FINANCIAL
MANAGEMENT
Interest Rates and Loan Amortization
Objectives
■ Differentiate and apply simple interest and compound interest
calculations.
■ Calculate future and present values of single cash flows.
■ Define and distinguish between ordinary annuities and annuities
due.
■ Loan Amortization
Interest Rate
■ Interest Money paid (earned) for the use of money.
■ There are two types of Interest rate been calculated: Simple Interest and
Compound Interest
1. Simple interest is interest that is paid (earned) on only the original amount, or
principal, borrowed (lent). The dollar amount of simple interest is a function of
three variables: the original amount borrowed (lent), or principal; the interest rate
per time period; and the number of time periods for which the principal is
borrowed (lent).
SI= PxRxT
100
■ SI = simple interest in dollars
■ P = principal, or original amount borrowed (lent) at time period
■ R = interest rate per time period
■ T = number of time periods
Interest Rate
■ For example, assume that you deposit $100 in a savings account paying 8
percent simple interest and keep it there for 10 years. At the end of 10 years,
the amount of interest accumulated is determined as follows:
■ $100(0.08)(10)
■ = $80
■ 100+80= 180$ end of 10th year
Interest Rate
2. Compound interest: Interest paid (earned) on any previous interest earned,
as well as on the principal borrowed (lent).
■ A = P(1 + i)^n
■ = $100(1.08)^10 = $ 215.89
Future value & Present value
1. Future value (terminal value):The value at some future time of a present
amount of money, or a series of payments, evaluated at a given interest rate.
FV = PV (1+R)T
• P is the Principal Invested Value
• R is the Expected Rate of return
• T is the time for which investment is done
The future value of a single cash flow implies that how much will be worth of
money after a few years if it is invested today at a prevalent rate of interest
• For Eg Aman has invested $ 50,000 in Fixed Deposit for 3 years, with an
expected return of 10% per year, he wants to know the maturity value or the
future value of his investment after 3 years?
• FV = 50,000 (1 + 0.1)3
• 50,000(1.1)3= $ 66,550.00
• 50,000X1.1X1.1X1.1= 66,550
Future value & Present value
The future value of a multiple cash flow implies the sum of the FV of each cash
flow. The sum the FV of each cash flow, each must be calculated to the same point
in the future
FV = PV (1+R)T+ PV (1+R)2+ PV (1+R)3+ PV
• Finding the future value (FV) of multiple cash flows means that there are more
than one payment/ investment, and a business wants to find the total FV at a
certain point in time. These payments can have varying sizes, occur at varying
times, and earn varying interest rates, but they all have a certain value at a
specific time in the future
Future value & Present value
2. Present value :The current value of a future amount of money, or a series of
payments, evaluated at a given interest rate. It is determined by discounting the
future value by the estimated rate of return that the money could earn if invested
Present Value= FV
(1+r) n
where:
FV=Future Value
r=Rate of return
n=Number of periods
• For Eg, Let’s say you loaned a friend $10,000 for five years with interest rate 5%,
how much is the $10,000 worth on the date of the initial borrowing?
In this case, (PV) = $10,000 ÷ (1 + 5%)^5 = $7,835
Future value & Present value
The present value of a multiple cash flow implies the sum of the PV of each cash
flow. The sum the PV of each cash flow, each must be calculated to the same point
in the future
PV = Fv+ FV1 + FV2 + FV3+ ... +
(1+r) 1 (1+r) 2 (1+r) 3
• Finding the present value (PV) of multiple cash flows means that there are more
than one payment/ investment, and a business wants to find the total PV at a
certain point in time. These payments can have varying sizes, occur at varying
times, and earn varying interest rates, but they all have a certain value at a
specific time in the future
Difference Between Ordinary
Annuity and Annuity Due
■ Ordinary annuity means in which the inflow or outflow of cash fall due for
payment at the end of each period.
■In general, ordinary annuity payment is made on a monthly, quarterly, semi-
annual or annual basis. The present value of the ordinary annuity is computed
as of one period prior to the first cash flow, and the future value is computed as
of the last cash flow
■ Annuity Due is described as the series of cash flows occurring at the beginning
of each period
What Is an Amortized Loan?
■ An amortized loan is a type of loan with scheduled, periodic payments that are
applied to both the loan's principal amount and the interest accrued.
■ In banking and finance, an amortizing loan is a loan where the principal of the
loan is paid down over the life of the loan (that is, amortized) according to an
amortization schedule, typically through equal payments.
■ Each payment to the lender will consist of a portion of interest and a portion of
principal. Mortgage loans are typically amortizing loans. The calculations for an
amortizing loan are those of an annuity using the time value of money formulas,
and can be done using an amortization calculator.
■ An amortizing loan should be contrasted with a bullet loan, where a large
portion of the loan will be paid at the final maturity date instead of being paid
down gradually over the loan's life.
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