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Session 3 Class Discussion Summary

1) Annuity Due
It is an annuity where the cash flow occurs at the beginning of each period
Annuity Due Value = Ordinary Annuity Value x ( 1+ r)

2) Practice Problem
You want to lease a car from . The lease contract is in the form of 60 equal
monthly payments at a 10.4 % per annum rate, compounded monthly. Because the car
costs ₨.650,000, car trade wants the PV of the lease payments equal to Rs.650,000 to fully
recover the cost of the car from the lease rentals. Suppose that your first payment is due
immediately. What will your monthly lease payment be ?
Ans : 13,819

3) Growing Perpetuity
The cash flows are increasing at a constant rate for infinite time.

PV0 =
[r ≠ g ]
(r − g )

4) Growing Annuity :  1 1  (1 + g )  

 
PV of a growing annuity = C ×  r - g − r − g x  (1 + r )  
   

5) Practice problem 2
Your job pays you only once a year for all the work you did over the previous 12 months.
Today is December 31, you just received your salary of $ 50,000 and you plan to spend all
of it. However , you want to start saving for retirement beginning next year. You have
decided that one year from today, you will begin depositing 2 % of your annual salary in
an account that will earn 10% per year. Suppose your employer also promised that your
salary will increase at 4% per year throughout your career if you perform reasonably.
Given that you are motivated enough to perform reasonably and you stay on the same job
till retirement, how much money will you have on the date of your retirement 40 years
from today?
Ans : $701,276.07

6) Comparing rates.. Effects of frequent compounding

a) Interest rates are quoted with different compounding periods
b) Results of tradition, legislation, sometimes deliberately to confuse
c) 10% pa rate with semi annual compounding means= 5% interest paid every 6
months. Is it same as 10% per annum ??... No effective rate = 10.25%

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 APR 
d) EAR = 1 + 
 m 
e) Continuous compounding :
EAR = ( 1+ Quoted rate/m)m -1
If m→∞ then it can be shown that
EAR = er -1
7) Practice problem 3
Bank A doubles your money in 12 years, while Bank B gives you 1.5% per quarter. Who is
offering a better rate?
Ans : Bank B
8) Practice Problem 4
A bank claims to quadruple your money in 180 months. Is it offering a better rate than a
bank that gives you Rs.6 at the end of 20 years for every Rs.1 deposited today?
Ist bank better rate
9) Practice Problem 5
Suppose you are in a hurry to get your income tax refund. If you mail your tax return, you
will receive your refund in 3 weeks. If you file the return electronically through a tax
service, you can get the estimated refund tomorrow. The service subtracts a $50 fee and
pays you the remaining expected refund. The actual refund is then mailed to the
preparation service. Assume you expect to get a refund of $978. Is it worth to get the
online refund by paying $50 as service charge ? Assume the risk free rate to be 8%.

Rate they are charging is close to 150 % per annum!! Not worth it…
10) Problem Set 3
i) You are looking for an investment that has an effective annual rate of return equal to
18%. What is the effective semiannual return? The effective quarterly return? The
effective monthly return?

(Ans : 8.63% per six months, 4.22% per quarter,1.39% per month)

ii)You have just purchased a new flat for Rs.24,00,000. To finance the purchase you have
arranged for a 30-year mortgage loan for 80% of the purchase price. The monthly payment
on this loan will be Rs.13,000. What is the EAR on this loan? The APR?
( Ans: EAR=7.42%, APR = 7.17%)
• iii) Gold credit card which has an introductory rate of 2.5% per year compounded monthly
for the first six months, increasing thereafter to 17% per year compounded monthly.
Assuming that you transfer the Rs. 5000 balance from your existing SBI credit card to this
new card and make no subsequent payments, how much interest will you owe at the end
of the first year?
• (Ans : Rs. 508.70)
• iv). Suppose an investment offers to quadruple your money in 12 months. What is the
rate of interest per quarter that the investment is offering ?

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• (Ans: 41.42%)

v)A 15 year annuity pays $1500 per month and payments are made at the end of each month.
If the interest rate is 13% per annum compounded monthly for the first seven years, and 10%
per annum compounded monthly thereafter, what is the present value of the annuity ?

• ( Ans: $122,439.62 )

vi)What will be the expression for the PV of a growing perpetuity with a payment of ‘C’ one
period from today if the payment grows by ‘C’ every period?

• [Ans : C/r + C/r2]

11) Loan amortization

loans that are paid off in equal installments over its life.

• Suppose a Rs.5000 , 9% pa loan is to be paid in 5 yrs. What could be the equated annual

• Payment = an annuity of say C per annum such that PV of the annuity = Rs.5000 given that, rate
of interest is 9% and time period = 5 yrs.

• 5000 = c x { [(1-(1/1.095)]/0.09} i.e

• c=Rs.1285.46

• Loan payment schedule with this annuity becomes as follows :

Year Beginning Total payment Interest paid Principal Ending

Balanc at the end paid Balance
e of the
1 Rs.5000 Rs.1285.46 Rs.450 Rs.835.46 Rs.4164.54
2 4164.54 1285.46 374.81 910.65 3253.88
3 3253.88 1285.46 292.85 992.61 2261.27
4 2261.27 1285.46 203.51 1081.95 1179.32
5 1179.32 1285.46 106.14 1179.32 0.00
Totals Rs.6427.30 Rs.1427.30 Rs.5000

12) Partial Amortization….balloon payment

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Example : Suppose we have a $100,000 commercial mortgage with a 12% APR and a 20-
year ( 240 month) amortization. Further suppose the mortgage has a five year balloon.
What will the monthly payments be? How big will the balloon payment be ?
The monthly payment C is given by,
$100,000 = C *[1-(1/1.01240)]/.01 i.e C=$1101.09
After 60 months we still should have 180 months of payments remaining, with the interest
rate as 1% per month and the monthly payment being still $1101.09 per month. Hence the
loan balance should be PV of these remaining payments= $1101.09 x [(1-(1/1.01180))/.01] =
13) Practice problem 6
On March 1,2014 you bought a bike for Rs.90,000. You paid Rs.5000 as down payment and
financed the balance with a 5 year loan at a stated interest rate of 8.4% per annum,
compounded monthly. You started the monthly payments exactly one month after the
purchase ( i.e. April 1, 2014). Two years later at the end of April 2016, you will get a new
job and you have decided to pay off the loan . If the bank charges you a 1% pre payment
penalty based on the loan balance, how much should you pay the bank on May 1, 2016.

14) Problem Set 4

i) Prepare an amortization schedule for a five year loan of $36000. The interest rate
is 9% per year, and the loan calls for equal annual payments . How much interest
is paid in the third year ? How much total interest is paid over the life of the loan ?
ii) You have just arranged for a $450,000 mortgage to finance the purchase of a large
tract of land. The mortgage has an 8.5% APR, and it calls for monthly payments over the
next 30 years. However, the loan has an 8 year balloon payment provision, meaning that
the loan could be paid off then. How big will the balloon payment be ?


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