Tarheel Consultancy Services

Corporate Training and Consulting

1
 Interest Rates
&
The Time Value of Money

2
Interest Rates

3
 Introduction
• All of us have either paid and/or received
interest at some point of time.
– Those of us who have taken loans have paid
interest to the lending institutions.
– Those of us who have invested have received
interest from the borrowers.

4
 Introduction (Cont…)
• Types of Loans
– Educational Loans

– Housing Loans

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 Introduction (Cont…)
– Automobile Loans

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 Introduction (Cont…)
• Investments
– Savings accounts, and
– Fixed deposits (Time deposits) with banks

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 Introduction (Cont…)
– Bonds & Debentures

8
 Introduction (Cont…)
• Definition of interest
– Compensation paid by the borrower of capital
to the lender
• For permitting him to use his funds
• An economist’s definition
– Rent paid by the borrower of capital to the
lender
• To compensate for the loss of opportunity to use
the funds when it is on loan

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 Introduction (Cont…)
• Concept of rent
– When we decide not to live in an
apartment/house owned by us
• We let it out to a tenant
– The tenant pays a monthly rental
• Because as long as he is occupying our property
we are deprived of an opportunity to use it

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 Introduction (Cont…)
– The same concept applies to a loan of funds
• The difference is
– Compensation in the case of property is called RENT
– Compensation in the case of capital is called INTEREST

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 The Real Rate of Interest
• In a free market
– Interest rates are determined by
• Demand for capital
– And
• The supply of capital

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 The Real Rate (Cont…)
• One of the key determinants of Interest is
– The Pure rate of interest a.k.a
– The Real rate of interest

13
 The Real Rate (Cont…)
• Definition of the Real rate:
– The rate of interest that would prevail on a risk-less
investment in the absence of inflation.
• Example of a risk-less investment
– Loan to the Federal/Central government
• Such loans are risk-less because there is no risk
of default
– The central government of a country is the only
institution authorized to print money

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 The Real Rate (Cont…)
• But they say that certain governments (in
Latin America etc.) have defaulted on debt
– Yes they have defaulted on dollar
denominated debt
• The government of Argentina for instance can print
its own currency but not U.S. dollars

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 The Real Rate Illustrated
• The price of a banana is Rs 1

• Assume that the price of a banana next year

will also be Rs 1
– That is, there is no inflation
• In other words there is no erosion in the purchasing power
of money

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 Illustration (Cont…)
• Take the case of a person who lends
Rs 10 to the Government of India (GOI)
– Obviously there is no fear of non-payment
• If the GOI pays back Rs 11 after one year
– The amount will be sufficient to buy 11
bananas.

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 Illustration (Cont…)
• In this case a loan of Rs 10 has been
returned with 10% interest in money terms
• Since the investor is in a position to buy
10% more in terms of bananas
– The return on investment in terms of the
ability to buy goods is also 10%
– The rate of interest as measured by the ability
to buy goods and services is termed as
• THE REAL RATE of INTEREST
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 The Real Rate (Cont…)
• In the real world price levels are not
constant.
– Erosion in the purchasing power of money is a
fact of life
• This is termed as inflation

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 The Real Rate (Cont…)
• Most people who invest do so by acquiring
financial assets such as
– Shares of stock
– Shares of a mutual fund
– Or bonds/debentures
• Many also keep deposits with commercial
banks

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 The Real Rate (Cont…)
• Financial assets give returns in terms of
money
– Without any assurance about the investor’s
ability to acquire goods and services at the
time of repayment.
• Financial assets therefore give a
NOMINAL or MONEY rate of return.
– In the example, the GOI gave a 10% return on
an investment of Rs 10.
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 The Real Rate (Cont…)
• In the example the 10% money rate of
return was adequate to buy 10% more in
terms of bananas.
– This was because we assumed that the price
of a banana would remain fixed at Rs 1.

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 The Real Rate (Cont…)
• But what if the price of a banana after a year is
Rs 1.05.
– Rs 11 can then acquire only

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 The Real Rate (Cont…)
• In this case the nominal rate of return is 10%
• But our ability to buy goods has been enhanced
only by 4.80%
– Thus the REAL rate of return is only 4.80%
• The relationship between the nominal and real
rates of return is called the FISHER hypothesis
– Because it was first postulated by Irving Fisher.

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 The Fisher Equation
• Consider a hypothetical economy
– It consists of one good – say BANANAS
• The current price of a banana is Rs P0
– So Rs 1 can buy bananas.

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 The Fisher Equation (Cont…)
• Assume that the price of a banana next period
is P1.
– P1 is known with certainty today but need not be
equal to P0
– In other words although we are allowing for
inflation, we are assuming that there is no
uncertainty regarding the rate of inflation.
– So one rupee will be adequate to buy

bananas after one period

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 The Fisher Equation (Cont…)
• Assume that the economy has two types
of bonds available
– We have FINANCIAL bonds and GOODS
bonds
– If we invest Rs 1 in a Financial bond, we will
get Rs (1+R) after one period.
– If we invest 1 banana in a Goods bond we will
get (1+r) bananas after one period.

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 The Fisher Equation (Cont…)
• Rs 1 in a Financial bond → Rs (1+R)→

Rs 1 in a goods bond → bananas →

bananas after one period.

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 The Fisher Equation (Cont…)
• In order for the economy to be in equilibrium
both the bonds must yield identical returns.
• Therefore it must be true that:

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 The Fisher Equation (Cont…)
• Let us denote inflation or the rate of change in
the price level by π

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 The Fisher Equation (Cont…)
• This is the Fisher equation.
– R or the rate of return on a financial bond is
the nominal rate of return
– r or the rate of return on a goods bond is the
real rate of return

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 The Fisher Equation (Cont…)
• If r and π are very small, then the product
of the two will be much smaller.
– For instance if r = 0.03 and π = 0.03, the
product is 0.0009
• If we ignore the product we can rewrite the
expression as
R=r+π
• This is the approximate Fisher equation.
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 Uncertainty
• Thus far we have assumed that the rate of
inflation is known with certainty.
– In real life inflation is uncertain
– Consequently it is a random variable
• In the case of random variables
– We do not know the exact outcome in advance
– All we know is the expected value of the variable
• Which is a probability weighted average of the values that
the variable can take.

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Uncertainty (Cont…)
Inflation Probability

2.50% 0.20

5.00% 0.20

7.50% 0.20

10.00% 0.20

12.50% 0.20
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 Uncertainty (Cont…)
• The expected value is given by

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 Uncertainty (Cont…)
• The Fisher equation can therefore be re-
written as
– R = r + E(π)
• Thus when inflation is uncertain
– The actual real rate that we will eventually get
is unpredictable and uncertain

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 Uncertainty (Cont…)
• Assume that the required real rate is
4.50%
• Since the expected inflation is 7.50%
– an investor will demand a nominal rate of
return of 12%

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 Uncertainty (Cont…)
• Once the nominal rate is fixed, it will not
vary
• But there is no guarantee that the realized
rate of inflation will equal the expected
rate
– In this case if the realized inflation is 9%, the
realized real rate will be only 3%

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 Uncertainty (Cont…)
• Thus in real life even a default free
security will not give an assured real rate.
– It will give an assured nominal rate
– But the real rate that is eventually obtained
will depend on the actual rate of inflation

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 Ex-ante versus Ex-post
• An economist will say that the ex-ante rate
of inflation need not equal the ex-post rate
– Ex-ante means anticipated or forecasted
value
– Ex-post connotes actual or realized value
• Obviously the ex-ante real rate of interest
need not equal the ex-post real rate

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 Uncertainty & Risk Aversion
• In the real world investors are characterized by
RISK AVERSION.
– This does not mean that they will not take risk
– What does it mean therefore?
• To induce an investor to take a greater level of risk he must
be offered a higher expected rate of return.

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 Risk Aversion (Cont…)
• Given a choice between two investments with
the same expected rate of return
– The investor will choose the less risky option
• In the case of inflation
– The investor will not accept the expected inflation as
compensation
• Why?
– The actual inflation could be higher than anticipated
• Which implies that the actual real rate could be lower than
anticipated.

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 Risk Aversion (Cont…)
• To tolerate the inflation risk
– The investor will demand a POSITIVE risk
premium
• That is, compensation over and above the
expected rate of inflation
• The Fisher equation may be restated as
– R = r + E(π) + R.P.
– Where R.P is the risk premium

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 Risk Aversion (Cont…)
• Does the provision of a risk premium
guarantee that the
ex-ante real rate = ex-post real rate
• NO!
• Suppose the required real rate is 4.5%,
that E(π) = 7.5%, and that R.P = 1.5%
– Then the required nominal rate will be 13.50%

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 Risk Aversion (Cont…)
• In the absence of a risk premium
– A rate of inflation > 7.5% implies a realized real rate <
4.5%
• But when a risk premium is factored in
– A rate of inflation > 9% implies a realized real rate <
4.5%
• So the risk premium provides a bigger cushion
against inflation
– But it does not guarantee a minimum ex-post real rate

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 Other Determinants
• Besides
– the required real rate
– the expected inflation
– and the inflation risk premium
the following factors impact the required
nominal rate
• Length of the investment
• Credit Risk
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 Length of the Investment
• Lender like to lend short term
• Borrowers like to borrow long-term
• So how do we induce a lender to lend for
a longer period
– Offer a HIGHER nominal rate of return

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Typical Interest Rate Schedule in a
Bank
Period of Investment Interest Rate

< 1 year 7.50%

More than 1 year but < 8.00%

2years
More than 2 years but < 8.50%
3 years
More than 3 years but < 9.00%
5 years
More than 5 years 9.25% 48
 Credit Risk
• We have focused on default free
investments
– Loans to a Central Government
• In reality most investments are fraught
with risk
– Interest may not be paid
– Principal may not be repaid

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 Credit Risk (Cont…)
• This is called credit risk
– Applies to all investments except Central
government securities
• There is a difference between inflation risk
and credit risk
– Inflation is an economy wide phenomenon
– Credit risk however varies from borrower to
borrower

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 Credit Risk (Cont…)
• Because of credit risk
– The rate of return demanded by a lender will vary
from borrower to borrower
• Which is why
– For a given real rate
– For a given tenor of the loan
– For a given rate of inflation
a bank will charge different rates of interest on
loans made to different borrowers.

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Simple Interest & Compound
Interest

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 Measurement Period
• The unit in which time is measured is
called the Measurement Period
– The most common measurement period is
One Year.

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 Interest Conversion Period
• The unit of time over which interest is paid
once and is reinvested to earn additional
interest is called
– The Interest Conversion Period
• The interest conversion period is typically
less than or equal to the measurement
period.

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 Nominal Rate of Interest
• The quoted rate of interest per
measurement period is called
– The NOMINAL rate of interest

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 Effective Rate of Interest
• The interest that a unit of currency
invested at the beginning of a
measurement period would have earned
by the end of the period is called
– The EFFECTIVE Rate of Interest

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 Effective Rate (Cont…)
• If the length of the interest conversion
period is equal to the measurement period
– The effective rate will be equal to the nominal
rate
• If the interest conversion period is shorter
than the measurement period
– The effective rate will be greater than the
nominal rate

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 Variables and Symbols
• P ≡ principal invested at the outset
• N ≡ # of measurement periods for which
the investment is being made
• r ≡ nominal rate of interest per
measurement period
• i ≡ effective rate of interest per
measurement period
• m ≡ # of interest conversion periods per
measurement period
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 Simple Interest
• Consider an investment of Rs P for N
periods.
• According to this principle
– Interest earned every period is a constant
– That is, every period interest is computed and
credited only on the original principal
– No interest is payable on any interest that has
been accumulated at an intermediate stage

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 Simple Interest (Cont…)
• If r is the nominal rate of interest
– P → P(1+r) after one period→P(1+2r) after 2
periods →P(1+rN) after N periods
• So every period interest is paid only on the
original principal
• N need not be an integer
– Investments can be made for fractional
periods

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 Illustration-1
• Caroline has deposited Rs 10,000 with
Corporation Bank for 3 years
• The bank pays simple interest at the rate
of 10% per annum
• 10,000 will become 10000x1.1 = 11,000
after one year →10000x1.1 + 1,000 =
12,000 after two years → 13,000 after 3
years
• 13,000 = 10,000(1+ .10x 3) ≡P(1+rN)
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 Illustration-2
• Amit Gulati deposits Rs 10,000 with ICICI
Bank for 5 years and 6 months.
• Bank pays simple interest at 8% per
annum.
• Maturity value
= 10,000(1+.08x5.5) = Rs 14,400
– Notice: N need not be an integer

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 Compound Interest
• Consider an investment of Rs P for N
periods.
• Assume that the interest conversion
period is equal to the measurement
periods
– That is, the effective rate is equal to the
nominal rate

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 Compound Interest (Cont…)
• In the case of compound interest
– Every time interest is earned it is
automatically reinvested at the same rate for
the next conversion period.
– So interest earned every period is not a
constant
• It steadily increases
• P→P(1+r) after one period →P(1+r)2 after
two periods→P(1+r)N after N periods.
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 Illustration-3
• Caroline has deposited Rs 10,000 with
Corporation Bank
– Bank pays 10% per annum compounded
annually
• Rs 10,000→11,000 after one year→
11000x 1.1 = 12,100 after 2 years →
12,100x1.1= 13,310 after 3 years
– 13,310 = 10,000x (1.10)3

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 Illustration-4
• Gulati deposited Rs 10,000 with ICICI
Bank for 5 years and 6 months.
– Bank has been paying 8% compounded
annually
• P(1+r)N = 10,000(1.08)5.5 = Rs 15,269.71

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 Compound Interest (Cont…)
• Compounding yields greater benefits than
simple interest
– The larger the value of N the greater is the
impact of compounding
– Thus, the earlier one starts investing the
greater are the returns.

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 Illustration-5
• The East India Company came to India in 1600.
• Consider an investment of Rs 10 in 1600 with a
bank which pays 3% per annum compounded
annually.
– The balance in 2000 = 10x(1.10)400 =
Rs 1,364,237.18

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 Properties
• If N=1, that is, the investment is for one period,
both simple as well as compound interest will
give the same accumulated value.
• If N < 1, the accumulated value using simple
interest will be higher. That is:
– (1+rN) > (1+r)N if N < 1
• If N > 1, the accumulated value using compound
interest will be greater. That is:
– (1+rN) < (1+r)N if N > 1

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 Properties
• Simple interest is usually used for short-
term transactions – investments of one
year or less
– It is the norm for money market transactions
• For capital market securities – medium to
long term debt and equities – compound
interest is the norm.

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 Illustration-6
• Amit Gulati deposited Rs 10,000 with ICICI Bank
for 5 years and six months.
– The bank pays compound interest at 8% for the first 5
years and simple interest at 8% for the last six
months.
– 10,000(1+.08)5 = 14,693.28
– 14,693.28(1 + .08x.5) = Rs 15,281.01
– On the other hand 10000(1.1)5.5 = 15,269.71
• The difference is because for the last six months simple
interest yields more than compound interest.

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Effective versus Nominal Rates
• ICICI Bank is quoting 9% per annum
compounded annually
• HDFC Bank is quoting 8.75% per annum
compounded quarterly
• In the case of ICICI
– The nominal rate is 9% per annum
– The effective rate is also 9% per annum
• In the case of HDFC
– The nominal rate is 9%
– The effective rate is obviously higher

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 Effective…(Cont…)
• 8.75% per annum ≡ 2.1875% per quarter
– So a deposit of Rs 1→(1.021875)4 = 1.090413
• So the effective rate offered by HDFC is
9.0413% per annum
• Thus when the frequencies of
compounding are different
– Comparisons between alternative investments
should be based on effective rates and not
nominal rates

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 Effective (Cont…)
• The nominal rate is r% per annum
• Interest is compounded m times per annum
• The effective rate is:

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 Effective…(Cont…)
• We can also derive the equivalent nominal rate
if the effective rate is given

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 Illustration-7
• HDFC Bank is paying 10% compounded
quarterly.
– If Rs 10,000 is deposited for a year what will be the
terminal amount
– The terminal value will be

The effective annual rate is 10.38%

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 Illustration-8
• Suppose HDC Bank wants to offer an effective
annual rate of 10% with quarterly compounding
– What should be the quoted nominal rate

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 Equivalency
• Two nominal rates compounded at
different time intervals are said to be
Equivalent if the same principal invested
for the same length of time produces the
same accumulated value in either case.
– In other words two nominal rates
compounded at different intervals are
equivalent if they yield the same effective rate

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 Equivalency (Cont…)
• ICICI Bank is offering 9% per annum with semi-
annual compounding.
• What should be the equivalent rate offered by
HDFC Bank if it intends to compound quarterly.

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 Equivalency (Cont…)
• The issue is, what will be the nominal rate that
will give an effective annual rate of 9.2025% with
quarterly compounding

Thus 9% with semi-annual compounding is equivalent to

8.90% with quarterly compounding.

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 Continuous Compounding
• Consider Rs P that is invested for N periods at
r% per period.
• If interest is compounded m times per period,
the terminal value will be

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Continuous Compounding (Cont…)
• What about the limit as m→∞

This is the case of continuous compounding.

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 Illustration-9
• Narasimha Rao has deposited Rs 10,000 with
Corporation Bank for 5 years at 10% per
annum compounded continuously.
• The final balance is:

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 Illustration-10
• Canara Bank is quoting 10% per annum
with quarterly compounding.
• What should be the equivalent rate with
continuous compounding?
• Two nominal rates are equivalent if they
give the same effective annual rate.
• Let r be the nominal rate with quarterly
compounding, and k the nominal rate with
continuous compounding.
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Illustration-10 (Cont…)

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 Illustration-10 (Cont…)
• In this case:

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 The Limit
• Continuous compounding is the limit as
we go from
– Annual
• To semi-annual
– Quarterly
» Monthly
» Daily
» And shorter intervals

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 Illustration-11
• Sangeeta has deposited Rs 100 with ICICI
Bank.
• The interest rate is 10% per annum.
• What will be the terminal balance under the
following scenarios:
– Annual compounding
• Semi-annual compounding
– Quarterly compounding
» Monthly compounding
» Daily compounding
» Continuous compounding
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 Illustration-11 (Cont…)
Frequency of Terminal Balance
Compounding
Annual Rs 110.0000
Semi-annual Rs 110.2500
Quarterly Rs 110.3813
Monthly Rs 110.4713
Daily Rs 110.5156
Continuously Rs 110.5171
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 Future Value
• When an amount is deposited for a time period
at a given rate of interest
– The amount that is accrued at the end is called the
future value of the original investment
– So if Rs P is invested for N periods at r% per period

90
 FVIF
• (1+r)N is the amount to which an investment of
Rs 1 will grow at the end of N periods.
• It is called FVIF – Future Value Interest Factor.
– It is a function of r and N.
– It is given in the form of tables for integer values of r
and N
– If the FVIF is known, the future value of any principal
can be found by multiplying the principal by the factor.
– The process of finding the future value is called
Compounding.

91
 Illustration-12
• Suhasini has deposited Rs 10,000 for 5 years at
10% compounded annually.
• What is the Future Value?

Thus F.V. = 10,000 x 1.6105 = Rs 16,105

92
 Illustration-13
• Swapna has deposited Rs 10,000 for 4 years at
10% per annum compounded semi-annually.
• What is the Future Value?
– 10% for 4 years is equivalent to 5% for 8 half-years

Thus F.V. = 10,000 x 1.4775 = Rs 14,775

93
 Illustration-14
• GIC has collected a one time premium of
Rs 10,000 from Suhasini and has
promised to pay her Rs 23,000 after 10
years.
• The company is in a position to invest the
premium at 10% compounded annually.
• Can it meet its obligation?

94
 Illustration-14 (Cont…)
• The future value of Rs 10,000 =
10,000 x 2.5937 = Rs 25,937
• This is greater than the liability of
Rs 23,000
• So GIC can meet its commitment

95
 Illustration-15
• Syndicate Bank is offering the following
scheme
– An investor has to deposit Rs 10,000 for 10
years
– Interest for the first 5 years is 10%
compounded annually
– Interest for the next 5 years is 12%
compounded annually
– What is the Future Value?
96
 Illustration-15 (Cont…)
• The first step is to calculate the future value
after 5 years:

The next step is to treat this as the principal and compute its
terminal value after another 5 years.

97
 Present Value
• When we compute the future value we
seek to determine the terminal value of an
investment that has earned a given rate of
interest for a specified period.
• Now consider the issue from a different
angle?
– If we want a specified terminal value, how
much should we invest at the outset, if the
interest rate is r% and the number of periods
is N.
98
 Present Value (Cont…)
• So instead of computing the terminal value
of a principal we seek to compute the
principal that corresponds to a given
terminal value.
• The principal amount that we compute is
called the Present Value of the terminal
amount.

99
 The Case of Simple Interest
• An investment yields Rs F after N periods.
• If the interest rate is r%, what is the present
value?
• We know that:
F = P.V.x(1+rN)
So obviously

100
 Illustration-16
• Venkatachalam wants to ensure that he has
saved Rs 12,000 after 4 years.
– So he deposits Rs P with a bank
– If the bank pays 5% per annum on a simple interest
basis, what should be P?

101
The Case of Compound Interest
• An investment pays r% per period on a
compound interest basis.
• If we want Rs F after N periods, how much
should we deposit today?

102
 Illustration-17
• Priyanka wants to ensure that she has
Rs 15,000 after 3 years.
• The bank pays 10% compounded annually
• How much should she deposit?

103
 PVIF
• 1/ (1+r)N is the amount that has to be deposited
to yield Rs 1 after N periods if the periodic
interest rate is r%
– It is called the Present Value Interest Factor (PVIF)
– It is a function of r and N
– It is given in the form of tables for integer values of r
and N
– If we know the factor, we can find the present value of
any terminal amount by multiplying the two.
– The process of finding the principal value of a terminal
amount is called Discounting
– PVIF is the reciprocal of FVIF

104
 The Additivity Principle
• Suppose you want to find the present or future
value of a series of cash flows, where the rate of
interest is r%, and the last cash flow is received
after N periods.
• You have to simply find the present or the future
value of each cash flow and add up the terms to
compute the present or future value of the
series.
• Thus Present and Future Values are additive.

105
 Illustration-18
• Consider the following vector of cash
flows.
• The interest rate is 10% compounded
annually.
YEAR Cash Flow
1 2,500
2 4,000
3 5,000
4 7,500
106
5 10,000
Illustration-18 (Cont…)

107
 Illustration-18 (Cont…)
• The relationship between the present and future
values is given by
FV = PV(1+r)N
• In this case

108
 The Internal Rate of Return
• Suppose that we are told that an investment of
Rs 18,000 will entitle us to the following vector of
cash flows.
– The question is what is the rate of return?

109
 The IRR (Cont…)
• The rate of return is the solution to the following
equation:

110
 The IRR (Cont…)
• The solution to this equation is called the
Internal Rate of Return (IRR)
• It can be obtained using the IRR function
in EXCEL.
– In this case, the solution is 14.5189%

111
 Effective Rates
• Suppose we are asked to calculate the present
or future values of a series of cash flows arising
every six months.
• And we are given an annual rate of interest
without specifying the compounding frequency.
– The normal practice is to divide the interest rate by 2
to determine the periodic interest rate
– That is, the quoted rate is treated as a nominal rate
and not as an effective rate

112
 Illustration-19
• Consider the following vector of cash flows.
• Assume that the annual interest rate is given as
10%.

113
 Illustration-19 (Cont…)
• The Present Value will be calculated as:

•Similarly the future value will be

114
 Illustration-19 (Cont…)
• But what if it is explicitly stated that the effective
annual rate is10%?
– Then the calculations will change

•And the future value is given by

115
 Effective Rates (Cont…)
• The present value is greater when we use
an effective annual rate of 10% for
discounting.
– This is because the lower the discount rate
the higher will be the present value
– And an effective rate of 10% per annum is
lower than a nominal rate of 10% with semi-
annual compounding.
– By the same logic the future value is lower
when we use an effective annual rate of 10%
116
 Evaluating an Investment
• Kotak Mahindra is offering an instrument
that will pay Rs 10,000 after 5 years.
• The price that is quoted is Rs 5,000.
• If the investor wants a 10% rate of return,
should he invest.
• The problem can be approached in three
ways.

117
 The Future Value Approach
• Assume that the instrument is bought for
5,000.
• If the rate of return is 10% the future value
is
5,000 x 1.6105 = Rs 8,052.50
• Since the instrument promises a terminal
value of Rs 10,000 which is greater than
the required future value, the investment is
attractive.
118
 The Present Value Approach
• The present value of Rs 10,000 using a discount
rate of 10% is
10,000 x 0.6209 = Rs 6,209
• So if Rs 6,209 is paid at the outset the rate of
return will be 10%
• If we pay more at the outset, the rate of return
will be lower and vice versa.
• In this case the investment of Rs 5,000 is less
than Rs 6,209
• So the investment is attractive
119
 The Rate of Return Approach
• Suppose you invest Rs 5,000 and receive
Rs 10,000 after 5 years.
• What is the rate of return?
• It is given by:

120
 The Rate…(Cont…)
• The solution is 14.87%
• Since the actual rate of return is greater
than the required rate of 10%, the
investment is attractive.

121
Annuities

122
 Annuities (Cont…)
• What is an annuity?
– It is a series of identical payments made at
equally spaced intervals of time
• Examples
– House rent till it is revised
– Salary till it is revised
– Insurance premia
– EMIs on housing/automobile loans

123
 Annuities (Cont…)
• In the case of an ordinary annuity
– The first payment is made one period from now

124
 Annuities (Cont…)
• The interval between successive
payments is called the
– PAYMENT Period
• We will assume that the payment period is
the same as the interest conversion period
– That is, if the annuity pays annually, we will
assume annual compounding
– If it pays semi-annually we will assume semi-
annual compounding

125
Present Value

126
Present Value (Cont…)

127
Present Value (Cont…)

128
 Present Value (Cont…)

Is called the Present Value Interest Factor Annuity (PVIFA)

It is the present value of an annuity that pays Rs 1 per period
The present value of annuity that pays a periodic cash flow of
Rs A can be found by multiplying A by PVIFA. 129
 Illustration-20
• Apex Corporation is offering an instrument
that will pay Rs 1,000 per year for 20
years, beginning one year from now.
• If the rate of interest is 5%, what is the
present value?
– 1,000xPVIFA(5,20) = 1,000 x 12.4622
= Rs 12,462.20

130
Future Value

131
Future Value (Cont…)

132
 Future Value (Cont…)

Is called the Future Value Interest Factor Annuity (FVIFA)

It is the future value of annuity that pays Rs 1 per period.
For any annuity that pays Rs A per period, the future value
can be found by multiplying A by the factor.
133
 Illustration-21
• Pooja expects to receive Rs 10,000 per
year for the next 5 years, starting one year
from now.
• If the cash flows can be invested at 10%
per annum what is the Future Value?
– F.V. = 10,000 x FVIFA(10,5) = 10,000 x
6.1051 = Rs. 61,051

134
Relationship Between
PVIFA and FVIFA

135
 Annuity Due
• In the case of an Annuity Due, the cash flows
occur at the beginning of the period.

136
Present Value

137
Present Value (Cont…)

138
 Present Value (Cont…)
• The present value of an annuity due that makes
N payments is greater than that of an annuity
that makes N payments
• Why?
– Because each cash flow has to be discounted for one
period less.
• Example of an annuity due?
– An insurance policy
• The first premium has to be paid as soon as the policy is
purchased.

139
 Illustration-22
• David has bought an LIC policy
• The annual premium is Rs 12,000 and he has to
make 25 payments.
• What is the present value if the discount rate is
10% per annum?

140
Future Value

141
 Future Value (Cont…)
• The future value of an annuity due that
makes N payments, is greater than that of
a corresponding annuity, if the future value
is computed at the end of N periods.
• Why?
– Because each cash flow has to be computed
for one period more.

142
 Illustration-23
• If David takes an LIC policy with a premium of
Rs 12,000 per year for 25 years, what is the
cash value at the end of 25 years?

143
 Perpetuities
• An annuity that pays forever is called a
PERPETUIY.
• The future value of a perpetuity is
obviously infinite.
• But a perpetuity has a finite present value.

144
Perpetuities (Cont…)

145
 Illustration-24
• A financial instrument promises to pay
Rs 1000 per year forever.
• If the investor requires a 20% rate of return, how
much should he be willing to pay for it?

146
 Amortization
• The amortization process refers to the
process of repaying a loan by means of
equal installment payments at periodic
intervals.
• The installments obviously form an
annuity.
– The present value of the annuity is the loan
amount.

147
 Amortization (Cont…)
• Each installment consists of
– Partial repayment of principal
– And payment of interest on the outstanding
balance
• An amortization schedule shows the
division of each payment into a principal
component and interest component,
together with the outstanding loan balance
after the payment is made.

148
 Amortization (Cont…)
• Consider a loan which is repaid in N installments
of Rs A each.
• The original loan amount is Rs L, and the periodic
interest rate is r.

149
Amortization (Cont…)

150
Amortization (Cont…)

151
Amortization (Cont…)

152
Amortization (Cont…)

153
 Illustration-25
• Srividya has borrowed Rs 10,000 from
Syndicate Bank and has to pay it back in five
equal annual installments.
• The interest rate is 10% per annum on the
outstanding balance.
• What is the installment amount?

154
Amortization Schedule

155
 Analysis
• At time 0, the outstanding principal is 10,000
• After one period an installment of Rs 2,637.97 is made.
– The interest due for the first period is 10% of 10,000 or Rs 1,000
– So the excess payment of Rs 1,637.97 is a partial repayment of
principal.
– After the payment the outstanding principal is Rs 8,362.03
– After another period a second installment is paid.
– The interest for this period is 10% of 8,362.03 which is
Rs 836.20.
– The balance of Rs 1,801.77 constitutes a partial repayment of
principal.

156
 Analysis (Cont…)
• The value of the outstanding balance at
the end should be zero.
• After each payment the outstanding
principal keeps declining.
• Since the installment is constant
– The interest component steadily declines
– While the principal component steadily
increases

157
 Amortization with a Balloon
Payment
• Uttara has taken a loan of Rs 100,000
from ICICI Bank.
• She has to pay in 5 equal annual
installments along with a terminal payment
of Rs 25,000
• The terminal payment which has to be
made over and above the scheduled
installment in year 5
– Is called a BALLOON payment.

158
 Balloon (Cont…)
• If the interest rate is 10% per annum, the annual
installment may be calculated as

Obviously, the larger the balloon the smaller will be the periodic
installment for a given loan amount. 159
Amortization Schedule

160
 Types of Interest Computation
• Financial institutions employ a variety of
different techniques to calculate the
interest on the loans made by them.
• The interest that is effectively paid on the
loan may be very different from the rate
that is quoted.
– THUS WHAT YOU SEE IS NOT WHAT YOU
ALWAYS GET

161
 The Simple Interest Method
• In this technique, interest is charged for
only the period of time that a borrower has
actually used the funds.
– Each time principal is partly repaid, the
interest due will decrease.

162
 Illustration
• Alfred has borrowed $5,000 from the bank
for a year.
• The bank charges simple interest at the
rate of 8% per annum.
• If the loan is repaid at the end of one year:
– Interest payable = 5000x0.08 = 400
– Total amount repayable = 5,400

163
 Illustration (Cont…)
• Assume the loan is repaid in two equal
semi-annual installments.
– After six months principal of $2,500 is repaid.
– Interest will however be charged on 5,000.
– Amount repayable = 2500 + 5000x0.08x.5
= 2700

164
 Illustration (Cont…)
• For the next six months interest will be
charged only on $2,500.
– The amount payable at the end of the second
six-monthly period
= 2500 + 2500x0.08x.5 = $2,600
– Total outflow on account of principal plus
interest = 2700 + 2600 = 5300
– Obviously the more frequently the principal is
repaid the lower is the interest.

165
 The Add-on Rate Approach
• In this case interest is first calculated on the full
principal.
• The sum of interest plus principal is then divided
by the total number of payments in order to
determine the amount of each payment.
• In Alfred’s case if he repays in one annual
installment, there will be no difference with this
approach as compared to the simple interest
approach.

166
 Add-on…(Cont…)
• What if he repays in two installments?
– Interest for the entire year = 400
– This will be added to the principal and divided
by 2.
– Thus each installment = (5000 + 400)
____________
2
= 2700

167
 Add-on…(Cont…)
• The quoted rate is 8% per
annum.
• But the actual rate will be higher.
• The actual rate is given by

168
 Add-on (Cont…)
• The solution is i = 10.5758%
– This is of course the nominal annual rate.
– The effective annual rate is 10.8554%

169
 The Discount Method
• In this approach the total interest is first
computed on the entire loan amount.
• This is then deducted from the loan
amount.
• The balance is lent to the borrower.

170
 Illustration
• Alfred borrows 5000 at 8% for a year.
• The interest for the year is 400.
• So Alfred will be given 4600 and will have to
repay 5000 at the end.
• The effective rate of interest
= (5000 – 4600)
___________ x 100 = 8.6957%
4600

171
 Discount Loan (Cont…)
• Such loans usually do not require
installments and are settled in one lump
sum at the end.

172
 Compensating Balances
• Many banks require that borrowers keep a
certain percentage of the loan amount with
them as a deposit.
• This is called a Compensating Balance.
• It raises the effective interest rate
– Since the borrower cannot use the entire
amount that is sanctioned

173
 Illustration
• Alfred is sanctioned $ 5,000 at the rate of
8%.
• But he has to keep 10% of the loan
amount with the bank for the duration of
the loan.
• So while he pays an interest of $400, the
usable amount is only
5000x0.9 = $ 4,500

174
 Illustration (Cont…)
• The effective interest cost is
400
________ x 100 = 8.8889%
4500
• Quite obviously
– The higher the compensating balance, the
greater will be the effective interest rate.

175
Annual Percentage Rate (APR)
• The effective rate of interest that is paid by
a borrower is a function of the type of loan
that is offered to him.
• Since different lenders used different loan
structures, comparisons between
competing loan offers can be difficult.

176
 APR (Cont…)
• To ensure uniformity the U.S. Congress
passed the
– Consumer Credit Protection Act
– This is commonly known as
• The Truth-in-Lending Act
• The law requires institutions extending
credit to use a prescribed method for
computing the quoted rate.

177
 APR (Cont…)
• Every lending institution is required to
compute the APR and report it before the
loan agreement is signed.
• The most accurate way to compute the
APR is by equating the present value of
the repayments made by the borrower to
the loan amount.

178
 APR (Cont…)

• For the examples that we have

considered the precise APR would be:
Loan Type APR

Simple Interest-One Installment 8%

Simple Interest-Two Installments 7.90%

Add-on Method-Two Installments 10.5758%

Discount Method-One 8.6957%

Installment
Compensating Balance-One 8.8889%
Installment
179
 The Approximate APR
• There is a technique for calculating the
approximate APR known as the Constant-
Ratio method.
• The formula is:
APR = 2xNo. Of pmts. Per yr.xAnn.Int.Costx100
______________________________________
(Tot. No. of Loan Pmts. +1)xPrincipal Amount

180
The Approximate APR (Cont…)

Loan Type Approximate APR

Simple Interest-One 8%
Installment
Simple Interest-Two 8%
Installments
Add-on Method-Two 10.67%
Installments
Discount Method-One 8.6957%
Installment
Compensating Balance- 8.8889%
One Installment
181
 APR (Cont…)
• The approximate formula gives the exact
APR when the loan is repaid in one
installment per year.
• But it overstates the APR when loans are
repaid by way of multiple installments in a
year.

182