304-ch7-I_SU17.ppt - 7.1 INTERPRETATION OF A RATE OF RETURN...

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1 7.1 INTERPRETATION OF A RATE OF RETURN VALUE In rate of return problems you seek an unknown interest rate (i*) that satisfies the following: PW i* (+ cash flows) – PW i* ( - cash flows) = 0 This means that the interest rate – i*, is an unknown parameter and must be solved or approximated.
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2 7.1 Unrecovered Investment Balance Consider the following loan You borrow $1000 at 10% per year for 4 years You are to make 4 equal end of year payments to pay off this loan Your payments are: A=$1000(A/P,10%,4) = $315.47
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3 7.1 Reconsider the following Assume you invest $1000 over 4 years The investment generates $315.47/year Draw the cash flow diagram 0 1 2 3 4 P=$-1,000 A = +315.47
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4 7.1 Investment Problem What interest rate equates the future positive cash flows to the initial investment? We can state: -$1000= 315.47(P/A, i*,4) Where i* is the unknown interest rate that makes the PW(+) = PW(-)
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5 7.1 Investment Problem $1000= 315.47(P/A, i*,4) Solve the above for the i* rate (P/A,i*,4) = 1000/315.47 = 3.16987 Given n = 4 what value of i* yields a P/A factor value = 3.16987?
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