Ignacio Lezaun

UNIT 5

English edition
2021

Fundamentals of Finance

1
 2
UNIT 5
Contents of the course

1. The role of the Chief Financial Officer

2. Statement of cash flows
3. Working capital management
4. Short-term finance instruments
5. The time value of money
6. Conclusions

11/20/2021
 3
UNIT 5

Calculating payment of loans

 Payment of loans
UNIT 5

• How much of my loan do I have to repay on a regular interval?

• Depends on present value, future value, loan duration, annual interest rate

• Same formula rearranged:

PMT

• Luckily, Excel has a built in formula called “PMT” to calculate the annual payment of loans, which can be
adapted for payment periods of monthly, weekly, etc.
Calculate monthly quota
UNIT 5

Principal: 2,000,000.00 €
Interest: 4% yearly
Number of payments: 8 years

Answer: See excel file

 6
UNIT 5

Calculating future values and present values

Simple interest UNIT 5
 UNIT 5
Simple interest: Examples

1. Juan wants to buy a car and asks you for help, he tells you to leave him € 400 and
promises that he will return it with his first payroll, which he hopes will be when
he finishes his degree, in one year. How much money will Juan return to you, if you
agree to an interest of 5%?

2. If you invest $500 (the present value) for 6 years at a 12% interest rate, what will
the future value be after the 6 years?

3.1 And if Juan only asks me for the money for 8 months and we agree to an annual
interest of 7%, what is the interest for the the period?

3.2 How much money should he give me back?

Simple interest: Example 1 UNIT 5

Juan wants to buy a car and asks you for help, he tells you to leave him € 400
and promises that he will return it with his first payroll, which he hopes will be
when he finishes his degree, in one year. How much money will Juan return to
you, if you agree to an interest of 5%?

Future Value = Present Value x (1 + Interest Rate)

€ 420 = 400* (1 + 0.05)

Simple interest: Example 2
UNIT 5
Future Value = Present Value x (1 + Interest Rate)

• If you invest $500 (the present value) for 6 years at a 12% annual
interest rate, what will the future value be after the 6 years?

• Future value = 500 x [1 +(0.12 x 6)]

= 860
 UNIT 5
Simple interest: Example 3.1

And if Juan only asks me for the money for 8 months

and we agree to an annual interest of 7%, how much
is the interest for the period?

Amount of interest in period = (Annual interest rate x time period) / 365

4.60% = 7% * (8 * 30) / 365
 UNIT 5
Simple interest: Example 3.2

And if Juan only asks me for the money for 8 months

and we agree to an annual interest of 7%, how much
money should he give me back?

Amount of interest in period = (Annual interest rate x time period) / 365

4.60% = 7% * (8 * 30) / 365

Future Value = Present Value x (1 + Interest Rate)

€ 1,024.65 = 1,000 * (1 + 0.024658)

Compound interest UNIT 5

• First work out the interest for the first period

• Add this to the original total for the new total
• For the next period, the interest is on the new total, and so on …
 Compound interest: Examples
UNIT 5

1. If an amount of $8,000 is deposited into a savings account at an annual

interest rate of 3%, compounded annually, what is the value of the
investment after 5 years?

2. If the same amount is deposited at the same interest rate but compounded
monthly, what is the value after 7 years?
 Compound interest: Example 1
UNIT 5

1. If an amount of $8,000 is deposited into a savings account at an annual

interest rate of 3%, compounded annually, what is the value of the
investment after 5 years?
Future Value = Present Value x (1 + Interest Rate/n)tn

Where t = the time the money is invested or borrowed for

n = the number of times that interest is compounded per unit t
Present value = 8000
Interest = 3%
n=1
t=5
Future value = 8000 x (1 + 0.03 / 1) 5 * 1
= 8000 x 1.035
=9274.19
 Compound interest: Example 2
UNIT 5

If the same amount (8000) is deposited at the same interest rate (3%) but
compounded monthly, what is the value after 7 years?

Future Value = Present Value x (1 + Interest Rate/n)tn

Where t = the time the money is invested or borrowed for

n = the number of times that interest is compounded per unit t

Present value = 8000

Interest = 3%
n = 12
t=7
Future value = 8000 x (1 + 0.03 / 12) 12 * 7 = 8235.05
= 8000 x (1.0025)84 = 9866.84
 Effective annual rate
UNIT 5
• The Effective Annual Rate (EAR) is the rate of interest actually earned on an investment as a
result of compounding the interest over a given period of time
• Increasing number of compounding periods makes the EAR increase with time

x
x
Effective annual rate: Examples UNIT 5

1. Calculate the EAR of a loan with an annual rate of 27% and interest
charged monthly

2. Calculate the EAR of a loan with an annual rate of 27% and interest
charged quarterly

3. Which one gives a higher EAR and why?

Effective annual rate: Example 1 UNIT 5

Calculate the EAR of a loan with an annual rate of 27% and interest charged
monthly

Effective annual rate = [(1+ i/n)n] – 1

Where:
i = Stated interest rate
n = Compounding periods
EAR = (1+0.27/12)12 – 1
= (1+0.0225)12 – 1
= 0.30605 = 30.61%.
Effective annual rate: Example 2 UNIT 5

Calculate the EAR of a loan with an annual rate of 27% and interest charged
quarterly

Effective annual rate = [(1+ i/n)n] – 1

Where:
i = Stated interest rate
n = Compounding periods
EAR = (1+0.27/4)4 – 1
= (1+0.0675)4 – 1
= 0.298588 = 29.86%
Effective annual rate: Example 3 UNIT 5

Which one gives a higher EAR and why?

Monthly compounding is gives a higher EAR (30.61%) than quarterly

compounding (29.86%) because the frequency of compounding is higher
(monthly = 12, quarterly = 4)
 How much present value do we need for a
UNIT 5
specific future value? Examples

1. I want $1000 a year from now on an annual interest of 5% How

much do I need to invest now?

2. I want $5000 10 years from now on an annual interest of 3%

How much do I need to invest now?
 How much present value do we need for a specific future value? Example 1
UNIT 5

I want $1000 a year from now on an annual interest of 5% How much do I need
to invest now?

Present Value = Future Value / (1 + Interest Rate/n)tn

Where t = the time the money is invested or borrowed for

n = the number of times that interest is compounded per unit t

PV = $1,000 / (1 + (5% / 1) (1 x 1) = $982.28

 How much present value do we need for a specific future value? Example 2
UNIT 5

I want $5000 10 years from now on an annual interest of 3% How much do I need
to invest now?

Present Value = Future Value / (1 + Interest Rate/n)tn

Where t = the time the money is invested or borrowed for

n = the number of times that interest is compounded per unit t

 n=1, t=10
PV = $5000 / (1 + 3% / 1) (10 x 1)
= $5000/(1 + 0.03)10
= $5000/1.030408
= $3720.47