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Chapter III

{ Interest & Equivalence


Reporter: Dinah Fe T. Olitan
Describe each alternative as cash
receipts or disbursements at
different points in time.
Example 1
The manager has decided to purchase a new
$30,000 mixing machine. The machine may be
paid for in one of two ways:
1. Pay the full price now minus a 3% discount.
2. Pay $5000 now; at the end of one year, pay
$8000; at the end of each of the next four years,
pay $6000.
List the alternatives in the form of a table of cash
flows.
Solution
End of Year Pay in Full Now Pay in 5years
0 (now) -$29,100 -$5000
1 0 -$8000
2 0 -$6000
3 0
-$6000
4 0
-$6000
5 0
-$6000
Example 2
A man borrowed $1000 from a bank at 8%
interest. He agreed to repay the loan in two
end-of-year payments. At the end of the first
year, he will repay half of the $1000 principal
amount plus the interest that is due. At the
end of the second year, he will repay the
remaining half of the principal amount plus
the interest for the second year. Compute the
borrower's cash flow.
Solution
Year 1 = 0.08 x $1000 = $80 plus half
the $1000 loan
Year 2 = 0.08 x $500 = $40 plus the
remaining half the $1000 loan

End of Year Cash Flow


0 (now) +$1000
1 -580
2 -540
A peso today does not have the same worth two
interest
years from today because of the interest it can earn.

interest

interest

Time value of money


{ Interest
interest

interest
MONEY CAN BE RENTED IN
ROUGHLY THE SAME WAY ONE
RENTS AN APARTMENT, ONLY WITH
MONEY, THE CHARGE IS CALLED
INTEREST INSTEAD OF RENT.

INTEREST
– A CHARGE FOR BORROWED MONEY.
– THE PROFIT IN GOODS OR MONEY
THAT IS MADE ON INVESTED
CAPITAL.
Simple Interest
- is interest that is computed only on the
original sum and not on accrued interest.
I = Pin (3-1)
F = P + Pin = P (1 + in) (3-2)

Where:
P - present sum of money
i - simple annual interest rate (a decimal)
n - period of years
I - the amount of interest you would receive
F - the amount of money due at the end of n years
Simple Interest Example
You have agreed to loan a friend $5000 for 5 years
at a simple interest rate of 8% per year.
a. How much interest will you receive from the
loan?
b. How much will your friend pay you at the end of
5 years?
I = Pin = ($5000)(0.08)(5yrs) = $2000
F = P + Pin = 5000 + 2000 = $7000
Compound Interest
- an interest on top of interest. Any interest owed
but not paid at the end of the year is added to
the balance due.
Where:
P = amount of the principal/ present value
F = P (1+i)n i = Rate of interest
𝑟
w/r: i = n = number of interest periods
𝑚
F = future total amount
n = mxn r = is the nominal annual interest rate
𝑟 (ex. 5%, 10%)
F = P (1+𝑟 mn) m = no. of interest periods each year
F = P (1+ ) 𝑚
mn 𝑚 = 1 (compounded annually);
= 2 (semi-annually); = 4 (quarterly);
= 12 (monthly); = 6 (bimonthly)
Compound Interest
Amount @ the Amount @ the
Interest for
YEAR Beginning of End of Interest
Period
Interest Period Period

1 P Pi P+Pi = P(1+i)
P(1+i)+P(1+i)I
2 P(1+i) P(1+i)i P(1+i)(1+i)
P(1+i)2
P(1+i)2+P(1+i)2i
3 P(1+i)2 P(1+i)2 i P(1+i)2(1+i)
P(1+i)3
n P(1+i)n-1 P(1+i)n-1 i P(1+i)n
Compound Interest Example
You have agreed to loan a friend $5000 for 5 years
at a compound interest rate of 8% per year.
a. How much interest will you receive from
the loan?
b. How much will your friend pay you at the
end of 5 years?
Compound Interest Example
Year Total Interest (I) Owed at Total Amount Due at
Principal (P) the End of Year n the
End of Year n
1 $5000 $5000 x 0.08 = 400 $5000+ 400 =5400

2 5400 5400 x 0.08 = 432 5400 + 432 = 5832

3 5832 5832 x 0.08 = 467 5832+ 467 = 6299

4 5832 6299 x 0.08 = 504 6299 + 504 = 6803

5 6803 6803 x 0.08 = 544 6803 + 544 = 7347

$347 more than


Simple Interest
Repaying a Debt
Repaying a Debt
Equivalence
Definition: Combination of interest rate (rate of
return) and time value of money to determine
different amounts of money at different points
in time that are economically equivalent.
How It works: Use rate i and time t in
upcoming relations to move money (values of
P, F and A) between time points t = 0, 1, …, n
to make them equivalent (not equal) at the
rate i
Equivalence

Since Plan 1, like Plan 2, repays a present sum of


$5000 with interest at 8%, the plans are
equivalent to $5000 now; therefore, the
alternatives are equally attractive. This cannot
be deduced from the given cash flows alone. It is
necessary to learn this by determining the
equivalent values for each alternative at some
point in time, which in this case is "the present."
Repaying a Debt
Repaying a Debt
Equivalence
EQUIVALENCE is Dependent
on INTEREST RATE
Repaying a Debt

5450 1000
4360 1000
3270 1000
2180 1000
1090 1000
THANK YOU!

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