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ORIE 350
September 26, 2006
Time Value of Money
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Time Value of Money
Interest is the cost of borrowing money or the return
from lending money.
If you lend someone $5 today
and you receive $6 one year from now, the
difference of $1 represents the interest paid on the
amount borrowed.
Interest rates are usually stated as annual rates.
If
you borrow $100 from the bank at 6% per annum
(per year), payable in one year, you must pay the
bank $100 + $6 (0.06 × $100) or a total of $106 at
the end of the year.
Interest Rates
The interest rate applicable in an economic
transaction is affected by the perceived risk
or probability of nonpayment in the
transaction.
A bank may lend money to a low
risk customer at 7.5%, but a high risk person
may have to borrow money at the pawn shop
at 36% or more.
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An interest rate has three components:
1.
A riskfree component
based on an economic
concept called the marginal productivity of capital.
Many economists believe this rate is about 3 or 4
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This note was uploaded on 04/05/2009 for the course ORIE 350 taught by Professor Callister during the Summer '08 term at Cornell University (Engineering School).
 Summer '08
 CALLISTER

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