CH#3 SQ

Chapter 3
Define interest :
Money paid for the use of money is called interest
What is interest rate :
1. Interest rates represent the cost of borrowing money or the return on investment.
2. They are expressed as a percentage of the principal amount.
3. Interest rates are determined by factors like monetary policy, inflation, supply and demand for
credit, and overall economic conditions
What is simple interest:
1. Simple interest is interest that is paid or earned only on the original amount borrowed or lent,
known as the principal.
OR
Interest paid (earned) on only the original amount, or principal, borrowed (lent)
2. Formula : The dollar amount of simple interest (SI) is calculated using the formula:
SI = Po ( I )( n )
where:
SI = simple interest in dollars
Po = principal or original amount borrowed/lent
i = interest rate per time period
n = number of time periods
What is compound interest:
Interest paid (earned) on any previous interest earned, as well as on the principal borrowed(lent)
What is Future Value:

Define: The value of future cash flow after a certain future period. This is a type of cash that will be
received at a specified future date
Time frame: It is the value of asset or investment at end of particular time period
Inflation effect : for future value inflation is not considered
Formula:
• FVn FVn=Po(1+i)n
• Po is the future value
• is the initial principal,
inis the interest rate,
la • is the number of periods
What is present Value :
Define: The current value of cash flow in the future. It is basically cash in hand on todays date
Time frame: It is the value of asset or investment at starting of particular time period
Inflation effect : for present value inflation is not considered
𝑭𝑽
PV = (𝟏+𝒊)^𝐧
What is perpetuity :
A perpetuity is an ordinary annuity with payments or receipts that continue indefinitely.
MIAN ZAID
𝑅
PVA∞=
• R = periodic receipt or payment
• i = interest rate per period
What is Annuity :
An annuity is a contract between you and an insurance company in which you
make a lump-sum payment or series of payments and, in return, receive
regular disbursements, beginning either immediately or at some point in the
future.
What is Ordinary Annuity
Definition : An annuity refers to a series of equal payments or receipts occurring over a specified number
of periods. In an ordinary annuity, payments or receipts occur at the end of each period.
For future value Annuity : FVA = R (FVIFA I,n)
For present value Annuity : PVA = R(PVIFA I,n)
What is Annuity Due:
An annuity due is a series of equal payments or receipts occurring at the beginning of each period, is
called annuity due.
Future Value Annuity Due : FVADₙ = R(FVIFAᵢ,ₙ)(1 + i)
Present Value Annuity Due : PVADₙ = (1 + i)(R)(PVIFAᵢ,ₙ).
BACK EXERCISE
1. What is simple interest?
Simple interest is interest that is paid (earned) on only the original amount, or principal, borrowed (lent).
2. What is compound interest? Why is it important?
With compound interest, interest payments are added to the principal and both then earn interest
for subsequent periods. Hence interest is compounded. The greater the number of periods and the
more times a period interest is paid, the greater the compounding and future value.
3. What kinds of personal financial decisions have you made that involve compound interest?
The answer here will vary according to the individual. Common answers include a savings
account and a mortgage loan.
4. What is an annuity? Is an annuity worth more or less than a lump sum payment received
now that would be equal to the sum of all the future annuity payments?
An annuity is a series of cash receipts of the same amount over a period of time. It is worth less
than a lump sum equal to the sum of the annuities to be received because of the time value of
money.
5. What type of compounding would you prefer in your savings account? Why?
Interest compounded continuously. It will result in the highest terminal value possible for a given
nominal rate of interest.
6. Contrast the calculation of future (terminal) value with the calculation of present value.
MIAN ZAID
What is the difference?
In calculating the future (terminal) value, we need to know the beginning amount, the interest rate, and
the number of periods. In calculating the present value, we need to know the future value or cash flow,
the interest or discount rate, and the number of peri- Thus, there is only a switch of two of the four
variables.
7. What is the advantage of using present value tables rather than formulas?
They facilitate calculations by being able to multiply the cash. Otherwise, it is flow by the
appropriate discount factor. necessary to raise 1 plus the discount rate to the nth power and
divide. Prior to electronic calculators, the latter was quite laborious. With the advent of
calculators, it is much easier and the advantage of present-value tables is lessened.
8. If you are scheduled to receive a certain sum of money five years from now but wish to
sell your contract for its present value, which type of compounding would you prefer to
be used in the calculation? Why?
Interest compounded as few times as possible during the five years. Realistically, it is likely to be at least
annually. Compounding more times will result in a lower present value.
9. The “Rule of 72” suggests that an amount will double in 12 years at a 6 percent compound
annual rate or double in 6 years at a 12 percent annual rate. Is this a useful rule, and is it an
accurate one?
For interest rates likely to be encountered in normal business situations the "Rule of 72" is a
pretty accurate money doubling rule. Since it is easy to remember and involves a calculation that
can be done in your head, it has proven useful.
10. Does present value decrease at a linear rate, at an increasing rate, or at a decreasing rate
with the discount rate? Why?
Decreases at a decreasing rate. The present value equation, 1/(1+i)n , is such that as you divide 1 by
increasing (linearly) amounts of i, present value decreases toward zero, but at decreasing rate.
11. Does present value decrease at a linear rate, at an increasing rate, or at a decreasing rate with
the length of time in the future the payment is to be received? Why?
Decreases at a decreasing rate. The denominator of the present value equation increases at an
increasing rate with n. Therefore, present value decreases at a decreasing rate.
12. Sven Smorgasbord is 35 years old and is presently experiencing the “good” life. As a result, he
anticipates that he will increase his weight at a rate of 3 percent a year. At present he weighs
200 pounds. What will he weigh at age 60?
A lot. Turning to FVIF Table 3-3 in the chapter and tracing down the 3 percent column to 25
years, we see that he will increase his weight by a factor of 2.09 on a compound basis. This
translates into a weight of about 418 pounds at age 60.
MIAN ZAID

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Chapter 3

What is Future Value:

1. What is simple interest?

2. What is compound interest? Why is it important?

be used in the calculation? Why?

with the discount rate? Why?

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