1
Chapter 6 Class Notes
Simple interest vs. Compound interest:
o
Simple interest amount = Principal * annual interest rate * period
o
Compound 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 value
of a single sum
= Present value * (1+ r)
n
Future value of $1000 after 3 years:
$1,000 × [1.06]
3
= $1,191.02
(b)
Present value
of 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 balance
1,000.00
$
First year interest
60.00
Balance, end of year 1
1,060.00
$
Balance, beginning of year 2
1,060.00
$
Second year interest
63.60
Balance, end of year 2
1,123.60
$
Balance, beginning of year 3
1,123.60
$
Third year interest
67.42
Balance, end of year 3
1,191.02
$

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