Ans 1.

Compounding and Discounting effects are critical in understanding the

concept of Time value of money. It states that money in hand today is more valuable
than an identical amount of money received in the future.

Compounding effect takes place when interest paid on the investment during the first
period is added to the principal and during the second period interest is earned on
the original principal plus the interest earned during the first period. The annual rate
of compound interest is often called as nominal annual rate and is represented by the
following equation:

i = j / k, where

i = periodic rate of compound interest

j = annual rate of compound interest
k = number if times interest is compounded each year

From the equation, it can be inferred that the greater the number of periods in a year,
more will be the compounding effect and greater will be the annual interest rate.
Compounding effect also helps us identify future value of an investment by adding
the initial investment and the compounded interest earned on it. This is represented
by the equation:

FV = PVn / (1+i) n, where

FV = future value of an investment adding up the compounded interest

PV = present value of the investment
n = number of compounding periods
i = periodic rate of compound interest

Discounting on the other hand, is a process of converting a future value to its present
value. The discount rate is the rate of compound interest when it is used to convert
future value to its present value. In the equation above, the factor 1/ (1+i) n is known
as the discounting factor as its coverts a particular future sum of money to its present
value.

In Conclusion, compounding finds the future value of a present value using a

compound interest rate. Discounting finds the present value of some future value,
using a discount rate. They are inverse relationships. This is perhaps best illustrated
by demonstrating that a present value of some future sum is the amount which, if
compounded using the same interest rate and time period, results in a future value of
the very same amount.
Ans 2. The data given in the problem is as follows:
N = 2 years
PV = $5,000
I = 12%
FV =?

a. Interest is compounded annually, thus

N= 2
PV = $5,000
I = 12%
FV = $6,272 (from the excel sheet)
Thus, the total interest paid to the borrower is $1,272 at the end of 2 years.

b. Interest is compounded monthly, thus

N = 2* 12 = 24 months
PV = $5,000
I = 12%/12 = 1% per month
FV = $6,348.67 (from the excel sheet)
Thus, the total interest paid to the borrower is $1,348.67 at the end of 2 years.

Comparing the results for part (a) and (b), by compounding the interest rate from
yearly to monthly, an additional sum of $76.67 is payable to the borrower.
Ans 3. The nominal interest rate is used to specify how interest is computed. For
example, if a rate (j) is compounded (m) times per annum, it means that the interest
is compounded at a rate (i) per period. Thus, per period rate (i) is relevant for
computing purpose.

As seen in the above problem (Ans. 2), as the number of compounding periods
increases, the compounded interest rate per annum also increase and thus the
effective interest paid on the principal amount. This raises the concept of ‘true’
interest rate that considers the compounding effect within a given year.

The ‘true’ interest rate also called as the effective annual rate is equated as:

EAR = (1+i) m – 1, where

EAR = effective annual rate
i = period interest rate
m = number of compounding periods in a year

In the problem above (Ans. 2b), the true interest rate can be calculated as:
EAR = (1+0.01) 12 – 1
= (1.01) 12 – 1
= 1.1268 – 1
= 12.68 %

Thus, the nominal interest rate for both scenarios in the above problem is the same
at 12 % per annum. However, due to monthly compounding effect in scenario (b), the
‘true’ rate of interest increase to 12.68%.

The main role of the effective interest rate is to make interest rates comparable on a
common scale. For example, you are given two quoted interest rates, one at 12%
compounded annually and the other at 12% compounded monthly. These rates of
12% appear identical. However, as these rates are not compounded the same
number of times per year, there is a difference of 0.68% between the two. Therefore,
to make interest rates comparable, it is necessary to convert them to a common
basis into an effective annual interest rate.
Ans 4. An annuity is a series of equal payments for a specified number of periods. It
can also be used to calculate overall future or present value by adding up the
individual annuity values. However, with increase in the number of period, this
calculation becomes difficult.

Ordinary annuity is a series of equal payments made at the end of each period. Most
annuities are ordinary annuities. Instalment loans and coupon bearing bonds are
examples of ordinary annuities. While calculating future value of an annuity
investment, the interest is not added until the 2nd period as the annuity is paid at the
end of the 1st period. In the case of loan amortisation, the interest is charged for the
whole principal amount in the first period as the repayment occurs at the end of the
period. To calculate the future and present value of ordinary annuity, we can use the
following equations:

FVn = PMT * ((1+i)n – 1) / i)

PVn = PMT * (1 – (1+i)-n) / i, where

FV = Future value
PV = Present value
PMT = periodic annuity
n= number of periods
i = period interest rate

In contrast, an annuity due has cash flows payments that occur at the beginning of
each period. Rent payments, which are typically due on the day commencing with the
rental period, are an example of an annuity-due. In effect, annuity due is like an
ordinary annuity except for the first payment being shifted back one period.

A more simplistic way of expressing the distinction is to say that payments made
under an ordinary annuity occur at the end of the period while payments made under
an annuity due occur at the beginning of the period. To calculate the present value of
annuity due, we can use the following equation:

PVdue = PMT * (1 + (1 – (1+i)-(n-1)) / i, where

PV = Present value
PMT = periodic annuity
n= number of periods
i = period interest rate

In conclusion, each payment of an ordinary annuity belongs to the payment period

preceding its date, while the payment of an annuity-due refers to a payment period
following its date.
Ans 5. The data given in the problem is as follows:

The borrowed amount, Present Value = $300,000

Duration of Loan, Period = 25 years
Interest rate = 8% and 10%
Annual commitment, PMT =?

a. Considering the interest rate at 8% p.a.

The annual commitment of the borrower, PMT = $28,103.63 (from the excel sheet)

b. Considering the interest rate being increased to 10% p.a.

The annual commitment of the borrower, PMT = $33,050.42 (from the excel sheet)

Comparing the above result, the increase in interest rate would increase the annual
interest paid on the borrowed loan amount and thus would increase the annual
commitment. The annual commitments of a typical borrower would increase by
$4,946.79 every year.