{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Class 2 Jan 9th Completed

# 11 interest and interest rates o interest i is the

This preview shows pages 11–17. Sign up to view the full content.

11

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
‘Interest’ and ‘Interest Rates’ O Interest I is the price someone who borrows money (borrower, debtor) pays the lender (creditor) for the use of the borrowed money. – Also, money earned on deposited funds (e.g. a savings account). O Usually expressed as an annual percentage of the outstanding balance (‘principal outstanding’): => Interest rate r O Interest rate charged depends on: – Credit risk of borrower (likelihood of not being paid back either principal or interest plus principal). – Duration of loan. – Inflation rate. – We distinguish between simple and compound interest. 12 r = \$ I \$ P ! \$ I = r *\$ P
Visual Aid: The Timeline O A timeline is a linear representation of the timing of potential cash flows. O Drawing a timeline of the cash flows lets you visualize a financial problem that involves cash outflows and inflows at different points in time. -1 0 1 2 Periods O ----|--------------------|--------------------------|-------------------------|--------- Cash Flows One period ago Today End of Period 1 = Beginning of Period 2 13 Year 1 Year 2 Period 1 Period 2

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
Different Time Lines 0 1 2 3 4 Periods |----------|----------|----------|---------|---- Cash Flows (CFs) -1 0 1 2 3 4 Periods -|---------|----------|----------|----------|---------|--- CFs T S R Q K P Periods -|---------|----------|----------|----------|---------|-- CFs Interest rate you use has to be the effective interest rate for the length of a period. 14
Cash Flows and The Timeline O One can differentiate between two types of cash flows: – Inflows are positive cash flows. – Outflows are negative cash flows, which are indicated with a – (minus) sign. – Example: You borrow \$10,000 from a friend. You repay him in two installments of \$5,500 at the end of each of the next two years. – Your cash flows look like this: -1 0 1 2 Periods O ----|--------------------|--------------------------|-------------------------|--------- \$10,000 - \$5,500 - \$5,500 O What do your friend s cash flows look like? 15

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
Simple Interest O Interest that is paid only on the amount originally invested but not on any interest that accrues subsequently. O >Not very common in finance< O Interest payments are given by I =r*P each period, where r is the simple rate of interest O Over n periods, the original amount invested grows to FV n = P + r*P+ r*P + r*P = P + n*r*P = P(1 + n*r) O Example: Firm borrows \$100 at 5% simple interest due at the end of 4 years. What amount must firm repay after 4 years?
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### Page11 / 20

11 Interest and Interest Rates O Interest I is the price...

This preview shows document pages 11 - 17. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online