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# 4. Money-Time Relationships: Capital Returns and Interests
# 4. Money-Time Relationships: Capital Returns and Interests
# 4. Money-Time Relationships
the principal,
N:
i:
Example: Borrow $1,000 for 3 years with annual interest rate 10%.
The total amount of interest is $300.
Important: Timing of the interest payment unspecied! Or, to put it
equivalently: the interests do not accumulate.
Shuzhong Zhang
IE 5441
Compounding Interest:
Another way of calculation:
Borrowed
Interest
Year 1
Year 2
Year 3
1000
1100
1210
100
110
121
Year n
Year N
Borrowed
P (1 + i)n1
P (1 + i)N 1
Interest
Pi
P (1 + i)n1 i
P (1 + i)N 1 i
n=1
Shuzhong Zhang
IE 5441
Shuzhong Zhang
IE 5441
Continuous Compounding:
Suppose that the interest is accumulated in every minute, every second
... What should be paid at time T ?
Divide T into N periods, each with the length T /N . Suppose that the
overall interest rate is r per unit of time, i.e. each period requires a
compounding interest rate of rT /N .
Then in N periods of time, the total amount of interests plus principal
is:
P + I = P (1 + rT /N )N .
If N then the above quantity
lim P (1 + rT /N )N = P erT
where e 2.718.
If one borrows $100 at 10% continuous annual rate, then in one year
time he needs to pay back $100 e0.1 110.52.
Shuzhong Zhang
IE 5441
Shuzhong Zhang
IE 5441
Assume that the annual interest rate is 10% and we borrow $8,000 for
four years. Compare the following four paying schemes.
Y
P.P.
T.P.
P.P.
T.P.
8,000
800
2,000
2,800
8,000
800
800
6,000
600
2,000
2,600
8,000
800
800
4,000
400
2,000
2,400
8,000
800
800
2,000
200
2,000
2,200
8,000
800
8,800
Total:
10,000
Total:
11,200
P.P.
T.P.
P.P.
T.P.
8,000
800
1,724
2,524
8,000
800
6,276
628
1,896
2,524
8,800
880
4,380
438
2,086
2,524
9,680
968
2,294
230
2,294
2,524
10,648
1,065
10,648
11,713
Total:
10,096
Total:
11,713
These four schemes are equivalent in the sense that we just mentioned.
Important: It depends critically on the assumption that the interest
rate is constantly 10%!
Shuzhong Zhang
IE 5441
N:
number of periods;
P:
F:
A:
amortized payment.
Shuzhong Zhang
IE 5441
t=0
t=1
t=2
time
t=N 1
t=N
cash flows
Shuzhong Zhang
IE 5441
Interest Formulas.
We always assume that i and N are given.
Task: derive one parameter, provided another parameter is given.
We will adopt the following functional symbol
(F/P, i%, N )
meaning:
nd the future worth, provided that the present worth P is
given (nominally 1 dollar), interest per period is i, and the
number of periods is N .
Similarly, we speak of
(P/F, i%, N ), (P/A, i%, N ), and (A/F, i%, N ), and so on.
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IE 5441
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(1 + i)n1 = (1 + i)N 1.
1i
n=1
Now, the principal amount, $1, has to be paid as well. So, the total
equivalent amount is
(1 + i)N .
In other words,
(F/P, i%, N ) = (1 + i)N .
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IE 5441
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IE 5441
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(1 + i)N 1
.
i
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Therefore,
(1 + i)N 1
.
(F/A, i%, N ) =
i
Example: If you deposit $10,000 in a bank every year for 18 years at
interest rate 8%. Then this amount becomes
F = 10, 000 (F/A, 8%, 18) = $374, 502.
What this amount will be if the interest rate is 10%?
What if N = 20?
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IE 5441
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1
i
=
.
N
(F/A, i%, N )
(1 + i) 1
Example: How much do you need to invest every year in order to yield
$1 million in 30 year?
A = 1, 000, 000 (A/F, 8%, 30) = $8, 827.
How much will this amount be if the interest rate is 10%?
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IE 5441
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=
=
=
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Example. Suppose that you are 22 years old now. You start investing
in a plan with interest rate 10% for 15 years with annual investment
$1,000. Then you leave the money in the account until you retire at
65. What will the amount be?
At age 36, the accumulated amount is
1, 000 (F/A, 10%, 15) = $31, 772.50
At age 65 this amount becomes
1, 000 (F/A, 10%, 15) (F/P, 10%, 29)
=
$504, 010
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IE 5441
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Suppose that you have a friend with the same age as you. She decides
to delay the investment for 10 years. From age 32 onwards she will
start investing $2,000 per year until the retirement at 65. How about
her lump sum amount at age 65? Well, it is
2, 000 (F/A, 10%, 65 32 + 1) = $490, 953
Moral: Better start saving early!
Shuzhong Zhang
IE 5441
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...
Cash Flow
2G
...
(N 1)G
(1 + i)N 1 1 (1 + i)N 2 1
(1 + i)1 1
+
+ +
i
i
i
N 1
1
N
(1 + i)n
i n=0
i
1
N
N
[(1
+
i)
1]
i2
i
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All other formulas for nding P and A can be derived using the
formula above.
Formula for (P/G, i%, N ) (Given G nd P ).
(P/G, i%, N )
= (F/G, i%, N )(P/F, i%, N )
(
)
1
N
N
N
=
[(1
+
i)
1]
(1
+
i)
i2
i
[
]
1 1
1
1
=
(N + )
.
i i
i (1 + i)N
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1]
=
i2
i (1 + i)N 1
1
N
=
.
N
i
(1 + i) 1
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Cash Flow
-8,000
-7,000
-6,000
-5,000
Suppose that the interest rate is 15%. What is the present expense of
this project?
P
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An (1 + i)n
n=1
A1 (1 + g)n1 (1 + i)n
n=1
N
A1 1 + i n
) .
(
1 + g n=1 1 + g
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1+i
1+g
1=
ig
1+g ;
A1
1+g
and
that is,
A1
ig
(P/A, (
)%, N ).
1+g
1+g
A convenient way to remember this formula is to introduce
iCR =
1+i
1.
1+g
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Example: Suppose that you own a car. Its maintenance costs grow
over time. You expect to spend $1,000 in the coming year on the car
and the cost will grow by a factor of g = 20% each year. Decide the
present equivalent expense of keeping the car for additional four years.
(The interest rate is 10%).
In this case,
iCR
10
=
%
1.2
and
P
10
1, 000
(P/A,
%, 4)
1.2
1.2
$4, 163
=
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If the interest rates vary each year, then a similar procedure can still
be applied.
Suppose that the interest rate for year n is in , n = 1, ..., N . Then, $1
at present will become
(1 + i1 )(1 + i2 ) (1 + iN )
at the end of year N . In other words,
FN =
(1 + in ).
n=1
1
= $653.
1.1 1.12 1.13 1.1
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IE 5441
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6%
10%
15%
24%
6.09%
10.25%
15.56%
25.44%
6.14%
10.38%
15.87%
26.25%
12
6.17%
10.47%
16.08%
26.82%
365
6.18%
10.52%
16.18%
27.11%
N. of C.
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IE 5441
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IE 5441
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The timing of payments will become very crucial if the interest rate
involved is large.
Compare two scheme of equal payments, each with $100,000 payment
per month for one year. The nominal annual interest rate is 120%.
One scheme requires to pay at the beginning of every month; and the
other is to pay at the end of every month.
The dierence at the end of the year is
100, 000 ((1 + 10%)12 1) = $213, 840
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IE 5441
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(P/A, r%, N )c
erN 1
er 1
erN 1
erN (er 1)
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Example: Suppose that one has a loan amount of $1,000. What is the
equivalent uniform end-of-year payment A for 10 years provided that
the nominal interest rate is 20% and compounded continuously?
We have
erN (er 1)
(A/P, r%, N )c =
.
rN
e 1
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IE 5441
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Additional Exercises:
A student makes $500 payment semi-annually into an account with 8%
nominal annual rate compounded weekly. What will this investment
be in 20 years time?
Every 26 weeks, the eective interest rate is
(
)26
0.04
1+
1 = 4.08%.
26
In 20 years time, this becomes
1.040840 1
500
= $48, 419.
0.0408
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IE 5441
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