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Unformatted text preview: Time Value of Money IEMS 326 Lecture 1 Goal • Value streams of future cashflows. • Project valuation: are we better off with or without this cashflow stream? • Bonds: how much would we pay for this cashflow stream? Simple Interest • Borrowing i.e. renting money: a 4% annual interest rate means that it costs $4 = (0.04)(100) to rent $100 for 1 year, with the rent paid at the end . • With the same simple annual rate, it costs $2 to rent $100 for 6 months (repay $102) or $8 to rent $100 for 2 years (repay $108). Simple interest is rare. Paying Interest Like Rent • If you paid the rent every period, the total amount paid would be the same as with simple interest. • Pay $4 at year 1, $4 at year 2 because the principal (amount owed) is still $100. • Total payment: $8. • Compare to simple interest: $8 at year 2. Compound Interest • When the rent is not paid, but accumulates. • Recall: at 4% simple annual interest, a loan of $100 for 2 years must be repaid with $8 interest: $4 for each year, at the end. • With annual compounding, – $104 is owed after 1 year – $108.16 = ($104)(1.04) after 2 years. • Same rate, different meaning, different value. Simple vs. Compound • Simple interest at 4%: repay $108 at year 2. • Compounding at 4%: $108.16 at year 2....
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This note was uploaded on 04/07/2008 for the course IEMS 326 taught by Professor Staum during the Winter '07 term at Northwestern.
 Winter '07
 STAUM

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