Session 1

Statistical Thinking and

Methods for Describing
Sets of Data
Pre University-Mathematics for Business
1

Learning Objectives
solve problems involving the time value of
money.
solve problems with interest is compounded
continuously.
introduce the notions of ordinary annuities and
annuities due.

It is really simple
When people are feeling good about
their circumstances, they spend more.
When people are worried about their
futures, they save more.
t

n
o
d
y
h
,
e
W
v
a
s
we how
and h
c
u
m u ld w e
o
?

Why is Interest Interesting?

Simple Interest
Interest calculated only on the money youve
deposited.

Earned Interest
Payment you receive
(because you are a LENDER)
4

Why is Interest Interesting?

Compound interest
It is interest calculated on both your deposits
made and prior interest earned.
l
u
f
r
Interest on Interest
owe

e
p
c
t
n
s
a
o
n
m
f
l
e
a
h
n
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so
of
r
e
e
p
On
n
i
l es
p
i
c
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i
r
p

The Power of Compounding

$ 10
Interest Rate

1 Year

2 Years

4 Years

6 Years

4%

$10.40

$10.82

$11.70

$12.65

8%

$10.80

$11.66

$13.60

$15.87

Compound Interest
Compound amount S at the end of n interest periods at
the periodic rate of r is as

S P 1 r

Example 1 Compound Interest

Suppose that $500 amounted to $588.38 in a savings
account after three years. If interest was compounded
semiannually, find the nominal rate of interest, compounded
semiannually, that was earned by the money.
7

Solution:
There are 2 3 = 6 interest periods.
5001 r 588.38
6

1 r 6 588.38
500

588.38
1 r
500
6

r 6

588.38
1 0.0275
500

The semiannual rate was 2.75%, so the nominal rate was

5.5 % compounded semiannually.
8

Effective Rate
The effective rate of interest is the
amount of money that one unit (one dollar)
invested at the beginning of a (the first)
period will earn during the period, with
interest being paid at the end of the (first)
period.

Effective Rate
The effective rate re for a year is given by

r
re 1
n

Example 5 Effective Rate

To what amount will $12,000 accumulate in 15 years if it is invested
at an effective rate of 5%?
Solution:

S 12,0001.05

15

$24,947.14
10

Comparing Interest Rates

If an investor has a choice of investing money at 6% compounded
1
6
daily or 8% compounded quarterly, which is the better choice?
Solution:
Respective effective rates of interest are

0.06
re 1

365

365

0.06125
re 1

1 6.18% and
4

1 6.27%

The 2nd choice gives a higher effective rate.

11

Present Value
P that must be invested at r for n interest periods
so that the present value, S is given by
P S 1 r

Example 1 Present Value

Find the present value of $1000 due after three years if the interest
rate is 9% compounded monthly.
Solution:
For interest rate,
Principle value is

r 0.09. / 12 0.0075
36
.
P 10001.0075 $764.15
12

Net Present Value

Net Present Value NPV Sum of present values - Initial investment

Example 5 Net Present Value

You can invest $20,000 in a business that guarantees you
cash flows at the end of years 2, 3, and 5 as indicated in the
table.
Year

Cash Flow

$10,000

8000

6000

Assume an interest rate of 7% compounded annually and

find the net present value of the cash flows.
13

Solution:

NPV 10,0001.07
$457.31

80001.07

60001.07

14

20,000

Example
Each of following mutually exclusive projects involve an
initial cash outlay of $240,000. The estimated net cash flows
for the projects are:

Year Project A ($) Project B ($)

1

140000

20000

80000

40000

60000

60000

20000

100000

20000

180000

15

 The companys required rate of return is

11 percent. Calculate the NPV for both
projects. Which project should be chosen?
Why?

16

Solution
NPVA

$240 000 +

140 000 80 000 60 000 20 000 20 000

+
+

2
3
4
1.11 1.11 1.11 1.11 1.11 5

= $20 000 (to nearest thousand)

17

Solution
NPVB

20 000
40 000
$240 000 +
+
1.11
1.11 2
60 000 100 000 180 000
+
+
+
3
4
1.11
1.11
1.11 5
= $27 000 (to nearest thousand)
Using the NPV method, project B should be selected.
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Exercises
ABC firm is considering to invest in one of three mutually
exclusive projects X, Y and Z. The initial investment and
annual net cash inflows over the life of each project are shown
in the following table:
Initial
investmen
t
Year
1
2
3
4
5
6
7

Project X
$78,000

Project Y
$52,000

Project Z
$66,000

$17,000
$25,000
$33,000
$41,000
----------------

Net cash flows

$28,000
$15,000
$38,000
$15,000
-----$15,000
-----$15,000
-----$15,000
-----$15,000
19
-----$15,000

All the projects have equal risk and firms required rate of
return for these projects is 14%. Calculate the NPV for
each project over its life. Rank the projects in descending
order based on NPV.

20