deposit and can earn
.75% per month
– How many months could you receive the $5000
payment?
– How much could you receive every month for 5
years?
3-60

Future Values for Annuities

• Suppose you begin saving for your retirement

by depositing $2000 per year in a
superannuation fund. If the interest rate is
7.5%, how much will you have in 40 years?
– FV = 2000(1.07540 – 1)/.075 = $454,513.04
3-61

Annuity Due

• You are saving for a new house and you put

$10,000 per year in an account paying 8%.
The first payment is made today. How much
will you have at the end of 3 years?
– FV = 10,000[(1.083 – 1) / .08](1.08) =
$35,061.12
3-62

Annuity Due Timeline

0 1 2 3

$10,000 $10,000 $10,000

$35,061.12
3-63

Table 3.2
3-64

Quick Quiz: Part 4

• You want to have $1 million to use for retirement in

35 years. If you can earn 1% per month, how much
do you need to deposit on a monthly basis if the first
payment is made in one month?
• What if the first payment is made today?
• You are considering preference shares that pay a
quarterly dividend of $1.50. If your desired return is
3% per quarter, how much would you be willing to
pay?
3-65

Effective Annual Rate (EAR)

• This is the actual rate paid (or received)

after accounting for compounding that
occurs during the year
• If you want to compare two alternative
investments with different compounding
periods you need to compute the EAR
and use that for comparison
3-66

Annual Percentage Rate

• This is the annual rate that is quoted by law

• By definition APR = period rate times the
number of periods per year
• Consequently, to get the period rate we
rearrange the APR equation:
– Period rate = APR/number of periods per year
• You should NEVER divide the effective rate
by the number of periods per year – it will
NOT give you the period rate
3-67

Computing APRs

• What is the APR if the monthly rate is 0.5%?

– 0.5(12) = 6%
• What is the APR if the semiannual rate is 0.5%?
– 0.5(2) = 1%
• What is the monthly rate if the APR is 12% with
monthly compounding?
– 12 / 12 = 1%
– Can you divide the above APR by 2 to get the
semiannual rate? NO!!! You need an APR based
on semiannual compounding to find the
semiannual rate
3-68

Things to Remember
• You ALWAYS need to make sure that the interest rate and the time
period match
– If you are looking at annual periods, you need an
annual rate
– If you are looking at monthly periods, you need a
monthly rate
• If you have an APR based on monthly compounding, you have to use
monthly periods for lump sums, or adjust the interest rate appropriately if
you have payments other than monthly
3-69

Computing EARs – Example

• Suppose you can earn 1% per month on $1 invested today.
– What is the APR? 1(12) = 12%
– How much are you effectively earning?
• FV = 1(1.01)12 = 1.1268
• Rate = (1.1268 – 1) / 1 = .1268 = 12.68%
• Suppose if you put it in another account, you earn 3% per quarter.
– What is the APR? 3(4) = 12%
– How much are you effectively earning?
• FV = 1(1.03)4 = 1.1255
• Rate = (1.1255 – 1) / 1 = .1255 = 12.55%
3-70

EAR – Formula

m
 APR 
EAR = 1 +  − 1
 m 
Remember that the APR is the quoted
rate
3-71

Decisions, Decisions II

• You are looking at two savings accounts.

One pays 5.25%, with daily compounding.
The other pays 5.3% with semiannual
compounding. Which account should you
use?
– First account:
• EAR = (1 + .0525/365)365 – 1 = 5.39%
– Second account:
• EAR = (1 + .053/2)2 – 1 = 5.37%
• Which account should you choose and why?
3-72

Decisions, Decisions II Continued

• Let’s verify the choice. Suppose you invest

$100 in each account. How much will you
have in each account in one year?
– First Account:
• Daily rate = .0525 / 365 = .00014383562
• FV = 100(1.00014383562)365 = $105.39
– Second Account:
• Semiannual rate = .0539 / 2 = .0265
• FV = 100(1.0265)2 = $105.37
• You will have more money in the first
account
3-73

Computing APRs from EARs

• If you have an effective rate, how can you

compute the APR? Rearrange the EAR
equation and you get:


APR = m (1 + EAR)
1
m
-1
 
3-74

APR – Example

• Suppose you want to earn an effective rate of

12% and you are looking at an account that
compounds on a monthly basis. What APR
must they pay?
 
APR = 12 (1 + .12) − 1 = .1138655152
12

or 11.39%
3-75

Computing Payments with APRs

• Suppose you want to buy a new computer system and the store is willing
to sell it to allow you to make monthly payments. The entire computer
system costs $3500. The loan period is for 2 years and the interest rate is
16.9% with monthly compounding. What is your monthly payment?
– Monthly rate = .169 / 12 = .01408333333
– Number of months = 2(12) = 24
– 3500 = C[1 – 1 / 1.01408333333)24] /
.01408333333
– C = $172.88
3-76

Future Values with Monthly Compounding

• Suppose you deposit $50 a month into an

account that has an APR of 9%, based on
monthly compounding. How much will you
have in the account in 35 years?
– Monthly rate = .09 / 12 = .0075
– Number of months = 35(12) = 420
– FV = 50[1.0075420 – 1] / .0075 = $147,089.22
3-77

Present Value with Daily Compounding

• You need $15,000 in 3 years for a new car. If

you can deposit money into an account that
pays an APR of 5.5% based on daily
compounding, how much would you need to
deposit?
– Daily rate = .055 / 365 = .00015068493
– Number of days = 3(365) = 1095
– FV = 15,000 / (1.00015068493)1095 = $12,718.56
3-78

Quick Quiz: Part 5

• What is the definition of an APR?

• What is the effective annual rate?
• Which rate should you use to compare
alternative investments or loans?
• Which rate do you need to use in the time
value of money calculations?
3-79

Pure Discount Loans – Example

• Bank bills are excellent examples of pure

discount loans. The principal amount is
repaid at some future date, without any
periodic interest payments.
• If a bank bill promises to repay $10,000 in 12
months and the market interest rate is 7
percent, how much will the bill sell for in the
market?
– PV = 10,000 / 1.07 = $9345.79
3-80

Interest Only Loan – Example

• Consider a 5-year, interest only loan with a

7% interest rate. The principal amount is
$10,000. Interest is paid annually
– What would the stream of cash flows be?
• Years 1 – 4: Interest payments of .07(10,000) = $700
• Year 5: Interest + principal = $10,700
• This cash flow stream is similar to the cash
flows on corporate bonds and we will talk
about them in greater detail later
3-81
Amortised Loan with Fixed Payment – Example

• Each payment covers the interest expense

plus reduces principal
• Consider a 4 year loan with annual payments.
The interest rate is 8% and the principal
amount is $5000.
– What is the annual payment?
• 5000 = C[1 – 1 / 1.084] / .08
• C = $1509.60
3-82

Amortisation Table – Example

Year Beginning Total Interest Principal End
Balance Payment Paid Paid Balance
1 5000.00 1509.60 400.00 1109.60 3890.40

2 3890.40 1509.60 311.23 1198.37 2692.03

3 2692.03 1509.60 215.36 1294.24 1397.79

4 1397.79 1509.60 111.82 1397.78 .01

Totals 6038.40 1038.41 4999.99

3-83

Example: Spreadsheet Strategies

• Each payment covers the interest expense plus
reduces principal
• Consider a 4 year loan with annual payments. The
interest rate is 8% and the principal amount is
$5000.
– What is the annual payment?
• 4N
• 8 I/Y
• 5000 PV
• CPT PMT = -1509.60
3-84

Example: Work the Web

• Several web sites have calculators that will prepare amortisation tables
quickly
• One such site is westpac.com.au
• Go to their web site and enter the following information into their loan
calculator:
– Loan amount = $20,000
– Term = 10 years
– Interest rate = 7.625%
– What is the monthly payment?
– Using the calculator you will get $238.71
3-85

Quick Quiz: Part 6

• What is a pure discount loan? What is a good

example of a pure discount loan?
• What is an interest only loan? What is a good
example of an interest only loan?
• What is an amortised loan? What is a good
example of an amortised loan?