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ENGR 390 Lecture 7: Review

Winter 2007  Effective Annual Interest Rate i

a = (1+

/

r M

)

M 1

r = nominal interest rate per year

i a = effective annual interest rate

M = number of interest periods per year

ENGR 390 Lecture 7: Review

Winter 2007 Interest Rates …

EFFECTIVE INTEREST RATE

i = [1+

/

r CK

]

C 1

C = number of interest periods per payment period K = number of payment periods per year r /K = nominal interest rate per payment period

Continuous Compounding i = [1+

/

r CK

]

C 1

where CK = number of compounding periods per year

C →∞

continuous compounding => r
1/
K
= e
(
)
1

i =

lim[( 1

+

/

r CK

)

C

1]

ENGR 390 Lecture 7: Review

Winter 2007 TimingTiming

Equal Payment Series (Annuity)

Equal cash flows

Equal time between cash flows

First cash flow at end of first period

Last cash flow at end of last period 0
123
F = A(F/A,i,N)

F ?

N

A

0 P ?
123

P = A(P/A,i,N)

N

A TimingTiming

Uniform (Linear) gradient of amount G

0 at end of Period 1

G at end of Period 2

2G at end of Period 3

(N-1)G at end of Period N

0 P ?
123
G
P = G(P/G,i,N)

N

ENGR 390 Lecture 7: Review

Winter 2007 TimingTiming

Geometric gradient of amounts A1 and g

A1

A1 * (1 + g)

A1 * (1+ g) ^ 2 at end of Period 3

at end of Period 2

at end of Period 1  Complex Cash Flows

Complex Cash Flows – Separate complex cash flows into component cash flows in order to use the standard formulas.

Remember: You can only combine cash flows if they occur at the same point in time.

ENGR 390 Lecture 7: Review

Winter 2007 LoansLoans

When we calculate the annual payment of a loan (A), the payment is actually composed of interest and payment on principal.

The mechanics are best shown through an example. ProblemProblem 11

You borrow \$1,000 to help pay for rent, food, and books. It is to be repaid in 3 equal, annual payments starting one year from now. Interest on the loan is 12% per year, compounded annually.

Determine the amount of the loan payments (A), the corresponding principal (P) and interest (I) amounts in each payment and the remaining balance (B) after each payment

ENGR 390 Lecture 7: Review

Winter 2007 Solution

Given: P = \$1,000; i = 12%; N= 3

Find: A, I 1 , I 2 , I 3 ; P 1 , P 2 , P 3 ; B 1 , B 2 , B 3

A = \$1,000(A/P, 12%, 3) = \$416.35 B 0 = P = \$1,000 I 1 = B 0 i = \$1,000*0.12 = \$120 P 1 = A – I 1 = \$416.35 - \$120 = \$296.35 B 1 = B 0 – P 1 = \$1000 - \$296.35 = \$703.65 I 2 = B 1 i =\$703.65*0.12 = \$84.44 P 2 = = A – I 2 = \$416.35 - \$84.44 = \$331.91 B 2 = B 1 – P 2 = \$703.65 - \$331.91 = \$371.74

Method 1: Generalizing For the nth payment

B n = P – (A – Pi) (F/A, i, n)

I n = (B n-1 )i

P n = A - I n

ENGR 390 Lecture 7: Review

Winter 2007 ApproachesApproaches……

LoanLoan problemsproblems cancan bebe workedworked twotwo ways:ways:

1.1. CreateCreate aa TableTable……

2.2. WorkWork problemsproblems inin thethe samesame mannermanner wewe’’veve beenbeen usingusing formulaeformulae CreateCreate aa TableTable……

Year or payment number

Payment size

Interest payment

Cumulative interest payment

Principal payment

Remaining principal

ENGR 390 Lecture 7: Review

Winter 2007

Solution Pmt # Size Interest Cumul. Principal Remaining Payment Interest Payment Balance 1 416.35 120.00 120.00 296.35 703.65 2 416.35 84.44 204.44 331.91 371.74 3 416.35 44.61 249.05 371.74 0.00 ProblemProblem 22

You wish to payoff the loan at the end of 2 years after making your second loan payment.

How much do you owe?

371.74

ENGR 390 Lecture 7: Review

Winter 2007

Method 2: Remaining Balance B n = A(P/A, i, N-n)

I n = (B n-1 )i = A(P/A, i, N-n+1)i

P n = A(P/F, i, N-n+1) ProblemProblem 33

A student borrowed \$5,000, which she will repay in 30 equal monthly installments. After making her 25 th payment, she desires to pay the remainder of the loan in a single payment.

At 12% per year, compounded monthly, what is the amount of the payment?

ENGR 390 Lecture 7: Review

Winter 2007

Solution 0 DIAGRAM:
\$ 5 000
1
2
3
30
\$A
B 25 = ?

Given: P = \$5,000; i = 1%; N = 30 months

Find B 25 = A(P/A,i, N-n)

A = \$5,000(A/P,1%,30) =

\$193.74

After 25 payments:

N-n = 30-25 = 5 B 25 = \$193.74(P/A,1%,5) = \$939.64 ProblemProblem 44

A company has obtained a \$10,000 loan at an interest rate of 15% per year, compounded annually. The loan requires \$500 payments at the end of each of the next 3 years (starting one year from now).

Determine how much must be paid 4 years from now in order to payoff the loan.

ENGR 390 Lecture 7: Review

Winter 2007 Solution

Given: P = \$10,000; i = 15%; A = \$500 Find: B 4 B 0 = P = \$10,000 I 1 = B 0 i = \$10,000*0.15 = \$1500 B 1 = \$10,000 + \$1,500 - \$500 = \$11,000 I 2 = B 1 i =\$11,000*0.15 = \$1,650 B 2 = \$11,000 + \$1,650 - \$500 = \$12,150 I 3 = B 2 i = \$12,150*0.15 = \$1,822.5 B 3 = B 2 + I 3 - \$500 = \$13,472.5 I 4 = B 3 i = \$13,472.5*0.15 = 2020.85 B 4 = B 3 + I 4 = \$15,493.375

Alternative Solution B n = P – (A – Pi) (F/A, i, n) + A

B 4 = \$10,000 – (500- 10,000*0.15)(F/A,15%,4) + A

B 4 = \$10,000 + \$5000 + \$500 = \$15,500

ENGR 390 Lecture 7: Review

Winter 2007 PerspectivePerspective ……

LenderLender isis indifferentindifferent betweenbetween loanloan paymentspayments andand investinginvesting loanloan amountamount atat interestinterest rate.rate.

ΣΣ PaymentsPayments == InterestInterest PaidPaid ++(Beginning(Beginning –– EndingEnding Principal)Principal)

PWPW ofof LoansLoans == PWPW ofof PaymentsPayments

HW 1 Problem 1 4.7 a What is the amount accumulated by \$7000 in 8 years at 9% compounded annually?

ENGR 390 Lecture 7: Review

Winter 2007

HW 1 Problem 1  HW 1 Problem 2 4.18 b. What is the future worth of \$2,000 at the end of each year for 10 years at 8.25% compounded annually?

ENGR 390 Lecture 7: Review

Winter 2007 HW 1 Problem 2 HW 1 Problem 3 4.26. An individual deposits an annual bonus into a savings account that pays 6% interest, compounded annually. The size of the bonus increases by \$1,000 each year, and the initial bonus amount was \$3,000. Determine how much will be in the account immediately after the 5 th deposit.

ENGR 390 Lecture 7: Review

Winter 2007 HW 1 Problem 3 HW 1 Problem 4 4.30a An oil well is expected to produce 100,000 barrels of oil during its first year. Its subsequent production is expected to decrease by 10% over the previous year’s production. The oil well has a reserve of 1,000,000 barrels. If the price per barrel remains steady at \$30, what is the present worth of the anticipated stream of revenue at an annual interest of 12% compounded annually over the next 7 years?

ENGR 390 Lecture 7: Review

Winter 2007 HW 1 Problem 4 HW 1 Problem 5 4.53. You have \$10,000 available for investment in stock. You are looking for a growth stock whose value is \$35,000 over 5 years. What kind of growth rate are you looking for?

ENGR 390 Lecture 7: Review

Winter 2007 HW 1 Problem 5 HW 2 Problem 1 A store offers a credit card that charges 0.95% per month, compounded monthly. What is the nominal interest rate for this credit card? What is the effective annual interest rate?

ENGR 390 Lecture 7: Review

Winter 2007 HW 2 Problem 1 HW 2 Problem 2 5.6. A company is advertising a 24-month lease of a car for \$520 payable at the beginning of each month. There is a \$2,500 down payment, plus a \$500 refundable deposit. Alternatively, it offers a 24-month lease with a single up-front payment of \$12,780 plus a \$500 refundable security deposit. If the interest rate is 6% compounded monthly, which lease is preferred?

ENGR 390 Lecture 7: Review

Winter 2007 HW 2 Problem 2 HW 2 Problem 3 5.20a. What is the future worth of \$3,000 at the end of each 6 month period for 10 years at 6% compounded semi-annually?

ENGR 390 Lecture 7: Review

Winter 2007 HW 2 Problem 3 HW 2 Problem 4 5.27. What is the amount A, such that you will be able to withdraw the amounts shown in the cash flow diagram if the interest rate is 8% compounded quarterly?

ENGR 390 Lecture 7: Review

Winter 2007 HW 2 Problem 4 HW 2 Problem 5 5.34. Sam plans to retire in 15 years. He deposits equal amounts quarterly in a bank that gives him an interest of 8% compounded quarterly. If he want to withdraw \$25,000 semi-annually over the 5 years of his retirement how much should he deposit quarterly? The first withdrawal occurs at the end of 6 months after his retirement.

ENGR 390 Lecture 7: Review

Winter 2007 HW 2 Problem 5  HW 2 Problem 5 (continued)  