Ch3-Money Management
Ch3-Money Management
Ch3-Money Management
Nominal and
Effective Interest
Rates
Equivalence
Calculations
Changing Interest
Rates
Debt Management
1
Understanding Money
Management
Financial institutions often quote
interest rate based on an
APR(annual percentage rate).
In all financial analysis, we need to
convert the APR into an appropriate
effective interest rate based on a
payment period.
When payment period and interest
period differ, calculate an effective
interest rate that covers the payment 2
period.
Understanding Money
Management
3
Focus
1. If payments occur more frequently than
annual, how do we calculate economic
equivalence?
2. If interest period is other than annual,
how do we calculate economic
equivalence?
3. How are commercial loans structured?
4. How should you manage your debt?
4
Nominal Versus Effective Interest
Rates
5
18% Compounded Monthly
Nominal Interest
interest rate period
Annual
percentage
rate (APR) 6
Effective Annual Interest Rate
(Annual Effective Yield)
M
ia = (1 + r /M ) −1
r = nominal interest rate per year
ia = effective annual interest rate
M = number of interest periods per
year Year 1 Year 2 Year 3
0 1 2 3 4 5 6 7 8 9 10 11 12
7
18% Compounded Monthly
What It Really Means?
Interest rate per month (i) = 18%/12 = 1.5%
Number of interest periods per year (N) = 12
In words,
Bank will charge 1.5% interest each month on
your unpaid balance, if you borrowed money
You will earn 1.5% interest each month on
your remaining balance, if you deposited
money
8
18% compounded monthly
Question: Suppose that you invest $1 for 1
year at 18% compounded monthly. How
much interest would you earn?
Solution: i=%18/12
F= $1(1 + i)12 = $1(1 + 0.015 )12
= $1.1956
ia = 0.1956 or 19.56%
18%
: 1.5% 9
18%
: 1.5%
18% compounded monthly
or
1.5% per month for 12 months
=
13
Solution
(a) Interest rate per quarter: Interest rate
per quarter
9%
i= = 2.25%
4
(b) Annual effective interest rate:
ia = (1 + 0.0225) 4 − 1= 9.31%
(c) Balance at the end of one year (after 4 quarters)
F = $10, 000( F / P, 2.25%, 4) or Annual
F = $10, 000( F / P, 9.31% ,1) interest
rate
= $10, 931
14
Effective Annual Interest Rates
(9% compounded quarterly)
First quarter Base amount $10,000
+ Interest (2.25%) + $225
Compounding Period
Payment Period
17
12% compounded monthly !!!!!Formula or converting to
interest
Payment Period = Quarter periods to payment periods
Compounding Period = Month
Find annual effective interest rate?
1% 1% 1%
3.030 %
One-year
• Effective interest rate per quarter
iq = (1 + 0 .01 ) 3 − 1 = 3 .030 %
• Effective annual interest rate
ia = (1 + iq )4− 1 = 1 2.68% quarterly
OR
im=%12/12 18
ia = (1 + im)12− 1 = 1 2 .68% monthly
Effective Interest Rate per Payment
Period (i)
19
Effective Interest Rate per Payment
Period with Continuous Compounding
i = [1+ r / CK ] −1 C
iq=%8/4=%2
ia = [1 +0.02] 1− 1
= 2 . 0 0 0 % pe r q u a r te r
21
Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly
1st Q
= 2 . 0 1 3 % pe r q u a r te r
22
Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q
23
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q
8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly
25
How many weeks are
there in a quarter?
26
How many days are
Practice Example there in a quarter?
365/4
1000 YTL initial deposit.
Effective interest rate per quarter
id= 8% /365
27
We have to turn the
continuous
Practice Example compounded version
to quarters
1000 YTL initial deposit.
Effective interest rate per quarter
How many
quarters are there
F = 1000(F | P,2.0201%,12) in 3 years?
4*3=12
28
Practice Example
2000 YTL borrowed. How much must be returned at
the end of 3 years if i=6% compounded monthly?
0.06
Interest rate per month(im) = = 0.005
12
How many
F = 2000 ( F | P, 0.5%, 36) months are
or there in a year?
30
Principle: Find the effective interest
rate that covers the payment period
Case 1: compounding period = payment period
31
When Payment Periods and
Compounding periods coincide
< Step 1: Identify the number of compounding
periods (M) per year
< Step 2: Compute the effective interest rate per
payment period (i)
i = r/M
< Step 3: Determine the total number of payment
periods (N)
N=M
< Step 4: Use the appropriate interest formula
using i and N above
32
When Payment Periods and Compounding periods coincide
Payment Period = Interest Period
$20,000
1 2 3 4 48
0
A
Given: P = $20,000, r = 8.5% per year compounded monthly
Note: Assumes constant price per pack, the money banked weekly and an
annual interest rate of 5.5%
Source: USA Today, Feb. 20, 1997 33
Sample Calculation: One Pack per
Day
Step 1: Determine the effective interest rate per payment
period.
Payment period = weekly
“5.5% interest compounded weekly”
i = 5.5%/52 = 0.10577% per week
Step 2: Compute the equivalence value.
Weekly deposit amount
A = $1.75 x 7 = $12.25 per week
Total number of deposit periods
N = (52 weeks/yr.)(50 years)
= 2600 weeks
36
Compounding more frequent than payments
Discrete Case Example: Quarterly deposits
with monthly compounding
38
Continuous Case: Quarterly deposits with
Continuous compounding
1 2 24 25 48
0
$20,000
1 2 24 25 48
0
$492.97 $492.97
25 payments that were 23 payments that are
already made still outstanding
Remaining
492.97(P | A,8.5% /12,16) = 7431.12 balance after
32 payments
Interest
7431.12(0.0071) = 52.76 component of the
33rd payment
43
Buying versus Lease Decision
Option 1 Option 2
Debt Financing Lease Financing
Price $14,695 $14,695
Down payment $2,000 0
APR (%) 3.6%
Monthly payment $372.55 $236.45
Length 36 months 36 months
Fees $495
Cash due at lease end $300
Purchase option at lease $8.673.10
end
Cash due at signing $2,000 $731.45 44
6% compounded monthly
45
Which Option is Better?
Debt Financing:
Pdebt = $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
Lease Financing:
Please = $495 + $236.45 + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
46
Example
Suppose you borrowed $10000 at an
interest rate of 12% compounded
monthly over 36 months. At the end of
the first year (after 12 payments), you
want to negotiate with the bank to pay
off the remainder of the loan in 8 equal
quarterly payments. What is the
amount of this quarterly payment, if the
interest rate and compounding
frequency remain the same?
47
Example Solution
A = 10000( A | P,1%,36) = 332.14
Remaining debt (end of 1st) = 332.14(P | A,1%,24) = 7055.77
Effective rate per quarter = (1+ 0.01)3 −1 = 3.03%
A = 7055.77( A | P,3.03%,8) = 1006.41per quarter
48