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THEORY OF

INTEREST
Demetilla, Krizzia
Salomson, Claudine Carie
Ubalde, Christine Evan
The Basics of
Interest Theory

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INTEREST
IS AN AMOUNT CHARGED TO A BORROWER FOR THE
USE OF LENDERS MONEY OVER A PERIOD OF TIME.

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Example 1.
If you have borrowed $100 and you promised to pay back $ 105 after
one year.

Lender is making a profit of $5

Interest is sometimes referred to as the TIME VALUE OF MONEY

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PRINCIPAL(s)- The money invested in financial transactions.

AMOUNT OF INTEREST- The difference between the Amount


value and Principal. (I = A - P)

INTEREST RATE- Interest expressed as a percent of the Principal.

AMOUNT VALUE(S)- The amount that the investment has grown.

MEASUREMENT PERIOD- The unit in which time of investment is


being measured.
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ANNUAL INTEREST RATE
EXAMPLE 1

You deposited $1000 into a savings account. One year later, The
account has accumulated to $1,050.

(a)What is the principal of investment?


(b)What is the interest earned?
(c)What is the annual interest rate?

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ANNUAL INTEREST RATE
EXAMPLE 2
A bank offers you for your deposits an annual interest rate of 10%
compounded semi annually. If you deposited $1000 now, how much
will you earn in one year?

EXAMPLE 3
You borrowed $12,000 from a bank. The loan is to be repaid in full in
one years time with a payment due of $12,750.What is the interest
paid on loan? The annual interest rate?

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COMPOUNDING
The process of adding accumulated interest
back to the Principal.

Formula: A = P(1 + r/n)^nt


The interest earned in each period is added to
the principal of the previous period to become
the principal for the next period.
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EXAMPLE

You borrow $10,000 for three years at 5% annual interest


compounded annually. What is the amount value at the end of
three years?

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The EFFECTIVE RATE OF INTEREST is the amount of
money that one unit invested at the beginning of a period will
earn during the period, with interest being paid at the end of the
period.

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EXAMPLE
Suppose you deposit $1000 into a savings account that pays
the annual interest rate of 0.4% compounded quarterly.
What is the effective interest rate?

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DISCOUNTING

The process of finding the present value of an


amount of cash at some future date.

By the present value we mean the principal that must be invested


now in order to achieve a desired accumulated value over a
specified period of time.

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EXAMPLE

If $1150 is the discounted value of $1250, due at the end of 7


months,the discount on $1250
Is 100. What is the interest on $1150 for the same period of time?

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EXAMPLE

Find the present value of $100 in 5 years time if the annual


compound interest is 12%.

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EFFECTIVE RATE OF RETURN

Is the rate of interest on an investment annually when


compounding occurs more than once.

n
ERR = (1 + i/ n) -1

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.
EFFECTIVE RATE OF RETURN

Here; i stands for the annual interest rate


N stands for the number of compounding periods
It can be said that the Effective Rate Of Return
determines the effect of compounding for the annual
interest rate

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EFFECTIVE RATE OF RETURN
If we move on to the importance of the effective rate
of return then it is said to be important for 2 reasons.
First one is that it is accurate. It is much more than
estimating returns only. It helps in determining all the
details that might be needed for compounding.
Secondly, it is being popularly used as it is based on
simple calculations of interests.

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EFFECTIVE RATE OF RETURN
The effective rate of return helps to determine the
return that will be gained on each investment and it
covers up a number of marketing instruments, loans
and investments.

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EXAMPLE

You buy a house for $100,000. A year later you sold it


for $80,000. What is the effective rate of return on
your investment?

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2. ANNUITY

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Annuities are series of equal
payments that are made at
equidistant points such as monthly,
quarterly, or annually over a finite
period of time.
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ORDINARY ANNUITY
Payments are made at the end of each period.
Recurring, identical, cash payment amounts
(payments, receipts, rents) at the end of each
equal period.

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ORDINARY ANNUITY - EXAMPLES
An automobile loan taken out on February
14, 2017 requires a monthly payment of PhP
18,000 for 70 months.
A commitment made on January 1, 2017
requires Php10,000 to be paid on each
December 31 for five years.
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ORDINARY ANNUITY
5-year Ordinary Annuity with Payments of $100
at the end of each year.

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FUTURE VALUE OF ORDINARY ANNUITY

FVn = FV of annuity at the end of nth period.


PMT = annuity payment deposited or received at the end of each
period
i = interest rate per period
n = number of periods for which annuity will last
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FUTURE VALUE OF ORDINARY ANNUITY - EXAMPLE

How much money will you accumulate by


the end of year 10 if you deposit Php3,000
each for the next ten years in a savings
account that earns 5% per year?

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FUTURE VALUE OF ORDINARY ANNUITY - EXAMPLE
How much money will you accumulate by the end of year 10 if you deposit Php3,000 each for the next
ten years in a savings account that earns 5% per year?

FV = Php3000 {[ (1+.05)10 - 1] (.05)}


= 3,000 { [0.63] (.05) }
= 3,000 {12.58}
= Php 37,740
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ORDINARY ANNUITY - SOLVE FOR PMT
Suppose you would like to have Php500,000 saved 6
years from now to pay towards your down payment
on a new house. If you are going to make equal
annual end-of-year payments to an investment
account that pays 7%, how big do these annual
payments need to be?

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ORDINARY ANNUITY - SOLVE FOR PMT
Suppose you would like to have Php500,000 saved 6 years from now
to pay towards your down payment on a new house. If you are going
to make equal annual end-of-year payments to an investment account
that pays 7%, how big do these annual payments need to be?

FVn = Php 500,000


n=6
i=7%
PMT = ? 29
ORDINARY ANNUITY - SOLVE FOR PMT

Php 500,000 = PMT {[ (1+.07)6 - 1] (.07)}


= PMT{ [.50] (.07) }
= PMT {7.153}
$500,000 7.153 = PMT = Php 69,901
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ORDINARY ANNUITY - PRESENT VALUE

The present value of an ordinary annuity


measures the value today of a stream of cash
flows occurring in the future.

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ORDINARY ANNUITY - PRESENT VALUE
Your grandmother has offered to give you $1,000 per year for
the next 10 years. What is the present value of this 10-year,
$1,000 annuity discounted back to the present at 5 percent?

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ORDINARY ANNUITY - PRESENT VALUE

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ORDINARY ANNUITY - PRESENT VALUE

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ORDINARY ANNUITY - PRESENT VALUE

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Sources:
Pearson Prentice Hall 2011
http://www.accountingcoach.com/present-value-of-an-ordinary-annuity/explanation/2
http://www.investopedia.com/university/annuities/\

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RATE OF RETURN OF AN INVESTMENT
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Rate of Return of an Investment
Discounted Cash Flow Technique (DCF)
Net Present Value (NPV)
Internal Rate of Return (IRR)

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DISCOUNTED CASH FLOW (DCF)
A valuation method used
to estimate the
attractiveness of an
investment opportunity.

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DISCOUNTED CASH FLOW (DCF)
DCF analysis uses future
free cash flow projections
and discounts them to
arrive at the present value
estimate, which is used to
evaluate the potential for
investment.
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DISCOUNTED CASH FLOW (DCF)

If the value arrived at


through DCF analysis is
higher than the current cost
of the investment, the
opportunity may be a good
one.
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SAMPLE PROBLEM:
Find the PV of each cash flow at 12% rate of
return:
1
Yr 1 : $200 / (1.12) = $178.57
2
Yr 2 : $400 / (1.12) = $318.88
3
Yr 3 : $600 / (1.12) = $427.07
4
Yr 4 : $800 / (1.12) = $508.41
$2,000 $1,432.93 44
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SAMPLE PROBLEM:
PAY $100 today GET $105 at Yr 1

Future Cash Flow $ 105


Investment $ 100
Net Value $ 5

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SAMPLE PROBLEM:
PAY $100 today GET $105 at Yr 1
Interest: 6%

NVP = - $100 (1.06)0 + $ 105(1.06)-1


= - $ 100 + $ 99.06
T !!!
= ($ 0.94)
EC
REJ 50
SAMPLE PROBLEM:
Year Contribution Returns Interest: 12%

0 $ 1,200

1 $0 $ 200

2 $0 $ 400

3 $0 $ 600

4 $0 $ 800
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SAMPLE PROBLEM:
!
T!!
Future Cash Inflow
E P
Yr 1 : $200 (1.12)-1 = $178.57 C
AC
Yr 2 : $400 (1.12)-2 = $318.88
Yr 3 : $600 (1.12)-3 = $427.07
Yr 4 : $800 (1.12)-4 = $508.41 $ 1,432.93
- Initial Investment ($ 1,200.00) Net
Present Value $ 232.93
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VS

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$100 $100 $100
$1000
10% 55
$250 $500 $400 $150

%=?
$1000

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Breakeven discount rate 57
@ 10% $ 43.47
CF 0 $ (1,000.00)

CF 1 $ 250.00

CF 2 $ 500.00 @ 15% $ (55.77)


CF 3 $ 400.00

CF 4 $ 150.00
@ 12% $ 1.85

0= -$1,000(1+r)0 + 250(1+r)-1 + 500(1+r)-2 + 400(1+r)-3 + 150(1+r)-4

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SIGNIFICANCE OF THE IRR
As the borrowing cost (cost of capital) rises, the NPV
declines

IRR is the limit of cost of capital for the project

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SIGNIFICANCE OF THE IRR
Borrowing cost > IRR = -NPV Project=NEGLECTED

Borrowing cost < IRR = +NPV Project=ACCEPTED

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THANKS!
LETS PLACE OUR SELFIE
HERE!!!

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QUESTION No. 2
To save up for a wedding, you targeted to save
up Php600,000 and should be saved 5 years
from now. If you are going to make equal annual
payments to an investment account that pays 4%
annually, how much these annual payments
should be?

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ANSWER

Php($110,776.27)

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QUESTION No. 2

consider a loan with a stated interest


rate of 5 percent that is compounded
monthly.what is the effective interest
rate
Answer: 5.12 percent
QUESTION No. 3
Supposing we have the same loan and
interest rate from the previous
problem, what is the effective rate if it
is compounded daily?
Answer: 5.13%
QUESTION No. 4

Suppose Karen has $1000 that she invests in an


account that pays 3.5% interest compounded
quarterly. How much money does Karen have at
the end of 5 years?
Answer
QUESTION No. 5

How much money will you accumulate


by the end of year 5 if you deposit
Php2,000 each for the next ten years in a
savings account that earns 2% per year?

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ANSWER

Php10,408.08

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QUESTION No. 6
Find the PV of each cash flow at 10% rate of
return:
Yr 1 = $ 350
Yr 2 = $ 600
Yr 3 = $ 500

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ANSWER: $ 1,189.71

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QUESTION No. 7
find the NPV at 15% rate

CONTRIBUTION RETURNS

YR 0 $ 550

YR 1 $ 100

YR 2 $ 200

YR 3 $300

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ANSWER: $ 114.56
CREDITS
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