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Lesson 4

The document discusses present value calculations and equivalent interest rates. It provides formulas and examples for finding present value given a future value, interest rate, and time period. It also covers equivalent rates and continuous compounding.

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Jean Leyson
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49 views6 pages

Lesson 4

The document discusses present value calculations and equivalent interest rates. It provides formulas and examples for finding present value given a future value, interest rate, and time period. It also covers equivalent rates and continuous compounding.

Uploaded by

Jean Leyson
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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2.

4 Finding the Present Value


It often happens that we wish to find the present value at a given rate of interest of an
amount of money due at some future date. Let’s say you want to have 1M in 5 years the amount
you would have to invest now is somewhat less than 1M. How much less depends on how much
interest the money could earn, and that depends on the interest rate you could receive.
The PRESENT VALUE is the amount you would have to invest now at a certain interest
rate so that you would end up with some predetermined future sum of money (e.g. 1M 5 years
from now). The difference between the future value and the present value is the compound
interest or commonly called the COMPOUND INTEREST. The formula for the present value or
discounted value of an amount F is given by
𝐹
𝑃= or P = F (1 + 𝑖)−𝑛
(1+𝑖)𝑛

Example:
Discount 5, 000 for 7 years at 9% converted quarterly. Determine the amount of discount.
Solution:
9% 0.09
Let F = 5, 000 n = 4(7) i= 4 = 4
= 28 = 0.0225
Then P = 5,000 (1.0225)−28
= 5, 000 (0.53632388)
= 2, 681.62

2.5 Finding the Present Value for n Not an Integer


The following problems involve an interest rate which is not found on the table and a
term which is not an integer.
Example:
1
Find the present value of 4,000 for 7 years and 7 months at 6 2% compounded quarterly.

Solution:
7 6.5% 5
Let F = 4,000 n = 4 (7 12 ) i= =18%
4

1
= 30 3 = 0.01625

Then,
1
P = 4,000 (1.01625)−30 3

= 4, 000 (0.61326718)

= 2, 453. 07

2.6 EQUIVALENT RATES


Two interest rates are said to be equivalent if they give equal compound amounts at the
end of the same term. Generally, the nominal rate 𝑗1 is equivalent to the nominal rate 𝑗2 if and
only if the accumulated value of any amount P at a nominal rate 𝑗1 is equal to the accumulated
value of the same amount P at nominal rate 𝑗2 for equal period of investment.

ILLUSTRATION

At 𝑗1 = 8. 4116% and m = 4, if P = 1,000 and t = 2 years, then the accumulated value is

0.084116 4(2)
F = 1,000 ( 1 + )
4

= 1,000 (1.0210029)8

= 1, 181.15

The nominal rate 8.5% compounded semiannually is equivalent to the nominal rate
8.4116% compounded quarterly since the amount 1,000 when invested at these nominal rates
yielded equal accumulated values was 1, 181.15, at the end of 2 years.

Problems involving equivalent rates will require the students to know the relationship
between the nominal rates 𝑗1 and 𝑗2 by deriving a formula for the unknown rate. This is done by
equating the accumulated values of any amount A at (𝑗1, 𝑚1 ) and at (𝑗2 , 𝑚2 .

The formula for 𝑗1 is given as,


𝑚2
𝑗2
𝑗1 = 𝑚1 [(1 + 𝑚2
) 𝑚1 -1]
To find w which is equivalent to j at the same term t, the formula for w is given by

𝑗
w = (1 + ) 𝑚 -1
𝑚

Example:

Find the effective rate which is equivalent to a nominal rate 8% compounded quarterly.

Solution:

Let = j = 0.08 m=4 w =?

𝑗
Then, w = (1 + ) 𝑚 -1
𝑚

0.08 4
= (1 + ) -1
4

= (1 .02) 4 -1

= 0.0824

w = 8.24%

2.7 CONTINUOUS COMPOUNDING


It is significant to note that for any nominal rate j, as the conversion period m increases,
the value of its equivalent effective rate w also increases. However, as m frequently increases,
such as daily, hourly, or even infinitely, the increase in the value of w becomes less and less
rapid as it takes a limiting value 𝑒 𝑗 where e = 2.71828. This condition of j is called an interest
rate which is compounded continuously. Hence, the formula for finding the accumulated value of
any amount P at an interest rate j, compounded continuously, is given by

F = 𝑃𝑒 𝑗𝑡

In case of equivalent rates, the nominal rate j, compounded continuously (also called
force of interest) is equivalent to an effective rate w if

F = F
(at a force of interest) (at an effective rate)

𝑃(1 + 𝑤)𝑡 = P 𝑒 𝑗𝑡 Cancelling P and t

1+w = 𝑒𝑗

Hence, the formula for the effective rate which is equivalent to the given force of interest
is

w = 𝑒𝑗 − 1

While the formula for the force of interest which is equivalent to the given effective rate
is derived from

𝑃(1 + 𝑤)𝑡 = P 𝑒 𝑗𝑡

1 + w = 𝑒𝑗

Log (1 + w) = j log e

log(1+𝑤)
j= log 𝑒

Example 1:

Find the amount if 5, 000 is invested for 5 years at 10% compounded continuously.

Solution:

Let P = 5, 000 t = 5yrs. J = 10%

Then

F = P 𝑒 𝑗𝑡

= 5, 000 𝑒 (0.10)(5)

= 5, 000 (2.71828)0.5

= 5, 000 (1.6487213)

= 8, 243.61

Example 2:
1
Find the rate compounded continuously which is equivalent to 8 2 % effective.

Solution:

Let w = 0.085 and j =?

Then,

log(1.08)
j= log 𝑒

0.0354297
= 0.4342944

Hence, j = 0.815799

= 8.16%
ACTIVITY NO. 4

1. Find the present value of 18,000 due in 5 yrs. If money is worth 4% compounded
semiannually.
2. Find the present value of 12,500 for 9 yrs. at 15% compounded.
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
1
3. Find the amount if 6, 000 were invested for 5 2 years at 6.5% compounded continuously.
3
4. Find the present value of 15,250 due in 8 years at 12 4 % compounded continuously.
1 1
5. Which interest rate has a better yield: 8 2 % compounded semi-annually or 8 4 %

compounded bi-monthly? (Hint: Compare their equivalent effective rates).

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