Finance 257 Chapter 5
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What is the difference between simple interest and compound interest?
- With simple interest, interest is earned on the principle only.
- With compound interest, interest is earned on both principal and reinvested interest.
Suppose you have $500 to invest and you believe that you can earn 8% per year over the next 15 years.
1. How much would you have at the end of 15 years using compound interest?
2. How much would you have using simple interest?
1. N=15; I/Y = 8; PV = 500; CPT FV = -1586.08
2. 500 + 15(500)(.08) = 1100
What is the relationship between present value and future value?
The mathematical relationship is PV = FV / (1 + r)t. The present value is always less than the future value when we have positive rates of interest.
Suppose you need $15,000 in 3 years. If you can earn 6% annually, how much do you need to invest today?
N = 3; I/Y = 6; FV = 15,000; CPT PV = -12,594.29
Suppose you need $15,000 in 3 years. If you could invest the money at 8%, would you have to invest more or less today than at 6%? How much?
N = 3; I/Y = 8; FV = 15,000; CPT PV = -11,907.48 (Difference = 686.81)
You can invest $500 today and receive $600 in 5 years. The investment is considered low risk. What is the implied interest rate?
N = 5; PV = -500; FV = 600; CPT I/Y = 3.714%
You can invest $500 today and receive $600 in 5 years. The investment is considered low risk. Or you can invest the $500 in a bank account paying 4%. Which investment should you choose?
Choose the bank account because it pays a higher rate of interest.
If you were borrowing $500 today and repaying in five years, would you choose to repay at 4% or repay $600?
You would choose to repay $600 because you would be paying a lower rate.
Suppose you want to buy some new furniture for your family room. You currently have $500 and the furniture you want costs $600. If you can earn 6%, how long will you have to wait if you don’t add any additional money?
PV = -500; FV = 600; I/Y = 6; CPT N = 3.13 years
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