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Lecture Ch 3 No Notes

Chapter 3 of BUS2016H discusses the time value of money, explaining why interest is paid and differentiating between simple and compound interest. It covers key concepts such as accumulation factors, present values, and discount rates, providing examples to illustrate the calculations involved. The chapter emphasizes the principle of consistency in investment outcomes and the importance of understanding present values for future payments.

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4 views

Lecture Ch 3 No Notes

Chapter 3 of BUS2016H discusses the time value of money, explaining why interest is paid and differentiating between simple and compound interest. It covers key concepts such as accumulation factors, present values, and discount rates, providing examples to illustrate the calculations involved. The chapter emphasizes the principle of consistency in investment outcomes and the importance of understanding present values for future payments.

Uploaded by

khulumazebsingini
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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BUS2016H

Ms Elsa Gouws
Chapter 3
Time value of money
Content
 Why interest is paid (time value of money)
 Interest
 Simple
 Compound
 Accumulation factors
 Principle of consistency
 Present values
 Discount rates
 Simple (payable in advance)
 Compound (payable in advance)
 Discount factors
 Effective rates of interest and discount
Why do we expect to be paid interest?

 reward paid by one person or organisation for the use of an asset

Some terminology:
 If amount expressed in monetary terms:
o capital also called principal
o accumulated value
o interest = accumulated value – principal
Note: this assumes no other payments made or received
 some factors influencing interest
o risk of default allowance
o purchasing power eroded
o opportunity cost
1.Interest
 simple
o interest, once credited to an account, does not
itself earn further interest

 compound
o interest itself earns interest

Which will be higher?


1.1 Simple interest

C is deposited in an account that pays simple


interest at the rate of i% per annum.
Accumulated value @ t=n:
C(1+ ni) (1.1)
 n = # time units →does not have to be
years→ does not have to be any integer
 time units of n and i must correspond i.e.
n is number of months the i must be
monthly interest rate
Question
An investor deposits R10,000 in a bank account that pays
simple interest at a rate of 5% pa. What will the deposit
have accumulated to after 3 years?

@ t= 1: Interest = 10,000 * 0.05 = 500


Total: 10,500
@ t= 2: Interest = 10,000 * 0.05 = 500
Total: 11,000
@ t= 3: Interest = 10,000 * 0.05 = 500
Total: 11,500
Using (1.1) 10,000 + 10,000*0.05*3=11,500

*** Only earn interest on initial capital***


Question
An investor puts R5,000 in a savings account that pays 10% simple interest
at the end of each year. Compare how much the investor would have after 6
years if the money was:

(i) invested for 6 years

(ii) invested for 3 years, then immediately reinvested for a further 3 years.
Question
An investor puts R5,000 in a savings account that pays 10% simple interest
at the end of each year. Compare how much the investor would have after 6
years if the money was:

(i) invested for 6 years

(ii) invested for 3 years, then immediately reinvested for a further 3 years.

(ii) 5,000 + 5,000*0.1*6 = 8,000

(ii) 5,000 + 5,000*0.1*3 = 6,500


6,500 + 6,500*0.1*3 = 8,450

8,000 vs 8,450 Why?


1.2Compound (effective) interest
Suppose an amount C is deposited in an account that pays
compound interest at the rate of i% per annum.

Accumulated value @ t=n: C(1+ i)n (1.2)


 n = # time units →does not have to be years→
does not have to be an integer
 time units of n and i must correspond i.e. n is
number of months the i must be monthly
interest rate
Question
An investor deposits R10,000 in a bank account that pays compound interest
at a rate of 5% pa. What will the deposit have accumulated to after 3 years?

@ t= 1: Interest = 10,000 * 0.05 = 500


Total: 10,500
@ t= 2: Interest = 10,500 * 0.05 = 525
Total: 11,025
@ t= 3: Interest = 11,025 * 0.05 = 551.25
Total: 11,576.25

Using (1.2) 10, 000(1.05)3 =11,576.25

*** Earning interest on total amount in account***


Question
An investor puts R5,000 in a savings account that pays 10%
compound interest at the end of each year. Compare how much
the investor would have after 6 years if the money was:

(i) Invested for 6 years


(ii) Invested for 3 years and then re-invested for a
further 3 years
Question
An investor puts R5,000 in a savings account that pays 10%
compound interest at the end of each year. Compare how much
the investor would have after 6 years if the money was:

(i) Invested for 6 years


(ii) Invested for 3 years and then re-invested for a
further 3 years

(i) 5, 000(1.1)6 =8,858

(ii) 5, 000(1.1)3 =6,655


6,655(1.1)3 =8,858
1.3 Accumulation factors
For t1 £ t2

we define A(t1,t2 ) = the accumulation at time t2 of an investment of 1


at time t1 → accumulation factor because C.A(t1,t2 ) = accumulation
of C from t1 to t2.
Special case where t1 = 0,
A(0,n) = A(n) so A(t) is the accumulation of 1 unit of capital (eg R1) from time
zero to time t
A(0,n ) = (1+ ni) for simple interest or (1+ i)n for compound interest
Question
An investment of R1,000 in an account accumulated to R2,500 after 5 years.

(i) State the accumulation factor A(0,5) .

What: (a) simple annual interest rate which would give the accumulation factor in (i)?
2.5 = 1* (1+ 5i) Þ i = 30%
(b) annual compound interest rate which would give the accumulation factor in
part (i)?
2.5 = 1* (1+ i)5 Þ i = 20%

Required simple i > compound i (all else being equal) and n


>1
Principle of consistency

In a consistent market accumulated proceeds should not depend on the course of


action taken by the investor.
Meaning for 0 <= t <= n
A(0,n) = A(0,t) x A(t,n)
2. Present values
How much do we need to invest now to provide payments at a later time?

Very relevant to insurance companies.


→ the present value (PV) or discounted value of the payments

Question
An investor must make a payment of R5,000 in 5 years’ time. The investor
wishes to make provision for this payment by investing a single sum now in
a deposit account that pays 10% per annum compound interest.

How much should the initial investment be?


• Store values in computer – showing about 5 decimals in your interim
workings (unless question states otherwise)
2. Discount rates
Alternate method for
Question

Discount R10,000 for 3 years using a simple discount rate of 5% pa.

Can also calculate as : 10,000(1-0.05*3) = 8,500

normal commercial practice, d is usually encountered only for


periods of less than a year → rate of commercial discount.
Eg Treasury bills
Ie get discount Ie get interest
on discount on interest
Ie Present value = Accumulated value x (1 – d) x (1 – d) where
considering 2 periods of compound discount. Simple discount
present value = (1 – 2 d)
Use ? Formula

Use ? formula

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