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1

2

Part-01:Interest Rates

&

The Time Value of Money

3

Interest Rates

4

Introduction

All of us have either paid and/or received

interest at some point of time.

Those of us who have taken loans have paid

interest to the lending institutions.

Those of us who have invested have received

interest from the borrowers.

5

Introduction (Cont)

Types of Loans

Educational Loans

Housing Loans

6

Introduction (Cont)

Automobile Loans

7

Introduction (Cont)

Investments

Savings accounts, and

Fixed deposits (Time deposits) with banks

8

Introduction (Cont)

Bonds & Debentures

9

Introduction (Cont)

Definition of interest

Compensation paid by the borrower of capital to

the lender

For permitting him to use his funds

An economists definition

Rent paid by the borrower of capital to the

lender

To compensate for the loss of opportunity to use the

funds when it is on loan

10

Introduction (Cont)

Concept of rent

When we decide not to live in an

apartment/house owned by us

We let it out to a tenant

The tenant pays a monthly rental

Because as long as he is occupying our property we

are deprived of an opportunity to use it

11

Introduction (Cont)

The same concept applies to a loan of funds

The difference is

Compensation in the case of property is called RENT

Compensation in the case of capital is called INTEREST

12

The Real Rate of Interest

In a free market

Interest rates are determined by

Demand for capital

And

The supply of capital

13

The Real Rate (Cont)

One of the key determinants of Interest is

The Pure rate of interest a.k.a

The Real rate of interest

14

The Real Rate (Cont)

Definition of the Real rate:

The rate of interest that would prevail on a risk-less

investment in the absence of inflation.

Example of a risk-less investment

Loan to the Federal/Central government

Such loans are risk-less because there is no risk

of default

The central government of a country is the only

institution authorized to print money

15

The Real Rate (Cont)

But they say that certain governments (in Latin

America etc.) have defaulted on debt

16

The Real Rate (Cont)

Yes they have defaulted on dollar

denominated debt

The government of Argentina for instance can

print its own currency but not U.S. dollars

17

The Real Rate Illustrated

The price of a banana is Rs 1

Assume that the price of a banana next year

will also be Rs 1

That is, there is no inflation

In other words there is no erosion in the purchasing

power of money

18

Illustration (Cont)

Take the case of a person who lends

Rs 10 to the Government of India (GOI)

Obviously there is no fear of non-payment

If the GOI pays back Rs 11 after one year

The amount will be sufficient to buy 11

bananas.

19

Illustration (Cont)

In this case a loan of Rs 10 has been

returned with 10% interest in money terms

Since the investor is in a position to buy

10% more in terms of bananas

The return on investment in terms of the ability

to buy goods is also 10%

The rate of interest as measured by the ability

to buy goods and services is termed as

THE REAL RATE of INTEREST

20

The Real Rate (Cont)

In the real world price levels are not

constant.

Erosion in the purchasing power of money is a

fact of life

This is termed as inflation

21

Inflation

22

The Real Rate (Cont)

Most people who invest do so by acquiring

financial assets such as

Shares of stock

Shares of a mutual fund

Or bonds/debentures

Many also keep deposits with commercial

banks

23

The Real Rate (Cont)

Financial assets give returns in terms of

money

Without any assurance about the investors

ability to acquire goods and services at the time

of repayment.

Financial assets therefore give a

NOMINAL or MONEY rate of return.

In the example, the GOI gave a 10% return on

an investment of Rs 10.

24

The Real Rate (Cont)

In the example the 10% money rate of

return was adequate to buy 10% more in

terms of bananas.

This was because we assumed that the price of

a banana would remain fixed at Rs 1.

25

The Real Rate (Cont)

But what if the price of a banana after a year is

Rs 1.05.

Rs 11 can then acquire only

26

The Real Rate (Cont)

In this case the nominal rate of return is 10%

But our ability to buy goods has been enhanced

only by 4.80%

Thus the REAL rate of return is only 4.80%

The relationship between the nominal and real

rates of return is called the FISHER hypothesis

Because it was first postulated by Irving Fisher.

27

The Fisher Equation

Consider a hypothetical economy

It consists of one good say BANANAS

The current price of a banana is Rs P

0

So Rs 1 can buy

bananas.

28

The Fisher Equation (Cont)

Assume that the price of a banana next period

is P

1.

P

1

is known with certainty today but need not be equal

to P

0

In other words although we are allowing for inflation,

we are assuming that there is no uncertainty

regarding the rate of inflation.

So one rupee will be adequate to buy

bananas after one period

29

The Fisher Equation (Cont)

Assume that the economy has two types

of bonds available

We have FINANCIAL bonds and GOODS

bonds

If we invest Rs 1 in a Financial bond, we will get

Rs (1+R) after one period.

If we invest 1 banana in a Goods bond we will

get (1+r) bananas after one period.

30

The Fisher Equation (Cont)

Rs 1 in a Financial bond Rs (1+R)

Rs 1 in a goods bond

bananas

bananas after one period.

31

The Fisher Equation (Cont)

In order for the economy to be in equilibrium

both the bonds must yield identical returns.

Therefore it must be true that:

32

The Fisher Equation (Cont)

Let us denote inflation or the rate of change in

the price level by

33

The Fisher Equation (Cont)

This is the Fisher equation.

R or the rate of return on a financial bond is the

nominal rate of return

r or the rate of return on a goods bond is the

real rate of return

34

The Fisher Equation (Cont)

If r and are very small, then the product

of the two will be much smaller.

For instance if r = 0.03 and = 0.03, the

product is 0.0009

If we ignore the product we can rewrite the

expression as

R = r +

This is the approximate Fisher equation.

35

Uncertainty

Thus far we have assumed that the rate of

inflation is known with certainty.

In real life inflation is uncertain

Consequently it is a random variable

36

Uncertainty (Cont)

In the case of random variables

We do not know the exact outcome in

advance

All we know is the expected value of the

variable

Which is a probability weighted average of the

values that the variable can take.

37

Uncertainty (Cont)

Inflation Probability

2.50% 0.20

5.00% 0.20

7.50% 0.20

10.00% 0.20

12.50% 0.20

38

Uncertainty (Cont)

The expected value is given by

39

Uncertainty (Cont)

The Fisher equation can therefore be re-

written as

R = r + E()

Thus when inflation is uncertain

The actual real rate that we will eventually get is

unpredictable and uncertain

40

Uncertainty (Cont)

Assume that the required real rate is

4.50%

Since the expected inflation is 7.50%

an investor will demand a nominal rate of return

of 12%

41

Uncertainty (Cont)

Once the nominal rate is fixed, it will not

vary

But there is no guarantee that the realized

rate of inflation will equal the expected rate

In this case if the realized inflation is 9%, the

realized real rate will be only 3%

42

Uncertainty (Cont)

Thus in real life even a default free

security will not give an assured real rate.

It will give an assured nominal rate

But the real rate that is eventually obtained will

depend on the actual rate of inflation

43

Ex-ante versus Ex-post

An economist will say that the ex-ante rate

of inflation need not equal the ex-post rate

Ex-ante means anticipated or forecasted value

Ex-post connotes actual or realized value

Obviously the ex-ante real rate of interest

need not equal the ex-post real rate

44

Uncertainty & Risk Aversion

In the real world investors are characterized by

RISK AVERSION.

This does not mean that they will not take risk

What does it mean therefore?

To induce an investor to take a greater level of risk he

must be offered a higher expected rate of return.

45

Risk Aversion (Cont)

Given a choice between two investments with

the same expected rate of return

The investor will choose the less risky option

In the case of inflation

The investor will not accept the expected inflation as

compensation

Why?

The actual inflation could be higher than anticipated

Which implies that the actual real rate could be lower than

anticipated.

46

Risk Aversion (Cont)

To tolerate the inflation risk

The investor will demand a POSITIVE risk

premium

That is, compensation over and above the expected

rate of inflation

The Fisher equation may be restated as

R = r + E() + R.P.

Where R.P is the risk premium

47

Risk Aversion (Cont)

Does the provision of a risk premium

guarantee that the

ex-ante real rate = ex-post real rate

NO!

Suppose the required real rate is 4.5%,

that E() = 7.5%, and that R.P = 1.5%

Then the required nominal rate will be 13.50%

48

Risk Aversion (Cont)

In the absence of a risk premium

A rate of inflation > 7.5% implies a realized real rate <

4.5%

But when a risk premium is factored in

A rate of inflation > 9% implies a realized real rate <

4.5%

So the risk premium provides a bigger cushion

against inflation

But it does not guarantee a minimum ex-post real rate

49

Other Determinants

Besides

the required real rate

the expected inflation

and the inflation risk premium

the following factors impact the required

nominal rate

Length of the investment

Credit Risk

50

Length of the Investment

Lender like to lend short term

Borrowers like to borrow long-term

So how do we induce a lender to lend for a

longer period

Offer a HIGHER nominal rate of return

51

Typical Interest Rate Schedule in a Bank

Period of Investment Interest Rate

< 1 year 7.50%

More than 1 year but <

2years

8.00%

More than 2 years but <

3 years

8.50%

More than 3 years but <

5 years

9.00%

More than 5 years 9.25%

52

Credit Risk

We have focused on default free

investments

Loans to a Central Government

In reality most investments are fraught

with risk

Interest may not be paid

Principal may not be repaid

53

Credit Risk (Cont)

This is called credit risk

Applies to all investments except Central

government securities

There is a difference between inflation risk

and credit risk

Inflation is an economy wide phenomenon

Credit risk however varies from borrower to

borrower

54

Credit Risk (Cont)

Because of credit risk

The rate of return demanded by a lender will vary from

borrower to borrower

Which is why

For a given real rate

For a given tenor of the loan

For a given rate of inflation

a bank will charge different rates of interest on

loans made to different borrowers.

55

Simple Interest & Compound Interest

56

Measurement Period

The unit in which time is measured is

called the Measurement Period

The most common measurement period is One

Year.

57

Interest Conversion Period

The unit of time over which interest is paid

once and is reinvested to earn additional

interest is called

The Interest Conversion Period

The interest conversion period is typically

less than or equal to the measurement

period.

58

Nominal Rate of Interest

The quoted rate of interest per

measurement period is called

The NOMINAL rate of interest

59

Effective Rate of Interest

The interest that a unit of currency

invested at the beginning of a

measurement period would have earned

by the end of the period is called

The EFFECTIVE Rate of Interest

60

Effective Rate (Cont)

If the length of the interest conversion

period is equal to the measurement period

The effective rate will be equal to the nominal

rate

If the interest conversion period is shorter

than the measurement period

The effective rate will be greater than the

nominal rate

61

Variables and Symbols

P principal invested at the outset

N #of measurement periods for which

the investment is being made

r nominal rate of interest per

measurement period

i effective rate of interest per

measurement period

m #of interest conversion periods per

measurement period

62

Simple Interest

Consider an investment of Rs P for N

periods.

According to this principle

Interest earned every period is a constant

Every period interest is computed and credited

only on the original principal

No interest is payable on any interest that has

been accumulated at an intermediate stage

63

Simple Interest (Cont)

If r is the nominal rate of interest

P P(1+r) after one periodP(1+2r) after 2

periods P(1+rN) after N periods

So every period interest is paid only on the

original principal

N need not be an integer

Investments can be made for fractional periods

64

Illustration-1

Caroline has deposited Rs 10,000 with

Corporation Bank for 3 years

The bank pays simple interest at the rate

of 10% per annum

10,000 will become 10000x1.1 = 11,000

after one year 10000x1.1 + 1,000 =

12,000 after two years 13,000 after 3

years

13,000 = 10,000(1+ .10x 3) P(1+rN)

65

Illustration-2

Amit Gulati deposits Rs 10,000 with ICICI

Bank for 5 years and 6 months.

Bank pays simple interest at 8% per

annum.

Maturity value

= 10,000(1+.08x5.5) = Rs 14,400

Notice: N need not be an integer

66

Compound Interest

Consider an investment of Rs P for N

periods.

Assume that the interest conversion period

is equal to the measurement period

That is, the effective rate is equal to the nominal

rate

67

Compound Interest (Cont)

In the case of compound interest

Every time interest is earned it is automatically

reinvested at the same rate for the next

conversion period.

So interest earned every period is not a

constant

It steadily increases

PP(1+r) after one period P(1+r)

2

after

two periodsP(1+r)

N

after N periods

.

68

Illustration-3

Caroline has deposited Rs 10,000 with

Corporation Bank

Bank pays 10% per annum compounded

annually

Rs 10,00011,000 after one

year11000x 1.1 = 12,100 after 2 years

12,100x1.1= 13,310 after 3 years

13,310 = 10,000x (1.10)

3

69

Illustration-4

Gulati deposited Rs 10,000 with ICICI

Bank for 5 years and 6 months.

Bank has been paying 8% compounded

annually

P(1+r)

N =

10,000(1.08)

5.5 =

Rs 15,269.71

70

Compound Interest (Cont)

Compounding yields greater benefits than

simple interest

The larger the value of N the greater is the

impact of compounding

Thus, the earlier one starts investing the

greater are the returns.

71

Illustration-5

The East India Company came to India in 1600.

Consider an investment of Rs 10 in 1600 with a

bank which pays 3% per annum compounded

annually.

The balance in 2000 = 10x(1.10)

400

= Rs 1,364,237.18

72

Properties

If N=1, that is, the investment is for one period,

both simple as well as compound interest will

give the same accumulated value.

If N < 1, the accumulated value using simple

interest will be higher. That is:

(1+rN) > (1+r)

N

if N < 1

If N > 1, the accumulated value using compound

interest will be greater. That is:

(1+rN) < (1+r)

N

if N > 1

73

Properties

Simple interest is usually used for short-

term transactions investments of one

year or less

It is the norm for money market transactions

For capital market securities medium to

long term debt and equities compound

interest is the norm.

74

Illustration-6

Amit Gulati deposited Rs 10,000 with ICICI Bank

for 5 years and six months.

The bank pays compound interest at 8% for the first 5

years and simple interest at 8% for the last six months.

10,000(1+.08)

5

= 14,693.28

14,693.28(1 + .08x.5) = Rs 15,281.01

On the other hand 10000(1.1)

5.5

= 15,269.71

The difference is because for the last six months simple

interest yields more than compound interest.

75

Effective versus Nominal Rates

ICICI Bank is quoting 9% per annum

compounded annually

HDFC Bank is quoting 8.75% per annum

compounded quarterly

In the case of ICICI

The nominal rate is 9% per annum

The effective rate is also 9% per annum

In the case of HDFC

The nominal rate is 8.75%

The effective rate is obviously higher

76

Effective(Cont)

8.75% per annum 2.1875% per quarter

So a deposit of Rs 1(1.021875)

4

= 1.090413

So the effective rate offered by HDFC is

9.0413% per annum

Thus when the frequencies of

compounding are different

Comparisons between alternative investments

should be based on effective rates and not

nominal rates

77

Effective (Cont)

The nominal rate is r% per annum

Interest is compounded m times per annum

The effective rate is:

78

Effective(Cont)

We can also derive the equivalent nominal rate

if the effective rate is given

79

Illustration-7

HDFC Bank is paying 10% compounded

quarterly.

If Rs 10,000 is deposited for a year what will be the

terminal amount

The terminal value will be

The effective annual rate is 10.38%

80

Illustration-8

Suppose HDC Bank wants to offer an effective

annual rate of 10% with quarterly compounding

What should be the quoted nominal rate

81

Equivalency

Two nominal rates compounded at

different time intervals are said to be

Equivalent if

The same principal invested for the same

length of time

Produces the same accumulated value in either

case.

82

Equivalency (Cont)

In other words two nominal rates

compounded at different intervals are

equivalent if they yield the same effective

rate

83

Equivalency (Cont)

ICICI Bank is offering 9% per annum with semi-

annual compounding.

What should be the equivalent rate offered by

HDFC Bank if it intends to compound quarterly.

84

Equivalency (Cont)

The issue is, what will be the nominal rate that

will give an effective annual rate of 9.2025% with

quarterly compounding

Thus 9% with semi-annual compounding is equivalent to

8.90% with quarterly compounding.

85

Continuous Compounding

Consider Rs P that is invested for N periods at

r% per period.

If interest is compounded m times per period,

the terminal value will be

86

Continuous Compounding (Cont)

What about the limit as m

This is the case of continuous compounding.

87

Illustration-9

Narasimha Rao has deposited Rs 10,000

with Corporation Bank for 5 years at 10% per

annum compounded continuously.

The final balance is:

88

Illustration-10

Canara Bank is quoting 10% per annum

with quarterly compounding.

What should be the equivalent rate with

continuous compounding?

Two nominal rates are equivalent if they give

the same effective annual rate.

Let k be the nominal rate with quarterly

compounding, and r the nominal rate with

continuous compounding.

89

Illustration-10 (Cont)

90

Illustration-10 (Cont)

In this case:

91

The Limit

Continuous compounding is the limit as we

go from

Annual

To semi-annual

Quarterly

Monthly

Daily

And shorter intervals

92

Illustration-11

Sangeeta has deposited Rs 100 with ICICI

Bank.

The interest rate is 10% per annum.

What will be the terminal balance under the

following scenarios:

Annual compounding

Semi-annual compounding

Quarterly compounding

Monthly compounding

Daily compounding

Continuous compounding

93

Illustration-11 (Cont)

Frequency of

Compounding

Terminal Balance

Annual Rs 110.0000

Semi-annual Rs 110.2500

Quarterly Rs 110.3813

Monthly Rs 110.4713

Daily Rs 110.5156

Continuously Rs 110.5171

94

Future Value

When an amount is deposited for a time period

at a given rate of interest

The amount that is accrued at the end is called the

future value of the original investment

So if Rs P is invested for N periods at r% per period

95

FVIF

(1+r)

N

is the amount to which an investment of

Rs 1 will grow at the end of N periods.

It is called FVIF Future Value Interest Factor.

It is a function of r and N.

It is given in the form of tables for integer values of r and

N

If the FVIF is known, the future value of any principal

can be found by multiplying the principal by the factor.

The process of finding the future value is called

Compounding.

96

Illustration-12

Suhasini has deposited Rs 10,000 for 5 years at

10% compounded annually.

What is the Future Value?

Thus F.V. = 10,000 x 1.6105 = Rs 16,105

97

Illustration-13

Swapna has deposited Rs 10,000 for 4 years at

10% per annum compounded semi-annually.

What is the Future Value?

10% for 4 years is equivalent to 5% for 8 half-years

Thus F.V. = 10,000 x 1.4775 = Rs 14,775

98

Illustration-14

GIC has collected a one time premium of

Rs 10,000 from Suhasini and has

promised to pay her Rs 23,000 after 10

years.

The company is in a position to invest the

premium at 10% compounded annually.

Can it meet its obligation?

99

Illustration-14 (Cont)

The future value of Rs 10,000 =

10,000 x 2.5937 = Rs 25,937

This is greater than the liability of

Rs 23,000

So GIC can meet its commitment

100

Illustration-15

Syndicate Bank is offering the following

scheme

An investor has to deposit Rs 10,000 for 10

years

Interest for the first 5 years is 10% compounded

annually

Interest for the next 5 years is 12% compounded

annually

What is the Future Value?

101

Illustration-15 (Cont)

The first step is to calculate the future value

after 5 years:

The next step is to treat this as the principal and compute its

terminal value after another 5 years.

102

Present Value

When we compute the future value we

seek to determine the terminal value of an

investment that has earned a given rate of

interest for a specified period.

Now consider the issue from a different

angle?

If we want a specified terminal value, how much

should we invest at the outset, if the interest

rate is r% and the number of periods is N.

103

Present Value (Cont)

So instead of computing the terminal value

of a principal

we seek to compute the principal that

corresponds to a given terminal value.

The principal amount that we compute is

called the Present Value of the terminal

amount.

104

The Case of Simple Interest

An investment yields Rs F after N periods.

If the interest rate is r%, what is the present

value?

We know that:

F = P.V.x(1+rN)

So obviously

105

Illustration-16

Venkatachalam wants to ensure that he has

saved Rs 12,000 after 4 years.

So he deposits Rs P with a bank

If the bank pays 5% per annum on a simple interest

basis, what should be P?

106

The Case of Compound Interest

An investment pays r% per period on a

compound interest basis.

If we want Rs F after N periods, how much

should we deposit today?

107

Illustration-17

Priyanka wants to ensure that she has

Rs 15,000 after 3 years.

The bank pays 10% compounded annually

How much should she deposit?

108

PVIF

1/ (1+r)

N

is the amount that has to be deposited to yield

Rs 1 after N periods if the periodic interest rate is r%

It is called the Present Value Interest Factor (PVIF)

It is a function of r and N

It is given in the form of tables for integer

values of r and N

If we know the factor, we can find the present value

of any terminal amount by multiplying the two.

The process of finding the principal value of a

terminal amount is called Discounting

PVIF is the reciprocal of FVIF

109

The Additivity Principle

Suppose you want to find the present or future

value of a series of cash flows, where the rate of

interest is r%, and the last cash flow is received

after N periods.

You have to simply find the present or the future

value of each cash flow and add up the terms to

compute the present or future value of the

series.

Thus Present and Future Values are additive.

110

Illustration-18

Consider the following vector of cash

flows.

The interest rate is 10% compounded

annually.

YEAR Cash Flow

1 2,500

2 4,000

3 5,000

4 7,500

5 10,000

111

Illustration-18 (Cont)

112

Illustration-18 (Cont)

The relationship between the present and future

values is given by

FV = PV(1+r)

N

In this case

113

The Internal Rate of Return

Suppose that we are told that an investment of

Rs 18,000 will entitle us to the following vector of

cash flows.

The question is what is the rate of return?

114

The IRR (Cont)

The rate of return is the solution to the following

equation:

115

The IRR (Cont)

The solution to this equation is called the

Internal Rate of Return (IRR)

It can be obtained using the IRR function

in EXCEL.

In this case, the solution is 14.5189%

116

Effective Rates

Suppose we are asked to calculate the present

or future values of a series of cash flows arising

every six months.

And we are given an annual rate of interest

without specifying the compounding frequency.

The normal practice is to divide the interest rate by 2 to

determine the periodic interest rate

That is, the quoted rate is treated as a nominal rate and

not as an effective rate

117

Illustration-19

Consider the following vector of cash flows.

Assume that the annual interest rate is given as

10%.

118

Illustration-19 (Cont)

The Present Value will be calculated as:

Similarly the future value will be

119

Illustration-19 (Cont)

But what if it is explicitly stated that the effective

annual rate is10%?

Then the calculations will change

And the future value is given by

120

Effective Rates (Cont)

The present value is greater when we use

an effective annual rate of 10% for

discounting.

This is because the lower the discount rate the

higher will be the present value

And an effective rate of 10% per annum is lower than

a nominal rate of 10% with semi-annual

compounding.

By the same logic the future value is lower when we

use an effective annual rate of 10%

121

Evaluating an Investment

Kotak Mahindra is offering an instrument

that will pay Rs 10,000 after 5 years.

The price that is quoted is Rs 5,000.

If the investor wants a 10% rate of return,

should he invest.

The problem can be approached in three

ways.

122

The Future Value Approach

Assume that the instrument is bought for

5,000.

If the rate of return is 10% the future value

is

5,000 x 1.6105 = Rs 8,052.50

Since the instrument promises a terminal

value of Rs 10,000 which is greater than

the required future value, the investment is

attractive.

123

The Present Value Approach

The present value of Rs 10,000 using a discount

rate of 10% is

10,000 x 0.6209 = Rs 6,209

So if Rs 6,209 is paid at the outset the rate of

return will be 10%

If we pay more at the outset, the rate of return will

be lower and vice versa.

In this case the investment of Rs 5,000 is less than

Rs 6,209

So the investment is attractive

124

The Rate of Return Approach

Suppose you invest Rs 5,000 and receive

Rs 10,000 after 5 years.

What is the rate of return?

It is given by:

125

The Rate(Cont)

The solution is 14.87%

Since the actual rate of return is greater

than the required rate of 10%, the

investment is attractive.

126

Annuities

127

Annuities (Cont)

What is an annuity?

It is a series of identical payments made at

equally spaced intervals of time

Examples

House rent till it is revised

Salary till it is revised

Insurance premia

EMIs on housing/automobile loans

128

Annuities (Cont)

In the case of an ordinary annuity

The first payment is made one period from now

129

Annuities (Cont)

The interval between successive

payments is called the

PAYMENT Period

We will assume that the payment period is

the same as the interest conversion period

That is, if the annuity pays annually, we will

assume annual compounding

If it pays semi-annually we will assume semi-

annual compounding

130

Present Value

131

Present Value (Cont)

132

Present Value (Cont)

133

Present Value (Cont)

Is called the Present Value Interest Factor Annuity (PVIFA)

It is the present value of an annuity that pays Rs 1 per period

The present value of annuity that pays a periodic cash flow of

Rs A can be found by multiplying A by PVIFA.

134

Illustration-20

Apex Corporation is offering an instrument

that will pay Rs 1,000 per year for 20

years, beginning one year from now.

If the rate of interest is 5%, what is the

present value?

1,000xPVIFA(5,20) = 1,000 x 12.4622

= Rs 12,462.20

135

Future Value

136

Future Value (Cont)

137

Future Value (Cont)

Is called the Future Value Interest Factor Annuity (FVIFA)

It is the future value of annuity that pays Rs 1 per period.

For any annuity that pays Rs A per period, the future value

can be found by multiplying A by the factor.

138

Illustration-21

Pooja expects to receive Rs 10,000 per

year for the next 5 years, starting one year

from now.

If the cash flows can be invested at 10%

per annum what is the Future Value?

F.V. = 10,000 x FVIFA(10,5) = 10,000 x 6.1051

= Rs. 61,051

139

Relationship Between

PVIFA and FVIFA

140

Annuity Due

In the case of an Annuity Due, the cash flows

occur at the beginning of the period.

141

Present Value

142

Present Value (Cont)

143

Present Value (Cont)

The present value of an annuity due that makes

N payments is greater than that of an annuity

that makes N payments

Why?

Because each cash flow has to be discounted for one

period less.

Example of an annuity due?

An insurance policy

The first premium has to be paid as soon as the policy is

purchased.

144

Illustration-22

David has bought an LIC policy

The annual premium is Rs 12,000 and he has to

make 25 payments.

What is the present value if the discount rate is

10% per annum?

145

Future Value

146

Future Value (Cont)

The future value of an annuity due that

makes N payments, is greater than that of

a corresponding annuity, if the future value

is computed at the end of N periods.

Why?

Because each cash flow has to be computed

for one period more.

147

Illustration-23

If David takes an LIC policy with a premium of

Rs 12,000 per year for 25 years, what is the

cash value at the end of 25 years?

148

Perpetuities

An annuity that pays forever is called a

PERPETUITY.

The future value of a perpetuity is obviously

infinite.

But a perpetuity has a finite present value.

149

Perpetuities (Cont)

150

Illustration-24

A financial instrument promises to pay

Rs 1000 per year forever.

If the investor requires a 20% rate of return, how

much should he be willing to pay for it?

151

Amortization

The amortization process refers to the

process of repaying a loan by means of

equal installment payments at periodic

intervals.

The installments obviously form an

annuity.

The present value of the annuity is the loan

amount.

152

Amortization (Cont)

Each installment consists of

Partial repayment of principal

And payment of interest on the outstanding

balance

An amortization schedule shows the

division of each payment

into a principal component and

interest component

together with the outstanding loan balance after

the payment is made.

153

Amortization (Cont)

Consider a loan which is repaid in N installments

of Rs A each.

The original loan amount is Rs L, and the periodic

interest rate is r.

154

Amortization (Cont)

155

Amortization (Cont)

156

Amortization (Cont)

157

Amortization (Cont)

158

Illustration-25

Srividya has borrowed Rs 10,000 from

Syndicate Bank and has to pay it back in five

equal annual installments.

The interest rate is 10% per annum on the

outstanding balance.

What is the installment amount?

159

Amortization Schedule

160

Analysis

At time 0, the outstanding principal is 10,000

After one period an installment of Rs 2,637.97 is made.

The interest due for the first period is 10% of 10,000 or Rs 1,000

So the excess payment of Rs 1,637.97 is a partial repayment of

principal.

After the payment the outstanding principal is Rs 8,362.03

After another period a second installment is paid.

The interest for this period is 10% of 8,362.03 which is

Rs 836.20.

The balance of Rs 1,801.77 constitutes a partial repayment of

principal.

161

Analysis (Cont)

The value of the outstanding balance at

the end should be zero.

After each payment the outstanding

principal keeps declining.

Since the installment is constant

The interest component steadily declines

While the principal component steadily

increases

162

Amortization with a Balloon Payment

Uttara has taken a loan of Rs 100,000

from ICICI Bank.

She has to pay in 5 equal annual

installments along with a terminal payment

of Rs 25,000

The terminal payment which has to be

made over and above the scheduled

installment in year 5

Is called a BALLOON payment.

163

Balloon (Cont)

If the interest rate is 10% per annum, the annual

installment may be calculated as

Obviously, the larger the balloon the smaller will be the periodic

installment for a given loan amount.

164

Amortization Schedule

165

Types of Interest Computation

Financial institutions employ a variety of

different techniques to calculate the

interest on the loans made by them.

The interest that is effectively paid on the

loan may be very different from the rate

that is quoted.

THUS WHAT YOU SEE IS NOT WHAT YOU

ALWAYS GET

166

The Simple Interest Method

In this technique, interest is charged for

only the period of time that a borrower has

actually used the funds.

Each time principal is partly repaid, the interest

due will decrease.

167

Illustration

Alfred has borrowed $5,000 from the bank

for a year.

The bank charges simple interest at the

rate of 8% per annum.

If the loan is repaid at the end of one year:

Interest payable = 5000x0.08 = 400

Total amount repayable = 5,400

168

Illustration (Cont)

Assume the PRINCIPAL is repaid in two

equal semi-annual installments.

After six months principal of $2,500 is repaid.

Interest will however be charged on 5,000.

Amount repayable = 2500 + 5000x0.08x.5

= 2700

169

Illustration (Cont)

For the next six months interest will be

charged only on $2,500.

The amount payable at the end of the second

six-monthly period

= 2500 + 2500x0.08x.5 = $2,600

Total outflow on account of principal plus

interest = 2700 + 2600 = 5300

Obviously the more frequently the principal is

repaid the lower is the interest.

170

The Add-on Rate Approach

In this case interest is first calculated on the full

principal.

The sum of interest plus principal is divided by

the total number of payments to determine the

amount of each payment.

In Alfreds case if he repays in one annual

installment, there will be no difference with this

approach as compared to the simple interest

approach.

171

Add-on(Cont)

What if he repays in two installments?

Interest for the entire year = 400

This will be added to the principal and divided

by 2.

Thus each installment = (5000 + 400)

____________

2

= 2700

172

Add-on(Cont)

The quoted rate is 8% per

annum.

But the actual rate will be higher.

The actual rate is given by

173

Add-on (Cont)

The solution is i = 10.5758%

This is of course the nominal annual rate.

The effective annual rate is 10.8554%

174

The Discount Method

In this approach the total interest is first

computed on the entire loan amount.

This is then deducted from the loan amount.

The balance is lent to the borrower.

175

Illustration

Alfred borrows 5000 at 8% for a year.

The interest for the year is 400.

So Alfred will be given 4600 and will have to

repay 5000 at the end.

The effective rate of interest

= (5000 4600)

___________ x 100 = 8.6957%

4600

176

Discount Loan (Cont)

Such loans usually do not require

installments and are settled in one lump

sum at the end.

177

Compensating Balances

Many banks require that borrowers keep a

certain percentage of the loan amount with

them as a deposit.

This is called a Compensating Balance.

It raises the effective interest rate

Since the borrower cannot use the entire

amount that is sanctioned

178

Illustration

Alfred is sanctioned $ 5,000 at the rate of

8%.

But he has to keep 10% of the loan

amount with the bank for the duration of

the loan.

So while he pays an interest of $400, the

usable amount is only

5000x0.9 = $ 4,500

179

Illustration (Cont)

The effective interest cost is

400

________ x 100 = 8.8889%

4500

Quite obviously

The higher the compensating balance, the

greater will be the effective interest rate.

180

Annual Percentage Rate (APR)

The effective rate of interest that is paid by

a borrower is a function of the type of loan

that is offered to him.

Since different lenders used different loan

structures, comparisons between

competing loan offers can be difficult.

181

APR (Cont)

To ensure uniformity the U.S. Congress

passed the

Consumer Credit Protection Act

This is commonly known as

The Truth-in-Lending Act

The law requires institutions extending

credit to use a prescribed method for

computing the quoted rate.

182

APR (Cont)

Every lending institution is required to

compute the APR and report it before the

loan agreement is signed.

The most accurate way to compute the

APR is by equating the present value of

the repayments made by the borrower to

the loan amount.

183

APR (Cont)

For the examples that we have

considered the precise APR would be:

Loan Type APR

Simple Interest-One Installment 8%

Simple Interest-Two Installments 7.90%

Add-on Method-Two Installments 10.5758%

Discount Method-One

Installment

8.6957%

Compensating Balance-One

Installment

8.8889%

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