Time Value of Money

Chapter 5

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 Overview

Future Value

Present Value

Finding I and N

Annuities

Rates of Return

Amortization

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 Time Lines

 Show the timing of cash flows.

 Tick marks occur at the end of periods, so Time
0 is today; Time 1 is the end of the first period
(year, month, etc.) or the beginning of the
second period.

0 1 2 3
I%

CF0 CF1 CF2 CF3

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 Drawing Time Lines

$100 lump sum due in 2 years

0 1 2
I%

100

3-year $100 ordinary annuity

0 1 2 3
I%

100 100 100

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 Drawing Time Lines

Uneven cash flow stream

0 1 2 3
I%

-50 100 75 50

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 TVM Components

 Basic Components
• PV = Initial Deposit
• i = Interest Rate
• n = Number of Periods (Years, Months, Days)
• FVn = Value at a specified future period

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 Calculator Conventions and Things to Note

 Cash Inflows are Positive

 Cash outflows are Negative
 Use ‘+|–’ key to convert positive to negative
numbers not the ‘–’ key which is used for
subtraction
 ALWAYS clear TVM function on the calculator
between new problem attempts

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 Future Value

 Time value of money calculations involve

Present value (what a cash flow would be worth
to you today) and Future value (what a cash
flow will be worth in the future).

 Finding the FV of a cash flow or series of cash

flows is called compounding.

 FV can be solved by using the step-by-step,

financial calculator, and spreadsheet methods.

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 Future Value

 What is the future value (FV) of an initial $100

after 3 years, if I/YR = 4%?

0 1 2 3
4%

100 FV = ?

n
FVn PV (1  i )

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 Solving for FV:
The Step-by-Step and Formula Methods

After 1 year:
• FV1 = PV(1 + I) = $100(1.04) = $104.00
After 2 years:
• FV2 = PV(1 + I)2 = $100(1.04)2 = $108.16
After 3 years:
• FV3 = PV(1 + I)3 = $100(1.04)3 = $112.49
After N years (general case):
• FVN = PV(1 + I)N

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 Solving for FV:
Calculator and Excel Methods

 Solves the general FV equation.

 Requires 4 inputs into calculator, and will solve
for the fifth. (Set to P/YR = 1 and END mode.)

INPUTS 3 4 -100 0
N I/YR PV PMT FV
OUTPUT 112.49

 Excel: =FV(rate,nper,pmt,pv,type)

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 Example 1

 What is the value of 100 dollars that is invested

in an account that earns 15% for 1 year? For 5
years?

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 Example 1

 PV = Investment = -$100
 FV = ?
 I/Y = interest rate = 15
 N= Periods = 5
 CPT FV = $201.14

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 Example 2

 What happens to your money if you spend

$1,000 on a credit card that charges 24% per
annum after 5 months? After 1 year? Assume
the interest is compounded monthly. Repeat the
1 year calculations if the interest is compounded
daily.

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 Example 2

After 5 Months
 PV = $1000
 N= Periods = 5
 i = interest rate = 24%/12=2%
 FV = ?
 CPT FV = -$1104.08

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 Example 2

After 1 year (compounded monthly):

 N=12
 CPT FV = -1268.214

After 1 year (compounded daily):

 PV = $1000
 i = 24%/365 = 0.0658
 N = 365
 CPT FV = -1271.15
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 Present Value: The Key Question

 What is value today of cash flow to be received

in the future?
 The answer to this question requires computing
the present value (PV) - the value today of a
future cash flow
 Finding the PV of a cash flow or series of cash
flows is called discounting (the reverse of
compounding).

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 Present Value: The Key Question

 What is value today of cash flow to be received

in the future?
 The answer to this question requires computing
the present value (PV) - the value today of a
future cash flow
 Finding the PV of a cash flow or series of cash
flows is called discounting (the reverse of
compounding).

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 Present Value

 What is the present value (PV) of $100 due in

3 years, if I/YR = 4%?

0 1 2 3
4%

PV = ? 100

FVn
PV  n
(1 i)

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 Solving for PV:
The Formula Method

 Solve the general FV equation for PV:

PV = FVN /(1 + I)N

PV = FV3 /(1 + I)3

= $100/(1.04)3
= $88.90

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 Solving for PV:
Calculator and Excel Methods

 Solves the general FV equation for PV.

 Exactly like solving for FV, except we have
different input information and are solving for a
different variable.

INPUTS 3 4 0 100
N I/YR PV PMT FV
OUTPUT -88.90

 Excel: =PV(rate,nper,pmt,fv,type)

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 Example 3

 What is the value today of $2,000 you will

receive at the end of year 3 if the interest rate is
8% compounded annually?

 What if the discount rate is 5%? 15%?

 What if the length of time is now 20 years?

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 Example 3

After 3 Years
 FV = $2,000
N = 3
i = 8
 CPT PV = -1587.66

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 Further Examples

 How much do you need to invest to have 10K in

5 years earning 12%?

 How much cash do you need to have today in

order to retire in 35 years with 1million
assuming you can earn 5% on average?

 How much will your house be worth if it

appreciates at 7% a year, you bought it for
200,000 and you expect to sell it in 5 years?

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 Simple v/s Compound Interest

 You have a choice between investing $10,000 in

Bank 1 at a rate of 6% but only receive simple
interest for 10 years and the choice of Bank 2 at a
rate of 6% compounded annually for 10 years. What
do you choose and how much extra do you receive?
 How much more expensive would your $3,000 couch
be if you decided to purchase with an American
Express credit card which charged you 21% APR
compounded annually rather than with your Visa
card that was only charging 21% simple interest?
Assume you did not make intermediate payments
and paid the couch off all at once in 6 years.

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 Solving for N

 If sales grow at 10% per year, how long before

sales double?
• Solves the general FV equation for N.
• Hard to solve without a financial calculator or
spreadsheet.
INPUTS 10 -1 0 2
N I/YR PV PMT FV
OUTPUT 7.3

• EXCEL: =NPER(rate,pmt,pv,fv,type)

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 Rule of 72

 It determine the number of years it will take to

double the value of your investment.
N = 72/interest rate
 For example, if you are able to generate an
annual return of 9%, it will take 8 years
(=72/9)

to double the value of investment.

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 Time Period Examples

 You need to buy a car when you graduate

college. You want to purchase a car for $40,000
but only have $25,000 saved for your car. If you
can earn 8% how long do you have to stay in
college?

 You have been saving to start a business and

realize you still have to pay the patent lawyers
to file for a patent. You have only $50,000. A
patent costs $75,000. How much longer do you
need to wait to file the patent if your money
earns 14% compounded annually?

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 Solving for I

 What annual interest rate would cause $100 to

grow to $119.10 in 3 years?
• Solves the general FV equation for I/YR.
• Hard to solve without a financial calculator or
spreadsheet.

INPUTS 3 -100 0 119.10

N I/YR PV PMT FV
OUTPUT 6

• Excel: =RATE(nper,pmt,pv,fv,type,guess)

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 Interest Examples

 If you have $1,000 today and you need $10,000

in 35 years, what rate do you need to earn?

 A firm must buy a warehouse in 25 years for

$1.5 million. The firm sells its last asset today
for $965,000. What rate of return does it need
to earn to make the investment?

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 Further Examples

 At 6% interest (compounded annually), how many

years would it take for a $100 investment to grow to
$133.82?
 If you invested $100 now and it grew to $146.93 in 5
years, what rate of interest (compounded annually)
would you be earning?
 How much would you need to invest today at 9%
(compounded annually), for your investment to grow to
$5,000 in 3 years?
 You expect to inherit $1 million from a trust when you
turn 30 years old. Prevailing interest rates are 4%
(compounded annually) How much is this worth to you
today? (Assume you just turned 22 years old.)

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 Further Examples (Answers)

 At 6% interest (compounded annually), how many years would it

take for a $100 investment to grow to $133.82?
• 5 years
 If you invested $100 now and it grew to $146.93 in 5 years, what
rate of interest (compounded annually) would you be earning?
• ~8%
 How much would you need to invest today at 9% (compounded
annually), for your investment to grow to $5,000 in 3 years?
• $3860.92
 You expect to inherit $1 million from a trust when you turn 30 years
old. Prevailing interest rates are 4% (compounded annually) How
much is this worth to you today? (Assume you just turned 22 years
old.)
• $730,690.21

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 Further Examples

 If interest rates are 6%, (compounded annually) ,

how much would you pay to buy the right to receive
$1,000,000 in four years?
 If you were able to buy the right in question 1 for
$750,000, what rate of interest (yield) would you be
earning ? More or less than 6%?
 How much would you need to invest today at 8%
(compounded annually) , to retire in 30 years with
$1,000,000?
 In the above question, how many years would you
have to wait to have $2,000,000?

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 Further Examples (Answers)

 If interest rates are 6%, (compounded annually) , how much

would you pay to buy the right to receive $1,000,000 in four
years?
• $792,094 (or less)
 If you were able to buy the right in question 1 for $750,000,
what rate of interest (yield) would you be earning ? More or less
than 6%?
• 7.46%
 How much would you need to invest today at 8% (compounded
annually) , to retire in 30 years with $1,000,000?
• $99,377.33
 In the above question, how many years would you have to wait
to have $2,000,000?
• 39.01 years

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 Annuity and Annuity Due

 An annuity is a series of equal dollar payments

that are made at the end of equidistant points in
time (such as monthly, quarterly, or annually)
over a finite period of time (such as three
years).
 If payments are made at the end of each period,
the annuity is referred to as ordinary annuity.
 If payments are made at the beginning of each
period then the annuity is an annuity due.

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 Annuity and Annuity Due

Ordinary Annuity
0 1 2 3
I%

PMT PMT PMT

Annuity Due
0 1 2 3
I%

PMT PMT PMT

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 Solving for FV

 Given a 3-Year Ordinary Annuity of $100 at 4%

• $100 payments occur at the end of each period,
but there is no PV.

INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 312.16

• Excel: =FV(rate,nper,pmt,pv,type)
• Here type = 0.

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 Solving for PV

 Given a 3-year Ordinary Annuity of $100 at 4%

• 100 payments still occur at the end of each
period, but now there is no FV.

INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -277.51

• Excel: =PV(rate,nper,pmt,fv,type)
• Here type = 0.

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 Solving for FV:
3-Year Annuity Due of $100 at 4%

 Now, $100 payments occur at the beginning of

each period.
FVAdue= FVAord(1 + I) = $312.16(1.04) = $324.65
 Alternatively, set calculator to “BEGIN” mode and
solve for the FV of the annuity due:
 Begin Mode is set by pressing
2ND -> PMT (BGN) -> 2ND -> Enter (Set)
 Don’t forget to set PMT Mode back to End after
finishing working on the problem
 End is set by pressing the same sequence of keys
2ND -> PMT (BGN) -> 2ND -> Enter (Set)

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 Solving for FV:
3-Year Annuity Due of $100 at 4%

 Excel: =FV(rate,nper,pmt,pv,type)
 Here type = 1.

BEGIN
INPUTS 3 4 0 -100
N I/YR PV PMT FV
OUTPUT 324.65

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 Solving for PV:
3-Year Annuity Due of $100 at 4%

 Again, $100 payments occur at the beginning of each

period.
PVAdue = PVAord(1 + I) = $277.51(1.04) = $288.61
 Alternatively, set calculator to “BEGIN” mode and solve for
the PV of the annuity due:
BEGIN
INPUTS 3 4 100 0
N I/YR PV PMT FV
OUTPUT -288.61

 Excel: =PV(rate,nper,pmt,fv,type)
 Here type =1
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 PV Calculation

 What is the present value of a 5-year

$100 ordinary annuity at 4%?
• Be sure your financial calculator is set
back to END mode and solve for PV:
 N = 5, I/YR = 4, PMT = -100, FV = 0.
 PV = $445.18.

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 Annuities Over Time

10-year • N = 10, I/YR = 4, PMT = -100, FV = 0;

annuity solve for PV = $811.09.

25-year • N = 25, I/YR = 4, PMT = -100, FV = 0;

annuity solve for PV = $1,562.21.

Perpetuity • PV = PMT/I = $100/0.04 = $2,500.

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 The Power of Compound Interest

 A 20-year-old student wants to save $5 a day for

her retirement. Every day she places $5 in a
drawer. At the end of the year, she invests the
accumulated savings ($1,825) in a brokerage
account with an expected annual return of 8%.

How much money will she have when

she is 65 years old?

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 Solving for FV

 If she begins saving today, how much will she

have when she is 65?
• If she sticks to her plan, she will have $705,373
when she is 65.

INPUTS 45 8 0 -1825
N I/YR PV PMT FV
OUTPUT 705,373

• Excel: =FV(.08,45,-1825,0,0)

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 Solving for FV

 If you don’t start saving until you are 40 years

old, how much will you have at 65?
• If a 40-year-old investor begins saving today, and
sticks to the plan, he or she will have $133,418 at
age 65. This is $571,954 less than if starting at
age 20.
• Lesson: It pays to start saving early.
INPUTS 25 8 0 -1825
N I/YR PV PMT FV
OUTPUT 133,418

• Excel: =FV(.08,25,-1825,0,0)
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 Solving for PMT

 How much must the 40-year old deposit annually

to catch the 20-year old?
• To find the required annual contribution, enter the
number of years until retirement and the final goal
of $705,372.75, and solve for PMT.
INPUTS 25 8 0 705373
N I/YR PV PMT FV
OUTPUT -9,648.64

• Excel: =PMT(rate,nper,pv,fv,type)
=PMT(.08,25,0,705373,0)

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 PMT Examples

 What will your monthly payment be for a car

you purchase for $43,500 where the bank will
finance it for you for 48 months at 5.5%?

 You can save $500 per month, earn interest at

3% per year for 18 years. How much will you
have for your children’s college? Does it matter
how its compounded? (Annual v/s Monthly)

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 PMT Examples

 What will your monthly payment be for a car

you purchase for $43,500 where the bank will
finance it for you for 48 months at 5.5%?
• -1011.6567

 You can save $500 per month, earn interest at

3% per year for 18 years. How much will you
have for your children’s college? Does it matter
how its compounded? (Annual v/s Monthly)
• Annual: 140,486
• Monthly: 142,970

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 Perpetuities

A perpetuity is an annuity that continues forever

or has no maturity. For example, a dividend stream
on a share of preferred stock. There are two basic
types of perpetuities:

PMT
PV 
i

 Example:
• You receive a dividend of $20 each year forever
and will invest it at 8%. What is it worth today?
• PV = 20/.08 = 250
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 What is the PV of this uneven cash flow stream?

0 1 2 3 4
4%

100 300 300 -50

96.15
277.37
266.70
-42.74
597.48 = PV

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 Solving for PV: Uneven Cash Flow Stream

 Input cash flows in the calculator’s “CFLO”

register:

CF0 = 0

CF1 = 100

CF2 = 300

CF3 = 300

CF4 = -50

 Enter I/YR = 4, press NPV button to get NPV =

$597.48. (Here NPV = PV.)
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 Will the FV of a lump sum be larger or smaller if compounded
more often, holding the stated I% constant?

LARGER, as the more frequently compounding occurs,

interest is earned on interest more often.
0 1 2 3
10%

100 112.49
Annually: FV3 = $100(1.04)3 = $112.49

0 1 2 3
0 1 2 3 4 5 6
5%

100 112.62

Semiannually: FV6 = $100(1.02)6 = $112.62

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 PV/FV Examples

 How much is the price of a house today if the payment is

calculated to be 1500 per month at a stated rate of 8%
which is compounded monthly over a 30 year period.
 How much is an annuity worth today if it pays $675 a
year for 15 years assuming the interest rate is 7%.
 If you buy an annuity in your retirement account (it gets
reinvested) and the annuity pays $1,000 per year over
the next 20 years, how much will you have when you
retire? Assume this is your only investment and you
earn a rate of 7%
 You win the lottery and can take either a lump sum
payment or $200,000 per month for the next 35 years.
Assume the State of CA has a discount rate of 4% per
annum. What is the lump sum you could take?

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 PV/FV Examples

 How much is the price of a house today if the payment is calculated to be

1500 per month at a stated rate of 8% which is compounded monthly over a
30 year period.
• 204,425.24
 How much is an annuity worth today if it pays $675 a year for 15 years
assuming the interest rate is 7%.
• 6147.84
 If you buy an annuity in your retirement account (it gets reinvested) and the
annuity pays $1,000 per year over the next 20 years, how much will you
have when you retire? Assume this is your only investment and you earn a
rate of 7%
• 40995.49
 You win the lottery and can take either a lump sum payment or $200,000 per
month for the next 35 years. Assume the State of CA has a discount rate of
4% per annum. What is the lump sum you could take?
• 45,169,694

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 Rate Examples

 You win the lottery worth 64M. You can either

take the after tax cash payment today (48.3M)or
receive an annuity over the next 30 years in the
amount of 2.9M per year. What is the discount
rate the State of Texas is assuming? What about
if you receive 241,667 per month?

 You purchase a car for $25,000 and amortize it

over a 5 year period. Your payment is $456 per
month. Assume the car is fully amortized at the
end of the 5 years. What is your annual rate of
interest? How much will you save if you pay the
car off in 4 years?

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 Rate Examples (Answers)

 You win the lottery worth 64M. You can either take the
after tax cash payment today (48.3M)or receive an
annuity over the next 30 years in the amount of 2.9M per
year. What is the discount rate the State of Texas is
assuming? What about if you receive 241,667 per month?
• Annual: 4.312%
• Monthly: 4.393%

 You purchase a car for $25,000 and amortize it over a 5

year period. Your payment is $456 per month. Assume
the car is fully amortized at the end of the 5 years. What
is your annual rate of interest? How much will you save if
you pay the car off in 4 years?
• Diff = 475.30
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 Classification of Interest Rates

Nominal rate (INOM): also Periodic rate (IPER): amount

called the quoted or stated of interest charged each
rate. An annual rate that period, e.g. monthly or
ignores compounding effects. quarterly.

IPER = INOM/M, where M is the

INOM is stated in contracts.
number of compounding
Periods must also be given,
periods per year. M = 4 for
e.g. 4% quarterly or 4% daily
quarterly and M = 12 for
interest.
monthly compounding.

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 Classification of Interest Rates

 Effective (or equivalent) annual rate (EAR = EFF%): the annual

rate of interest actually being earned, considering
compounding.
• EFF% for 4% semiannual interest
EFF% = (1 + INOM/M)M – 1
= (1 + 0.04/2)2 – 1 = 4.04%
• Calculator:

2ND -> ICONV (Above Number 2) -> Enter the nominal rate -

> Enter -> Down Arrow Twice -> Enter the number of

compounding periods -> Enter -> Up Arrow -> CPT

• Should be indifferent between receiving 4.04% annual interest
and receiving 4% interest, compounded semiannually.

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 The Importance of Effective Rates of Return

Investments with different compounding intervals

provide different effective returns.

To compare investments with different

compounding intervals, you must look at their
effective returns (EFF% or EAR).

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 The Importance of Effective Rates of Return

 See how the effective return varies between

investments with the same nominal rate, but
different compounding intervals.

EARANNUAL 4.00%
EARSEMIANNUALLY 4.04%
EARQUARTERLY 4.06%
EARMONTHLY 4.07%
EARDAILY (365) 4.08%

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 When is each rate used?

 INOM: Written into contracts, quoted by banks and

brokers. Not used in calculations or shown on
time lines.
 IPER: Used in calculations and shown on time
lines. If M = 1, INOM = IPER = EAR.
 EAR: Used to compare returns on investments
with different payments per year. Used in
calculations when annuity payments don’t
match compounding periods.

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 Example

 Which bank loan would you prefer to take?

• Bank A: 15% compounded daily
• Bank B: 15.5% compounded quarterly
• Bank C: 16 % compounded annually

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 End of Chapter 5

© 2019 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website,
in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise
on a password-protected website or school-approved learning management system for classroom use.
Cover image attribution: “Finance District” by Joan Campderrós-i-Canas (adapted) https://flic.kr/p/6iVMd5