This preview shows pages 1–8. Sign up to view the full content.
ORIE 350
February 27, 2007
Time Value of Money
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
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.
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
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
percent in a riskfree 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.
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
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
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.
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?
This preview has intentionally blurred sections. Sign up to view the full version.
View Full Document
This is the end of the preview. Sign up
to
access the rest of the document.
This note was uploaded on 03/04/2008 for the course ORIE 350 taught by Professor Callister during the Fall '08 term at Cornell University (Engineering School).
 Fall '08
 CALLISTER

Click to edit the document details