Tarheel Consultancy Services

Bangalore
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.
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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%