• Happy Harry has just bought a scratch lottery ticket and won €10,000.

He wants to finance the future study of his

newly born daughter and invests this money in a fund with a maturity of 18 years offering a promising yearly
return of 6%. What is the amount available on the 18th birthday of his daughter?

FV = €10,000 * 1.0618 = €10,000 * 2.854339 = €28,543.39

You borrowed Rs 8500 from your sister and you have promised to pay her Rs 10,000 after 3 years . With the
annual compounding find the implied rate of interest for this loan

8500(1+r)^3= 10,000 = 5.57%

Do Question no 4, and 17

A bank account pays 5.5% annual interest rate, compounded monthly .how long it will take the money to double in this account

2= 1(1+.55/12)^n
Log2=n log (1.00458)
N= log 2/ log1.00458= 151.69 months = 12 years and 6 months
Compounding - Periodic
•  If is invested for years at a nominal interest rate , compounded m
times per year, then the total number of compounding periods is

• the interest rate per compounding period is

• Expressed in decimals
• and the future value is

Solve Q5
• Alan and Milan want to have Rs.200,000 in Meera’s college fund on
her eighteenth birthday, and they want to know the impact on this
goal of having Rs.10,000 invested at 9.8%, compounded quarterly, on
her first birthday. To advise Alan and Milan regarding this, find
• (a) the future value of the Rs.10,000 investment,
• (b) the amount of compound interest that the investment earns, and
Solution
•  a) Future value of the Rs.10,000 investment

•3
• b) Amount of interest earned is
Continuous Compounding
• Because more frequent compounding means that interest is paid more often (and
hence more interest on interest is earned), it would seem that the more frequently the
interest is compounded, the larger the future value will become.

  general, if $P is invested for t years at a nominal rate r compounded continuously, then the future
In
value is given by the exponential function

Refer qns : 11
 Continuous compounding  
𝑺=𝑷 𝒆 𝒓𝒕

•  (a) Find the future value if $1000 is invested for 20 years at 8%, compounded
continuously.

• $4,953.03
• (b) What amount must be invested at 6.5%, compounded continuously, so that
it will be worth $25,000 after 8 years?
 Rule 72
• In finance, the Rule of 72 is a formula that estimates the amount of time it
takes for an investment to double in value, earning a fixed annual rate of return

You are the owner of a coffee machine manufacturing company. Due to the large capital needed to establish a factory and
warehouse for coffee machines, you have turned to private investors to fund the expenditure. You meet with John, who is a
high net-worth individual willing to contribute $1,00,000 to your company. However, John is only willing to contribute said
amount on the presumption that he will get a 12% annual rate of return on his investment, compounded yearly. He wants
to know how long it will take for his investment in your company to double in value.(Using the Rule of 72)
 Annual Percentage Yield
• When
  we invest money at a given compound interest rate, the method of compounding
affects the amount of interest we earn. As a result, a rate of 8% can earn more than 8%
interest if compounding is more frequent than annually. The rate of interest earned in reality
per year is called annual percentage yield (APY), or effective annual rate (EAR).
Let represent the annual (nominal) interest rate for an investment.

• Periodic Compounding. If is the number of compounding periods per year, then is the
interest rate per period, and and in continuous compounding
Comparing Yields
• Suppose a young couple such as Alan and Milan from our Application Preview
found three different investment companies that offered college savings plans:
• a) one at 10% compounded annually,
• b) another at 9.8% compounded quarterly, and
• c) a third at 9.65% compounded continuously.
• Find the annual percentage yield (APY) for each of these three plans in order to
discover which plan is best.
Comparing Yields
Solutions to questions in previous slide

•  a) For the annual compounding the stated rate is the

• b) 9.8% compounded quarterly, the number of periods per year is 4

(m)

• c) 9.65% compounded continuously

 EFFECTIVE VERSUS NOMINAL RATE
The nominal rate of interest is 8 %, calculate EAR if(a) compounded annually,
semi annually , quarterly and monthly

Nominal and Effective Rates of Interest

Effective Rate %
  Nominal Annual Semi-annual Quarterly Monthly
Rate % Compounding Compounding Compounding Compounding
8 8.00 8.16 8.24 8.30
Time

• How long does it take an investment of $10,000 to double if it is

invested at
• (a) 8%, compounded annually?
FV of Annuity

 The sum of all payments plus all interest earned is called the future amount
of the annuity or its future value. The value of can be computed directly
with a financial calculator or found in an annuity table.
Annuities

• Refer Qns 2
•  Ordinary Annuity • Annuity Due
( Investment at the end of the (Investment at the beginning)
period)

Ie Ordinary annuity (1+i)

• Find the future value of an investment if Rs 1500 is deposited at the
end of each month for 9 years and the interest rate is 7.2% p.a
compounded monthly

• Find the future value of an investment if Rs 1500 is deposited at the

beginning of each month for 9 years and the interest rate is 7.2% p.a
compounded monthly

• Today is 01.01.2019 and Mr. A is planning to save Rs 20,000 per year

starting 31.12.2019 for his daughters' marriage. He plans to continue
saving for 7 years in a Recurring deposit (RD) bank account which pays
10 % p.a. How much money will he have after 7 years?
 Future Value of Annuities
• Twins graduate from college together and start their careers. Twin 1 invests
$2000 at the end of each of 8 years in an account that earns 10%,
compounded annually. After the initial 8 years, no additional contributions
are made, but the investment continues to earn 10%, compounded
annually, , for 36 more years (until twin 1 is age 65). How much does twin 1
have at age 65?

• Twin 2 invests no money for 8 years but then contributes $2000 at the end of
each year for a period of 36 years (to age 65) to an account that pays 10%,
compounded annually. How much money does each twin have at age 65?
Twins
Continued

•  Twin 1 invests $2000 at the end of each of 8 years in an account that

earns 10%, compounded annually. After the initial 8 years, no
additional contributions are made, but the investment continues to
earn 10%, compounded annually, for 36 more years (until twin 1 is
age 65). How much does twin 1 have at age 65?
• The first part is an ordinary annuity

• This is then reinvested in the a deposit

Comparing the value of TWINS

Contribution per Number of Total Account value @65

year years Contribution
Twin 1 $2000 8 $16000 $707,028
Twin 2 $2000 36 $72,000 $598,254

Note that twin 1 contributed $56,000 less than twin 2 but had $108,774 more at age 65.
This illustrates the powerful effect that time and compounding have on investments
 Application of Future value annuity – Sinking fund
• A young couple wants to save $50,000 over the next 5 years and then to use this
amount as a down payment on a home. To reach this goal, how much money
must they deposit at the end of each quarter in an account that earns interest at
a rate of 5% p.a, compounded quarterly?

• A company establishes a sinking fund to discharge a debt of $300,000 due in 5

years by making equal semiannual deposits, the first due in 6 months. If the
deposits are placed in an account that pays 6% p.a , compounded semiannually,
what is the size of the deposits?

• You want to buy a house after 5 years when it is expected to cost Rs.2 million( Rs
20,00,000). How much should you save annually if your savings earn a
compound return of 12 percent ?
 Time Value Adjustment

• Two most common methods of adjusting cash flows for time

value of money:
• Compounding—the process of calculating future values of cash flows
and
• Discounting—the process of calculating present values of cash flows.

22
Future Value
• Compounding is the process of finding the future values of
cash flows by applying the concept of compound interest.
• Compound interest is the interest that is received on the
original amount (principal) as well as on any interest
earned but not withdrawn during earlier periods.
• Simple interest is the interest that is calculated only on the
original amount (principal), and thus, no compounding of
interest takes place.
 Present Value
• Present value of a future cash flow (inflow or outflow) is the amount
of current cash that is of equivalent value to the decision-maker.
• Discounting is the process of determining present value of a series of
future cash flows.
• The interest rate used for discounting cash flows is also called the
discount rate.

24
 Present Value of a Single Cash
Flow
• The following general formula can be employed to calculate the present
value of a lump sum to be received after some future periods:

Fn
P  F 
n  (1  i ) n

(1  i ) n

• The term in parentheses is the discount factor or present value factor

(PVF), and it is always less than 1.0 for positive i, indicating that a future
amount has a smaller present value.
PV  Fn  PVFn,i

25
 Present Value/Future Value
• Determine the Present Value of an investment (or payment) in the Future.
• You are due a $10,000 signing bonus to be paid to you after you have completed 2 yrs
of service with your new company. What is the present value of that bonus given 7%
interest?

• Determine the Future Value of an investment made today

• What is $10,000 worth if kept in a bank for 10 years at 3% p a(compound) interest
• How much would you be willing to pay today for the right to
receive $1,000 five years from now, given you wish to earn 6% on
your investment?

• Rudy will retire in 20 years. This year he wants to fund an amount

of €15,000 to become available in 20 years. How much does he
have to deposit into a pension plan earning 7% annually?

• If you invest $15,000 for ten years, you receive $30,000. What
is your annual return?
• Suppose your friend has agreed to return your money in 4
consecutive installments of Rs 1000, Rs 2000 and Rs 3000 and Rs
3500. He will pay these instalment after at the end of each year
1,2,3,4. Calculate the present value
 Present Value of an Annuity
• The computation of the present value of an annuity can be
written in the following general form:
1 1 
P  A   OR
 i i  1  i  
n

• The term within parentheses is the present value factor of an

annuity of Re 1, which we would call PVFA, and it is a sum of
single-payment present value factors.

P = A × PVAFn, i
• Suppose you can invest in a project that will return $100 at the end of
each year for the next 3 years. How much should you be willing to
invest today, given you wish to earn an 8% annual rate of return on
your investment?

• Suppose you can expect an amount of Rs 1000 for the next 5 years.
Cash flow will occur at the end of the each year. Calculate the present
value of annuity at a discount rate of 10 percent
Present Value
•  What is the present value of an annuity of $1500 payable at the end
of each 6-month period for 2 years if money is worth 8%,
compounded semiannually?

• Find the lump sum that one must invest in an annuity in order to
receive $1000 at the end of each month for the next 16 years, if the
annuity pays 9%, compounded monthly.
Annuities Due
•  What lump sum will be needed to generate payments of ₹5000 at the
beginning of each quarter for a period of 5 years if money is worth
7%, compounded quarterly?
Application of PV annuity - EMI
• Waleed just purchased a new house for Rs. 120,000. He was able to
make a down payment equal to 25% of the value of the house; the
balance was mortgaged. The rate by the bank is 10% compounded
annually. The mortgage has a 20 year amortization period (this means
that payments are calculated assuming it will take 20 years to pay off
the loan).
• (a) What will be the size of the payments by factor formula?
Present Value of Perpetuity

• Perpetuity is an annuity that occurs indefinitely.

Perpetuities are not very common in financial
decision-making:
Perpetuity
Present value of a perpetuity 
Interest rate

Refer Qns 12 and Qns 13