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IE 5441

# 4. Money-Time Relationships

Capital Returns and Interests.


Simple Interest:
I = (P )(N )(i)
where
P:

the principal,

N:

the number of periods,

i:

interest per period.

Example: Borrow $1,000 for 3 years with annual interest rate 10%.
The total amount of interest is $300.
Important: Timing of the interest payment unspecied! Or, to put it
equivalently: the interests do not accumulate.
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IE 5441

Compounding Interest:
Another way of calculation:

Borrowed
Interest

Year 1

Year 2

Year 3

1000

1100

1210

100

110

121

So the total amount of interest to be paid by the end of Year 3 is $331!


In general:
Year 1

Year n

Year N

Borrowed

P (1 + i)n1

P (1 + i)N 1

Interest

Pi

P (1 + i)n1 i

P (1 + i)N 1 i

Total amount interest by Year N :


I = Pi

(1 + i)n1 = P [(1 + i)N 1]

n=1

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IE 5441

It is clear that a deal involving interests and cash payments in the


future time needs specications of:
What is the interest rate? (What type?)
How long is the time period?
The timing of the payments?

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IE 5441

Continuous Compounding:
Suppose that the interest is accumulated in every minute, every second
... What should be paid at time T ?
Divide T into N periods, each with the length T /N . Suppose that the
overall interest rate is r per unit of time, i.e. each period requires a
compounding interest rate of rT /N .
Then in N periods of time, the total amount of interests plus principal
is:
P + I = P (1 + rT /N )N .
If N then the above quantity
lim P (1 + rT /N )N = P erT

where e 2.718.
If one borrows $100 at 10% continuous annual rate, then in one year
time he needs to pay back $100 e0.1 110.52.
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IE 5441

Equivalence Under a Given Interest Rate.


Suppose that the annual (compounding) interest rate is 10%. Then,
one is indierent between $100 today and $110 in one year time, or
$121 in two years time.
Equivalent:
(a) Get $200 today;
(b) Get nothing today, but will receive $110 in one year time and
another $121 in two years time.
Of course, this equivalence depends critically on the fact that we
assume the interest rate is 10%!

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IE 5441

Assume that the annual interest rate is 10% and we borrow $8,000 for
four years. Compare the following four paying schemes.
Y

P.P.

T.P.

P.P.

T.P.

8,000

800

2,000

2,800

8,000

800

800

6,000

600

2,000

2,600

8,000

800

800

4,000

400

2,000

2,400

8,000

800

800

2,000

200

2,000

2,200

8,000

800

8,800

Total:

10,000

Total:

11,200

P.P.

T.P.

P.P.

T.P.

8,000

800

1,724

2,524

8,000

800

6,276

628

1,896

2,524

8,800

880

4,380

438

2,086

2,524

9,680

968

2,294

230

2,294

2,524

10,648

1,065

10,648

11,713

Total:

10,096

Total:

11,713

These four schemes are equivalent in the sense that we just mentioned.
Important: It depends critically on the assumption that the interest
rate is constantly 10%!

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IE 5441

Useful acronyms to remember:


i:

interest rate per period;

N:

number of periods;

P:

present sum of money;

F:

future sum of money;

A:

amortized payment.

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IE 5441

Cash Flow Diagram:


t=0

t=1

t=2

time
t=N 1

t=N

cash flows

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IE 5441

Interest Formulas.
We always assume that i and N are given.
Task: derive one parameter, provided another parameter is given.
We will adopt the following functional symbol
(F/P, i%, N )
meaning:
nd the future worth, provided that the present worth P is
given (nominally 1 dollar), interest per period is i, and the
number of periods is N .
Similarly, we speak of
(P/F, i%, N ), (P/A, i%, N ), and (A/F, i%, N ), and so on.

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IE 5441

10

What if (F/P, i%, N ) is known, but our present worth is 2 rather


than 1?
Well, it is simply 2 (F/P, i%, N ).
In general, if the present worth is p dollars, then the equivalent worth
in N periods is
p (F/P, i%, N ).
There is a linear relation!
This is true for all formulae to come.

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IE 5441

11

Now we try to derive those formulae explicitly.


Formula for (F/P, i%, N ) (Given P nd F ).
As we saw before, the interest for period n will be i(1 + i)n1 ,
i = 1, ..., N . So, at the end of year N , the total amount of interests
will be
N

(1 + i)n1 = (1 + i)N 1.
1i
n=1

Now, the principal amount, $1, has to be paid as well. So, the total
equivalent amount is
(1 + i)N .
In other words,
(F/P, i%, N ) = (1 + i)N .

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IE 5441

12

Let us see examples to illustrate the usage of this formula.


Let i = 10% and N = 15. Then,
(F/P, 10%, 15) = (1 + 10%)15 = 4.1772.
Example: Suppose that you have a child of 3 years old. There is a
bank oering 10% annual interest return. You want to invest in this
opportunity for the college fee of your child. Suppose that you have
$100,000 to invest. What will this amount become in 15 years time?
Well, it is
100, 000 (F/P, 10%, 15) = 417, 720.
Example:
F = 8, 000 (F/P, 10%, 4) = $11, 713.

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IE 5441

13

Formula for (P/F, i%, N ) (Given F nd P ).


It is reciprocal to (F/P, i%, N ):
1
(P/F, i%, N ) =
= (1 + i)N .
(F/P, i%, N )
Example: How much money you need to put in a bank with annual
interest rate 8% in order to save for $1 million in 30 years time?
P = 1, 000, 000 (P/F, 8%, 30) = $99, 400.

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IE 5441

14

These two formulas involve only a single payment. Next we consider


cash ows involve more than two payments.
We start with Uniform Series.
Formula for (F/A, i%, N ) (Given annual payment A nd F ):
If one receives $1 each year, then this accumulates into
(F/P, i%, N 1) + + (F/P, i%, 0)
= (1 + i)N 1 + + (1 + i)1 + 1
=

(1 + i)N 1
.
i

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IE 5441

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Therefore,
(1 + i)N 1
.
(F/A, i%, N ) =
i
Example: If you deposit $10,000 in a bank every year for 18 years at
interest rate 8%. Then this amount becomes
F = 10, 000 (F/A, 8%, 18) = $374, 502.
What this amount will be if the interest rate is 10%?
What if N = 20?

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IE 5441

16

Formula for (A/F, i%, N ) (Given F nd A).


This is simply reciprocal to (F/A, i%, N ), i.e.
(A/F, i%, N ) =

1
i
=
.
N
(F/A, i%, N )
(1 + i) 1

Example: How much do you need to invest every year in order to yield
$1 million in 30 year?
A = 1, 000, 000 (A/F, 8%, 30) = $8, 827.
How much will this amount be if the interest rate is 10%?

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IE 5441

17

Formula for (P/A, i%, N ) (Given A nd P ).


We can simply do it in two steps. First we compute (F/A, i%, N ) and
then multiple it with (P/F, i%, N ), i.e.,
(P/A, i%, N )

=
=
=

(F/A, i%, N ) (P/F, i%, N )


(1 + i)N 1
(1 + i)N
i
(1 + i)N 1
.
N
i(1 + i)

Example: You are running a bank. A customer agrees to pay you


$100,000 each year with annual interest rate of 10% for 5 years. How
much money will you lend to him?
100, 000 (P/A, 10%, 5) = $379, 080.

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IE 5441

18

Formula for (A/P, i%, N ) (Given P nd A).


It is again reciprocal to (P/A, i%, N ):
i(1 + i)N
(A/P, i%, N ) =
.
N
(1 + i) 1
Example: You want to buy an apartment at the price of $400,000. You
will do this with a mortgage from a bank at the annual interest rate
8% for 30 years. What is your annual payment?
A = 400, 000 (A/P, 8%, 30) = $35, 520
($2,960 per month).
Example: Remember the example before?
8, 000 (A/P, 10%, 4) = 2, 524

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IE 5441

19

The annual payment will be less and less as N becomes larger.


However, this amount will not go to zero in any way. In fact, if N is
suciently large, then A P i.
Another interesting point is to understand how much in each annual
payment is devoted to interest and how much to principal.
It can be calculated that in year n, the interest payment is
(1 + i)N (1 + i)n1
In = P i
(1 + i)N 1
the payment for reducing the principal is
(1 + i)n1
Bn = P i
,
(1 + i)N 1
and the remaining principal is
(1 + i)N (1 + i)n
Pn = P
.
N
(1 + i) 1
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IE 5441

20

More Interest Rate Formulas


The formulas discussed so far can be used to derive other formulas.
For example, consider the present worth of deferred annuity:
(P/A, i%, N J)(P/F, i%, J)
or,
(P/A, i%, N ) (P/A, i%, J).
Example. A father wants to decide how much he has to put in an
account which gives 12% annual interest, in order to be able to
withdraw $2,000 on his new born sons 18th, 19th, 20th and 21th
birthday?
It is
2, 000 (P/A, 12%, 4) (P/F, 12%, 17) = $884.46.

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IE 5441

21

Example. Suppose that you are 22 years old now. You start investing
in a plan with interest rate 10% for 15 years with annual investment
$1,000. Then you leave the money in the account until you retire at
65. What will the amount be?
At age 36, the accumulated amount is
1, 000 (F/A, 10%, 15) = $31, 772.50
At age 65 this amount becomes
1, 000 (F/A, 10%, 15) (F/P, 10%, 29)
=

$504, 010

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IE 5441

22

Suppose that you have a friend with the same age as you. She decides
to delay the investment for 10 years. From age 32 onwards she will
start investing $2,000 per year until the retirement at 65. How about
her lump sum amount at age 65? Well, it is
2, 000 (F/A, 10%, 65 32 + 1) = $490, 953
Moral: Better start saving early!

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IE 5441

23

Uniform Gradient Series.


Period

...

Cash Flow

2G

...

(N 1)G

Formula for (F/G, i%, N ) (Given G nd F ).


We have
(F/G, i%, N )
= (F/A, i%, N 1) + (F/A, i%, N 2) + + (F/A, i%, 1)
=
=
=

(1 + i)N 1 1 (1 + i)N 2 1
(1 + i)1 1
+
+ +
i
i
i
N 1
1
N
(1 + i)n
i n=0
i
1
N
N
[(1
+
i)

1]

i2
i
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IE 5441

24

All other formulas for nding P and A can be derived using the
formula above.
Formula for (P/G, i%, N ) (Given G nd P ).
(P/G, i%, N )
= (F/G, i%, N )(P/F, i%, N )
(
)
1
N
N
N
=
[(1
+
i)

1]

(1
+
i)
i2
i
[
]
1 1
1
1
=
(N + )
.
i i
i (1 + i)N

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IE 5441

25

Formula for (A/G, i%, N ) (Given G nd A).


A/G, i%, N )
= (F/G, i%, N )(A/F, i%, N )
)
(
N
i
1
N
[(1
+
i)

1]

=
i2
i (1 + i)N 1
1
N
=

.
N
i
(1 + i) 1

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IE 5441

26

Exercise: Suppose we have a project with the future cash ows as


follows:
Year

Cash Flow

-8,000

-7,000

-6,000

-5,000

Suppose that the interest rate is 15%. What is the present expense of
this project?
P

= 8, 000(P/A, 15%, 4) + 1, 000(P/G, 15%, 4)


= 8, 000 2.855 + 1, 000 3.79
= 19, 050

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IE 5441

27

Geometric Gradient Series.


In year n + 1, the cash ow is
An+1 = An (1 + g)
where g > 0 is a given factor.
The present worth of this cash ow is
P

An (1 + i)n

n=1

A1 (1 + g)n1 (1 + i)n

n=1

N
A1 1 + i n
) .
(
1 + g n=1 1 + g

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IE 5441

28

Therefore the eect of this series is the same as: annuity


interest rate

1+i
1+g

1=

ig
1+g ;

A1
1+g

and

that is,

A1
ig
(P/A, (
)%, N ).
1+g
1+g
A convenient way to remember this formula is to introduce
iCR =

1+i
1.
1+g

Everything else looks quite the same as if there were no geometric


series.

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IE 5441

29

Example: Suppose that you own a car. Its maintenance costs grow
over time. You expect to spend $1,000 in the coming year on the car
and the cost will grow by a factor of g = 20% each year. Decide the
present equivalent expense of keeping the car for additional four years.
(The interest rate is 10%).
In this case,
iCR

10
=
%
1.2

and
P

10
1, 000
(P/A,
%, 4)
1.2
1.2
$4, 163
=

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IE 5441

30

If the interest rates vary each year, then a similar procedure can still
be applied.
Suppose that the interest rate for year n is in , n = 1, ..., N . Then, $1
at present will become
(1 + i1 )(1 + i2 ) (1 + iN )
at the end of year N . In other words,
FN =

(1 + in ).

n=1

Example: If i1 = 10%, i2 = 12%, i3 = 13%, i4 = 10%, then the


equivalent amount of $1,000 in 4 years time equals
1, 000

1
= $653.
1.1 1.12 1.13 1.1

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IE 5441

31

Nominal and Eective Interest Rates.


If the compounding period is not a whole year, then it is customary
to linearly extend it to an annual rate, known as nominal rate.
Example: money drawn quarterly with interest rate 3% has a nominal
annual rate 12%.
The eective rate is: (1 + 0.03)4 1 12.55% per annum.
In general, let r be the nominal rate, M be the compounding periods
in a year. Then the eective annual rate is
i = (1 + r/M )M 1.
Exercise: Show that the continuous rate is an upper bound for the
eective annual rate.

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IE 5441

32

Eective versus Nominal Interest Rates


Nominal

6%

10%

15%

24%

6.09%

10.25%

15.56%

25.44%

6.14%

10.38%

15.87%

26.25%

12

6.17%

10.47%

16.08%

26.82%

365

6.18%

10.52%

16.18%

27.11%

N. of C.

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IE 5441

33

Example: Suppose that you bought a home with $200,000. The


nominal mortgage rate is 9%, compounded monthly. Suppose that no
down payment is made, and the mortgage period is 7 years. What is
the monthly cost of the mortgage?
(
)
3
A = 200, 000 A/P, %, 12 7 = $3, 210.
4
Example: Suppose that the nominal rate is 12% compounded
quarterly. You will receive $1,000 at the end of each year for 10 years.
What is the equivalent worth in 10 years?
The eective rate is (1 + 3%)4 1 = 12.55%. Therefore,
F = 1, 000(F/A, 12.55%, 10) = $18, 022

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IE 5441

34

The timing of payments will become very crucial if the interest rate
involved is large.
Compare two scheme of equal payments, each with $100,000 payment
per month for one year. The nominal annual interest rate is 120%.
One scheme requires to pay at the beginning of every month; and the
other is to pay at the end of every month.
The dierence at the end of the year is
100, 000 ((1 + 10%)12 1) = $213, 840

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IE 5441

35

Formulas with Continuous Compounding.


If the continuous compounding rate is r, then in N years time one
dollar becomes erN . Thus,
(P/F, r%, N )c = erN .
In general, let i = er 1. We can derive the following formulas:
(F/A, r%, N )c

(P/A, r%, N )c

erN 1
er 1
erN 1
erN (er 1)

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IE 5441

36

Example: Suppose that one has a loan amount of $1,000. What is the
equivalent uniform end-of-year payment A for 10 years provided that
the nominal interest rate is 20% and compounded continuously?
We have

erN (er 1)
(A/P, r%, N )c =
.
rN
e 1

In our example, N = 10, r = 20%. Therefore,


(A/P, 20%, 10)c = 0.2561.
So, the equivalent end-of-year payment is $256.1.

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IE 5441

37

Additional Exercises:
A student makes $500 payment semi-annually into an account with 8%
nominal annual rate compounded weekly. What will this investment
be in 20 years time?
Every 26 weeks, the eective interest rate is
(
)26
0.04
1+
1 = 4.08%.
26
In 20 years time, this becomes
1.040840 1
500
= $48, 419.
0.0408

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IE 5441

38

An individual makes ve annual deposits of $2,000 in a savings


account that pays interest at a rate of 4% per year. One year after
making the last deposit, the interest rate changes to 6% per year. Five
years later after the last deposit the accumulated money is withdrawn
from the account. How much is the amount?
At the end of year 5, the amount is
$2, 000 (F/A, 4%, 5) = $10, 832.6
This becomes
$10, 832.6 (F/P, 4%, 1) = $11, 266
at the end of year 6.
This becomes
$11, 266 (F/P, 6%, 4) = $14, 233
at the end of year 10.
Shuzhong Zhang