it.
Why?
Inflation!
If the compound interest rate is i %, future
value is the value that the rupees grows to
after a period of time.
If i = 10%, Rs 100 grows to Rs 110 after one
year and so the future value of Rs 100 after
one year (written as FV
1
) is Rs 110.
After two years? FV
2
is Rs 121.
After n years? FV
n
is Rs 100(1.1)
n
.
In general, if the rate is i %, then the future value of P
rupees
one period from today is PV(1+i),
two periods from today is PV(1+i)
2
,
n periods from today is FV
n
= PV(1+i)
n
PV FV
n
= PV(1+i)
n
0 1 2 3 n
If the compound interest rate is i %, present value
of FV
n
rupees is the value PV to be invested n
periods back that grows to FV
n
.
If i = 10% and FV
1
= Rs 100, the present value PV =
Rs 90.91
because Rs 90.91 grows to Rs100 after one year.
If FV
2
= Rs 100, what is PV?
PV = Rs 82.64.
If FV
n
= Rs100, what is PV?
PV = Rs 100/(1.1)
n
.
In general, if the discount rate is i %, present
value of
FV
1
rupees is FV
1
/(1+i),
FV
2
is FV
2
/(1+i)
2
FV
n
is FV
n
/(1+i)
n
.
FV
n
0 1 2 3 n
PV =FV
n
/ (1+i)
n
Mansingh, a courtier of Akbar, purchased a township
land of 1000 acres near Agra, from the local villagers
for approximately Rs 24 in 1643
It is often claimed that the villagers got a raw deal.
What do you think?
What would Rs 24 in 1637 be worth in 2013? Certainly more
than Rs 24 if invested prudently
1643 2013
Rs24
Rs ?
Assess the worth of Rs24 today if invested in a
conservative project that earns 8% per year for 370
years.
FV
1
= 24(1.08)
= Rs25.92
1643 1644
Rs24
Rs 25.92
After two years?
FV
2
= 24(1.08)
2
= Rs28.00
1643 1644
Rs24
Rs 28.00
After fifty years?
FV
50
= 24(1.08)
50
= Rs1125.64
1643 1693
Rs24 Rs 1126
After 370 years?
Rs55,847,118,732,148 = Rs55 trillion
or Rs 555,84,711 crores
If Rs 500 grows to Rs 1039.50 at a rate of 5%. How
many years was the amount invested?
1039.50 = 500(1+0.05)
n
and we need to solve for n.
Take the logarithm?
FV = Rs 1039.50, PV = Rs500, Rate = 5%,
Time = 15 years
A zerocoupon bond is a bond that pays no
coupon and sells at a discount.
A zerocoupon bond promises to pay Rs1000
after 28 years.
The appropriate discount rate for the bond
(given its risk characteristics) is 9.5%.
What is the bonds current market price?
Market Price = PV = 1000/(1+0.095)
28
= Rs78.78.
If you believe that the proper discount rate for the
bond is 9.2%, would you buy or sell it at the
market price of Rs78.78?
By your reckoning PV = 1000/(1+0.092)
28
=
Rs85.07.
So you will buy the bond at Rs78.78 until......the
price rises to Rs85.07 ...or until you change your
mind about the discount rate of 9.2% seeing that
several investors in the marketplace believe that
the discount rate is above 9.2%.
100
0
1
2
3
225 140
140/(1.1)
3
225/(1.1)
2
100/(1.1)
What happens when you have two or more cash flows? Can
we write their present value? If r = 10% and we have:
Therefore, present value (PV) of the cash flows is
the sum of the present values of the three flows,
i.e., 90.91+185.95+105.18 = Rs382.04
Consider a set of cash flows {PMT
t
} and a discount rate
i. The cash flows can be depicted on a time line:
PMT
1
PMT
2
PMT
3
PMT
n
0 1 2 3 n
Perpetuity is a constant payment of Rs PMT every
period forever. By assumption, the payment PMT
occurs at the end of each period. The first
payment occurs at t=1, the second at t=2, etc.:
PMT PMT PMT
0 1 2 n
The present value of a perpetuity is:
i
PMT
PV =
Multiplying the equation by (1+i):
Subtracting the first equation from
the second:
+
+
+ +
+
+
+
+
+
=
n
i) (
PMT
...
i) (
PMT
i) (
PMT
i) (
PMT
PV
1 1 1 1
3 2
+
+
+ +
+
+
+
+ = +
1 2
1 1 1
1
n
i) (
PMT
...
i) (
PMT
i) (
PMT
PMT PV i) (
In the 1800s, the British Government decided to
consolidate all its debt thru a single issue of 2.5%
consols.
A 2.5% consol was a perpetuity promising to pay 25
British Pounds each year forever.
Suppose the appropriate discount rate for a consol is
10.5%. What is the price of a consol?
PV = PMT / i = 25/0.105 = 238.09 British Pounds.
A growth perpetuity is a payment that starts with
Rs PMT and grows every period at a growth rate g
forever. By assumption, the payment occurs at the
end of each period. The first payment occurs at
t=1, the second at t=2, etc.:
PMT PMT(1+g) PMT(1+g)
n1
0 1 2 n
We can write the present value of a growth perpetuity
as:
+
+
+
+ +
+
+
+
+
+
+
+
=
n
i
n
g PMT
i
g PMT
i
g PMT
i
PMT
PV
) 1 (
1
) 1 (
...
3
) 1 (
2
) 1 (
2
) 1 (
) 1 (
) 1 (
g i
PMT
PV
=
The sum of this infinite series is finite if
i > g and can be written as:
A business house proposes to endow a chair at FORE
School of Management
The proposal is to provide Rs1,500,000 plus a raise of 5%
each year.
Suppose the interest rate earned by endowments is 10%.
How much should the benefactor donate?
1,500,000 1,500,000(1.05) 1,500,000(1.05)
t1
0 1 2 t
000 , 000 , 30
05 . 0 10 . 0
000 , 1500
Rs
g i
PMT
PV
=
=
An annuity is like a perpetuity except that it
does not go on forever: it is a constant payment
PMT every period until time n.
By assumption, the payment PMT occurs at the
end of each period. The first payment occurs at
t = 1, the second at t = 2, etc..
The present value of an annuity is easiest to
work out by thinking of it as a difference
between two perpetuities.


.

\

+
=
(
+
+
+
+ +
+
+
+
+
+
+
+ +
+
+
+
=
(
+
+
+
+
+
+
+
+
+
+
+ +
+
+
+
=
+
+ +
+
+
+
=
+ +
+ + + +
n
n n n n
n n n n n
n
n
i) ( i
PMT
...
i) (
PMT
i) (
PMT
i) (
...
i) (
PMT
i) (
PMT
i) (
PMT
...
i) (
PMT
i) (
PMT
...
i) (
PMT
i) (
PMT
...
i) (
PMT
i) (
PMT
i) (
PMT
...
i) (
PMT
i) (
PMT
i) (
PMT
...
i) (
PMT
i) (
PMT
PVA
1
1
1
1 1 1
1
1 1 1 1 1
1 1 1 1 1 1 1
1 1 1
2 2 1 2
2 1 2 1 2
2
PMT
0 1 2 n n+1 n+2
PMT PMT PMT PMT
PMT PMT
MCD is considering offering 60 year care contracts for its
parks.
It estimates that maintenance will average Rs250,000 every
year.
If the appropriate discount rate is 5.5%, how much one
needs to charge to break even on a perpetual care contract?
. 460 , 362 , 4
) 055 . 0 1 (
1
1
055 . 0
250000
60
Rs
Rs
PV =
(
+
=
The present value of a constantly growing annuity
is given below:
1
= 1
1
n
A g
P
i g i
(
+
 
(

+
\ .
(
(
+ =
+ =


.

\

+
=
1 ) 1 (
) 1 (
) 1 (
1
1
n
i
i
PMT
n
PVA
n
i
n
FVA
n
i
i
PMT
n
PVA
) 1 ( ) 1 (

.

\

+ +
=
n
g
n
i
g i
PMT
n
FVA
5 . 337 , 43 , 84
) 08 . 0 1 (
1
1
08 . 0
000 , 750
30
Rs
Rs
=
(
= +
How much Rahul needs to save every year for 40 years to
have Rs844,333.75 at the end if he can invest money at 8%.
Compounding does not have to be on an annual
basis.
Compounding can be done quarterly, monthly,
daily, or even continuously!
What is the effect of compounding two times
during the same year? Or more times?
Intuitively, the money should grow faster. Why?
Because interest is paid earlier and reinvested.
The same formulas still work, but
n now becomes the number of compounding periods
i becomes the interest earned in a compounding period
For example, if we compounded monthly for 4 years at 12%,
the number of compounding periods n would be 48, and
the interest rate i would be 1%.
An annual interest rate of 10% compounded four
times a year, is an interest rate of 2.5% paid every
quarter.
If we invest Rs 1 for one year at this rate, we would
use our compounding formula with n = 4 and i =
2.5% to find out its future value after a year.
Therefore, after one year Rs 1 becomes...
Rs1 x (1 + 0.025)
4
= Rs1.1038.
Therefore, Rs 1 invested at an annual rate of 10%
compounded quarterly becomes Rs1.1038 in a year.
It was as if a rate of 10.38% was applied only one time
during that year.
We refer to the nominal rate of 10% as the Annual
Percentage Rate (APR).
Also, we refer to the annualized rate of 10.38% that
incorporates the effect of compounding, as the Effective
Annual Rate (EAR).
m
m
APR
EAR
(
+ = + 1 1
In general, if Rs PMT is invested at an APR of i % and
compounded m times during the year, we can write the
following relation between APR and EAR:
n m
m
APR
PMT
n
FV
(
+ = 1
Alternatively, if Rs PMT is invested at an APR of i %
compounded m times during a year, for n years, we can
write its future value after n years as:
This also means that the present value of Rs PMT
that is received after n years, is:
n m
m
APR
PMT
PV
+
=
1
Yield Rate
8.82 8.55
OneYear FD
m
m

.

\

+ =
0855 . 0
1 0882 . 1
We want to compound 8.55% sufficient number of times
to make it yield 8.82%.
You can solve the equation mathematically, or by trial and
error.
The answer is m = 4 and so Mera Bank will compound an
annual APR of 8.55% each quarter, giving you a quarterly
rate of 2.1375%.
n m
m
APR
PMT
n
FV
(
+ = 1
We know that if Rs PMT is invested at an APR of i %
compounded m times during a year, for n years, its
future value after n years is:
If m approaches infinity, we get:
( ) APR n
e PMT
n
FV
=
Sinking fund is a fund, which is created out of fixed
payments each period to accumulate to a future sum
after a specified period. For example, companies
generally create sinking funds to retire bonds
(debentures) on maturity.
The factor used to calculate the annuity for a given
future sum is called the sinking fund factor (SFF).
=
(1 ) 1
n
n
i
A F
i
(
(
+
Capital recovery is the annuity of an investment
made today for a specified period of time at a given
rate of interest. Capital recovery factor helps in the
preparation of a loan amortisation (loan
repayment) schedule.
The reciprocal of the present value annuity factor is
called the capital recovery factor (CRF).
,
1
=
PVAF
n i
A P
(
(
= CRF
n,i
A P
Annuity due is a series of fixed receipts or
payments starting at the beginning of each period
for a specified number of periods.
Future Value of an Annuity Due
Present Value of an Annuity Due
,
= CVFA (1 )
n n i
F A i +
= PVFA (1 + )
n, i
P A i
Net present value (NPV) of a financial decision is
the difference between the present value of cash
inflows and the present value of cash outflows.
0
1
NPV =
(1 + )
n
t
t
t
C
C
k
=
\

APR
r
Rs
r
Rs
A loan of Rs6000 at 15% interest rate is to be repaid
in four equal installments at the end of each year.
What is the annual payment of the loan?
( )
58 . 101 , 2
6000
015 . 0 1
1
1
015 . 0
4
Rs PMT
PMT
=
=
(
+
=
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