Lecture 10 0227 - ORIE 350 Time Value of Money Time Value...

Info icon This preview shows pages 1–8. Sign up to view the full content.

View Full Document Right Arrow Icon
    ORIE 350 February 27, 2007 Time Value of Money
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
    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.
Image of page 2
    Interest Rates The interest rate applicable in an economic transaction is affected by the perceived risk or probability of non-payment 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.
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
    An interest rate has three components: 1. A risk-free component based on an economic concept called the marginal productivity of capital. Many economists believe this rate is about 3 or 4 percent in a risk-free and inflation free environment. 2. A risk component to compensate for uncertainty or the possibility of nonpayment. 3. An inflation component applicable in periods of inflation. In periods of inflation, lenders demand higher rates of return to compensate for the decline in purchasing power between the time money is lent and the time it is paid.
Image of page 4
    Simple Interest Simple interest is interest earned only on the original principal. The formula for calculating simple interest is I = P×i×n I = simple interest P = principal (amount borrowed or lent) i = interest rate per year n = number of years or fraction thereof
Image of page 5

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
    Compound Interest Compound interest is interest that is earned on both principal and interest. When interest is compounded, interest is earned on the original principal and on the interest accumulated for the preceding periods. This is used for home mortgages, car loans, credit cards, and many (but not all) commercial loans.
Image of page 6
    Example 1 You borrow $500 on January 1, 2000 at 10% interest, compounded annually. You pay the loan on Dec. 31, 2004. What will your total payment be?
Image of page 7

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 8
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern