Time Value of Money

Gitman and Hennessey, Chapter 5

Spring 2004

Outline of the Lecture

• Future Value and Compounding

• Present Value and Discounting

• More on Present and Future Values

2
 Future Value and Compounding

Future value refers to the amount of money an investment would

grow to over some length of time at a given rate of interest.
To determine this value, it is important to know when interest is
calculated. Is it once a year? Every six months? Each month?
When many payments are involved, it is also important to know
the timing of these payments.

Future Value and Compounding

Investing for a Single Period

Suppose $100 is invested in an account that pays 10% per year.

This investment will then be worth

100 + 0.10 × 100 = (1 + 0.10) × 100

= 1.1 × 100
= $110

after one year.

4
 Future Value and Compounding

Investing for More than One Period

Suppose $100 is invested in an account that pays 10% per year.

After one year, this investment will be worth $110. If the interest
payment is reinvested, this investment will be worth, after two
years,

110 + 0.10 × 110 = 1.1 × 110

= 1.1 × 1.1 × 100
= (1.1)2 × 100 = $121.

5.1 Future Value and Compounding

Decomposing (1.1)2 × 100 gives us

¡ 2
¢
1.1 × 1.1 × 100 = 1 + .2 + .1 × 100
= 100 +
|{z} 20
|{z} + 1
|{z}
Capital Interest Interest
on capital on interest
⇓ ⇓
Simple Compound
interest interest

6
 Future Value and Compounding

More generally, $m invested at a period interest rate r will grow

to

(1 + r)t × m = m
|{z} + t|× {z
r × m} + Compound interest
Capital Simple
interest
after t periods.

Future Value and Compounding

Compound interest can be significant over the long run.

Take $100 invested for T years at 10% compounded annually:
Ending Simple Compound
T Amount Capital Interest Interest
1 110.00 = 100 + 10 + 0.00
5 161.05 = 100 + 50 + 11.05
10 259.37 = 100 + 100 + 59.37
15 417.72 = 100 + 150 + 167.72
20 672.75 = 100 + 200 + 372.75

8
 Future Value and Compounding

Examples of Future Value Calculations

1. $2,250 invested for 30 years at 18% compounded annually

gives
2, 250 × (1.18)30 = $322, 583.94.

2. $9,310 invested for 15 years at 6% compounded annually

gives
9, 310 × (1.06)15 = $22, 311.96.

Future Value and Compounding

One More Example

3. You are scheduled to receive $22,000 in two years. When

you receive it, you will invest it for six more years at 6
percent per year. How much will you have in eight years?
Answer:

22, 000 × (1.06)8−2 = 22, 000 × (1.06)6 = $31, 207.42.

10
 5.2 Present Value and Discounting

Present value refers to the amount of money that has to be

invested today to obtain a specific amount of money after a
specific length of time at a given rate of interest.
If, for example, we want to know how much to invest to obtain
$1 after one year at 10% interest, we need to solve
1
Present value × 1.1 = $1 ⇒ Present value = = $0.909.
1.1

11

Present Value and Discounting

More generally, the amount of money that needs to be invested

today to obtain $1 in t years at the annual rate of interest r is
1
PV = .
(1 + r)t
This amount is the present value, as of today, of $1 to be received
in t years discounted at the annual rate r.

12
 Present Value and Discounting

Examples of Present Value Calculations

1. The present value of $15,000 to be received in 5 years,

discounted at the annual rate 12%, is
15, 000
PV = = $8, 511.40.
(1.12)5

2. The present value of $25,000 to be received in 10 years,

discounted at the annual rate 8%, is
25, 000
PV = = $11, 579.84.
(1.08)10

13

5.3 More on Present and Future Values

With a period rate of interest r and a number of periods t, we can

define

Future value factor = (1 + r)t

1
Present value factor =
(1 + r)t

14
 More on Present and Future Values

Let PV0 denote the present value, as of today (date 0), of an

investment that will grow to the future value FVt in t periods, the
period interest rate being r. Then
FVt
PV0 × (1 + r)t = FVt and, equivalently PV0 = .
(1 + r)t
This result is the basic present value equation.

15

More on Present and Future Values

Determining the Discount Rate

What must r be for PV0 to grow to FVt in t periods?

PV0 × (1 + r)t = FVt

FVt
(1 + r)t =
PV0
µ ¶
FVt 1/t
1+r =
PV0
µ ¶
FVt 1/t
r = − 1.
PV0

16
 More on Present and Future Values

Example of Discount Rate Determination

You are offered an investment that requires you to put up
$12,000 today in exchange for $40,000 12 years from now. What
is the annual rate of return on the investment?
Answer: In this example, PV0 = 12, 000, FVt = 40, 000 and
t = 12. Therefore,
µ ¶
40, 000 1/12
r = − 1 = 10.55%.
12, 000

17

More on Present and Future Values

Finding the Number of Periods

What must t be for PV0 to grow to FVt at a rate r?
Note: We will be using the following rules:

ln (ab) = ln(a) + ln(b)

¡ b¢
ln a = b ln(a)
³a´
ln = ln(a) − ln(b).
b

18
Finding the Number of Periods

PV0 × (1 + r)t = FVt

¡ ¢
ln PV0 × (1 + r)t = ln (FVt )
¡ t
¢
ln (PV0 ) + ln (1 + r) = ln (FVt )
ln (PV0 ) + t ln(1 + r) = ln (FVt )
ln (FVt ) − ln (PV0 )
t =
ln(1 + r)
ln (FVt /PV0 )
t =
ln(1 + r)

19

How Long to Double Your Money?

Knowing r, how many periods is needed for PV0 to double?

ln (FVt /PV0 )
t =
ln(1 + r)
ln (2PV0 /PV0 )
=
ln(1 + r)
ln(2)
=
ln(1 + r)

20
 The Rule of 72

Note that

• when r is small, ln(1 + r) ≈ r (slightly below r);

• ln(2) = 0.6931 (slightly below 0.72).

A good approximation of the time it takes to double an

investment is
0.72 72
= .
r 100r
If r = 8%, PV0 will double in approximately 72/8 = 9 years.

21

The Rule of 72

ln(2) 72
r ln(1 + r) ln(1+r) 100r
2% 0.01980 35.00 36
4% 0.03922 17.67 18
6% 0.05827 11.90 12
8% 0.07696 9.01 9
10% 0.09531 7.27 7.2
12% 0.11333 6.12 6
14% 0.13103 5.29 5.14

22
 The Rule of 72

The rule of 72 holds exactly at around 7.85%.

The rule of 72 will

• overestimate the time it takes to double an investment when

r < 7.85%;

• underestimate the time it takes to double an investment when

r > 7.85%;

23

The Rule of 72

When r is small, the error will be insignificant.

The error is significant when using large numbers.
Take r = 72%, for instance. According to the rule of 72, an
investment doubles in approximately one year at this rate.
This makes no sense: it takes r = 100% to double an investment
in one year.

24
 Finding the Number of Periods: An Example

You are trying to save to buy a new $120,000 Ferrari. You have
$40,000 today that can be invested at 8% compounded annually.
How long will it take before you have enough money to buy the
car?
Answer:
ln(120, 000/40, 000) ln(3)
t = = = 14.27 years.
ln(1.08) ln(1.08)

25

Future and Present Values of Multiple Cash Flows

Future Value with Multiple Cash Flows

Suppose $100 is invested today and another $100 is invested in
one year at an annual rate of 8%. How much will this investment
be worth in two years?
0 1 2
-
×1.08 - Time
$100 $108
$100
×1.08 -
$208 $224.64

26
 Future Value with Multiple Cash Flows

The same example, put differently:

0 1 2
-
×1.08 - ×1.08 - Time
$100 $108 $116.64
×1.08 -
$100 $108.00
$224.64

That is,

FV = $100 × (1.08)2 + $100 × 1.08 = $224.64.

27

Future Value with Multiple Cash Flows

Suppose now that the two payments are made at the end of each
period. This gives us
0 1 2
-
×1.08 - Time
$100 $108
$100
$208

and thus, in this case

FV = $100 × 1.08 + $100 = $208.

28
 Future Value with Multiple Cash Flows

More generally, let

dt ≡ payment made in period t;
r ≡ period interets rate;
T ≡ the total number of periods.
Then

FV = (1 + r)T d0 + (1 + r)T −1 d1 + . . . + (1 + r)dT −1 + dT

T
= ∑ (1 + r)T −t dt .
t=0

29

An example with T = 4.
0 1 2 3 4

×(1 + r) ×(1 + r) ×(1 + r) ×(1 + r) - (1 + r)4 d0

d0
×(1 + r) ×(1 + r) ×(1 + r) - (1 + r)3 d1
d1
×(1 + r) ×(1 + r) - (1 + r)2 d2
d2
×(1 + r) - (1 + r)d3
d3

d4
4
∑ (1 + r)4−t dt
t=1

30
 Present Value with Multiple Cash Flows

What is the present value of $100 to be received one year from

now and another $100 to be received in two years, the annual rate
of interest being 8%?
0 1 2
-
$92.59 ¾×1/1.08 $100 Time

$85.73 ¾×1/1.08 ×1/1.08

$100
$178.32

That is,
$100 $100
PV = + = $178.32.
1.08 (1.08)2

31

Future Value with Multiple Cash Flows

More generally, let

dt ≡ payment made in period t;
r ≡ period interets rate;
T ≡ the total number of periods.
Then
d1 d2 dT
PV = d0 + + + . . . +
1+r (1 + r)2 (1 + r)T
T
dt
= ∑ (1 + r)t .
t=0

32
 A Note on Cash Flow Timing

Unless specified otherwise, cash flows are assumed to take place

at the end of each period.
A cash flow in year 2, for instance, means a cash flow to be
received two years from now, and thus at the end of the second
year.

33

A Note on Cash Flow Timing

If you are told that a three-year investment has a first-year cash

flow fo $100, a second-year cash flow of $200 and a third-year
cash flow of $300, then the timing of cash flows is as follows:
0 1 2 3
-
$100 $200 $300

34
 6.2 Valuing Level Cash Flows

A ordinary annuity is a series of constant, or level, cash flows that

occur at the end of each period for some fixed number of periods.
An annuity due is a series of constant, or level, cash flows that
occur at the beginning of each period for some fixed number of
periods.
A perpetuity is an annuity in which the cash flows continue
forever.

35

A Note on How to Value Level Cash Flows

Let
T
S = ∑ qt = q + q2 + q3 + . . . + qT −1 + qT .
t=1

Then
T
qS = q ∑ qt = q2 + q3 + q4 + . . . + qT + qT +1 ,
t=1

and thus, if q ≥ 0 and q 6= 1,

T +1 q − qT +1 q ¡ T
¢
S − qS = q − q ⇒ S = = 1−q .
1−q 1−q

36
 A Note on How to Value Level Cash Flows

If q = 1, then S = ∑t=1
T
qt = T .

What happens when T is arbitrarily large?


q ¡ ¢  q if 0 ≤ q < 1,
1−q
lim 1 − qT =
T →∞ 1 − q  ∞ if q > 1.

37

A Note on How to Value Level Cash Flows

Suppose that we have

µ ¶2 µ ¶3
1 1 1
S = + + .
1+r 1+r 1+r
1
Let q = 1+r , where r > 0 is a discount rate. Then
q ¡ ¢
S = q + q2 + q3 = 1 − q3 .
1−q

38
 A Note on How to Value Level Cash Flows

1
Replace q with in the last equation. This gives
1+r
à µ ¶3 !
1/(1 + r) 1
S = 1−
1 − 1/(1 + r) 1+r
à µ ¶3 !
1 1
= 1−
1+r−1 1+r
à µ ¶3 !
1 1
= 1−
r 1+r

39

A Note on How to Value Level Cash Flows

So if we have
T µ ¶t µ ¶2 µ ¶T
1 1 1 1
S = ∑ = + + ... + ,
t=1 1 + r 1 + r 1 + r 1 + r

then à µ ¶T !
1 1
S = 1− .
r 1+r

40
 Present Value of Annuity Cash Flows

Consider an ordinary annuity that pays $C each period for T

periods, the first payment being made one period from now.
What is the present value of this annuity if the period rate of
interest is r?

41

C C C C
PV = + + + . . . +
1+r (1 + r)2 (1 + r)3 (1 + r)T
à µ ¶2 µ ¶3 µ ¶T !
1 1 1 1
= C + + + ... +
1+r 1+r 1+r 1+r
à µ ¶T !
1 1
= C× 1−
r 1+r
à µ ¶T !
C 1
= 1−
r 1+r

42
 Present Value of Annuity Cash Flows

The term
¡ 1 T
¢
1− 1+r
r
is often referred to as the present value interest factor for
annuities and abbreviated PVIFA(r,T ).
Note that
¡ 1 T
¢
1− 1+r 1 − Present Value factor
PVIFA(r, T ) = =
r r

43

Present Value of Annuity Cash Flows

Consider now an annuity due involving T payments of $C, the

period interest rate being r. Then
C C C
PV = C + + + ... +
1+r (1 + r)2 (1 + r)T −1
à µ ¶2 µ ¶3 µ ¶T !
1 1 1 1
= (1 + r)C + + + ... +
1+r 1+r 1+r 1+r
à µ ¶T !
1 1
= (1 + r)C × 1−
r 1+r

= (1 + r) ×C × PVIFA(r, T ).

44
 Present Value of Annuity Cash Flows

The present value of an annuity due is equal to 1 + r times its

ordinary counterpart.
Using the above equations, we can answer questions similar to
those in chapter 5, such as finding the fixed payment that will
repay a loan, or finding the number of periods necessary to repay
a loan, etc..

45

Present Value of Annuity Cash Flows

Example 1
An investment offers $2,250 per year for 15 years, with the first
payment occurring one year from now. If the required return is
10 percent, what is the value of the investment?
Answer:
à µ ¶15 !
2, 250 1
PV = 1− = $17, 113.68.
0.1 1.1

46
 Present Value of Annuity Cash Flows

Example 2
Betty’s Bank offers a $25,000, seven-year loan at 11 percent
annual interest payable in equal annual amounts. What will the
annual payment be?
Answer:
PV 25, 000
C = ³ ¡ 1 ¢T ´ = ³ ¡ 1 ¢7 ´ = $5, 305.38.
1 1
r 1 − 1+r 0.11 1 − 1.11

47

Present Value of Annuity Cash Flows

Example 3
How long does it take to repay a $25,000 loan with fixed annual
payments of $4,000 at an 11% annual interest rate?
We will be using the “ln” trick to solve this problem.

48
Example 3
Answer:
à µ ¶T !
C 1
PV = 1−
r 1+r

µ ¶T
rPV 1
= 1−
C 1+r
µ ¶T
1 rPV
= 1−
1+r C
µ ¶ µ ¶
1 rPV
T ln = ln 1 −
1+r C
³ ´
ln 1 − rPV
C
T = ¡ 1 ¢
ln 1+r

49

Example 3
Answer:
³ ´
rPV
ln 1 − C
T = ¡ 1 ¢
ln 1+r
³ ´
0.11×25,000
ln 1 − 4,000
= ¡ 1 ¢
ln 1.11

= 11.15 years,

and thus it takes 12 years to repay such a loan, the last payment
being less than $4,000.

50
 Present Value of Annuity Cash Flows

Example 4
What must the annual rate of interest be in order to fully repay a
$25,000 loan in 10 years with fixed annual payments of $4,000?
Answer:
à µ ¶T !
C 1
PV = 1−
r 1+r
à µ ¶10 !
4, 000 1
25, 000 = 1− .
r 1+r

Can’t solve this equation analytically.

51

Example 4
The solution can be found by trial-and-error or by using a
computer.
In Excel:

RATE(NPER,PMT,PV) = RATE(10,-4000,25000) = 9.61%.

52
 Future Value of Annuity Cash Flows

Consider an ordinary annuity that pays $C each period for T

periods, the first payment being made one period from now.
What is the future value of this annuity if the period rate of
interest is r?

53

Future Value of Annuity Cash Flows

Answer:
FV = (1 + r)T −1C + (1 + r)T −2C + . . . + (1 + r)C + C
³ ´
T −1 T −2
= C (1 + r) + (1 + r) + . . . + (1 + r) + 1
³ ´
T −2 T −1
= C 1 + (1 + r) + . . . + (1 + r) + (1 + r)

µ ¶
1 − (1 + r)T
= C
1 − (1 + r)
µ ¶
1 − (1 + r)T
= C
−r
µ ¶
(1 + r)T − 1
= C
r

54
 Future Value of Annuity Cash Flows

The term
(1 + r)T − 1
r
is often referred to as the future value interest factor for annuities
and abbreviated FVIFA(r, T ).
Note that
¡ 1 ¢T
(1 + r)T − 1 1 − 1+r
FVIFA(r, T ) = = (1 + r)T = (1 + r)T PVIFA(r, T ).
r r

55

Perpetuities

A perpetuity is an annuity with perpetual cash flows.

The future value of a perpetuity is always infinite.
The present value of a perpetuity paying $C forever at the end of
each period, the period interest rate being r > 0, is
à ¡ 1 ¢T !
1 − 1+r C
lim C = ,
T →∞ r r
¡ 1 T
¢
since limT →∞ 1+r = 0.

56
 Perpetuities

The present value of a perpetuity paying $C forever at the

beginning of each period, the period interest rate being r > 0, is
à ¡ 1 ¢T !
1 − 1+r (1 + r)C
lim C(1 + r) = .
T →∞ r r

57

Relationship between Annuities and Perpetuities

Consider the following perpetuities:

Perpetuity P 1: Pays $C forever, the first payment being made

one period from now.

Perpetuity P 2: Pays $C forever, the first payment being made

at time T + 1 (i.e. at the end of period T , which is the
beginning of period T + 1).

0 1 2 3 4 5 T −1 T T +1 T +2 T +3
... -
P1 : C C C C C C C C C C
P2 : C C C

58
 Relationship between Annuities and Perpetuities

Note that
P1 − P2 = A(C, T ),
where A(C, T ) denotes the (ordinary) annuity that pays $C for T
periods.
Hence, the present value of P1 − P2 must be equal to the present
value of A(C, T ).

59

Relationship between Annuities and Perpetuities

Let r denote the period interest rate. Then

C C/r
PV(P1) = and PV(P2) = ,
r (1 + r)T
and thus
C C/r
PV(P1 − P2) = −
r (1 + r)T
à µ ¶T !
C 1
= 1−
r 1+r

= PV(A(C, T )).

60
 Growing Annuities

Consider an annuity in which the payment grows at the rate g

from one period to the other. That is, the cash flows from this
annuity are as follows:

0 1 2 3 T −1 T
... -
C (1+g)C (1+g)2C (1+g)T−2C (1+g)T−1C

61

The present value of this annuity is

C (1 + g)C (1 + g)2C (1 + g)T −1C
PV = + + + . . . +
1+r (1 + r)2 (1 + r)3 (1 + r)T
à µ ¶2 µ ¶3 µ ¶T !
C 1+g 1+g 1+g 1+g
= + + + ... +
1+g 1+r 1+r 1+r 1+r

à µ ¶T !
C (1 + g)/(1 + r) 1+g
= × 1−
1 + g 1 − (1 + g)/(1 + r) 1+r

à µ ¶T !
C 1 1+g
= × 1−
1 + g (1 + r)/(1 + g) − 1 1+r

à µ ¶T ! à µ ¶T !
1 1+g C 1+g
= C× 1− = 1−
1 + r − (1 + g) 1+r r−g 1+r

62
 Growing Annuities

The present value of an annuity in which the payments grow at

the constant rate g, the first payment being C, is
à µ ¶T !
C 1+g
PV = 1− ,
r−g 1+r

where T is the number of payments and r is the period discount

rate.
What is the present value of a growing perpetuity?

63

Growing Annuities

µ ¶
1+g 1+g T
If g < r, then < 1 and lim = 0.
1+r T →∞ 1 + r
µ ¶
1+g 1+g T
If g > r, then > 1 and lim = ∞.
1+r T →∞ 1 + r

Therefore,
à 
µ ¶T !  C
C 1+g r−g if g < r,
lim 1− =
T →∞ r − g 1+r  ∞ if g ≥ r.

64
 Growing Annuities

Example
Problem 77. Consider a firm that is expected to generate a net
cash flow of $10,000 at the end of the first year. The cash flows
will increase by 3 percent a year for seven years and then the firm
will be sold for $120,000. The relevant discount rate for the firm
is 11 percent. What is the present value of the firm?

65

Answer: The total cash flows generated by this firm are the 8
cash flows from its operations and the terminal value of
$120,000, which will materialize eight years from now. The
present value of the firm is then (numbers in 000’s)
10 1.03 × 10 (1.03)2 × 10 (1.03)7 × 10 120
PV = + + + . . . + +
1.11 (1.11)2 (1.11)3 (1.11)8 (1.11)8
à µ ¶8 !
10 1.03 120
= 1− +
0.11 − 0.03 1.11 (1.11)8

= $108, 360.

66
 The Effect of Compounding

Interest rates can be quoted in many different ways.

How rates are quoted may come from tradition or regulation.
Very often, rates are quoted in a misleading manner.
What’s under a quoted rate?

67

Effective Annual Rates and Compounding

Suppose a rate is quoted at 10% compounded semiannually.

This means that 5% is charged every six months.
10%, the quoted rate, is the interest charged on the principal
during the year, it does not include the interest on interest
(compound interest).
The rate that takes into account compound interest is called the
effective annual rate (EAR).
What is the EAR in the above example?

68
 Effective Annual Rates and Compounding

With a 10% interest rate compounded semiannually, the EAR is

EAR = (1.05)2 − 1 = 1.1025 − 1 = 10.25%.

Note that
0.25% = 5% × 5%
is the interest on interest charged during the year.

69

Effective Annual Rates and Compounding

More generally, the EAR of a quoted annual rate compounded m

times during the year is
µ ¶
Quoted Rate m
EAR = 1 + − 1.
m

Compare the following rates:

Bank A: 15% compounded daily

Bank B: 15.5% compounded quarterly

Bank C: 16% compounded annually

70
 Effective Annual Rates and Compounding

Bank A:
µ ¶
0.15 365
EARA = 1 + − 1 = 16.18%.
365

Bank B:
µ ¶4
0.155
EARB = 1+ − 1 = 16.42%.
4

Bank C:
µ ¶1
0.16
EARC = 1+ − 1 = 16.00%.
1

71

Quoting a Rate

What is the quoted rate, compounded monthly, that provides an

effective return of 15%?

72
 Quoting a Rate

Answer:
µ ¶12
Quoted rate
0.15 = 1+ −1
12
µ ¶12
Quoted rate
1.15 = 1+
12

Quoted rate
(1.15)1/12 = 1+
12
Quoted rate
(1.15)1/12 − 1 =
12
³ ´
12 × (1.15)1/12 − 1 = Quoted rate = 14.06%.

73

Mortgages

Regulations for Canadian institutions require that mortgage rates

be quoted with semiannual compounding. Payments, however,
are made each month.
How to calculate monthly payments from a quoted mortgage
rate?

(i) When quoting a rate, a financial institution is thinking EAR,

so the first step is to find the EAR implied by the quoted rate.

(ii) Calculate the monthly rate prodiving the EAR in (i).

(iii) Using the annuity formula, find the monthly payment.

74
 Mortgages

Example 1
Find the monthly payment on a $300,000 mortgage quoted at 14
percent and amortized over 25 years.
µ ¶ µ ¶
Quoted rate m 0.14 2
EAR = 1 + −1 = 1+ − 1 = 14.49%.
m 2
Find the monthly rate that gives an EAR of 14.49%:

(1 + Monthly Rate)12 − 1 = 14.49%

⇒ Monthly Rate = (1.1449)1/12 − 1 = 1.13%.

75

Mortgages

Example 1 (continued)
Find the monthly payment (T = 25 × 12 = 300):
à µ ¶T !
C 1
PV = 1−
r 1+r
à µ ¶300 !
C 1
300, 000 = 1−
0.0113 1.0113

0.0113 × 300, 000

C = ¡ 1 ¢300
1 − 1.0113

C = $3, 510.61.

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 Mortgages

Example 2
An entrepreneur is considering the purchase of an office in a new
high-rise complex. The office is worth $1,000,000 and a bank is
offering a mortgage for the whole amount at 8 percent APR. If
the entrepreneur’s budget allows payments of $7,000 a month,
how long will it take to pay off the purchase?

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EARs and APRs

Cost of borrowing disclosure regulations in Canada require that

lenders disclose an annual percentage rate (APR) in a prominent
and unambiguous manner.
By law, the APR is the interest rate per period multiplied by the
number of periods in a year. This is indeed the quoted rate
mentioned earlier.
For example, the APR on a loan at 1.5% monthly interest rate is

12 × 1.5% = 18%.

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 Continuous Compounding

What is the EAR when the quoted rate is compounded every

nanosecond?
Take, for example, a 12% APR:
Compounded EAR
Annually 12.00%
Quarterly 12.55%
Monthly 12.68%
Weekly 12.73%
Daily 12.75%
Continuously ?

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Continuous Compounding

The more often a quoted rate is compounded, the greater the

EAR.
Continuous compounding thus yields the maximum EAR from a
given APR.
Given a quoted rate q,
³ q ´m
lim 1 + − 1 = eq − 1.
m→∞ m
Note that eq − 1 is the highest EAR that can be obtained with an
APR of q.

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 Loan Types and Loan Amortization

We will see three types of loan in this section:

Pure Discount Loans: Usually short-term loans, such as T-bills.

Interest-Only Loans: Usually long-term loans, such as

government and corporate bonds.

Amortized Loans: Majority of individual loans.

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Pure-Discount Loans

In a pure discount loan, the borrower receives money today and

makes one lump-sum payment at some time in the future.
Consider, for example, a T-bill that promises to pay $1,000 in one
year. When the interest rate is 3.48%, the value of this T-bill is
1, 000
PV = = $966.37.
1.0348

If the repayment (L) takes place after t periods, the present value
of the loan is
L
PV = .
(1 + r)t

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 Interest-Only Loans

With this type of loan, the borrower pays interest each period and
repays the principal at some point in the future.
Take, for example a 5-year loan of $1,000 at an 8% annual
interest rate.
Each year the borrower pays $80 in interest and the principal
($1,000) is repaid after 5 years. Cash flows to the lender are then

0 1 2 3 4 5
-
Interest $80 $80 $80 $80 $80
Principal $1,000

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Interest-Only Loans

The present value of the above loan, at a discount rate r, is

à µ ¶5 !
80 1 1, 000
PV = 1− + .
r 1+r (1 + r)5

Note that 

 > $1, 000 if r < 8%,

PV = $1, 000 if r = 8%,



< $1, 000 if r > 8%.

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 Amortized Loans

An amortized loan is such that interest and principal are repaid

each period.
This type of loan can be such that a constant amount of the
principal is repaid each period, or can be such that a constant
payment is made each period.
How long would it take to repay a $5,000 loan with an APR of
10% compounded monthly if $500 in principal has to be repaid
each month?

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