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ORIE 3150
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 account borrowed.
Interest rates are usually stated as annual rates.
If you borrow $100 from the bank at 6%
per annum (per year), you must pay the bank $100 + $6 (0.06 x $100) or a total of $106
at the end of the year.
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.
Simple Interest
.
Simple interest is interest earned only on the original principal.
The formula for
calculating simple interest is
n
i
P
I
×
×
=
Where I = simple interest
P = principal (amount borrowed or lent)
i = interest rate per year
n = number of years or fraction thereof
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.
Ex.
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?
Year
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This note was uploaded on 11/07/2008 for the course ORIE 3150 taught by Professor Callister during the Summer '08 term at Cornell University (Engineering School).
 Summer '08
 CALLISTER

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