Ch3-Money Management

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Chapter 3

Understanding 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

Nominal Interest Effective Interest


Rate: Rate:
Interest rate Actual interest
quoted based on earned or paid in
an annual period a year or some
other time period

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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
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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
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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
=

19.56 % compounded annually


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Practice Problem
 If your credit card calculates the
interest based on 12.5%
compounded monthly. What is your
monthly interest rate and annual
effective interest rate, respectively?
 Your current outstanding balance is
$2,000 and skips payments for 2
months. What would be the total
balance 2 months from now? 11
Solution
Monthly InterestRate:
12.5%
i= =1.0417%
12
Annual Effective InterestRate:
ia = (1+0.010417)12 -1 =13.24%
Total OutstandingBalance:
F = B2 = $2,000(F / P,1.0417%,2)
= $2,041.88
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Practice Problem
 Suppose your savings account pays 9%
interest compounded quarterly. If you
deposit $10,000 for one year, how
much would you have?

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
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Effective Annual Interest Rates
(9% compounded quarterly)
First quarter Base amount $10,000
+ Interest (2.25%) + $225

Second quarter = New base amount = $10,225


+ Interest (2.25%) +$230.06

Third quarter = New base amount = $10,455.06


+ Interest (2.25%) +$235.24

Fourth quarter = New base amount = $10,690.30


+ Interest (2.25 %) + $240.53
= Value after one = $10,930.83
year
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Nominal and Effective Interest Rates
with Different Compounding Periods
Effective Rates
Nominal Compoundi Compoundi Compounding Compounding Compounding
Rate ng Annually ng Semi- Quarterly Monthly Daily
annually
4% 4.00% 4.04% 4.06% 4.07% 4.08%
5 5.00 5.06 5.09 5.12 5.13
6 6.00 6.09 6.14 6.17 6.18
7 7.00 7.12 7.19 7.23 7.25
8 8.00 8.16 8.24 8.30 8.33
9 9.00 9.20 9.31 9.38 9.42
10 10.00 10.25 10.38 10.47 10.52
11 11.00 11.30 11.46 11.57 11.62
12 12.00 12.36 12.55 12.68 12.74
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What happens if we pay in some period of time but we
have interest rate per a different period??

Annual interest rate

Compounding Period

Payment Period

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12% compounded monthly !!!!!Formula or converting to
interest
Payment Period = Quarter periods to payment periods
Compounding Period = Month
Find annual effective interest rate?

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

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)

i = [1+ r / CK] −1C

C = number of interest periods per


payment period
K = number of payment periods per year
M = number of interest periods per year
(M=CK)

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Effective Interest Rate per Payment
Period with Continuous Compounding

i = [1+ r / CK ] −1 C

where CK = number of compounding periods


per year

continuous compounding => M (=CK) ∞


i = lim[( 1 + r / CK ) C − 1]
= (e r )1 / K − 1
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Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly
1st Q
2nd Q 3rd Q 4th Q
1 interest period Given r = 8%,

iq=%8/4=%2
ia = [1 +0.02] 1− 1
= 2 . 0 0 0 % pe r q u a r te r

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Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly
1st Q

2nd Q 3rd Q 4th Q


3 interest periods Given r = 8%, Firstly turn nominal
interest rate to interest period.
im=%8/12=%0.6
Secondly turn the interest rate
iq = [1 + im] − 1
3
to payment period as
effective interest rate

= 2 . 0 1 3 % pe r q u a r te r
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Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly
1st Q

2nd Q 3rd Q 4th Q


13 interest periods
Given r = 8%,
iw=%8/52=%2
iq = [1 + 0 .08 / (13 )( 4 )] 13 − 1
= 2 . 0 1 8 6 % pe r q u a rte r

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Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q 3rd Q 4th Q


∞ interest periods
Given r = 8%,
K = 4 payments per year
i = e r / K −1
= e 0.02 −1
= 2.0201 % per quarter
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Summary: Effective interest rate per
quarter
Case 0 Case 1 Case 2 Case 3

8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly continuously
Payments Payments Payments Payments
occur quarterly occur quarterly occur quarterly occur quarterly

2.000% per 2.013% per 2.0186% per 2.0201% per


quarter quarter quarter quarter

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How many weeks are
there in a quarter?

Practice Example Many firms define their


fiscal quarters as 13-
week periods.
 1000 YTL initial deposit.
 Effective interest rate per quarter

 Balance at the end of 3 years for a nominal

rate of 8% compounded weekly?


iw= 8% /52

iq = (1+iw)13 −1 = 2.0186% per quarter


How many
quarters are there
F = 1000(F | P,2.0186%,12) in 3 years?
4*3=12

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How many days are
Practice Example there in a quarter?
365/4
 1000 YTL initial deposit.
 Effective interest rate per quarter

 Balance at the end of 3 years for a nominal

rate of 8% compounded daily?

id= 8% /365

iq = (1+id)365/4-1=%2.0199 How many


quarters are there
F = 1000(F | P, iq ,12) in 3 years?
4*3=12

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We have to turn the
continuous
Practice Example compounded version
to quarters
 1000 YTL initial deposit.
 Effective interest rate per quarter

 Balance at the end of 3 years for a nominal

rate of 8% compounded continuously?


r 0.08
i = e k −1 = e 4 −1 = 2.0201% per quarter

How many
quarters are there
F = 1000(F | P,2.0201%,12) in 3 years?
4*3=12

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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?

Effective interest rate per year = ( 1+ im )12 − 1 = 6.168 %

F = 2000 (F | P, 6.168 %, 3) How many years


are there in 3
or years?
How many
months are the
Effective interest rate per quarter = ( 1+ im )3− 1 = 1.5075 %
in a quarter?
F = 2000 ( F | P,1.5075 %,12) How many
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quarters are
there in 3 years?
Equivalence Analysis using Effective
Interest Rate

 Step 1: Identify the payment period


(e.g., annual, quarter, month, week,
etc)
 Step 2: Identify the interest period
(e.g., annually, quarterly, monthly, etc)
 Step 3: Find the effective interest rate
that covers the payment period.

30
Principle: Find the effective interest
rate that covers the payment period
Case 1: compounding period = payment period

Case 2: compounding period < payment period

Case 3: compounding period > payment period

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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
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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

Find A (monthly payments)


< Step 1: M = 12
< Step 2: i = r/M = 8.5%/12 = 0.7083% per month
< Step 3: N = (12)(4) = 48 months
< Step 4: A = $20,000(A/P, 0.7083%,48) = $492.97
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Dollars Up in Smoke
What three levels of smokers who bought cigarettes every
day for 50 years at $1.75 a pack would have if they had
instead banked that money each week:
Level of smoker Would have had
1 pack a day $169,325

2 packs a day $339,650

3 packs a day $507,976

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

F = $12.25 (F/A, 0.10577%, 2600)= $169,325


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Compounding more frequent than payments
Discrete Case Example: Quarterly deposits
with monthly compounding

Suppose you make equal quarterly


deposits of $1000 into a fund that pays
interest at a rate of 12% compounded
monthly. Find the balance at the end of
year three.

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Compounding more frequent than payments
Discrete Case Example: Quarterly deposits
with monthly compounding

Year 1 Year 2 Year 3


F=?
0 1 2 3 4 5 6 7 8 9 10 11
12
Quarters
A = $1,000

Step 1: M = 12 compounding periods/year


K = 4 payment periods/year
C = 3 interest periods per quarter
Step 2: i = [1 + 0.12 /(3)(4)]3 −1
= 3.030 %
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
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Continuous Case: Quarterly deposits with
Continuous compounding

Suppose you make equal quarterly


deposits of $1000 into a fund that pays
interest at a rate of 12% compounded
continuously. Find the balance at the
end of year three.

38
Continuous Case: Quarterly deposits with
Continuous compounding

Year 1 Year 2 Year 3


F=?
0 1 2 3 4 5 6 7 8 9 10 11
12
Quarters
A = $1,000

Step 1: K = 4 payment periods/year


C = ∞ interest periods per quarter
Step 2: i = e0.12/4 −1
= 3.045% perquarter
Step 3: N = 4(3) = 12
Step 4: F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
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Compounding less frequent than payments

 Suppose you make $500 monthly deposits to


an account that pays interest at a rate of
10%, compounded quarterly. Compute the
balance at the end of 10 years.

i = (1+ 0.10 / 4)1/ 3 −1 = 0.826% per month


Whenever a deposit is made, it
F = 500(F | A,0.826%,120) = 101907.89 starts to earn interest.

Money deposited during a


F = 1500(F | A,2.5%,40) =101103.83
quarter does not earn interest
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Auto Loan
$20,000

1 2 24 25 48
0

Given: APR = 8.5%, N = 48 months, and


P = $20,000
Find: A
A = $20,000(A/P,8.5%/12,48)
= $492.97
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Suppose you want to pay off the remaining loan in
lump sum right after making the 25th payment.
How much would this lump be?

$20,000

1 2 24 25 48
0
$492.97 $492.97
25 payments that were 23 payments that are
already made still outstanding

P = $492.97 (P/A, 0.7083%, 23)


= $10,428.96 44
For the 33rd payment, what is the interest
payment and principal payment?

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

492.97 − 52.76 = 440.21 Principal payment


component of the
33rd payment

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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

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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

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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?
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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

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