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I = (P)(N)(i)
I : total interest
P : principal
N : number of interest periods
i : interest rate per interest period.
Plan 1,2 and 3 are all equivalent at the compound interest rate
of 10%! (Why? You can answer it at the end of this chapter.)
Beginning of
period 1
End of period 1 F
0
1 2 3 N-1 N
i % per period
Show the cash flow diagrams for Plans 2 and 3 from the credit
card company’s viewpoint. Identify i, P, F, A.
Plan 2 Plan 3
F = $13,310 A= $4,021
0 0
2 3=N 1 2 3=N
1
End of Year (EOY) End of Year (EOY)
P = $10,000 P = $10,000
$4,500
0 1 2 3 4 5
F = P(1 + i)N .
A A A A A
0 N
1 2 3 N-1
i % per period
P F
h i
i
A=F (1+i)N −1
h i
(1+i)N −1
P=A i(1+i)N
h i
i(1+i)N
A=P (1+i)N −1
FN = A(F/A, i%, N − J)
P0=?
5,000
6 7 8 9 10
0 1 2 3 4 5 11 12 13 14 15
(N-1)G
(N-2)G
3G
2G
G
0 1 2 3 4 N-1 N
i% per period
h i
G (1+i)N −1 GN G GN
F= i i − i ⇒F= i (F/A, i%, N) − i .
18,000
16,000
14,000
12,000
10,000
0 1 2 3 4 5
a) P=? b) A=?
0 1 2 3 4 5 0 1 2 3 4 5
$18,000
$16,000
$14,000
$12,000
$10,000
0 1 2 3 4 5
$8,000
$6,000
$10,000
$4,000
+ $2,000
0 1 2 3 4 5 0 1 2 3 4 5
i% per period
0 1 2 3 4 N-1 N
A1
A2=(1+f)A1
A3=(1+f)2A1
A4=(1+f)3A1
AN-1=(1+f)N-2A1
AN=(1+f)N-1A1
(
A1 [1−(P/F,i%,N)(F/P,f %,N)]
i−f 6 i
f =
P=
A1 N(P/F, i%, 1) f =i
0 1 2 … 5 6 … 13
…
…
$7,000(1.12)
$7,000
$35,000
$7,000(1.12)8
10,000
9,500
9,000
8,500
8,000
7,500
7,000
0 1 2 3 4 5 6 7 8 9
0 1 2 3 4 5 6 7 8 9
X=?
⇒ X = 9, 935.8
You are given two 1-year fixed deposit saving plans. The
interest rate of the two plans are:
Plan 1: 12% per year (compounded annually).
Plan 2: 12% per year compounded monthly.
You own a credit card which has a nominal interest rate of 15%
per year, compounded monthly. a) What is the effective annual
interest rate? b) Suppose your balance as of today (year 0) is
$10,000. How much will you owe to the credit card company at
the end of 3 years if you do not make any payments during 3
years?
Solution: 12
a) i = 1 + 0.15
12 − 1 = 16.07%
b) Use formula (F/P,i%,N). We can use effective annual interest
rate of i% and N=3.
P(F/P, i%, N) = 10, 000(F/P, 16.07%, 3) = 15, 637
Alternatively, we can use interest rate per month 0.15
12 = 0.0125
and N=3(12)=36.
P(F/P, i%, N) = 10, 000(F/P, 1.25%, 36) = 15, 639
The strategy in this case is to find the effective interest rate per
PP by using the relation (NOM-EFF).
Example 4.17: For the past 7 years, a quality manager has paid
$500 every 6 months for the software maintenance contract of
a LAN. What is the equivalent amount after the last payment, if
these funds are taken from a pool that has been returning 10%
per year compounded quarterly?
PP = 6 months; CP = 3 months.
0.05 2
i= 1+ − 1 = 0.05063.
2
PP = 1 month; CP = 3 months.
10% 1/3
i= 1+ − 1 = 0.826%
4
In this case,
Deposits (negative cash flows) are all regarded as
deposited at the end of the compounding period.
Withdrawals (positive cash flows) are all regarded as
withdrawn at the beginning of the compounding period.
Months
0 3 6 … 120
A = $500
Quarters
0 1 2 … 39 40
A = $1,500