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Chapter 5: Understanding
Money & Its Management
1. If interest period is other than
annual, how do we calculate
economic equivalence?
2. If payments occur more frequently
than annual, how do we calculate
economic equivalence?
S.V. Atre 1
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
ia = (1 + r / M ) − 1 M
S.V. Atre 2
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
S.V. Atre 3
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
i = [1 + r / CK ]C − 1
C = number of interest periods per
payment period
K = number of payment periods per year
r/K = nominal interest rate per
payment period
i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / (1 ) ( 4 ) ] 1 − 1
= 2 . 0 0 0 % p e r q u a r te r
S.V. Atre 4
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / ( 3 ) ( 4 ) ] 3 − 1
= 2 . 0 1 3 % p e r q u a r te r
i = [1 + r / C K ] C − 1
= [1 + 0 . 0 8 / (1 3 )( 4 )]1 3 − 1
= 2 . 0 1 8 6 % p e r q u a rte r
S.V. Atre 5
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
r = 12%, 0 1 2 3 4 5 6 7 8 9 10 11 12
Quarters
A = $1,000
Step 1: M = 12 compounding periods/year
K = 4 payment periods/year
C = 3 interest periods per quarter
Step 2: i
i = [1 + 0 .12 /( 3)( 4 )] 3 − 1
= 3 .030 %
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
S.V. Atre 6
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Problem 4
You will deposit $1000 every 3 months for
4 years into an account that pays interest
of 8% per year, compounded monthly. The
first deposit will be in 3 months. How
much will be in the account in 4 years?
GIVEN:
A = $1,000 r = 8%/yr i = [1 + 0 .08 /( 3)( 4 )] 3 − 1
C = 3 periods/qr K = 4 payments/yr
M = 12 mo/yr = 2 .0130 %
FIND F:
DIAGRAM: F?
N = 4(4) = 16
0 1 2 3 4 yrs
F = $1,000 (F/A, 2.013%, 16)
= $18,658.12
$1,000
Continuous Compounding
i = [1 + r / CK ]C − 1
where CK = number of compounding periods
per year
S.V. Atre 7
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
i = er / K −1
= e 0 .02 − 1
= 2 .0201 % per quarter
S.V. Atre 8
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
S.V. Atre 9
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Problem 5
Determine the total amount
accumulated in an account paying
interest at the rate of 10% per year,
compounded continuously if
deposits of $1,000 are made at the
end of each of the next 5 years.
DIAGRAM: F? GIVEN:
A = $1,000 r = 10%/yr
C = ∞ K = 1 payment/yr
0 1 2 3 5 yrs N = 5 yrs
FIND F:
$1,000
Problem 5
GIVEN:
A = $1,000 r = 10%/yr
C = ∞ K = 1 payment/yr
N = 5 yrs
FIND F:
i = e0.10/1 −1
DIAGRAM: F? = 10.517 % per year
0 1 2 3 5 yrs
N=5
F = $1,000 (F/A, 10.517%, 5)
$1,000 = $6,168.25
S.V. Atre 10
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Problem 6
A firm pays back a $10,000 loan with
quarterly payments over the next 5
years. The $10,000 returns 4% APR
compounded monthly. What is the
quarterly payment amount ?
DIAGRAM:
GIVEN:
$10,000 P = $10,000 r = 4%/yr
C = 3 interest periods/quarter
K = 4 payments/yr
1 2 3 5 yrs = 20 qtr
M = 12 compounding periods/yr
0
FIND A:
$A = ?
Problem 6
GIVEN:
P = $10,000 r = 4%/yr
C = 3 interest periods/quarter
K = 4 payment periods/yr
M = 12 compounding periods/yr
DIAGRAM: FIND A:
$10,000 i = [1 + 0 .04 /( 3)( 4 )] 3 − 1
= 1 .0033 %
1 2 3 5 yrs = 20 qtr
0
$A = ? N = 4(5) = 20
A = $10,000 (A/P, 1.0033%, 20)
= $554.30
S.V. Atre 11
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Problem 1
A construction firm is considering the purchase of an
air compressor.
S.V. Atre 12
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
GIVEN:
Problem 1 – Alt Soln 2
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
FIND P: P = PA + PG(PPG) = A(P|A,i,N) + G(P|G,i,N-1)(P|F,i,1)
= $800(P|A,12%,8) + $100(P|G,12%,7)(P|F,12%,1)
DIAGRAM: = $800(4.9676) + $100(11.6443)(0.8929) = $5,014
P? PA ?
1 2 3 4 1 2 3 4
N=8 N=8
0 0
$800 $800
$100 $200 PPG ? PG ?
0 1 2 3
$600 N=7
0 1
NOTE: PG MUST BE OFFSET ONE YEAR – SO PG ? $100 $200
BRING THE OFFSET YEAR BACK TO TIME ZERO $600
S.V. Atre 13
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Problem 2
A young couple has decided to make advance plans for
financing their 3 year old daughter’s college education.
Money can be deposited at 8% per year, compounded
annually.
What annual deposit on each birthday, from the 4th to the
17th (inclusive), must be made to provide $7,000 on each
birthday from the 18th to the 21st (inclusive)?
DIAGRAM: GIVEN:
$7,000
WITHDRAWALS18-21 = $7 000
4 17 i = r = 8%/YR, CPD YEARLY
FIND A4-17:
0 18 21 yrs
P17 = A(P|A,i,N) = A(F|A,i,N)
A?
= 7 000(P|A,8%,4) = A(F|A,8%,14)
STRATEGY: CAN BREAK INTO 2 CASH FLOWS,
SO PICK A CONVENIENT POINT IN TIME AND SET = 7 000(3.3121) = A(24.2149)
DEPOSITS EQUAL TO WITHDRAWALS…
A = $957
Problem 3
Anita Plass-Tuwurk, who owns an engineering consulting
firm, bought an old house to use as her business office. She
found that the ceiling was poorly insulated and that the heat
loss could be cut significantly if 6 inches of foam insulation
were installed. She estimated that with the insulation she
could cut the heating bill by $40 per month and the air
conditioning cost by $25 per month. Assuming that the
summer season is 3 months (June, July, August) of the year
and the winter season is another 3 months (December,
January, and February) of the year, how much can she
spend on insulation if she expects to keep the property for 5
years? Assume that neither heating nor air conditioning
would be required during the fall and spring seasons. She is
making this decision in April about whether to install the
insulation in May. If the insulation is installed, it will be paid
for at the end of May. Anita’s interest rate is 9%,
compounded monthly.
S.V. Atre 14
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
FIND P(SAVINGS OVER 5 YEARS):
1ST YR DIAGRAM: 5 YR DIAGRAM:
$40 PA
$25
0
0
1 2 3 4 5 6 7 8 9 10 11 12 MO 1 2 3 4 5 YRS
PA ? α β P?
i = r = 0.09 = 0.75% / MO
M 12
GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
FIND P(SAVINGS OVER 5 YEARS):
5 YR DIAGRAM: $186.94 $186.94
$186.94 +
= 0 0
1 2 3 4 5 YRS 1 2 3 4 5 YRS
0
1 2 3 4 5 YRS P0 ? PA ?
P? P = P0 + PA = A + A(P | A, i,N)
C = 12 K =1
C ⎡ (1 + i)N − 1⎤
⎛ r ⎞ = A + A⎢ N ⎥
i = ⎜1 + ⎟ −1
⎝ CK ⎠ ⎣ i(1 + i) ⎦
12 = $186.94 + $186.94(P | A,9.38%,4)
⎛ 0.09 ⎞
= ⎜1 + ⎟ −1 ⎡ (1 + 0.0938 )4 − 1 ⎤
⎝ 12(1) ⎠ = $186.94 + $186.94 ⎢ 4⎥
= 9.38% ⎣ 0.0938(1 + 0.0938 ) ⎦
= $186.94 + $186.94[3.21288 ] = $787.56
S.V. Atre 15
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Annual fees
Annual
percentage rate
Grace period
Minimum
payment
Finance charge
Adjusted The bank subtracts the amount of Your beginning balance is $3,000.
Balance your payment from the beginning With the $1,000 payment, your
balance and charges you interest on new balance will be $2,000. You
the remainder. This method costs pay 1.5% on this new balance,
you the least. which will be $30.
Average The bank charges you interest on the Your beginning balance is $3,000.
Daily average of the amount you owe each With your $1,000 payment at the
Balance day during the period. So the larger 15th day, your balance will be
the payment you make, the lower the reduced to $2,000. Therefore,
interest you pay. your average balance will be
(1.5%)($3,000+$2,000)/2=$37.50.
Previous The bank does not subtract any Regardless of your payment size,
Balance payments you make from your the bank will charge 1.5% on your
previous balance. You pay interest beginning balance $3,000:
on the total amount you owe at the (1.5%)($3,000)=$45.
beginning of the period. This method
costs you the most.
S.V. Atre 16
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Option 1 Option 2
Debt Financing Lease Financing
Price $14,695 $14,695
Down payment $2,000 0
APR (%) 3.6%
Monthly payment $372.55 $236.45
Length 36 months 36 months
Fees $495
Cash due at lease end $300
Purchase option at lease end $8.673.10
Cash due at signing $2,000 $731.45
S.V. Atre 17
ENGR 390 Lecture 5: Understanding Money Winter 2007
& Its Management - 2
Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
Lease Financing:
Please = $495 + $236.45 + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
Summary
S.V. Atre 18