Chapter 07

Interest
Rates and
Present
Value

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 Chapter Outline

• Interest Rates
• Present Value
• Future Value
• Kick It Up a Notch: Risk and Reward

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 Interest Rates
The Market for Money

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 Interest Rate
• The interest rate is the percentage,
usually expressed in annual terms,
of a balance that is paid by a
borrower to a lender that is in
addition to the original amount
borrowed or lent.

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Figure 1 The Market for Money
Interest
Supply
rate (r)

r*

Demand

$*
Money ($)
Borrowed/Saved
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Nominal vs. Real Interest Rates

• Nominal Interest Rate: the advertised

rate of interest
• Real Interest Rate: the rate of interest
after inflation expectations are
accounted for; the compensation for
waiting on consumption

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 Present Value
• Present Value is the interest adjusted
value of future payment streams.
• Mathematically, the present value of a
payment is
=(payment)/(1+r)n
Where
r is the interest rate
n is the number of years until the payment is
received/made.
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 The Amount Payable for Every Dollar
Borrowed (For several interest rates
and loan durations)
Interest
rate -> 20% 10% 5% 2% 1%
Years 

30 237.38 17.45 4.32 1.81 1.35

10 6.19 2.59 1.63 1.22 1.10
5 2.49 1.61 1.28 1.10 1.05
1 1.20 1.10 1.05 1.02 1.01

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 Examples From This Table
• If you borrow $1 and promise to pay it
back in 5 years at 5% interest you will owe
$1.28 which is the original $1 plus 28
cents in interest.
• If you borrow $1 and promise to pay it
back in 30 years at 20% interest you will
owe $237.38 which is the original $1 plus
$236.38 in interest.

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 Mortgages, Car Payments,
and other Multiple-Payment Examples
• Mortgages are loans taken out to buy
homes. Typically you borrow a large
sum of money and promise to pay it
back in even amounts each month for
10, 15, or 30 years.
• Car loans are similar to mortgages in
that you borrow a large sum but the
loan duration is usually two to six
years.
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 A Multiple Year Example @ 5%
Year Cost Benefit PV Cost PV Benefit
@5% @5%
1 100 100.00
2 100 95.24
3 100 90.70
4 100 86.38
5 100 82.27
6 100 78.35
7 100 74.62
8 100 71.07
9 100 67.68
10 100 64.46
11 100 61.39
12 100 58.47
500 700 454.60 476.05
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 A Multiple Year Example @ 8%
PV Benefit
Year Cost Benefit PV Cost @8% @8%
1 100 100.00
2 100 92.59
3 100 85.73
4 100 79.38
5 100 73.50
6 100 68.06
7 100 63.02
8 100 58.35
9 100 54.03
10 100 50.02
11 100 46.32
12 100 42.89
500 700 431.21 382.68
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A Multiple Year Example @ 10%
PV Benefit
Year Cost Benefit PV Cost @10% @10%
1 100 100.00
2 100 90.91
3 100 82.64
4 100 75.13
5 100 68.30
6 100 62.09
7 100 56.45
8 100 51.32
9 100 46.65
10 100 42.41
11 100 38.55
12 100 35.05
500 700 416.99 332.52
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 Internal rate of return
• Internal rate of return : The
interest rate where the present value
of costs and benefits are equal.

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 Monthly Payments Required on per
$1000 of loan (For Several Interest
Rates and Loan Durations)
Interest 20% 10% 5% 2% 1%
rate ->
Years 
30 16.71 8.78 5.37 3.70 3.22
10 19.33 13.22 10.61 9.20 8.76
5 26.49 21.25 18.87 17.53 17.09
1 92.63 87.92 85.61 84.24 83.79
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 Examples From This Table
• If you borrow $1000 and promise to
pay it back monthly over 5 years at 5%
interest you will owe $18.87 per
month.
• If you borrow $1000 and promise to
pay it back monthly over 10 years at
20% interest you will owe $19.33 per
month.

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 Future Value
• Future value: the interest-adjusted value
of past payments.

Future Value  payment  1  r 

n

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 Rule of 72
• Rule of 72: A short cut that allows you to
estimate the time it would take for an
investment to double by dividing 72 by the
annual interest rate.
• For example: How long would it take to double
your money ($10,000) at 4% interest?
• FV formula: $10,000x(1.04)^18=$20,258.17 (so a little
less than 18 years is the answer).
• Rule of 72: 72/4=18 years

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 Kick It Up A Notch:
Risk and Reward

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 Kick It Up A Notch: Risk and
Reward
• Risk: the possibility that the investor will not get
those anticipated payoffs
• Default Risk: the risk to the investor that the
borrower will not pay
• Market Risk: the risk that the market value of
an asset will change in an unanticipated manner
• Reward
• Risk Premium the reward investors receive for
taking greater risk

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 The Yield Curve
• Yield Curve: the relationship between reward and the
time until the reward is received
US Treasury Yield Curve (January 2005)
5.00

4.50

4.00
Interest Rate

3.50

3.00

2.50

2.00

Year

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