Compound Interest Interest paid (earned) on any previous interest earned as well on the principal borrowed (lent).

If a person deposits Rs.100 into a savings account at 8% interest rate compounded annually. How much will he have in his account at the end of :1st year = 100 (1+0.08)1 = Rs.108 2nd year= 100 (1+0.08)2 = Rs.116.64 3rd year = 100 (1+0.08)3 = Rs.125.97 FV= PV (1+i)n

Using Future Value to find out:Unknown Interest or Discount rate:Lets assume you invest Rs.1,000 today you will receive Rs.3,000 in exactly 8 years. What is the interest rate? FV= PV (1+i)n 3,000=1,000 (1+i)8 3=(1+i)8 31/8 = 1+i 1.1472-1=i i=0.1472 or 14.72%

Unknown number of periods How long would it take for an investment of Rs.1,000 to grow to Rs.1,900 if we invested it at compound interest rate of 10%? FV= PV (1+i)n 1900=1000(1+0.10)n 1.9=(1.1)n n (log 1.1) =log 1.9 n= log 1.9 log 1.1 =6.73 years

If we have to choose between Rs.1,000 today or Rs.2,000 ten years from today? What is Rs.2,000 received at the end of 10 years worth to you today? This amount is called the PV. Interest rate is also known as discount rate. Finding PV or (discounting) is simply reverse of compounding. PV = 2000 = 926 (1+.08)10

Frequency of Compounding
FVn = PV0(1 + [i/m])mn n: Number of years m: Compounding periods per year i: Annual Interest Rate FVn : FV at the end of year n PV0: PV of the Cash Flow today

Impact of Frequency
Mr.A has $1,000 to invest for 2 years at an annual interest rate of 12%. Annual FV2 = 1,000(1+ [.12/1])(1)(2) = 1,254.40 Semi FV2 = 1,000(1+ [.12/2])(2)(2) = 1,262.48

Qrtly
Monthly Daily

FV2= 1,000(1+ [.12/4])(4)(2) = 1,266.77 FV2 = 1,000(1+ [.12/12])(12)(2) = 1,269.73 FV2= 1,000(1+[.12/365])(365)(2) = 1,271.20

Nominal or stated Annual Rate Is the contractual or quoted annual rate of interest charged by a lender or promised by a borrower.

Effective annual rate Is the annual rate of interest actually paid or earned.

Effective Interest Rate m 1+ i 1 m Where m = no. of times in a year

ANNUITIES An annuity is a series of equal payments or receipts occurring over a specified no. of equidistant periods. Two types of Annuities:1. Ordinary Annuity 2. Annuity Due

Ordinary Annuity
Payments or receipts occur at the end of each period.
End of Period 1 End of Period 2 End of Period 3

1
$100

2
$100

3
$100

Today

Equal Cash Flows Each 1 Period Apart

Annuity Due
Payments or receipts occur at the beginning of each period.
Beginning of Period 1 Beginning of Period 2 Beginning of Period 3

0
$100

1
$100

2
$100

Today

Equal Cash Flows Each 1 Period Apart

Examples of Annuities
Student Loan Payments Car Loan Payments Insurance Premiums Mortgage Payments Retirement Savings

For example:You are receiving Rs.1,000 a year for 3 years and you deposit each annual receipt into a savings account earning 7% interest. How much money will you have at the end of three years?

Example of an Ordinary Annuity - FVA

Cash flows occur at the end of the period
0 1 2 3 4

7% 1,000 1,000 1,000

1,070
1,145 3,215 = FVA3

Example of an Annuity Due - FVAD

Cash flows occur at the beginning of the period
0 1 2 3 4

7% 1,000 1,000 1,000 1,070

1,145 1,225
3,440 = FVAD3

Lets assume the cash flows of Rs.1,000 a year for three years represent withdrawals from a savings account earning 8% compound annual interest. How much money would you have to place in the account right now (time period 0) such that you would end up with a zero balance after the last Rs.1,000 withdrawal?

Example of Ordinary Annuity PVA

Cash flows occur at the end of the period
0 1 2 3 4

7% 934.58 873.44 816.30 1,000 1,000 1,000

2,624.32 = PVA3

Example of an Annuity Due PVAD

Cash flows occur at the beginning of the period
0 1 2 3 4

7% 1,000.00 934.58 873.44 1,000 1,000

2,808.02 = PVADn

PVIF PVIFA FVIF FVIFA

PVAD = R(PVIFA i,n)(1+i) FVAD = R(FVIFA i,n)(1+i)

Using Future Value Annuity to find out:Unknown Interest Rate Suppose you need to have at least Rs.9,500 at the end of 7 years in order to send your parents on a vacation trip. To accumulate this sum you have decided to deposit Rs.1,000 at the end of each of the next 7 years in a savings account. If the bank compounds interest annually what minimum annual interest rate must the bank offer for your savings plan to work?

Unknown periodic payment or receipt How much must one deposit each year in a savings account earning 5% compound annual interest to accumulate Rs.10,000 at the end of 8 years?

Perpetuity Is an ordinary annuity whose payments or receipts continue forever.

To determine the PV of this special type of annuity :- PVA = PMT i For example if Rs.100 is received each year forever and interest rate is 8%. PVA = 1,250

Mixed Flows Example

What is the present value of Rs.600 to be received annually at the end of years 1 and 2, followed by Rs.400 at the end of years 3 and 4 and concluding with a final payment of Rs.100 at the end of year 5, all discounted at 5%?

1
10% $600

$600 $400 $400 $100

PV0

Solve individual cash flows

0
$545.45 $495.87 $300.53 $273.21 $ 62.09

1
10% $600

$600 $400 $400 $100

$1677.15 = PV0 of the Mixed Flow

Solve Group Wise

0
10% $600
$1,041.60 $ 573.57 $ 62.10
$1,677.3 = PV0 of Mixed Flow $600(PVIFA10%,2) = $600(1.736) = $1,041.60 $400(PVIFA10%,4 - PVIFA10%,2) = $400(3.170-1.736) = $573.6 $100 (PVIF10%,5) = $100 (0.621) = $62.10

$600 $400 $400 $100

Loan Amortization
Repayment of loan in equal installment Amortization Schedule
A table showing the repayment schedule of interest and pricipal necessary to pay off the loan by maturity

Amortizing a Loan
If you are borrowing Rs.10,000 at a compound annual interest rate of 12%. Amortize the loan if annual payments are made for 5 years. Step 1: Payment PV0 = PMT(PVIFA i%,n) $10,000 = PMT (PVIFA 12%,5) $10,000 = PMT(3.605) PMT = $10,000 / 3.605 = $2,774

Amortizing Schedule
End of Payment Interest Principal Ending Year Balance 0 ------$10,000 1 2 3 4 5 $2,774 2,774 2,774 2,774 2,775 $13,871 $1,200 1,011 800 563 297 $3,871 $1,574 1,763 1,974 2,211 2,478 $10,000 8,426 6,663 4,689 2,478 0

[Last Payment Slightly Higher Due to Rounding]