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INTEREST
term used in business
cost of using money over time
interest expense = borrower / debtor
interest income = lender / creditor
3 Factors:
1. Principal
2. Interest Rate
3. Time Period
2 Concepts:
a. Future Value
b. Present Value
FUTURE VALUE:
Principal = P 10,000
Interest = P 1,000 (10,000 x 10%)
FV = P 11,000
Simple Interest:
Principal = P 10,000
Interest =P 500 (10,000 x 10% x 6/12 )
FV = P 10,500
Simple Interest:
Principal = P 10,000
Interest = P 5,000 (10,000 x 10% x 5 )
FV = P 15,000
Compound Interest:
Alternative Solution:
FV = PV (1 + i/m)m*n
Where:
m refers to the number of times interest is
compounded in a year
Example:
Questions:
1. What is the FV of P 10,000 should ABC Corporation
opted to deposit it at BPI after 1 year?
2. What is the FV of P 10,000 at BDO after 1 year ?
3. Was the decision of ABC Corporation to deposit the
money at BDO right? By how much was the difference
in future values?
Solution:
A. FV = PV (1+ i) 1
= 10,000 ( 1.10)1
= 11,000
B. FV = PV (1+ i/m) nm
= 10,000 ( 1 + (.10/2)2*1
= 10,000 (1 + .05)2
= 10,000 (1.1025)
= 11,025
Effective Rate:
is also called - APR (annual percentage rate)
is the true interest rate
arises because of the frequency of
compounding in a year
APR = (1 +i/m)^m -1
= (1 + .10/2)^2 -1
= (1 + .05)^2 -1
= 1.1025 – 1
= .1025 or 10.25%
b) FV = P(1+i)^15
= 12,000 (1+0.12)^15
= 65,683
c) FV = P(1+i/m)^n*m
= 12,000 (1+.10/2)^25*2
= 137,609
Future Value of a Stream of Payments
FV = ϵ PV (1 +i) n-t
2 Types:
FVOA = A (FVIFAin)
FVIFAin = (1+i)n -1
i
where FVOA - means future value of ordinary annuity
A - means the amount of the fixed annuity
payment
FVIFAin - future value interest factor of an
ordinary annuity
Example:
FVOA = A (FVIFAin)
= 10,000 (3.310)
= 33,100
Future Value of a Stream of Payments
1. Annuity Due
FVAD = A (FVIFADin)
FVAD = A (FVIFADin)
= 10,000 (3.641)
= 36,410
Comparing FV of ordinary annuity and annuity due:
33,100 36,410
Ordinary Annuity
Annuity Due
Analysis:
The future value for the annuity due is greater
than the ordinary annuity because each
deposit made one year earlier earns interest
one year longer
Present Value:
Discount Rate:
Discounting:
PV = FV or PV = FV (1+i) -n
(1 + i) n
Example:
XYZ expects to receive P 10,000 one year from now. What is the
present value of this amount if the discount rate is 10 percent?
PV = FV or PV = FV (1+i) -n
(1 + i) n
= 10,000 = 10,000 (1+.10)-1
(1+.10)1 = 10,000 (.9091**)
= 9,090.91 = 9,090.91
* PVIF
Present Value of Stream of Payments:
PV = ϵ FV (PVIFin)
PVIFin = 1
(1+i)n
Example:
PV = ϵ FV (PVIFin)
= 10,000 (.909) + 11,500 (.826) + 20,000 (.751)
= 9,090 + 9,499 + 15,020
= 33,609
Present Value of Stream of Payments:
PVOA = A (PVIFAin)
PVIFAin = 1 – _1_
__(1+i)n
i
PVAD = A (PVIFADin)
Perpetuity
* is an annuity with an infinite life, that is the payments
continue indefinitely
PV of perpetuity = A nnuity
Discount rate
Example:
JBT Corporation wants to deposit an amount of money that will allow it
to withdraw P 1,500 indefinitely at the end of each year without
reducing the amount of the initial deposit. If the bank guarantees to pay
the firm by 10 percent interest on its deposits , the amount to be
deposited NOW is?
PV of perpetuity = 1,500
.10
\ = 15,000
EXERCISE;
The Billy Playhouse wants P 10,000 at the end of each
year for the next 6 years. How much must be deposited
today at 10% to yield this annuity?