cpd151 Lesson01

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LESSON 1
Finance Fundamentals I
Note: Selected readings can be found under "Lesson 1" on your course website
Assigned Reading
1. UBC Real Estate Division. 2014. CPD 151 Real Estate Finance Basics. Vancouver: UBC Real
Estate Division.
Lesson 1: Finance Fundamentals I
Recommended Reading
1. HP10BII: Introduction to the Calculator and Review of Mortgage Finance Techniques
2. HP10BII Computer Based Training. Learn how to use the HP 10BII calculator by using our new
interactive training tool. This will show you the steps on the calculator that are required to solve real
estate finance problems. Please note that this will link to the Hewlett Packard website and to view
this application, users must have Macromedia Shockwave Flash Player installed. To download this
free plug-in, visit the Macromedia website and follow the on-screen instructions.
3. Math Review Kit. An overview of math and algebra calculations. Provided with permission from
CGA Canada.
4. Excel tutorials.
 Microsoft: Various tutorials ranging from easy to advanced for Excel 2007, 2010, 2013, and
excel for Mac 2011.
http://office.microsoft.com/en-001/support/microsoft-office-2003-2007-2010-training-
FX010056500.aspx
 Learnfree.org: Provides quite basic instructions for various versions of Excel (2002, 2007,
2010, etc.). Explains the basic with screenshots and video tutorials. Some lessons include cell
basics, creating complex formulas, formatting, and creating tables.
www.gcflearnfree.org/excel?search=excel
Learning Objectives
After completing this lesson, the student should be able to:
1. explain the difference between simple and compound interest;

2. define and differentiate between a variety of interest rate types, including nominal, periodic,
effective, and equivalent rates of interest;
3. discuss the underlying mathematics for financial analysis and apply this in structuring solutions to
problems using both a financial calculator and spreadsheet software;
4. solve for the specific calculations necessary in lump sum problems, including present value (PV),
future value (FV), timeframe (N), or interest rate (I/YR); and
5. convert equivalent interest rates based on different compounding frequencies.
1.1
©Copyright: 2014 by the UBC Real Estate Division
Lesson 1
Instructor's Comments
This lesson outlines the basic tools and techniques required for real estate mathematics. The basis for all
financial analysis is interest rates. Since these can be quoted and applied in many different ways, it is crucial
to be fluent in working with the varying definitions and also to be able to apply these properly in
mathematical solutions. As a result, much of this initial lesson focuses on interest rate explanations and
calculations. This includes the difference between nominal and periodic rates, plus the calculations necessary
to convert equivalent interest rates where the compounding frequencies differ.
Financial Fluency
Mathematics is often described as another form of language. Like learning a new language, this requires
understanding the grammar and then a lot a memorization and repetition until you can use it without really
thinking about it. For financial analysis, the mathematics involves the use of formulas. These are usually
pre-programmed into a financial calculator or into a spreadsheet; therefore, most financial analysts do not
work with the formulas directly. However, in all cases, the interest rate must be correctly applied, or the
calculator/spreadsheet will not operate accurately. To be successful in financial analysis, you must be fluent
in your understanding of how interest rates are stated and in how to work between the different types as
required for the financial tool you are working with.
The financial calculations in this lesson will start out with somewhat simple problems, such as interest
accrual loans and investments involving the present and future value of a single cash flow. The calculations
will advance to more complicated examples in Lessons 2 and 3. Much like the construction of a high-rise,
you need a solid foundation before you can start building the upper floors. This lesson focuses on the
foundations of financial analysis.
Math Formulas and Financial Calculators

Finance calculations involve complicated mathematical formulas. If you are comfortable with algebra, these
formulas can be solved manually and using any calculator. However, financial calculators and spreadsheets
have the formulas pre-programmed into them, making financial calculations much easier. Once you have a
programmed tool, whether a calculator or computer software, the financial problems become less about
mathematics and more about structured problem solving: in general, you need only specify the inputs for the
problem, and the calculator/computer will do the mathematics for you.
In this course we will use the Hewlett Packard (HP) 10BII/10BII+ calculator to demonstrate analytical
techniques. There is nothing particularly special about this particular calculator; it is a standard financial
calculator that is able to carry out the necessary calculations and not a lot more. There are a variety of pre-
programmed financial calculators on the market, some of which perform more sophisticated calculations or
have greater programming capacity. Students in Real Estate Division courses are welcome to choose other
calculators if they prefer, but it is up to the student to ensure that the alternate calculator will perform all
necessary calculations and to determine its operations. As well, for Real Estate Division courses with
proctored final examinations, it is important to understand that only silent, cordless, hand-held calculators
that are not both alphanumeric and programmable are permitted in the examination room.
The problems covered in this course will initially provide both mathematical formulas and calculator steps.
In subsequent problems, this will be abbreviated to provide calculator steps only. As well, the use of
computer spreadsheets is becoming increasingly important in financial analysis, more or less a mandatory
tool in contemporary business. In recognition of this, the lessons will also provide the formulas and steps for
the equivalent analysis in Microsoft Excel at key points.
1.2
Real Estate Finance Basics
The HP10BII/10BII+ has some unique features, so some basic orientation will help avoid difficulties.
1. Setting Up Your Calculator
The HP 10BII+ has two O (shift) keys. One is orange (for financial functions); the other is blue (for
statistical functions). To access the financial functions on the calculator, students should always
use the ORANGE O (shift) key. All functions that are activated by the ORANGE O (shift) key are
located on the lower half of each of the calculator keys, and are also labeled in ORANGE. We do
not use the BLUE O (shift) key in this course.
Decimal Places: The HP10BII/II+ allows you to set the number of decimal places displayed using
the ORANGE O then DISP key. It is best to display more decimal places than you need, so you are
working with the most accurate numbers possible. O DISP 9 will display 9 digits for all problems
(and in fact, shows 9 zeros, even if not significant, such as 0.000000000). You may also use what
is known as "floating decimals", or SHIFT DISP. However, it also displays small and large numbers
in scientific notation or exponential functions, e.g., 4/19 = 2.10526316E-2. This same value set to 9
decimal places changes the display to 0.210526316. The use of floating decimal places gives
slightly more accuracy, but you have to be comfortable working with the exponents (E-n). This is
your personal preference, as the final decimal place does not significantly affect calculations. Note
that the calculator uses its full accuracy of up to 15 decimal places regardless of the level of display
chosen.
For ease of presentation, in each of the examples presented in this course, the calculator is
programmed to display a "fixed decimal point" set to six decimal places. This is accomplished by
turning the calculator ON, pressing the ORANGE O then DISP and then the 6 key. You will see
0.000000 on your display screen. However, note that on the display portion of calculator steps in
the lessons, we will not show the display with zeros when they do not impact the result (and are
mathematically insignificant).
2. Using Your Calculator to Solve Questions
The internal operation of the HP 10BII/10BII+ calculator requires that all financial calculations have
at least one positive and one negative cash flow. This means that at least one of the PV, FV, and
PMT keys will have to be shown and/or entered as a negative amount. Generally, cash flowing in is
positive, while cash flowing out is negative.
For example, in mortgage loan problems, the borrower receives loan funds at the beginning of the
term (cash in, so a positive amount) and pays back the loan funds either during or at the end of the
term (cash out, so negative amounts). In this type of problem, PV will be shown/entered as a
positive, while PMT and FV will be shown/entered as negatives. When entering a negative amount
the +/- key is used, not the - key.
Similarly, from an investor's perspective, the initial investment is paid out (cash out, so negative
amount) and the investor receives money in the future (cash in, so positive amount). In this type of
problem, PV will be shown/entered as a negative, while PMT and FV will be shown/entered as
positives.
Summary
Borrower's Perspective Investor's Perspective

PV + PV B
PMT B PMT +
FV B FV +
(continued on the following page)
1.3
Lesson 1
(continued)
3. Clearing Information on Your Calculator
Note that if you enter an incorrect number on the screen, it can be cleared by pushing C once or by
pressing the  key to delete the last entered digit. If you enter an incorrect number into any of the
six financial keys, N, I/YR, PMT, PV, FV, or P/YR, it can be corrected by re-entering the desired
number into that key. You can verify what information is stored in each of the above financial keys
by pressing RCL and then the corresponding financial key you are interested in. For example, if
you obtained an incorrect solution for a financial problem, you can check what is stored in N by
pressing RCL N; I/YR by pressing RCL I/YR, etc. The HP 10BII/10BII+ calculator has a "constant
memory". This means that whatever is stored in the keys remains there until it is expressly
changed (even when the calculator is turned off), unless the  C ALL function is used or the
batteries are removed.
4. Troubleshooting
i. Please be aware that the HP 10BII/10BII+ calculator has both Begin and End modes. The
Begin mode is needed for annuity due calculations, or those which require payments to be
made "in advance". For example, lease payments are generally made at the beginning of each
month, not at the end. On the other hand, interest payments are almost always calculated at
the end of each payment period, or "not in advance". These types of calculations each require
a different setting on the calculator. When your calculator is set in Begin mode, the bottom of
the display screen will show BEGIN or BEG. If BEG is not on your display screen, your
calculator must be in End mode, as there is no annunciator for this mode.
In this course, there are minimal calculations which require your calculator to be in Begin
mode, so your calculator should be in End mode at all times. You should not see the BEGIN or
BEG annunciator on your calculator's display for most of the calculations in this course. To
switch between modes, press O BEG/END.
ii. Please be aware that if the calculator is displaying a comma (,) instead of a decimal place (.),
this can be fixed by pressing  ./, or  ,/..
Alert!
Students may wish to view the "Introduction to the HP10BII/10BII+ Calculator" online video tutorial found
under "Tutorial Assistance" and "Course Materials" on the Course Resources webpage. As well, students
can consult the HP 10BII/10BII+ owner's manual for more information.
1.4
Calculations and Solutions to Math Problems
Calculator Steps: In developing this course, we have illustrated the mathematical solutions for only some
problems, i.e., providing the solution based on formulas. For most problems, the calculator steps are
illustrated with the Hewlett-Packard HP10BII/10BII+ financial calculator.
Spreadsheet Applications: To emphasize the real-world nature of many of these calculations, we have
provided spreadsheet applications for many of these, in Microsoft Excel format. You can find the Excel
spreadsheet "CPD 151 Lesson 1 Solutions" under "Online Readings" on the Course Resources webpage.
Interest Rates
The General Characteristics of Interest
In a general sense, interest is rent on borrowed capital, where the level of rent per dollar borrowed for each
type of investment is a function of general economic conditions plus the costs and risks associated with the
specific investment. However, in the discussion of the mathematics of real estate finance, such
macroeconomic factors are taken as given: interest is discussed in a very pragmatic sense as the cost of
borrowing and/or the revenue from lending or investing. The focus of analysis in this context is upon the
effects of different patterns of interest calculation and principal repayment on the costs and benefits of
mortgage lending and borrowing and other forms of real estate investment.
The basic concept of valuation of financial instruments focuses upon the relationship between when interest
must be paid and when principal must be repaid. In the case of simple interest, interest is paid or earned
each period on the original principal amount only, but not on any interest charged or paid. However, with
compound interest, the interest charged changes with the interest that accumulates over time. Compound
interest means that interest is charged (or earned) on interest (as well as on the principal amount).
The essential difference between simple and compound interest is that simple interest is based on the
principal amount only, whereas with compound interest, the interest charged changes with the interest that
accumulates over time. Note that compound interest need not be actually paid to the lender on a periodic
basis; unpaid interest may be added to the debt and itself earn interest.
It is important to remember that interest rates are generally stated as the rate that prevails for a full year,
regardless of whether the loan is for a very short period of time, exactly a year, or a very long period of
time, and regardless of whether simple or compound interest is charged. Also, in most cases, interest is
charged only at the end of some period of time over which the borrower has use of the funds advanced under
the loan agreement. Thus, interest rates will be stated as a certain percentage per annum not in advance.
This differs from charges for the use of space, such as rent, which are levied in advance of the use.
Simple Interest
simple interest
Simple interest is interest that is paid only on the amount of principal
interest that is paid only on
borrowed, but not on any interest charged or paid. Therefore, the amount the amount of principal
of interest due (I) at the term of the loan is dependent only upon the borrowed, but not on any
interest rate, the amount of principal borrowed, and the length of the loan interest charged or paid
period.1 The simple interest rate (r) is expressed as a percentage of the
1
As is shown in the next section, the amount of interest paid when compound interest is charged is a function of these three factors
plus the number of compounding periods during the term of the loan.
1.5
Lesson 1
principal borrowed (P), where that percentage would be charged for the use of funds for exactly one year.
The principal borrowed is expressed as a dollar figure, and cannot change during the term of a simple
interest loan, as no payments of principal or interest are made during the term. The length of the loan period
(t) is measured as the number of full (or elapsed) days between the initiation of the loan and its termination.
Thus, if a loan is made one day, and repaid the next, although two calendar days are involved, only one day
has elapsed: interest would be charged for one day only.
Loans and Investments
A Matter of Perspective: Most of the examples in this section focus on borrowing scenarios – evaluating the
interest cost for borrowers, the periodic payments required on a loan, or what is owing at the end of a loan
term. However, these could all just as easily be considered from a lender or investor’s perspective –
evaluating the yield on investment based on cash flow received back from it. Every investment has two
parties involved on either side of the transaction, for every borrower there must also be a lender – and
whether it is money paid out or money received, the financial math is the same!
The following illustration is representative of simple interest calculations and serves to introduce a number
of items relating to standard symbols used in financial analysis.
Illustration 1.1
Consider a loan in the amount of $100,000 at 5% per annum simple interest where the loan is outstanding
for two years. Calculate the amount of interest owing at the end of the loan and the total amount owed at the
end of the loan.
Solution
The amount of interest owing at the end as found as:
I = P  r  t
where
P = amount of principal borrowed
r = simple interest rate
t = term (in years)
I = $100,000  .05  2
I = $10,000
The amount owing at the end of the term is:
A = I+P
A = $10,000 + $100,000
A = $110,000
For simple interest calculations, only the basic arithmetic functions of the calculator are used.
Alternatively, one could obtain the same answer by expressing the loan term in days rather than years (I = P
 r  number of days in loannumber of days in year). In this example, I = $100,000  0.05  730 365
= $10,000.
1.6
Compound Interest: The Basis for Interest Accrual Loans and Investments
The preceding section dealt with real estate loans/investments where simple interest was charged: the
formulas presented are only applicable in the infrequent cases where such an arrangement is made.
However, the formulas do provide the basis for the analysis of the much more common practice of real
estate loans/investments where compound interest is charged. The remainder of this material is devoted to
the technical aspects of real estate finance using compound interest scenarios. In this section, the basic
concepts of compound interest calculations are presented as the foundation for the analysis of real estate
financing.
Compound interest occurs when interest is charged or calculated on

interest during the life of a loan. This occurs when interest (and some compound interest
principal) is paid when interest is calculated (as in the case of interest calculated on the initial
amortizing loans) or is added to the principal and therefore, earns principal and the accumulated
interest; interest on interest
interest (as in the case of interest accrual loans). We will discuss
interest accrual loans in this section and deal with amortizing loans in
a later section.
An interest accrual loan is one on which no payments of interest

interest accrual loan and no repayments of principal are made or received during the life
debt which is paid off as one lump of the loan. The full amount of principal and all interest that
sum, including principal plus
accumulates during the term are payable when the term expires. A
accumulated compound interest
loan with interest charged during the life of the loan which is added
to the principal amount and, in turn, earns interest over the
remainder of the contract, is called an accrual loan. In effect, the lender is actually lending the borrower
additional amounts of money equal to the amount of interest due during the life of the loan.
Illustration 1.2
Consider a $45,000 interest accrual loan on which interest is to be charged at the rate of 6% at the end of
each six-month period for a 2-year term. Calculate the amount owed at the end of the loan.
Solution
By the end of six months, the borrower will owe $47,700, the sum of the $45,000 principal plus $2,700
interest ($45,000  6%). At the end of the first year, the borrower will owe $50,562 which is broken down
as follows:
$45,000 Principal amount borrowed

+ 2,700 Interest during first six months ($45,000  .06)
= 47,700 Owing during second six months
+ 2,862 Interest during the second six months ($47,700  .06)
= $50,562 Total amount owing
The outstanding balance (amount owing to the lender) on this loan has grown from $45,000 when it was
advanced to $50,562 by the end of one year, and it continues to grow over time to $56,811.46 at the end of
the term as shown by Figure 1.1.
1.7
Lesson 1
Figure 1.1: Outstanding Balance on an Interest Accrual Loan
Since the lender receives no payments before the maturity of the loan, the entire $45,000 original investment
is at risk throughout the term of the loan. The income to the lender, which is the interest on the monies
advanced, is also at risk throughout the entire term. For these reasons, almost all interest accrual loans are
written for short terms, one year or less (note that a two-year term is used in this example, for illustration
purposes).
Many more examples of compound interest calculations will be provided later in this lesson. In fact, given
compound interest is the basis of most contemporary financial analysis, nearly all of the remaining
calculations in the course focus on compound interest! However, before we continue to illustrate further
examples, we must first deal with one additional aspect of working with interest rates: the difference
between nominal and periodic rates.
Nominal and Periodic Interest Rates
Interest rates can be stated in many different ways. In order to accurately work with interest rates in
financial analysis, we must first ensure that we are using the correct rate and using it properly.
Compound interest rates are generally expressed on an annual basis for convenience and to follow
convention. However, within the year, the compounding period may vary, e.g., daily, weekly, monthly,
quarterly, semi-annual, and annual compounding periods. These will result in significant differences in the
amounts of interest owing or earned. Therefore, it is not enough to simply state "a rate of x% per year" – it
is crucial to also specify the compounding period for the interest rate.
1.8
The annual interest rate quoted for compound interest is referred to as the nominal interest rate per annum.
The nominal rate is represented mathematically as jm:
jm  i  m
or
jm
i
m
where:
jm = nominal interest rate compounded "m" times per year
m = number of compounding periods per annum
i = interest rate per compounding period, or periodic interest rate
The nominal interest rate (jm) is always expressed as a

certain percentage per year compounded a specific number nominal interest rate
of times during the year (m). The "m" could be 365 for an interest rate quoted as a rate per
daily compounding, 12 for monthly compounding, or 52 for annum, with a stated compounding
weekly compounding. frequency; equals the interest rate
per compounding period multiplied by
the number of compounding periods
The periodic rate is the rate per compounding period, such
as the rate per day, per week, per month, or per half-year. periodic rate
an interest rate per compounding period
Consider the nominal rate of 12% per annum, compounded
monthly, not in advance2.
The nominal rate would be expressed as:
j12  12%
The periodic rate would be expressed as:
j12 12%
i   1%
12 12
Thus, if an interest rate is stated as 12% per annum, compounded monthly (not in advance), this indicates
that there are 12 compounding periods (m) per annum and that the interest is 1% (i = jm  m) in each
monthly compounding period.
This can be illustrated using a time diagram3 as shown below:
2
"Not in advance" refers to the fact that the amount of interest accruing over the compounding period is calculated at the end of the
compounding period, so that the borrower pays the interest at the end (or, not in advance) of the compounding period. Almost all
rates of interest are calculated "not in advance". Therefore, the statement "not in advance" is frequently not used, and the interest rate
would be quoted as 12% per annum, compounded monthly. Unless it is explicitly stated to be otherwise, students may assume that all
interest rates are "not in advance".
3
Time diagrams are shown as a horizontal line representing time. The present value is at the left (time 0) and the future value is at
the right. In financial arrangements, time is measured by compounding periods, and so 12 monthly compounding periods are shown
along the "time" line.
1.9
Lesson 1
j12 = 12% nominal interest rate (per year)

m = 12 12 monthly periods per year
i = 1% periodic interest rate (monthly period)
As a second example, if the nominal rate is 6% per annum, compounded semi-annually, not in advance, this
would be expressed as:
j2  6%
The periodic rate would be expressed as:
j2 6%
i   3%
2 2
Thus, if an interest rate is stated as 6% per annum, compounded semi-annually (not in advance), this
indicates that there are two compounding periods (m) per annum and that the interest is 3% (i = jm  m) in
each semi-annual compounding period.
This can be illustrated using a time diagram as shown below:
j2 = 6% nominal interest rate (per year)

m =2 12 monthly periods per year
i = 3% periodic interest rate (semi-annual period)
Nominal and Periodic Rates
The HP10BII/II+ calculator has pre-programmed financial interest rate keys that require nominal rates.
TheI/YR and/or NOM% keys require a rate per year entered in nominal form (e.g., 5% not 0.05).
Furthermore, the calculator needs to know the associated compounding frequency (P/YR). Alternatively, the
mathematical formulas, other calculators, and Excel require interest rates to be stated as a periodic interest
rate (i). This varies for every calculator and software package – and that is why you must be fluent in
working between these interest rate formats!
For a nominal interest rate "j", by definition you know it is a rate per year. However, without the "m"
specified, you do not know the compounding frequency. Therefore, to state "the interest rate is a nominal
rate of 6%" is incomplete. You must know the compounding frequency in order to carry out further
calculations.
1.10
Examples of nominal interest rates:
id x 365 = j365
iw x 52 = j52
imo x 12 = j12
iq x 4 = j4
isa x 2 = j2
ia x 1 = j1
You may have noticed that the final line shows that the interest rate
ia and j1 are equal. This is an annual interest rate with annual effective annual interest rate
an annual interest rate that is
compounding, also known as the effective annual interest rate. This compounded annually (j1)
rate is the most common basis for comparing interest rates on
loans/investments, as it effectively accounts for all complications in
trying to compare rates with different compounding. The effective annual rate is found in EFF% key on the
HP10BII/II+ calculator. We will use this key extensively later in this lesson, when carrying out equivalent
interest rate calculations. Effective annual rates (and the EFF% key) will be used in a future section to find
equivalent interest rates. Similarly, periodic rates must also have the frequency of compounding stated. The
following shorthand notation is used in this course to indicate the frequency of compounding for periodic
rates:
id represents an interest rate per daily compounding period

iw represents an interest rate per weekly compounding period
imo represents an interest rate per monthly compounding period
iq represents an interest rate per quarterly compounding period
isa represents an interest rate per semi-annual compounding period
ia represents an interest rate per annual compounding period
For example:
id = j365  365
iw = j52  52
imo = j12  12
iq = j4  4
isa = j2  2
ia = j1  1
Exercise 1 will help you become more familiarity with periodic interest rates, compounding frequency,
nominal rates, and the interrelationship between them. Remember, it is crucial that you be fluent in moving
between these rates, in order to be successful in the more complicated financial problems you will
experience later.
1.11
Lesson 1
Exercise 1
The tables below represent a sample of interest rates. Complete the tables by entering the appropriate values
for the question marks for either the periodic rate, the number of compounding periods, or the nominal rate.
Periodic Rate Number of Compounding Nominal Rate

Question i Periods per Year (m) (jm = i  m)
SAMPLE 3% 2 j2 = 6%
(a) 0.625% 12 j12 = ?
(b) 1.275% 4 j4 = ?
(c) 4% 1 j1 = ?
(d) 3.4% 2 j2 = ?
(e) 6% 2 j2 = ?
(f) 2.5% m=? jm = 10%
(g) 0.0356164% m=? jm = 13%
SAMPLE j2 = 5% 2 isa = 2.5%
(h) j12 = 6% 12 imo = ?
(i) j4 = 10% 4 iq = ?
(j) j365 = 8% 365 id = ?
(k) j52 = 13% 52 iw = ?
(l) j1 = 4% 1 ia = ?
(m) jm = 10% m=? isa = 5%
(n) jm = 4.5% m=? imo = 0.375%
Abbreviated Solution:
(a) j12 = 7.5%
(b) j4 = 5.1%
(c) j1 = 4%
(d) j2 = 6.8%
(e) j2 = 12%
(f) m=4
(g) m = 365
(h) imo = 0.5%
(i) iq = 2.5%
(j) id = 0.021918%
(k) iw = 0.25%
(l) ia = 4%
(m) m=2
(n) m = 12
1.12
Self-Help Exercise: Nominal and Periodic Rates
In order to become fluent with nominal and periodic rates, you need practice. Here’s an exercise you can
complete on your own. Make a list of nominal rates using a variety of compounding and your choice of
numbers:
Nominal Periodic Nominal

j2 = 12% ?
j4 = 8% ?
j52 = 7% ?
… …
Solve for the periodic rates (as shown in the second column):

j2 = 12% isa = 6%
j4 = 8% iq= 2%
j52 = 7% iw= 0.13462
… …
Now cover up the first column and work backwards from periodic to nominal.

isa = 6% ?
iq= 2% ?
iw= 0.13462 ?
… … …
Uncover the first column and your first and last columns should match. Do more practice on your own until
you are comfortable with this nominal/periodic relationship.

j2 = 12% isa = 6% j2= 12%
j4 = 8% iq= 2% j4= 8%
j52 = 7% iw= 0.134615 j52= 7%
… … …
Illustrations of Compound Interest Calculations

Now that we have the terminology of interest rates clarified, we can proceed to calculations involving
compound interest. For our first example of the nature of compound interest, we will complete a problem
quite similar to the example covered in the Interest Rates section.
Illustration 1.3
A commercial enterprise has arranged for an interest accrual loan whereby the $10,000 amount borrowed is
to be repaid in full at the end of one year. The borrower has agreed, in addition, to pay interest at the rate of
8% per annum, compounded annually on borrowed funds and this interest is to be calculated and paid at the
end of the loan's one-year term. Calculate the amount of interest due and the total amount owing at the end
of the term of the loan.
1.13
Lesson 1
Solution
Given that the borrower owes $10,000 throughout the year, the amount of interest owing at the end of the
one-year term is calculated as follows:
Interest owing = Principal borrowed  interest rate per interest calculation period (in this example,
interest is calculated per annual compounding period)
= $10,000  8%
= $10,000  0.08
Thus, the amount of interest owing at the end of the one year term is $800. The total amount owing at the
end of the one year term of this interest accrual loan would be the principal borrowed ($10,000) plus the
interest charged ($800) or $10,800.
This illustration introduces a number of very important definitions and concepts. Financial analysts use short
form abbreviations for the loan amount, interest rates and other mortgage items. In this shorthand notation,
the following symbols are used:
PV = Present value: the amount of principal owing at the beginning of an interest calculation
period;
FV = Future value: the amount of money owing in the future;
i = Interest rate per compounding period; the fraction (or percentage) used to calculate the
dollar amount of interest owing;
I = Interest owing, in dollars, at the end of an interest calculation (compounding) period; and
n = Number of compounding periods contracted for.
The amount of interest owing can be mathematically calculated as follows:
I = PV  i
I = $10,000  8%
I = $10,000  0.08
I = $800
The total amount owing at the end of the one-year term would be:
FV = PV + I
FV = $10,000 + $800
FV = $10,800
Press Display Comments

10000  .08 = 800 Equals interest owing
+ 10000 = 10,800 Equals total owing
For illustrations in this course, the HP10BII/II+ calculator is set to six decimal places by pressing O DISP 6.
However, for ease of presentation, on the display portion of calculator steps, we will not show the display
with zeros when they do not impact the result (and are mathematically insignificant).
1.14
This example can be illustrated on a time diagram:
The calculations in this illustration are extremely simple and probably do not need a calculator, but it is a
good opportunity to introduce its use. For illustrations throughout the text, we will provide each step in the
calculation, noting which button to press, what appears on the screen (display), and comments to explain
each new step as it is encountered.
Excel calculations will also be demonstrated for many illustrations. You can find the associated Excel file
under "Online Readings" section of the Course Resources webpage.
The Power of Spreadsheets
By using a spreadsheet like Excel, we can solve financial problems either by programming in math formulas
manually or by the use of Excel’s pre-programmed financial formulas. For this simple example, we identify
the loan amount (PV), interest rate, and length of loan. We then calculate the amount of interest and future
value amount. If we specify the numbers in separate cells, and then program the cell coordinates into the
formulas, it allows us the flexibility to easily change a number and then recalculate the future value. For
example, if we change the loan amount to $5,000, we change that one cell (B4) and then the interest
amount will change to $400 and future value to $5,400. This is a simple example of the dynamic nature of
spreadsheets – which can be very useful in working with highly complex, sophisticated analyses.
In this simple example, note that the answer is the same as would result if this was simple interest or
compound interest. This is because there is only one term in the loan. Let's see what happens when the loan
is for multiple terms.
Illustration 1.4
Assume that the commercial borrower in Illustration 1.3 arranged for another loan which was similar in all
respects, except that the contract specified a term of three years. Calculate the amount owing at the end of
the 3-year term of the interest accrual loan.
Solution
The amount owing at the end of the three year term is calculated in a series of steps based on the analysis
presented in Illustration 1.1. The amount owing at the end of the first compounding period (in this case, at
the end of the first year) must be calculated. This amount was calculated to be $10,800 (the $10,000
originally borrowed plus $800 interest). As a result, the amount owing during the second year (or second
annual compounding period) would be $10,800. The amount owing at the end of the second year of the
contract can be calculated in the same way as in Illustration 1.3.
I = PV  i
I = $10,800  8%
I = $10,800  0.08
I = $864
Thus, the amount of interest that is charged (but not paid) at the end of the second year of the loan term is
1.15
Lesson 1
$864. As no payments (of principal or interest) are due until the end of the loan term, this amount is added
to the balance owing at the end of year two.
FV = PV + I
FV = $10,800 + $864
FV = $11,664
The total amount owing during the third year of the contract would be $11,664. The amount owing at the
end of three years can be calculated in a similar fashion:
I = PV  i
I = $11,664  8%
I = $11,664  0.08
I = $933.12
FV = PV + I
FV = $11,664 + $933.12
FV = $12,597.12
This calculation above can be summarized on a time diagram, similar to Illustration 1.3:
The previous calculations show that the steps involved in determining the amount owing on an interest
accrual loan can be time-consuming. Therefore, to reduce the number of calculations involved in interest
accrual loans, the financial calculator has been pre-programmed to perform this function.
It was noted earlier that the amount owing at the end of year one could be determined by first calculating the
amount of interest at the end of the first (annual) compounding period, then adding this amount to the
principal borrowed. The formulas used to perform these calculations were I = PV  i and FV = PV + I.
By using these relationships in a repetitive fashion, the amount owing at the end of the term of an interest
accrual loan could be determined. However, there is a faster way to do these calculations.
In Illustration 1.4 you could have determined the amount owing at the end of the first year by calculating
108% of the amount owing during the year. This would involve simply multiplying the amount owing during
the year by 108% (or 1.08) to get $10,800, the product of multiplying $10,000 by 1.08. The amount owing
at the end of the second year will be the amount owing during the second year ($10,800), multiplied by
108% (or 1.08); i.e., $11,664. Finally, and recognizing that the borrower owes $11,664 during the third
year, the amount owing at the end of the third year can be calculated by multiplying this value by 108% (or
1.08) with the result of $12,597.12.
To summarize, the problem can be solved as follows:
Amount owing at end of year one = $10,000  1.08 = $10,800

Amount owing at end of year two = $10,800  1.08 = $11,664
Amount owing at end of year three = $11,664  1.08 = $12,597.12
1.16
A simpler calculation recognizes that for each annual compounding period the principal outstanding is
multiplied by 1.08:
FV = $10,000  1.08  1.08  1.08

FV = $12,597.12
Therefore, in determining the amount owing at the end of the term of an interest accrual loan, the principal
amount originally borrowed can be multiplied by one plus the rate of interest per compounding period
(expressed as a decimal) for the number of compounding periods during the contract term. To simplify the
analysis even further, standard mathematical notation can be used which represents the value of one plus the
rate of interest per compounding period as (1+i).
A superscript indicates that a number has been raised to a power (or multiplied by itself some number of
times) and the relationship may be restated as follows:
FV = $10,000  (1.08)3
or in more general terms:
FV = PV  (1 + i)n
where FV = Future value (or amount owing in the future)

PV = Present value (or original amount borrowed)
i = interest rate per compounding period expressed as a decimal
n = number of compounding periods in the loan term
Any financial or scientific calculator can do these kinds of repetitive multiplications, also known as
exponential calculations. The steps below show how the calculator can be used to determine the amount
owing on the loan by using the exponential function.

x
1.08 O y 3 = 1.259712 1.08 raised to the power of 3
 10000 = 12,597.12 Total amount owed at end of year three
The use of the exponential key (yx) reduces the number of repetitive calculations required in analyzing
interest accrual loans. You only need to determine the value of (1 + i)n at the appropriate rate of interest
(expressed as a decimal) and for the appropriate number of compounding periods and then multiply the
result by the principal amount borrowed. This type of exponential analysis is the basis for many algebra
calculations; therefore, this capability is programmed into all scientific or business calculators.
1.17
Lesson 1
Caution!
Interest Rates: Percent or Decimal? The HP10BII/II+ financial calculators require interest rates to be
entered in percent form (e.g., 3.5), not decimals (e.g., 0.035), and as a rate per year (nominal rate). When
using math formulas directly, you must instead specify interest rates in decimal form, not percentage form,
and as a rate per period. Excel similarly requires decimal expressions of interest rates in periodic form. For
example, if the calculator uses 8% in nominal (annual) percentage format, Excel and the math formula
solution would use 0.08. However, in Excel you may format the cells to show in “percentage” terms, in
which case Excel will automatically switch to a decimal for the calculation. Be careful in Excel that you have
specified your interest rates correctly … if you specify a rate as 8, but don’t set it as a percent, Excel may
translate this as 800%!
When using the HP 10BII/10BII+ calculator, the above formula, FV = PV  (1 + i)n, must be slightly
modified to consider nominal interest rates. Recall that a periodic rate is equal to the nominal rate divided by
the compounding frequency. Thus the formula becomes:
FV = PV  (1 + jm/m)n
where jm = nominal interest rate per annum
m = compounding frequency
n = number of compounding periods in the loan term
This modified version is necessary because this calculator only works with nominal interest rates. This
formula for interest accrual loans has been pre-programmed into the mortgage finance keys of the HP
10BII/10BII+ calculator. These keys are:
I/YR Nominal interest rate per year (jm) B entered as a percent amount (not as a decimal)
O P/YR "Periods per year" (m) B this indicates the compounding frequency of the nominal rate in
I/YR and is located below the PMT key
N Number of compounding or payment periods in the financial problem - this number will be
expressed in the same frequency as P/YR (in other words, if P/YR is 12, then N will
represent the number of months)
PV Present value
FV Future value after N periods
PMT Payment per period B this is expressed in the same frequency as P/YR and N (i.e., if N is
months, PMT represents the payment per month)
Illustration 1.4 is once again illustrated below with a time diagram, but with a new feature added. The cash
flows are placed along the horizontal line with an arrow representing positive or negative cash flows. An "up
arrow" represents a positive cash flow (money received), while a "down arrow" represents a negative cash
flow (money paid out).
To calculate this problem with the HP 10BII/10BII+ calculator, a number should be entered and then
"labelled" appropriately. For example, the loan in this example has a three-year term, so "3" should be
entered and then "N" pressed in order to enter a value of 3 as the number of compounding periods during
the term. By entering a number and then labelling it, you can enter the information in any order.
1.18

8 I/YR 8 Enter nominal interest rate per year
1 O P/YR 1 Enter compounding frequency
3N 3 Enter number of compounding periods
0 PMT 0 No payments during term
10000 PV 10,000 Enter present value4
FV -12,597.12 Computed future value5
This is the same answer as that calculated with either of the two approaches shown earlier, but with much
less work needed.
Future Value Calculations in Excel
You can solve Illustration 1.4 using Excel by either using the math formula or the pre-programmed financial
functions. With the pre-programmed FV function, you enter the periodic rate, the loan or investment period
(NPER), payment (0), PV (the loan amount), and type of loan (0). The type of loan is a value representing
the timing of the payment. If payments occur at the beginning of a period, the type is 1 and if the payments
occur at the end of a period, the type is 0. Since there is no payment in this calculation, the type is 0 or can
be omitted as 0 is the default option.
Notice that the result shows as a negative, like the calculator solution.
Note also that the compounding frequency of the interest rate must match the periods used in specifying the
loan or investment period (NPER) – if not, then an interest rate conversion is required … more on this topic
later in this lesson.
Recapping our progress: so far we have illustrated the difference between simple and compound interest and
shown that compound interest is the standard method for financial investments. Compound interest allows
"interest on the interest", which is an important consideration for investors making long-term loans.
The calculations shown so far have illustrated how compound interest works, in leading to a higher future
value for a loan or investment than would accrue in a simple interest scenario. We will now proceed to
illustrate further present value and future value calculations, from a variety of real estate finance and
investment contexts.
Note that these calculations all involve the future and present values of a single payment at some point in
time, which is called a lump sum amount (or single cash flow). The introduction of payments during the
loan or investment period adds further complexity – this will be examined in detail in Lesson 2.
4
Note that the borrower receives the cash; therefore, it is entered as a positive amount.
5
This will be paid out by the borrower; therefore, it is a negative amount.
1.19
Lesson 1
Structuring Present Value and Future Value Problems
Consider the interest accrual formulas already covered:
FV = PV × (1 + i)n or FV = PV × (1 + jm/m)n
If the values of any four of the five variables (FV, PV, j m, m, and n) are known, one may directly calculate
the value of the fifth variable. However, you need the following conditions for the above relationship (or the
financial calculator) to be used:
1. The present value must occur at the beginning of the first compounding period.
2. The future value must occur at the end of the last (or nth) compounding period.
3. Interest rates must be expressed as a rate of interest per compounding period when solving using
the exponent key yx, or as a nominal rate per year when using the calculator's pre-programmed
functions.
4. There can be no payments (made or received) during the term other than the present value and
future value, i.e., PMT = 0.
These conditions are summarized in the time diagram below:
Calculation of Future Value
A common interest accrual problem involves calculating the future value of a lump sum. When you receive
(or invest) a lump sum cash flow today and need to find the value of this cash flow with accrued interest at
some point in the future, it is known as the future value of a lump sum. The following illustrations
demonstrate how to use the pre-programmed feature of the HP 10BII/10BII+ calculator to solve these types
of problems. Excel spreadsheet solutions are provided under "Online Readings" on the Course Resources
webpage.
Illustration 1.5
A residential subdivision developer has purchased a 30-acre section of land for $400,000. The firm feels that
land values in the area will increase at the rate of 1% per month over the next three years. If this rate of
increase in property values proves to be correct, calculate the value of the parcel at the end of the three
years.
Solution
The objective of this problem is to calculate the future value of $400,000 at the end of 3 years, where the
rate of interest is 1% per monthly compounding period. This problem can be solved using the exponential yx
key. However, using the pre-programmed financial features, the solution may be done as follows. The
number of compounding periods during the investment period must be identified. The periodic rate of
interest was given as 1% per month and the investment horizon is three years; this means that the number of
compounding periods is 36 (12  3 = 36) and the nominal interest rate per year is j12 = 12% (1%  12 =
1.20
12%). The development firm will receive no income from the property during the three year investment
horizon and wants to know the likely future value of the parcel:
FV = PV  (1 + i)n
FV = $400,000  (1 + 1%)36
36
FV = $400,000  (1 + 0.01)
The financial arrangement involved may be illustrated by a time diagram:
Notice that the present value is shown as a negative in this example. This represents the funds needed to
purchase the land, which is an outflow of cash for the developer. The future value which will be calculated
represents the money received by the developer for selling the land in three years, which is a cash inflow
and a positive amount.

1  12 = I/YR 12 Enter nominal interest rate per year
3  12 = N 36 Enter number of compounding periods
0 PMT 0 No payments during term
400000 +/- PV -400,000 Enter present value
FV 572,307.513437 Computed future value
If property values rise at a rate of 1% per month, and the current value of the property is $400,000, the
property will have a value of $572,307.51 at the end of 3 years.
Excel Note
You must use the periodic rate (monthly rate for this example) for either the formula solution or the pre-
programmed FV function in Excel. Note that since this illustration is examined from the investor’s
perspective, we enter the amount invested (present value) as a negative (cash outflow) and the future value
is a positive (cash inflow). Keep in mind that you could reverse these, with PV as a positive and FV as a
negative; it makes no difference mathematically!
1.21
Lesson 1
Rounding Rules Alert!
When calculating monetary amounts, numbers will have to be rounded off, since it is impossible to pay or
receive an amount less than one cent. When rounding monetary values amounts (e.g., PV, FV, or PMT),
normal rounding rules are applied. This is the common mathematical rule which states:
 If the third decimal is 5 or greater, the number is rounded up: e.g. 8,955.436 would be rounded UP
to $8,955.44 (because the third decimal is a 6).
 If the third decimal is less than 5, the number is rounded down: e.g. 8,955.433 would be rounded
DOWN to $8,955.43 (because the third decimal is a 3).
Assume all monetary values are rounded to the nearest cent, unless instructed otherwise.
Illustration 1.6
An individual deposits $15,000 in an account bearing interest at the rate of 3% per semi-annual
compounding period. He intends to let the interest accrue on this deposit and then invest the total amount in
real estate. If the funds are deposited for a four-year period, what amount will be available at the end of this
time?
Solution
The information given in the problem is as follows:
PV = $15,000 (paid out, therefore a negative amount)

isa = 3% per semi-annual compounding period
n = 8 semi-annual compounding periods (4  2 = 8)
Now you need to calculate the future value, or the amount accumulated by the end of eight semi-annual
compounding periods (4 years):
FV = PV  (1 + i)n
FV = $15,000  (1 + 3%)8
FV = $15,000  (1 + .03)8
N = 8
isa = 3%
PMT = 0
PV = $15,000
FV = ?
1.22

3  2 = I/YR 6 Enter nominal interest rate per year
15000 +/- PV -15,000 Enter present value
42=N 8 Enter number of compounding periods
0 PMT 0 No intervening payments
Thus the investor will have accumulated a total of $19,001.55 by the end of the 8th semi-annual
compounding period (the end of four years).
Illustration 1.7
Assume for the moment that the investor in this question had to withdraw these funds after only three years.
How much would be available at the end of three years?
Solution
To calculate this amount, you only need to enter the variable that has changed (N) and re-calculate FV. All
of the other financial keys will still have the correct amount stored in them from the previous calculation
(you can verify this by pressing RCL and the corresponding financial keys). The following is the solution to
this problem:

19,001.551221 Displayed from previous calculation
32=N 6
FV 17,910.784448
The investor would have only accumulated $17,910.78 after three years.
Now assume that the investor will still have to withdraw the funds in 3 years, but will need to have at least
$30,000 accumulated by the end of this time. What interest rate must the investor earn in order to
accumulate this amount?
This calculation is similar to the preceding example. The only variable which will change is the future value
and the interest rate becomes the unknown amount that needs to be calculated. All of the other financial keys
are the same as in the previous calculation.
1.23
Lesson 1

17,910.784448 Displayed from previous calculation
30000 FV 30,000 Enter new future value
I/YR 24.49241 Computed interest rate (j2)
Therefore, the investor would need to receive a return of over 24.49% per annum, compounded semi-
annually (j2) to accumulate $30,000 in 3 years.
Rate Calculations in Excel
In order to solve for an interest rate using Excel, use the RATE function: enter the loan or investment period
(NPER), 0 for PMT, loan or investment amount (PV), FV, type (0), and omit guess (not required). Enter
either the PV or the FV amounts as a negative in order to obtain a solution.
As previously discussed, from an investor’s perspective, we enter the present value as a negative and the
future value as a positive.
Illustration 1.8
Assume that you invest $20,000 today in a venture that will earn an interest rate of 5% per annum,
compounded monthly. What is the future value of this investment after 15 months?
Solution
FV = PV  (1 + i)n or FV = PV  (1 + jm/m)n
Where PV = $20,000;
j12 = 5% (5% per annum, compounded monthly)
m = 12 (monthly compounding)
n = 15 months
FV = ?
The financial arrangement involved may be illustrated by a time diagram.
In the absence of information, it is assumed that there will be no payments made during the 15 month
investment period, and therefore payments are zero. Note that in this illustration, "n" is expressed in months
and the interest rate is compounded monthly.
1.24

5 I/YR 5 Enter stated nominal rate
12 O P/YR 12 Enter stated compounding
15 N 15 Enter number of months
20000 +/- PV -20,000 Enter amount of the initial investment
0 PMT 0 No payments
The future value of this investment after 15 months is $21,287.12.
Exercise 2
The table below provides a summary of four investment opportunities. For each investment, calculate the
amount that will be received at the end of the term based on the amount invested, investment period, and
interest rate earned.
Summary of Terms
Investment Amount to Invest (Today) Term (Years) Nominal Rate
1 $175,000 3 years j12 = 5%

2 $200,000 2 years j2 = 4%
3 $32,000 5 years j1 = 9%
4 $50,000 2.5 years j4 = 7.5%
1) FV = $203,257.64
2) FV = $216,486.43
3) FV = $49,235.97
4) FV = $60,206.89
Calculation of Present Value
In the previous section the calculator was used to solve future value
of lump sum problems. Another common lump sum problem is time value of money
calculating the present value of a cash flow received at some point in recognizes that money at the
the future. For example, you may need to calculate how much to present time is worth more than
pay for an investment today given its expected pay-off in the future. the same amount in the future
due to its potential earning
In this type of problem, the time value of money says that money capacity
received in the future is worth less than money received today; in
calculating the present value, you are determining how much less it
is worth, given the interest rate and length of time.
To calculate the present value of a lump sum, the future value formula provided earlier is rearranged as
follows:
PV = FV × (1 + i)-n or PV = FV × (1 + jm/m)-n
1.25
Lesson 1
However, this formula has been pre-programmed into the calculator, and as a result the only difference in
calculating the present value of a lump sum is that you enter the future value and calculate the present value.
The following illustration demonstrates how to use the pre-programmed feature of the HP 10BII/10BII+
calculator to solve these types of problems.
Present Value Calculations in Excel
Similar to the future value calculations in Excel, you can solve these problems by either using the formula or
the pre-programmed PV function. With the pre-programmed PV function, enter the periodic rate, the
investment or loan period (NPER), payment (0), FV, and type of loan (0). Similar to the previous
calculations, the compounding frequency of the interest rate must match the loan or investment period
(NPER).
Illustration 1.9
You are offered an investment that will produce $350,000 in 120 months. If you wish to earn 9% per
annum, compounded monthly, how much should you offer to pay for the investment today?
Solution
PV = FV  (1 + i)-n or PV = FV  (1 + jm/m)-n
where FV = $350,000
j12 = 9% (9% per annum, compounded monthly)
m = 12 (monthly compounding)
n = 120 months
The solution requires you to calculate the present value based on the desired yield. In this case, the
investment term is expressed in years (n) and the interest rate is compounded monthly.
The financial arrangement involved may be illustrated by a time diagram.
1.26

9 I/YR 9 Enter stated nominal rate
12 O P/YR 12 Enter stated compounding frequency
350000 FV 350,000 Enter expected future value
120 N 120 Enter number of months
0 PMT 0 No payments
PV -142,778.05674 Computed present value
If you wish to earn a 9% return per annum, compounded monthly, you should offer $142,778.06 for the
investment today.
Four Out of Five is All You Need!
One of the benefits of using the calculator’s pre-programmed financial keys is that you do not need to work
with math formulas in order to calculate math solutions. As long as you can determine what is required in
four of the five necessary keys, then you have enough information to calculate the fifth (missing) key. In the
examples shown so far, we have calculated PV and FV. However, you could actually calculate any one of
the elements: interest rate (I/YR), number of periods (N), or even the compounding period (P/YR).
For example, if the problem above was restructured to be "if you offered $142,778.06 for an investment that
accrued to $350,000 in only 90 months, what rate of interest would you earn, expressed as a j 12?" This
would require only changing N to 90 and pressing I/YR again … the interest rate is approximately 12.015%.
Alternatively, if the interest rate was j12=15%, how many months would it then take you to accrue the
required $350,000? This requires only changing I/YR to 15 and pressing N … the time frame is
approximately 72.179 months.
This scenario illustrates that you can easily calculate any of the needed numbers on the timeline. It also
highlights that these problems do not have to be solved in linear lock-step fashion; you can enter the
numbers in any order, you can change a number later and recalculate something else. As long as you have
four keys specified, you calculate the fifth … "it’s just that easy!"
Exercise 3
You are offered four investment opportunities that will produce the following amounts at the end of the
term. The table below provides a summary of the investments. For each investment, calculate the amount to
invest today in order to accumulate the desired future value.
Summary of Terms
Term Amount Received at the
Investment (Years) Nominal Rate end of term
1 2 years j12 = 3.5% $4,000

2 4 years j2 = 6% $35,000
3 1 year j1 = 2.75% $5,500
4 8 years j4 = 8% $90,000
1.27
Lesson 1
1) PV = $3,729.96
2) PV = $27,629.32
3) PV = $5,352.80
4) PV = $47,757.00
Equivalent Interest Rates

Much of this lesson so far has focused on the concepts of compound interest and compounding periods. However,
there has been a simplification in all of the problems that you will find often proves unrealistic in practice.
The problems so far have introduced loan and investment terms that can be modified to match the stated
interest rate. For example, if the interest rate is an annual rate with monthly compounding (j12) and the loan
term is 5 years, then you can simply specify N as 60 months ( 5 × 12). This easily allows you to ensure that
N and P/YR match frequency, as the HP10BII/II+ calculator requires.
However, consider if this was a loan calling for quarterly payments over this 5-year term; now the PMT key
will require a quarterly payment to be specified. Since there are 4 quarterly payments made per year over 5
years, there are 20 payments to be made in total; 20 is entered in N. Now N and PMT match in frequency,
as required. However, the interest rate is a j12 which does not match with the quarterly payments. You
cannot enter 12 into P/YR, because then this would not match the frequency in N and PMT. Without further
calculations, you cannot solve this problem with the HP10BII/II+ calculator.
To solve this problem, you must be able to calculate the j4 rate of interest that is equivalent to the j12 rate
stated in the question. Once you know the equivalent rate, then you may easily calculate the desired answer.
It is commonly required in financial analysis to calculate the nominal rate of interest for a particular
compounding frequency that is equivalent to a stated nominal rate of interest for a given compounding
frequency. In mortgage calculations, the most common calculation is to find the nominal rate of interest with
monthly compounding (j12) that is equivalent to a particular nominal rate of interest expressed with semi-
annual compounding (j2). This occurs because interest rates are usually stated as j2, but mortgage payments
tend to be monthly. Other commonly encountered examples include converting a semi-annually or monthly
compounded nominal rate to an equivalent nominal rate of interest with annual compounding (j1).
Matching Problem with Interest Rates
Mortgage interest rates are nearly always stated as annual rates with semi-annual compounding (j2);
however, the HP10BII/II+ requires a j12 interest rate so that the monthly payment requirement can be
calculated. Similarly, in this example, Excel would require a monthly periodic rate to work with this
mortgage. A part of the "financial fluency" is being able to move between nominal, periodic, and effective
rates effortlessly. Therefore, we will spend considerable time on this in the next part of the lesson, to ensure
you understand the distinctions and can work with each type.
You may find that many practitioners simply ignore the impact of compounding differences and try to
assume away the impact of compounding differences; e.g., assume that a j2=6% mortgage rate is simply a
j12 and divide it by 12 to obtain the 0.5% monthly periodic rate. When working with a 30-year forecasted pro
forma, with substantial future assumptions, this slight variation may not be significantly important. However,
there is no question that it is mathematically sloppy (and inaccurate). If a more accurate number is available
without substantial work, in our opinion it is a more sophisticated analysis, and a better showcase of your
professionalism, to work with the most accurate numbers possible, rather than assume away the hard stuff.
As the adage says, "if it was that easy, what would they need you for!"
1.28
Why Does Compounding Matter?
Consider a loan of $100,000 calling for monthly payments over 25 years at an interest rate of j2=12%. The
monthly payments are $1,031.90. However, if the interest rate is incorrectly used as j 12=12%, the monthly
payments are $1,053.23. The $21.33 per month difference is not massive, but certainly a borrower would
not want to pay any more extra interest than he or she has to, just as an investor would not want to give up
any extra return to which the investor is entitled.
The next section introduces the techniques necessary for interest rate standardization and conversion. This is
the final competency needed for interest rate fluency – and with this mastered, we can then move on to more
practical and realistic financial problems in Lessons 2 and 3.
The basis upon which interest rate calculations are performed is stated as follows:
Two interest rates are said to be equivalent if, for the same amount borrowed, over the
same period of time, the same amount is owed at the end of the period of time.
The effective annual rate (j1), introduced earlier, is one particular equivalent interest rate that is very helpful.
Because the effective rate is the annual rate with annual compounding, it does not hide any impacts from
compounding within the year – in effect, this serves as the clearest way to express the true rate of interest on
an annual basis. As such, the effective rate is often used to standardize interest rates to allow borrowers and
lenders to compare different rates on a common basis.
A variation of the above statement with reference to the effective rate:
If two interest rates accumulate the same amount of interest for the same loan amount
over the same period of time, they have the same effective annual interest rate.
Therefore, two interest rates are said to be equivalent if they result in the same
effective annual interest rate.
The HP10BII/II+ uses the effective annual interest rate directly in its functions to convert between
equivalent nominal interest rates. This same technique can be used in Excel. This relationship will be
demonstrated in Illustration 1.10.
Illustration 1.10
A borrower is considering interest accrual loans from two different lenders. Either loan would be for $100.
Loan A accrues interest at j12 = 11.234%, and Loan B accrues interest at j2 = 11.5%. Both loans have a
one-year term. How much interest accrues on each loan over the one-year term?
Solution
First, calculate how much interest will accrue with Loan A. This can be done either by solving for FV in the
formula, FV = PV (1 + jm/m)n, or by using the financial keys on the calculator. Only the method using the
financial keys will be shown, as it is quicker and is good practice for later operations. The calculation for
Loan A follows:
1.29
Lesson 1

11.234 I/YR 11.234 Enter stated nominal rate
12  P/YR 12 Enter stated compounding frequency
12 N 12 Enter number of compounding periods
100 PV 100 Enter present value
0 PMT 0 No payment during the term
FV -111.830865 Total amount owed at the end of the term
+/- –100 = 11.830865 Subtract original loan amount to find amount of
interest accrued
In Loan A, $11.83 of interest accrues on a $100 loan over one year. Now perform the same calculation for
Loan B.

11.5 I/YR 11.5 Enter stated nominal rate
0 PMT 0 No payments during the term
FV -111.830625 Total amount owed at end of term
+/- –100 = 11.830625 Subtract original loan amount to find amount of
interest accrued
This calculation shows that $11.83 in interest also accrues on the $100 of principal over one year in Loan B.
Recall the statement at the beginning of the section that two interest rates are said to be equivalent if, for the
same amount borrowed, over the same period of time, the same amount is owed at the end of the period of
time. From this example, it is clear that j2 = 11.5% and j12 = 11.234% are equivalent interest rates,
because for the same amount borrowed ($100), over the same period of time (1 year), the same amount is
owed at the end of the period of time ($111.83).6
Consider the time diagrams for these two loans:
6
Readers may notice that these two interest rates do not accrue exactly the same amount of interest and thus are not exactly
equivalent. This is due to rounding off of the j 12 interest rate to only three decimal places. To be fully accurate mathematically, you
could provide additional decimal places; however, this additional precision has little or no practical significance.
1.30
Now consider the second statement at the beginning of the section that if two interest rates accumulate the
same amount of interest for the same loan amount over the same time period, they have the same effective
annual interest rate. From the example, one can calculate the effective annual interest rate (j1) on both Loan
A and Loan B. The effective annual interest rate is the interest rate per annum with annual compounding.
The calculations have shown us that both loans accrue $11.83 in interest over the one-year term. This
amount comes due only once, at the end of the one-year term, and is therefore compounded annually. The
effective annual interest rate on both loans is 11.83%.

1  P/YR 1 Enter compounding frequency
111.83 +/- FV -111.83 Amount owed at the end of the term
0 PMT 0 No payments during the term
I/YR 11.83 Effective annual interest rate
These two loans, which accrue the same amount of interest for the same loan amount over the same time
period, do in fact have the same effective annual interest rate. This proves the final statement that two
interest rates are said to be equivalent if they result in the same effective annual interest rate. These two
interest rates, j2 = 11.5% and j12 = 11.234% are equivalent, and they do result in the same effective annual
interest rate. The fact that equivalent interest rates have the same effective annual interest rate will be used
in computing equivalent rates with the financial calculator.
There are several reasons to convert interest rates from one compounding frequency to another:
1.31
Lesson 1
 First, the Interest Act requires that Equivalent Interest Rate Calculations
the rate of interest quoted in a
mortgage contract be quoted as a There are two methods of calculating equivalent
nominal rate with either semi- interest rates. The first involves the use of
annual or annual compounding, so mathematical formulas. The second method uses the
interest rates quoted with any other calculator’s pre-programmed financial keys. The
compounding frequency must be calculator method is much easier, but we will show
converted to their equivalent you the mathematical method first, so you have an
nominal rates with semi-annual or understanding of what the calculator is doing.
annual compounding.
 Second, when comparing interest rates to one another, it is necessary to compare rates that have
the same frequency of compounding in order to accurately assess the cost of borrowing.
 Third, when using the financial calculator to compute periodic payments under a mortgage
contract, conversion is required to make the frequency of compounding for the interest rate
match the frequency of the periodic payments.
There are two methods of calculating equivalent interest rates. The first involves the use of mathematical
formulas. The method using the calculator financial keys is presented in the next section. As stated above,
Two interest rates are said to be equivalent if, for the same amount borrowed, over the
same period of time, the same amount is owed at the end of the period of time.
The amount owing at the end of one year for monthly compounding will be:
FV12 = PV(1 + imo)12
The amount owing at the end of the year for semi-annual compounding on the same amount of principal
(PV) must, at the equivalent semi-annual rate, also equal the same future amount (FV):
FV2 = PV(1 + isa)2
As both sets of frequencies of compounding and interest rates must result in the same FV in order for the
rates to be equivalent, the two calculations must be equivalent:
PV × (1 + imo)12 = FV = PV × (1 + isa)2
or PV × (1 + imo)12 = PV × (1 + isa)2
Dividing both sides by PV (the principal amount) and cancelling common terms, simplifies the relationship:
PV  (1+ i mo )12 PV  (1+ i mo ) 2

=
PV PV
(1 + imo)12 = (1 + isa)2
Note that the equation necessary to solve for a semi-annual rate that is equivalent to a particular monthly rate
is independent of the principal amount of the loan. All that remains is to rearrange the above equation to
solve for isa.
1.32
(1 + isa)2 = (1 + imo)12
Dividing the exponents on each side by two maintains the equality and reduces the exponent of the unknown
factor (left hand side) to unity:
(1 + isa)2/2 = (1 + imo)12/2
or (1 + isa)1 = (1 + imo)6
Subtracting one from each side results in an equation which can be solved for isa.
isa = (1 + imo)6 - 1
Illustration 1.11
Consider a mortgage loan where $150,000 is to be advanced and the lender and borrower have agreed to
interest at a rate of 6% per annum, compounded monthly. In order to satisfy the Interest Act requirement,
calculate the nominal rate of interest for semi-annual compounding (j2) that is equivalent to a rate of j12 =
6%.
Solution
Given a rate of j12 = 6% (imo = 0.5%) or 0.005 expressed as a decimal:
isa = (1 + 0.005)12/2 - 1
= (1.005)6 - 1
= 0.0303775
j2 = isa × 2 =0.0303775 × 2 = 0.06075502 or 6.075502%
This equation can be solved using the calculator as follows. Note that the method presented here does not
utilize the pre-programmed financial keys of the calculator.

6 ÷ 12 = 0.5 Monthly rate
÷ 100 = 0.005 Converting to a monthly rate as a decimal7
+1= 1.005 One plus the monthly rate
x
Oy 6= 1.030378 Raised to the power of 6
- 1= 0.0303775 Semi-annual rate as a decimal
× 100 = 3.037751 Semi-annual rate as a percentage
×2= 6.075502 Nominal rate for semi-annual compounding
Thus, given j12 = 6% (or imo = 0.5%), the equivalent semi-annual rate is isa = 3.03775% or j2 = (isa × m)
7
To convert a percentage to a decimal in a single step, you can also use the % key (not the same as NOM%):
Press Display
6 ÷ 12 = 0.5
% 0.005
1.33
Lesson 1
= (3.03775% × 2) = 6.075502%. The mortgage lender should include a statement in the mortgage contract
to the effect that the rate of interest charged on the principal amount is 6.075502% per annum, compounded
semi-annually.
In general, you can convert from a periodic rate for any frequency of compounding to an equivalent rate for
a different compounding frequency with reference to the following relationship:
(1 + id)365 = (1 + iw)52 = (1 + imo)12 = (1 + iq)4 = (1 + isa)2 = (1 + ia)1
By choosing an appropriate pair of equivalent terms in the above equation and following the steps described
above, you can calculate any equivalent rate. This calculation is necessary where interest rates must be
standardized, such as in comparing loan or investment alternatives.
In order to change a given rate to its equivalent effective annual rate, the following general formula can be
rearranged as follows:
jm m
j1 = ia = (1 + ) 1
m
where jm is the stated nominal rate and m is the stated compounding frequency.
Illustration 1.12
You are considering investing some money in one of two alternative GICs. They have the following rates:
either 3.5% per annum, compounded quarterly or 3% per annum, compounded weekly. Calculate the
equivalent effective annual rate (j1) for each in order to determine which option is the better investment
opportunity. Assume that all factors, other than the interest rate, are equivalent between the options.
Solution
Option 1: 3.5% per annum, compounded quarterly
To change from j4 = 3.5% into a j1 equivalent, we rearrange the following formula:
(1 + ia)1 = (1 + iq)4
Therefore,
ia = j1 = (1 + iq)4/1 - 1
ia = j1 = (1 + (0.035÷4))4/1 - 1
ia = j1 = (1 + 0.00875)4 - 1
ia = j1 = 3.546206%
1.34
The calculator steps are as follows:

3.5 ÷ 4 = 0.875 Quarterly interest rate (expressed as a %)
% 0.00875 Quarterly interest rate (expressed as a decimal)
+1 = 1.00875
x
Oy 4= 1.035462
- 1= 0.0354621 j1 equivalent expressed as a decimal
× 100 = 3.546206 j1 equivalent expressed as a percentage
Option 2: 3% per annum, compounded weekly
To change from j52 = 3% into a j1 equivalent, we rearrange the following formula:
(1 + ia)1 = (1 + iwk)52
Therefore,
ia = j1 = (1 + iwk)52/1 - 1
ia = j1 = (1 + (0.03÷52))52/1 - 1
ia = j1 = (1 + 0.000576923)52 - 1
ia = j1 = 3.044562%
The calculator steps are as follows:

3 ÷ 52 = 0.0576923 Weekly interest rate (expressed as a %)
% 0.000576923 Weekly interest rate (expressed as a decimal)
+1 = 1.000577
x
O y 52 = 1.030446
- 1= 0.0304456 j1 equivalent expressed as a decimal
× 100 = 3.044562 j1 equivalent expressed as a percentage
You should choose the rate of j4 = 3.5% over the rate of j52 = 3% as the former produces a higher effective
annual rate (j1).
Now that we have shown the mathematical solution, let's illustrate the alternative, but equally valid,
approach to calculate equivalent interest rates by using the financial keys of a business calculator.
There are two financial keys on the HP 10BII/10BII+ calculator that have not yet been introduced, but are
needed for interest rate conversion problems8. These are:
8
This lesson shows the calculator steps for finding equivalent interest rates using the HP 10BII/10BII+ calculator. If you elect to use
a different calculator, the onus will be on you to ensure that the alternative calculator will perform all necessary functions.
1.35
Lesson 1
 NOM% Nominal interest rate per year (jm)

 EFF% Effective interest rate (j1) which is calculated based on the nominal rate (j) entered in 
NOM% and the compounding frequency (m) entered in P/YR
HELPFUL HINT!
The interest rate conversion process has five steps: (1) enter both the stated nominal interest rate and (2)
its compounding frequency, (3) convert the nominal interest rate into its effective annual equivalent. (4)
Then enter the desired compounding frequency (which is usually the number of payment periods per year).
(5) The final step is to solve for the equivalent nominal rate with the desired compounding frequency.
The following could be used as an interest rate conversion template:
?  NOM% [Enter stated nominal rate for ?]

?  P/YR [Enter stated compounding frequency for ?]
 EFF% (Compute effective annual interest rate)
?  P/YR [Enter desired compounding frequency for ?]
 NOM% (Compute equivalent nominal rate with desired compounding frequency)
This template works for all interest rate conversions from one nominal rate to another nominal rate – just fill
in the blanks. Once you have practiced this in enough problems, the steps will become automatic!
In the interest rate conversions illustrated in this course, the first step shown is to enter the stated nominal
rate using  NOM%. Students may notice that similar results can also be achieved by pressing I/YR alone.
The Interest Act requires that a mortgage contract contain a statement indicating both the principal amount of
the loan and the rate of interest charged on the principal, expressed as an annual rate of interest, with either
semi-annual or annual compounding. Assume that a bank agrees to give a loan at an interest rate of 6% per
annum, compounded monthly. In order to determine the rate the bank must disclose under the Interest Act,
calculate the nominal rate per annum with semi-annual compounding (j2) that is equivalent to j12 = 6%.
Enter the given nominal rate and the stated number of compounding periods per year (12, in this case).
Solve for the effective annual rate (the nominal rate with annual compounding). Then, enter the desired
compounding periods (2, in this case). Solve for the equivalent nominal rate. Using the interest rate
conversion template shown in the Helpful Hint, the calculator steps are as follows:
Solving for Illustration 1.11 using the calculator's pre-programmed NOM% and EFF% keys, the steps are
as follows:

6  NOM% 6 Enter stated nominal rate
 EFF% 6.167781 Compute effective annual interest rate
2  P/YR 2 Enter desired compounding frequency
 NOM% 6.075502 Enter stated nominal rate
The nominal rate per annum with semi-annual compounding equivalent to j12 = 6% is j2 = 6.075502%.
Clearly this calculator method is much easier than the long-hand mathematical formulas! However, having a
conceptual understanding the underlying the math will better prepare you to do deal with unusual or more
complex situations in practice – it is useful to be fluent in both methods.
1.36
For this question, if it was necessary to state the periodic rate per semi-annual period, this could be done by
dividing the nominal rate (j2 = 6.075502%) by the number of compounding periods per year (2) to obtain a
periodic rate of 3.037751% (j2 = 6.075502%÷ 2).
We can also solve Illustration 1.12 using the calculator's pre-programmed NOM% and EFF% keys. The
calculator steps are as follows:

3.5  NOM% 3.5 Enter stated nominal rate

Equivalent Interest Rates using Excel
You can solve for equivalent interest rates in Excel by programming in the mathematical formulas: Periodic
rate =((1+(Nominal Rate/Stated Frequency))^(Stated Frequency /Desired Frequency))-1
Note that the formula solution generates a periodic rate (semi-annual) rate solution for Illustration 1.11. To
determine the j2 equivalent, we must multiply the semi-annual rate by the compounding frequency (2).
While we can use the mathematical formula solution, the syntax for this formula is difficult and prone to
errors. A much simpler solution in Excel uses its pre-programmed functions, NOMINAL and EFFECT, which
operate in much the same way as the NOM% and EFF% keys on the HP10BII/II+.
= NOMINAL (effective rate per year, N compounding periods per year)
= EFFECT (nominal rate per year, N compounding periods per year)
In the Excel file available under "Online Readings" on the Course Resources webpage, Illustrations 1.11
and 1.12 show the formula and mathematical solutions for equivalent interest rates. Illustration 1.13 and
beyond only use the pre-programmed EFFECT and NOMINAL functions.
Illustration 1.13
Assume that a bank agrees to give a loan at an interest rate of 4% per annum, compounded semi-annually
(j2). The bank requests monthly payments. Calculate the equivalent nominal rate per annum with monthly
compounding (j12).
Solution
You will find this is the most commonly required interest rate conversion. Mortgage interest rates tend to be
quoted as j2, since the Interest Act only allows for rates to be stated as j2 or j1. However, mortgage payments
tend to be monthly. As a result, the HP10BII/II+ calculator needs to have a j12 interest rate in the I/YR key
– an interest rate conversion is required, j2 to j12.
1.37
Lesson 1
Enter the given nominal rate and the stated number of compounding periods per year (2, in this case). Solve
for the effective annual rate (the nominal rate with annual compounding). Then, enter the desired number of
compounding periods per year (12, in this case). Solve for the equivalent nominal rate. The calculator steps
are as follows:

 NOM% 3.967068 Compute equivalent nominal rate with desired
compounding frequency
The nominal rate per annum with monthly compounding equivalent to j2 = 4% is j12 = 3.967068%. If it is
necessary to calculate the monthly periodic rate, this could be done by dividing the nominal rate (j12 =
3.967068%) by the number of compounding periods per year (12) to get the periodic rate (imo =
0.330589%).
Illustration 1.14
A borrower is considering a loan that will charge interest at a nominal rate of 5% per annum, compounded
monthly. The borrower is more familiar with interest rates that are quoted as nominal rates with semi-annual
compounding. What nominal rate with semi-annual compounding is equivalent to 5% per annum,
compounded monthly?
Solution
The borrower wishes to convert the interest rate of j12 = 5% to its j2 equivalent. The calculator steps are as
follows:

 EFF% 5.116189 Compute effective annual rate
 NOM% 5.052374 Compute nominal rate with semi-annual
compounding
This calculation shows that the nominal rate of j2 = 5.052374% is equivalent to j12 = 5%.
Illustration 1.15
A borrower is considering mortgage loans from two different lenders. Lender A will loan funds at a rate of
j2 = 9.5%. Lender B will loan funds at a rate of j12 = 9.4%. Which of these two interest rates represents the
lowest cost of borrowing?
1.38
Solution
When comparing interest rates, it is necessary that both of the interest rates being compared have the same
compounding frequency. Both interest rates should be converted to their equivalent effective annual interest
rates so they can be compared. The calculation to convert the rate from Lender A to its equivalent effective
annual rate using the financial keys on the calculator follows:

 EFF% 9.725625 Compute equivalent effective annual interest rate
This calculation shows that Lender A is charging an effective annual rate of j1 = 9.725625% on funds
loaned. Now, compute the effective annual interest rate charged by Lender B.

9.4  NOM% 9.4 Enter nominal rate with monthly compounding
 EFF% 9.815747 Compute equivalent effective annual interest rate
This calculation shows that Lender B charges an effective annual rate of j1 = 9.815747% on loans. By
comparing the two effective annual rates, it is evident that Lender A, who is charging a nominal rate of j2 =
9.5%, actually has a lower cost of borrowing than Lender B, who is charging a nominal rate of j12 = 9.4%.
This shows the importance of converting both rates to their equivalent effective annual rates before
comparing them. The rate which, at first glance, appears lower, j12 = 9.4%, actually represents a higher
effective annual rate, and thus a higher cost of borrowing, than the rate which appears to be higher, j 2 =
9.5%.
The following illustration converts a monthly periodic rate to an effective annual interest rate.
Illustration 1.16
A borrower has arranged a loan to fund the construction of a new house. This loan calls for interest to be
calculated at the rate of 0.4% per month, compounded monthly (imo). Since the borrower is more familiar
with interest expressed as an effective annual rate (j1), the borrower wants you to calculate the effective
annual interest rate that is equivalent to 0.4% per month, compounded monthly.
Solution
In the above illustration, the borrower is considering a contract in which interest is charged at the rate of
0.4% per month (imo = 0.4%). The borrower wants to calculate the equivalent effective annual interest rate
(j1). This will be done in two steps. First, convert the monthly periodic interest rate to a nominal interest rate
with monthly compounding, then use the financial keys on the calculator to convert this to the equivalent
effective annual interest rate. Remember from earlier in the lesson the relationship jm = i × m. In this case,
the relationship will be used to calculate j12.
j12 = imo × 12
j12 = 0.4% × 12
j12 = 4.8%
1.39
Lesson 1
Now, convert the j12 = 4.8% rate to its equivalent effective annual rate using the financial keys on the
calculator.

 EFF% 4.907021 Compute equivalent effective annual rate
The above analysis has demonstrated that an effective annual interest rate of j1 = 4.907021% is equivalent to
a periodic rate per month of imo = 0.4%.
Exercise 4
The following table is comprised of three columns:
1. the first column specifies a nominal rate of interest with a given compounding frequency;
2. the second column provides the desired compounding frequency;
3. the third column presents an equivalent nominal interest rate with the desired frequency of
compounding.
Readers should ensure that they can use the nominal rates of interest and desired frequencies of
compounding shown in the first two columns to calculate the equivalent nominal interest rate shown in the
third column.
Desired number of compounding Equivalent nominal interest rate with

Nominal Interest Rate
periods per annum desired compounding frequency
j12 = 5.5% 1 j1 = 5.640786%
j2 = 4% 12 j12 = 3.967068%
j4 = 8% 2 j2 = 8.08%
j1 = 9% 365 j365 = 8.618787%
j4 = 7.5% 12 j12 = 7.453607%
j1 = 6% 12 j12 = 5.841061%
Exercise 5
1. the first column specifies a periodic rate of interest with a given compounding frequency;
3. the third column presents an equivalent nominal interest rate with the desired frequency of
compounding.
Readers should ensure that they can use the periodic rates of interest and desired frequencies of
compounding shown in the first two columns to calculate the equivalent nominal interest rate shown in the
third column.
1.40
Desired number of compounding Equivalent nominal interest rate with

Periodic Interest Rate
id = 0.025% 2 j2 = 9.335173%
imo = 0.5% 1 j1 = 6.167781%
iw = 0.14% 4 j4 = 7.341467%
iq = 2.25% 12 j12 = 8.933331%
isa = 4% 365 j365 = 7.844986%
ia = 5% 52 j52 = 4.881306%
Exercise 6
1. the first column specifies a periodic rate of interest with a given compounding frequency;
3. the third column presents an equivalent periodic interest rate with the desired frequency of
compounding.
Readers should ensure that they can use the periodic rates of interest and desired frequencies of
compounding shown in the first two columns to calculate the equivalent periodic interest rate shown in the
third column.
Desired number of compounding Equivalent periodic interest rate with

Periodic Interest Rate
imo = 0.45% 1 ia = 5.535675%
isa = 3.5% 52 iw = 0.132401%
iq = 2.25% 2 isa = 4.550625%
ia = 6.15% 365 id = 0.016353%
iw = 0.115% 4 iq = 1.505359%
id = 0.022% 12 imo = 0.671336%
Summary
This lesson introduced several basic real estate finance topics. The lesson began with an explanation of
interest rate terms and the interrelationship between different forms of interest rates. The topics then
progressed to loan and investment calculations involving simple interest and compound interest scenarios.
Finally, we covered equivalent interest rates, a necessary tool for advancing the financial analysis in
upcoming lessons.
In covering these topics, we have presented the underlying mathematics, while also covering the techniques
for solving these problems with financial calculators and spreadsheets. The goal is a blend of theory and
practice that will equip you for tackling financial problems in realistic scenarios and also prepare you for the
more advanced analysis to come shortly.
In Lesson 2, we expand the discussion of accrual loans to consider repeated payments made over time. We
will address identify and explain the standard Canadian mortgage scenario and then calculate all the
necessary elements of standard Canadian mortgages. In Lesson 3, we will examine the mathematics involved
in sinking funds, such as those used in reserve fund planning, and also the tools for financial investment
analysis.
1.41
Lesson 1
Review and Discussion Questions

1. Use the internet to find out the interest rates offered on various credit cards. Convert all the given
interest rates to the effective annual rate and determine which credit cards offer the best rates.
2. Use a search engine to search for terms "compound interest" and "grains of rice" on the internet.
Did you find any interesting stories demonstrating the power of compound interest?
3. In Canada, the federal Interest Act requires mortgage interest rates to be quoted either with annual
or semi-annual compounding. Why do you think this provision was adopted by the government?
4. The industry standard in Canada has become to quote mortgage interest rates with semi-annual
compounding. Why do you think the mortgage lenders adopted semi-annual rather than annual
compounding?
5. A bank is offering a loan in the amount of $75,000, with a term of three years. The customer can
choose between two interest options that will be charged on the loan: simple or compound. If simple
interest is chosen, the interest rate will be 5% per annum with a single payment due at the end of the
three-year term. If the compound interest is chosen, the interest rate will be 5% per annum,
compounded semi-annually, with a single payment due at the end of the three-year term.
A. Explain the difference between simple and compound interest.
B. As a borrower, which interest option would you choose? Explain your answer.
C. As the lender, which interest option would you prefer the borrower choose? Explain your
answer.
6. What are the strengths and weaknesses of performing financial calculations on a financial calculator
and a spreadsheet program, such as Microsoft Excel?
1.42

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DISCLAIMER: This publication is intended for EDUCATIONAL purposes only.

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1. HP10BII: Introduction to the Calculator and Review of Mortgage Finance Techniques

After completing this lesson, the student should be able to:

1. explain the difference between simple and compound interest;

Math Formulas and Financial Calculators

1. Setting Up Your Calculator

2. Using Your Calculator to Solve Questions

Borrower's Perspective Investor's Perspective

Calculations and Solutions to Math Problems

Loans and Investments

The amount of interest owing at the end as found as:

The amount owing at the end of the term is:

Compound interest occurs when interest is charged or calculated on

An interest accrual loan is one on which no payments of interest

$45,000 Principal amount borrowed

Figure 1.1: Outstanding Balance on an Interest Accrual Loan

Nominal and Periodic Interest Rates

The nominal interest rate (jm) is always expressed as a

The nominal rate would be expressed as:

The periodic rate would be expressed as:

This can be illustrated using a time diagram3 as shown below:

j12 = 12% nominal interest rate (per year)

The periodic rate would be expressed as:

This can be illustrated using a time diagram as shown below:

j2 = 6% nominal interest rate (per year)

Nominal and Periodic Rates

Examples of nominal interest rates:

id represents an interest rate per daily compounding period

Periodic Rate Number of Compounding Nominal Rate

Self-Help Exercise: Nominal and Periodic Rates

Nominal Periodic Nominal

Nominal Periodic Nominal

Nominal Periodic Nominal

Nominal Periodic Nominal

Illustrations of Compound Interest Calculations

The amount of interest owing can be mathematically calculated as follows:

Press Display Comments

This example can be illustrated on a time diagram:

The Power of Spreadsheets

To summarize, the problem can be solved as follows:

Amount owing at end of year one = $10,000  1.08 = $10,800

FV = $10,000  1.08  1.08  1.08

or in more general terms:

where FV = Future value (or amount owing in the future)

Press Display Comments

Press Display Comments

Future Value Calculations in Excel

Structuring Present Value and Future Value Problems

Consider the interest accrual formulas already covered:

These conditions are summarized in the time diagram below:

Calculation of Future Value

The financial arrangement involved may be illustrated by a time diagram:

Press Display Comments

Rounding Rules Alert!

The information given in the problem is as follows:

PV = $15,000 (paid out, therefore a negative amount)

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Rate Calculations in Excel

The financial arrangement involved may be illustrated by a time diagram.

Press Display Comments