Part I:

Deterministic Cash Flow Streams

 Chapter 2:
The Basic Theory of Interest
Suggested Problems: 2, 3, 4, 5, 7, 8, 9, 10, 11, 12, 15

Rachel Koh, PhD, CFA

Hanyang BUS 5007
Principal and Interest
• Simple interest:
• Investment value grows linearly with time

𝑉 = 𝐴 ∗ 1 + 𝑟𝑡

• Compound interest
• Earning interest on interest; Geometric growth

𝑉 =𝐴∗ 1+𝑟 𝑡
The seven-ten rule: Money invested at 7% per year doubles in
approximately 10 years. Also, money invested at 10% per year doubles
in approximately 7 years.
• In general, the doubling time is 72/i, where i=interest rate in %.
 Frequent and Continuous Compounding
• Instead of at the end of every year, interests can be credited into the
account more frequently—semi-annually, quarterly, monthly, etc.

𝑟 𝑚𝑡
𝑉 =𝐴∗ 1+
𝑚

• Continuous compounding: the frequency of compounding pushed to the

limit, ∞.
𝑉 = 𝐴 ∗ 𝑒 𝑟𝑡
Effective Interest Rate
Effective interest rate: the equivalent yearly interest rate that would
produce the same result after 1 year without compounding.

𝑟 𝑚
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 1 + −1
𝑚
Present and Future Value
Ideal bank: the same interest rate used for lending and borrowing;
no transaction fees; no service charges.

Main Theorem on Present Value

Internal Rate of Return
• IRR: the interest rate implied by internal cash flow stream

• Not dependent on the prevailing market rate.

• As long as an initial cash outlay is followed by positive cash flows,
there is a unique positive solution.

Main Theorem of Internal Rate of Return

 Net Present Value

• NPV: present worth of net benefits

• Generally regarded as “the single best measure of an investment’s merit”
Conflicted ranking: NPV vs IRR
NPV vs IRR
• Advantages of NPV (Disadvantages of IRR)
• No ambiguity associated with multiple roots as in IRR.
• Can be broken into component pieces (NPV of a whole project = sum of the
NPVs of the pieces).
• Advantages of IRR (Disadvantages of NPV)
• Only depend on internal cash flows, without having to choose an interest
rate.

• If the project is repeatable (meaning the proceeds from the

investment can be repeatedly reinvested but scaled in size) → IRR
• If the project is single-cycle, one-time opportunity → NPV
Application and Extensions
• Net Flows: Net profit (income minus all the expenses) must be used.
• Cycle Problems: how to evaluate two alternatives with different cycle
lengths?
• Ex 2.7 and Ex 2.8
• Taxes and Depreciation
• Depreciation is a non-cash expense; must be deducted for the tax purposes.
• Inflation
• Discount real CF using real rate, and nominal CF using nominal rate
• Ex 2.10