Mert KAHRAMANTÜRK

18030451002 – MIS

Chapter3: Time Value Of Money Review

The Interest Rate

In a world in which all cash flows are certain, the rate of interest can be used to express the time
value of money.

Credit – initial loan + [Interest Payment] The price of the fund money

In the financial there are two different interest payment system. There are two different interest
payment systems in the finance. These are simple interest and compound interest.

Simple Interest Payment

Simple Interest = Payment X Interest Rate X Period

The dollar amount of simple interest is a function of three variables: the original amount borrowed
(lent), or principal; the interest rate per time period; and the number of time periods for which the
principal is borrowed (lent).

Compound Interest

Periodically added to the principal. As a result, interest is earned on interest as well as the initial
principal. It is this interest-on-interest, or compounding.

Compound Interest Rate System

Main Rule: Gain interest on interest.

 To compute FV = Payment X (1+r(interest rate) n

 PV - Payment X 1 / (1+r )n discount part

Futere Value – FV =X . (1+r)n

Present Value

Dollar today is worth more than a dollar to be received one, two, or three years from now.
Calculating the present value of future cash flows allows us to place all cash flows on a current footing
so that comparisons can be made in terms of today’s dollars.

PV = X / ( 1 + r ) n

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 Unknown Interest Rate

Sometimes we are faced with a time-value-ofmoney situation in which we know both the future and
present values, as well as the number of time periods involved. What is unknown, however, is the
compound interest rate (i) implicit in the situation. Let’s assume that, if you invest $1,000 today, you
will receive $3,000 in exactly 8 years. The compound interest (or discount) rate implicit in this
situation can be found by rearranging either a basic future value or present value equation. For
example, making use of future value.

Ordinary Annuity

An annuity is a series of equal payments or receipts occurring over a specified number of periods. In
an ordinary annuity, payments or receipts occur at the end of each period.

 Equal Payment / lost

 At the end of the each year / period / month

PVA = Equal Payments X [ ( 1 + Interest rate ) n – 1 / ( 1+ Interest rate )n X Interest rate ]

FVA = Equal Payments X [ ( 1 + Interest rate )n-1 / Interest rate ]

Semiannual And Other Compounding Periods

suppose that interest is paid semiannually. If you then deposit $100 in a savings account at a
nominal, or stated, 8 percent annual interest rate, the future value at the end of six months would
be FV0.5 = $100(1 + [0.08/2]) = $104

Countinuos Compounding

e = 2.71 PV X eixn

FV = PV x ( 1 + r )n

Effective Annual Interest Rate

Different investments may provide returns based on various compounding periods. If we want to
compare alternative investments that have different compounding periods, we need to state their
interest on some common, or standardized, basis.

NIR = RIR + Risk Factors

[ 1 + EAIR ] = [ 1+ nır/m ] MX1 Effective annual in rate formula.

Firstly compute nominal interest rate. Always EAIR >NIR That is main rule.m5

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 CHAPTER3 QUESTİONS.

Ex 1. The following are exercises in future (terminal) values:

a. At the end of three years, how much is an initial deposit of $100 worth, assuming a compound
annual interest rate of (i) 100 percent? (ii) 10 percent? (iii) 0 percent?

(i)- 100 x (1+1)3=800

(ii)- 100 x (1+0.1)3=133.1

(iii)- 100 x (1+0)3= 100

b. At the end of five years, how much is an initial $500 deposit followed by five year-end, annual
$100 payments worth, assuming a compound annual interest rate of (i) 10 percent? (ii) 5
percent? (iii) 0 percent?
(i)-500 x ( 1 + 0.1)5+500 x [(1+0.1)5-1]/0.1 = 3,857,8
(ii)- 638.1+500x[0.276]/0.05= 3,401.0
(iii)- 500 x (1)5+500 x [(1)5-1]/0=500
c. At the end of six years, how much is an initial $500 deposit followed by five year-end, annual
$100 payments worth, assuming a compound annual interest rate of (i) 10 percent? (ii) 5
percent? (iii) 0 percent?

(i)- 885.78+500x[0.61051]/0.1=3,938.3
(ii)- 670.05+500x[0.279]/0.05=3,432.9
(iii)- 500x16+500x[15-1]/0=500
d. At the end of three years, how much is an initial $100 deposit worth, assuming a quarterly
compounded annual interest rate of (i) 100 percent? (ii) 10 percent?

(i)- 100x14,55 = 1,455.2

(ii)- 100x1.34= 134.5

e. Why do your answers to Part (d) differ from those to Part (a)?

The lumpsum is getting compounded basis the rate of interest by the period of maturity the incestors
want to be compensated that is the criticallity of usage of funds with time is causing such diffrence.
The interest is being paid 4 times a year for quaterly compounding whereas it is being paid once for

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 latter case. Hence the value calculated compounded annually is being different with value
compounded quarterly.

f. At the end of 10 years, how much is a $100 initial deposit worth, assuming an annual interest
rate of 10 percent compounded (i) annually? (ii) semiannually? (iii) quarterly? (iv)
continuously?

(i) 100x2.59=259.4

(ii) 100x1.105=110.49

(iii) 100x2.69 = 268.51

(iv) 100x2.71=270.70

2- a. $100 at the end of three years is worth how much today, assuming a discount rate of (i) 100
percent? (ii) 10 percent? (iii) 0 percent?

İ- 100/(1+0.10)3 = 75.10

İİ- 100/(1+1)3 = 12.5

İİİ- İ 100/(1+0)3 = 100

b. What is the aggregate present value of $500 received at the end of each of the next three years,
assuming a discount rate of (i) 4 percent? (ii) 25 percent?

İ- 500X[1+0.04-1/(1+0.04)3X0.04=3857

İİ - 500X[1+0.25-1/(1+0.25)3X0.25=260

c. $100 is received at the end of one year, $500 at the end of two years, and $1,000 at the end of three
years. What is the aggregate present value of these receipts, assuming a discount rate of (i) 4 percent?
(ii) 25 percent?

İ-100/1+0.04+500/(1+0.04)2+1000/(1+0,04)3=1447

İİ-100/1+0.25+500/(1+0.25)2+1000/(1+0,25)3=9.333

d. $1,000 is to be received at the end of one year, $500 at the end of two years, and $100 at the end
of three years. What is the aggregate present value of these receipts assuming a discount rate of (i) 4
percent? (ii) 25 percent?

İ- 1000/1+0.04+500/(1+0.04)2+100/(1+0,04)3=1513,77

İİ-1000/1+0.25+500/(1+0.25)2+100/(1+0,25)3=1171,79

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 3- . Joe Hernandez has inherited $25,000 and wishes to purchase an annuity that will provide him with
a steady income over the next 12 years. He has heard that the local savings and loan association is
currently paying 6 percent compound interest on an annual basis.

X.[(1+0.06)12-1/(1X0,06)12X0,06=2982

4. You need to have $50,000 at the end of 10 years. To accumulate this sum, you have decided to save
a certain amount at the end of each of the next 10 years and deposit it in the bank. The bank pays 8
percent interest compounded annually for long-term deposits. How much will you have to save each
year (to the nearest dollar)?

5.0000 = X.[(1+0.08)10-1/0.08=3452

5. Same as problem above, except that you deposit a certain amount at the beginning of each of the
next 10 years. Now, how much will you have to save each year (to the nearest dollar)?

5.0000=X.[(1+0.08)10-1/0.08X(1+0.08)1

14-a: Establish loan amortization schedules for the following loans to the nearest cent: a 36-month
loan of $8,000 with equal installment payments at the end of each month. The interest rate is 1 percent
per month.x

8.000 X [(1+0,01)36X0.01/(1+0.01)36-1=265,718

20. Suppose that an investment promises to pay a nominal 9.6 percent annual rate of interest. What is
the effective annual interest rate on this investment assuming that interest is compounded: (a)
annually? (b) semiannually? (c) quarterly? (d) monthly? (e) daily (365 days)? (f) continuously?

a- (1+EAIR) = (1+0,096/1)
b- (1+EAIR) = (1+0,096/2)
c- (1+EAIR) = (1+0,096/4)
d- (1+EAIR) = (1+0,096/12)
e- (1+EAIR) = (1+0,096/365)
f- (1+EAIR) = e0,096

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