1Chapter 6 Class Notes Simple interest vs. Compound interest:oSimple interest amount = Principal * annual interest rate * period oCompound interest amount includes interest not only on the initial investment but also on the accumulated interest in previous periods. Example: Assume we will save $1,000 for three years and earn 6% interest compounded annually. Time value of Money:1.A single sum:Assume we will save $1,000 for three years and earn 6% interest compounded annually. On 1/1 in Year 1: $1,000 on Dec. 31 in Year3: $ 1,191.02 (a) Future valueof a single sum = Present value * (1+ r) nFuture value of $1000 after 3 years: $1,000 × [1.06]3= $1,191.02 (b)Present valueof a single sum = Future value *( 1/ (1+ r) n )Present value of $1,192.02: $1,191.02 × (1/ [1.06]3)= $1,000 Where r = interest rate n= compounding periods Original balance1,000.00$ First year interest60.00Balance, end of year 11,060.00$ Balance, beginning of year 21,060.00$ Second year interest63.60Balance, end of year 21,123.60$ Balance, beginning of year 31,123.60$ Third year interest67.42Balance, end of year 31,191.02$
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