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REV I S I O N O F SO ME CO N CE PT S + U S E O F E X CE L TO A P P LY TH ES E CO N CE PT S

SOME BASICS

Mary purchased some Energy Start Future Value (FV)

stock for Rs.6125.00. After 6 months,

the stock had risen in value by The amount an investment is worth after

Rs.138.00 and had paid dividends one or more periods.

totaling Rs.144.14. Simple interest

What is the simplest way to find her Interest earned only on the original

return principal amount invested.

SIMPLE INTEREST

FUTURE VALUE

If Rs.8000 is invested for 2 years at an annual interest rate of 9%, how much

(a)

interest will be received at the end of the 2-year period?

The future amount of an investment, or its future value, at the end of an interest

period is the sum of the principal and the interest. Thus, in Example (a), the future

value is

S = Rs.8000+Rs1440 = Rs.9,440.00

FUTURE VALUE

If Rs.4000 is borrowed for 39 weeks at an annual interest rate of 15%, how much

(b)

interest is due at the end of the 39 weeks?

Use with year. Thus

;

Similarly, the future amount of a loan, or its future value, is the amount of money

that must be repaid. In Example (b), the future value of the loan is the principal plus

the interest, or

S = Rs.4000+Rs.450 = Rs.4,450.00

The principal P of a loan is also called the face value or the present value of the

loan.

BACK TO THE FIRST EXAMPLE 3201

Mary purchased some Energy Start stock for Rs.6125.00. After 6 months, the stock

had risen in value by Rs.138.00 and had paid dividends totaling Rs.144.14.

What was her return on her investment?

To find the simple interest rate that Mary earned on this investment, we find the rate

that would yield an amount of simple interest equal to all of Mary’s gains (that is,

equal to the rise in the stock’s price plus the dividends she received).

Thus the principal is Rs.6125.00,

the time is ½ year, and the interest earned is the total of all gains

;

COMPOUND INTEREST

Suppose Alan and Milan established such a plan Compounding

for their baby daughter Meera. If this account

earns 9.8% compounded quarterly and if their The process of accumulating interest on an

goal is to have Rs.200,000 by Meera’s eighteenth investment over time to earn more interest.

birthday, what would be the impact of having

Rs.10,000 in the account by Meera’s first Interest on interest

birthday?

Interest earned on the reinvestment of

A compound interest investment (such as Alan previous interest payments.

and Milan’s account) is one in which interest is

paid into the account at regular intervals. In this Compound interest

section we consider investments of this type and

develop formulas that enable us to determine the Interest earned on both the initial principal

impact of making a Rs.10,000 investment in and the interest reinvested from prior

Meera’s college tuition account by her first periods.

birthday.

EXAMPLE

To see how compound interest is computed, consider the following table, which tracks

the annual growth of Rs.20,000 invested for 3 years at 10% compounded annually.

1 20,000.00 2,000.00 22,000.00

2 22,000.00 2,200.00 24,200.00

3 24,200.00 2,420.00 26,620.00

Excel function FV

MORE

Rs.3,000 is invested for 4 years at 9% compounded annually, how much interest is

If

earned?

to the nearest paisa. Sometimes the interest is compounded

1. Annually

2. Semiannually

3. Quarterly

4. Monthly

Unless specifically stated otherwise, a stated interest rate, called the nominal annual

rate, is the rate per year and is denoted by . The interest rate per period, denoted by

is the nominal rate divided by the number of interest periods per year

Excel function FV

COMPOUNDING

is invested for years at a nominal interest rate , compounded m times per year,

If

then the total number of compounding periods is

Expressed in decimals

and the future value is

OPENING EXAMPLE 3201

Alan and Milan want to have Rs.200,000 in Meera’s college fund on her eighteenth

birthday, and they want to know the impact on this goal of having Rs.10,000

invested at 9.8%, compounded quarterly, on her first birthday. To advise Alan and

Milan regarding this, find

(a) the future value of the Rs.10,000 investment,

(b) the amount of compound interest that the investment earns, and

(c) the impact this would have on their goal.

Excel function FV

SOLUTION

a) Future value of the Rs.10,000 investment

3

b) Amount of interest earned is

c) ??

APPLICATION As Figure shows, three years after

Google stock was first sold

publicly, its share price had risen

650%. The figure also shows that

this growth far exceeded

Microsoft’s performance at the

same point since its stock was first

publicly traded. Google’s 650%

increase means that $10,000

invested in Google stock at its

initial public offering (I.P.O.) was

worth $65,000 three years later.

What interest rate compounded

annually does this represent?

CONTINUOUS COMPOUNDING

Because more frequent compounding means that interest is paid more often (and

hence more interest on interest is earned), it would seem that the more frequently the

interest is compounded, the larger the future value will become.

CONTINUOUS COMPOUNDING

say that as the number of periods increases, the future value approaches a limit,

We

which is the number

In general, if $P is invested for t years at a nominal rate r compounded continuously,

then the future value is given by the exponential function

(a) Find the future value if $1000 is invested for 20 years at 8%, compounded

continuously.

(b) What amount must be invested at 6.5%, compounded continuously, so that it will

be worth $25,000 after 8 years?

Excel function EXP

CONTINUOUS COMPOUNDING

SOLUTIONS TO QUESTIONS IN PREVIOUS SLIDE

Find the future value if $1000 is invested for 20 years at 8%, compounded

(a)

continuously.

$4,953.03

(b) What amount must be invested at 6.5%, compounded continuously, so that it will

be worth $25,000 after 8 years?

ANNUAL PERCENTAGE YIELD

When we invest money at a given compound interest rate, the method of

compounding affects the amount of interest we earn. As a result, a rate of 8% can

earn more than 8% interest if compounding is more frequent than annually. The rate

of interest earned in reality per year is called annual percentage yield (APY), or

effective annual rate. This can be calculated as below

Let represent the annual (nominal) interest rate for an investment. Then the annual

percentage yield (APY) found as follows.

Periodic Compounding. If is the number of compounding periods per year, then is

the interest rate per period, and and in continuous compounding

COMPARING YIELDS 3201

Suppose a young couple such as Alan and Milan from our Application

Preview found three different investment companies that offered college

savings plans:

a) one at 10% compounded annually,

b) another at 9.8% compounded quarterly, and

c) a third at 9.65% compounded continuously.

Find the annual percentage yield (APY) for each of these three plans in order

to discover which plan is best.

TIME

How long does it take an investment of $10,000 to double if it is invested at

(a) 8%, compounded annually?

(b) 8%, compounded continuously?

FUTURE VALUE OF ANNUITIES

Twins graduate from college together and start their careers. Twin 1 invests $2000 at

the end of each of 8 years in an account that earns 10%, compounded annually. After

the initial 8 years, no additional contributions are made, but the investment continues

to earn 10%, compounded annually.

Twin 2 invests no money for 8 years but then contributes $2000 at the end of each

year for a period of 36 years (to age 65) to an account that pays 10%, compounded

annually. How much money does each twin have at age 65?

An annuity is a financial plan characterized by regular payments. We can view an

annuity as a savings plan in which the regular payments are contributions to the

account, and then we can ask what the total value of the account will become (as in

above). Also, we can view an annuity as a payment plan (such as for retirement) in

which regular payments are made from an account, often to an individual.

ANNUITIES

Annuities may be classified into two categories—annuities certain and contingent annuities.

An annuity certain is one in which the payments begin and end on fixed dates. In a

contingent annuity the payments are related to events that cannot be paced regularly, so the

payments are not regular.

To find the future value of your annuity at the end of the 5 years, we compute the future

value of each payment separately and add the amounts

FV OF ANNUITY

The sum of all payments plus all interest earned is called the future amount

of the annuity or its future value. The value of can be computed directly

with a financial calculator or found in an annuity table.

Excel function FV

EXAMPLES

Richard Lloyd deposits $200 at the end of each quarter in an account that pays 4%,

compounded quarterly. How much money will he have in his account in 2 ¼ years?

Twin 2 in the earlier example invests $2000 at the end of each year for 36 years

(until age 65) in an account that pays 10%, compounded annually. How much does

twin 2 have at age 65?

TWINS

CONTINUED

Twin 1 invests $2000 at the end of each of 8 years in an account that earns 10%,

compounded annually. After the initial 8 years, no additional contributions are made,

but the investment continues to earn 10%, compounded annually, for 36 more years

(until twin 1 is age 65). How much does twin 1 have at age 65?

The first part is an ordinary annuity

COMPARING THE VALUE OF

TWINS

Contribution per Number of Total Account value @65

year years Contribution

Twin 1 $2000 8 $16000 $707.028

Twin 2 $2000 36 $72,000 $598,254

Note that twin 1 contributed $56,000 less than twin 2 but had $108,774 more at age 65.

This illustrates the powerful effect that time and compounding have on investments

FUTURE VALUE OF

$1 FOR DIFFERENT

PERIODS AND

RATES

Excel function

TIME TO REACH A GOAL

NPER

Sometimes we want to know how long it will take for an annuity to reach a desired

future value. A small business invests $1000 at the end of each month in an account

that earns 6% compounded monthly. How long will it take until the business has

$100,000 toward the purchase of its own office building?

; ;

;;

;

PAYMENT FOR AN ORDINARY

ANNUITY

A young couple wants to save $50,000 over the next 5 years and then to use this

amount as a down payment on a home. To reach this goal, how much money must

they deposit at the end of each quarter in an account that earns interest at a rate of

5%, compounded quarterly?

SINKING FUNDS

A company establishes a sinking fund to discharge a debt of $300,000 due in 5 years

by making equal semiannual deposits, the first due in 6 months. If the deposits are

placed in an account that pays 6%, compounded semiannually, what is the size of the

deposits?

ANNUITIES DUE

Deposits in savings accounts, rent payments, and insurance premiums are examples

of annuities due. Unlike an ordinary annuity, an annuity due has the periodic

payments made at the beginning of the period. The term of an annuity due is from

the first payment to the end of one period after the last payment. Thus an annuity due

draws interest for one period more than the ordinary annuity.

ANNUITIES DUE

of each month for 9 years and the interest rate is 7.2%, compounded

monthly.

its production equipment. How much of each previous quarter’s profits

should be deposited at the beginning of the current quarter to reach this

goal, if the company’s investment earns 6.8%, compounded quarterly?

PRESENT VALUES OF

ANNUITIES

If you wanted to receive, at retirement, $1000

at the end of each month for 16 years, what

lump sum would you need to invest in an Discount

annuity that paid 9%, compounded monthly?

(See Example 2.)

Calculate the present value of some future

amount.

We call this lump sum the present value of

the annuity. Note that the annuity in this case Discount rate

is an account from which a person receives The rate used to calculate the present

equal periodic payments (withdrawals).

value of future cash flows.

Present value (PV)

Discounted Cash Flow (DCF) Valuation

The current value of future cash flows

discounted at the appropriate discount rate. Calculating the present value of a future

cash flow to determine its value today.

ORDINARY ANNUITIES

Suppose we wish to invest a lump sum of money (denoted by An ) in an annuity that

earns interest at rate i per period in order to receive (withdraw) payments of size $R

from this account at the end of each of n periods (after which time the account

balance will be $0). Recall that receiving payments at the end of each period means

that this is an ordinary annuity. To find a formula for , we can find the present value

of each future payment and then add these present values

ORDINARY ANNUITIES

Excel function PV

PRESENT VALUE

What is the present value of an annuity of $1500 payable at the end of each 6-month

period for 2 years if money is worth 8%, compounded semiannually?

Find the lump sum that one must invest in an annuity in order to receive $1000 at the

end of each month for the next 16 years, if the annuity pays 9%, compounded

monthly.

Excel function PMT

PAYMENTS FROM AN

ANNUITY

Suppose that a couple plans to set up an ordinary annuity with a $100,000

inheritance they received. What is the size of the quarterly payments they will

receive for the next 6 years (while their children are in college) if the account pays

7%, compounded quarterly?

NUMBER OF PAYMENTS FROM

Excel function

AN ANNUITY

NPER

inheritance of $250,000 is invested at 9%, compounded monthly. If $2500 is

An

withdrawn at the end of each month, how long will it be until the account balance is

$0?

BONDS

Bonds represent a relatively safe investment similar to a bank certificate of

deposit (CD), but unlike CDs (and like stocks), bonds can be traded. And, as

is also true of stocks, the trading or market price of a bond may fluctuate.

Most commonly, bonds are issued by the government, corporations, or

municipalities for periods of 10 years or longer. Bonds actually constitute a

loan in which the issuer of the bond is the borrower, the bond holders (or

purchasers) are the lender, interest payments to the bond holders are called

coupons. In the simplest case, a bond’s issue price, or par value, is the same

as its maturity value, and the coupons are paid semi-annually.

Excel functions PRICE,

BOND PRICING

YIELD

An investor will typically invest in the bond

only if the bond’s price makes its rate of

return comparable to the market rate. The

rate of return that the investor requires in

order to buy the bond is called the yield

rate. Hence the return from a bond is a mix

of its Coupon rate and Yield rate.

Suppose a 15-year corporate bond has a

maturity value of $10,000 and coupons at

5% paid semi-annually. If an investor wants

to earn a yield of 7.2% compounded semi-

annually, what should he or she pay for this

bond?

Each semi-annual coupon payment is

DISCOUNT AND PREMIUM

In this case the bond is said to be selling at a discount. This has to be the case in

order for the yield rate to exceed the coupon rate. Similarly, if the yield rate is lower

than the coupon rate, then the market price of the bond will exceed its maturity

value. When this happens, the bond is said to be selling at a premium. In general, the

market price of a bond moves in the opposite direction from current yield rates.

ANNUITIES DUE

ANNUITIES DUE

Excel function PMT

What lump sum will be needed to generate payments of ₹5000 at the beginning of

each quarter for a period of 5 years if money is worth 7%, compounded quarterly?

DEFERRED ANNUITIES

A deferred annuity is one in which the first payment is made not at the beginning or

end of the first period, but at some later date. An annuity that is deferred for k

periods and then has payments of $R per period at the end of each of the next n

periods is an ordinary deferred annuity.

Excel function PMT

A deferred annuity is purchased that will pay $10,000 per quarter for 15 years after

being deferred for 5 years. If money is worth 6% compounded quarterly, what is the

present value of this annuity?

Suppose a lottery prize of $50,000 is invested by a couple for future use as their

child’s college fund. The family plans to use the money as 8 semi-annual payments

at the end of each 6-month period after payments are deferred for 10 years. How

much would each payment be if the money can be invested at 8.6% compounded

semi-annually?

LOANS AND AMORTIZATION

Just as we invest money to earn interest, banks and Pure Discount Loans

lending institutions lend money and collect interest The pure discount loan is the simplest form of loan.

for its use. Although your aunt may lend you With such a loan, the borrower receives money today

money with the understanding that you will repay and repays a single lump sum at some time in the future.

the full amount of the money plus simple interest

at the end of a year, financial institutions generally Interest-only Loans

expect you to make partial payments on a regular When loan repayment plan calls for the borrower to pay

basis (often monthly). interest each period and to repay the entire principal (the

original loan amount) at some point in the future.

Most consumer loans (for automobiles, appliances,

televisions, and the like) are classed as equated Amortized Loans

monthly instalment (EMI) loans. A loan in which the lender may require the borrower to

repay parts of the loan amount over the period of the

This type of loan is usually repaid by making all loan. The process of providing for a loan to be paid off

payments (including principal and interest) of by making regular principal reductions is called

equal size. This process of repaying the loan is amortizing the loan

called amortization.

LOANS AND AMORTIZATION

When a bank makes a loan of this type, it is purchasing from the borrower an

ordinary annuity that pays a fixed return each payment period. The lump sum the

bank gives to the borrower (the principal of the loan) is the present value of the

ordinary annuity, and each payment the bank receives from the borrower is a

payment from the annuity.

Excel function PMT

PAYMENTS TO AMORTIZE A

DEBT

debt of $1000 with interest at 16%, compounded quarterly, is to be amortized by

A

20 quarterly payments (all the same size) over the next 5 years. What will the size of

these payments be?

PMT/IPMT/PPMT

Excel function

BUYING A HOME

A man buys a house for $200,000. He a)

makes a $50,000 down payment and

agrees to amortize the rest of the debt

with quarterly payments over the next

10 years. If the interest on the debt is

12%, compounded quarterly, find b)

(a) the size of the quarterly payments, c)

(b) the total amount of the payments,

and

(c) the total amount of interest paid.

AFFORDABLE HOME

Alan and Milan have ₹300,000 for a down payment, and their budget can

accommodate a monthly mortgage payment of ₹ 12,000.00. What is the most

expensive home they can buy if they can borrow money for 30 years at 7.8%,

compounded monthly?

AMORTIZATION TABLE

can construct an amortization schedule that summarizes all the information

We

regarding the amortization of a loan. For example, a loan of $10,000 with interest at

10% could be repaid in 5 equal annual payments of size

Each time this $2637.97 payment is made, some is used to pay the interest on the

unpaid balance, and some is used to reduce the principal.

For the first payment, the unpaid balance is $10,000, so the interest payment is 10%

of $10,000, or $1000. The remaining $1637.97 is applied to the principal.

An Amortization table summarizes the information regarding all payments of a loan

showing the split up of each payment and balance due on the loan.

AMORTIZATION TABLE

Balance

Period Payment Interest Reduction Unpaid balance

0 $ 10,000.00

1 $2,637.97 $ 1,000.00 $1,637.97 $ 8,362.03

2 $2,637.97 $ 836.20 $1,801.77 $ 6,560.25

3 $2,637.97 $ 656.03 $1,981.95 $ 4,578.30

4 $2,637.97 $ 457.83 $2,180.14 $ 2,398.16

5 $2,637.97 $ 239.82 $2,398.16 $ -

UNPAID BALANCE OF A LOAN

Excel function

CUMPRINC

The unpaid balance of a loan (also called the payoff amount and the outstanding

principal of the loan) is the present value needed to generate all the remaining

payments

UNPAID BALANCE

and earlier example we found that the monthly payment for a loan of $150,000 at

In

12%, compounded quarterly, for 10 years is $6489.36 (to the nearest cent). Find the

unpaid balance immediately after the 15th payment.

EFFECT OF PAYING AN EXTRA

AMOUNT

Consider the a loan $100,000 borrowed at 6% compounded monthly for 30 years,

with monthly payments of $599.55. The unpaid balance after 24 monthly payments

is $97,468.25. Suppose that from this point the borrower decides to pay $650 per

month.

(a) How many more payments must be made?

(b) How much would this save over the life of the loan?

GEOMETRIC SEQUENCES

$P is invested at an interest rate of i per period, compounded at the end of each

If

period, the future value at the end of each succeeding period is

The future values for each of the succeeding periods form a sequence in which each

term (after the first) is found by multiplying the previous term by the same number.

Such a sequence is called a geometric sequence.

A sequence is called a geometric sequence (progression) if there exists a number ,

called the common ratio, such that

GEOMETRIC SEQUENCES

Because each term after the first in a (b) 4, 2, 1, . . .

geometric sequence is obtained by

multiplying the previous term by , the The common ratio is ½ so the next three

second term is is the third is and the th terms are ½, ¼, 1/8

term is Thus we have the following (c) 3, -6, 12, . .

formula.

The common ratio is -2 so the next three

Write the next three terms of the terms are -24, 48, -96

following geometric sequences.

(a) 1, 3, 9, . . .

The common ratio is 3, so the next three

terms are 27, 81, 243.

TH TERM

SEQUENCEOF A GEOMETRIC

Find the seventh term of the geometric sequence with first term 5 and common ratio -2

Ans. 320

SUM OF A GEOMETRIC

SEQUENCE

(a)Find the sum of the first five terms of the geometric progression with first term 4 and

common ratio -3

244

(b) Find the sum of the first six terms of the geometric sequence

EXAMPLE

changing market conditions cause a company earning $8,000,000 in 2005 to

If

project a loss of 2% of its profit in each of the next 5 years, what profit does it

project in 2010?

RAMESH’S LIFETIME SALARY

Ramesh recently attended a seminar on human capital where the speaker talked

about a person's human capital as the present value of his life time earnings. Ramesh

is curious to find out the present value of his lifetime salary.

For the sake of simplicity assume that his present salary of Rs 400,000 will be paid

exactly one year from now, and his salary will be paid in annual installments. What

is the present value of his life-time salary, if the discount rate is 8 percent?

Remember that Ramesh expects his salary to increase at the rate of 12 percent per

year until his retirement 30 years from now..

References

Mathematical Applications for the Management, Life, and Social Sciences 9E; Ronald J. Harshbarger, Beaufort James J. Reynolds

Fundamentals Of Corporate Finance 10E; Ross Westerfield Jordan

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