Week 3 Tutorial

Time Value of Money

Valuing Bonds
 Compound vs. Simple Interest

• Compound interest:
– Both the principal and previously-earned
interest can generate new interest
– FV = PV * (1 + r)n
– Already covered in class

• Simple interest:
– Only the principal generates new interest
– Next slide will show FV = PV * (1 + r * n )
 Simple Interest (Cont’d)
Ending Balance = Beginning Balance+ Principal* r
• At t=0 (today), you invest $100
• At t=1 (the end of year 1), account value= $100+$100*6%
• At t=2, account value = [$100+$100*6%]+ ($100*6%)
= $100+ 100* 6%*2
• At t=3, account value =[$100+ 100* 6%*2] + ($100*6%)
= $100+ 100* 6%*3
• At t=N, account value= $100+ 100* 6%*N = $100*(1+6%*N)
• That is, FV = PV * (1 + r*n) under simple interest
• Total Interest Earned in N Years = $100* (1+6%*N)-100
= $100*6%*N
 Simple Interest vs. Compound Interest

Example 1:
In 1867, Secretary of State William H. Seward purchased
Alaska from Russia for $7,200,000, or about two cents per
acre. At the time, the deal was dubbed Seward’s Folly, but
from our vantage point today, did Seward get a bargain after
all? What would it cost today (in 2021) if the land were in
exactly the same condition as it was 154 years ago and the
prevailing interest rate over this time were 4%?
(1) Calculate the cost of land today assuming compound
interest.
(2) Calculate the cost of land today assuming simple interest.
Comparing Loan Payment Methods
Example 2

Roseanne wants to borrow $40,000 for a period of 5 years.

The lenders offers her three choices:
1) Pay all of the interest (10% per year) and principal in one lump
sum at the end of 5 years;
2) Pay interest at the rate of 10% per year for 4 years and then a
final payment of interest and principal at the end of the 5th year;
3) Pay 5 equal payments at the end of each year inclusive of interest
and part of the principal.

Under which of the three options will Roseanne pay the least
interest? Calculate the total amount of the payments and the amount
of interest paid under each alternative.
 Bond Pricing
Example 3
Bond A pays annual coupon of 6%, has a maturity of 10
years, and currently trades at $950. Bond B is a zero coupon
bond with a maturity of 10 years, and its current price is
$523. Both Bond A and Bond B have the same yield and par
value ($1,000). Calculate the price of Bond C, which pays an
annual coupon of 4% and has a maturity of 10 years, par
value of $100, and the same yield with Bond A and B.