Ravi Kiran

The Interest Rate

Which would you prefer Rs 1,00,000 today or Rs 1,00,000 in 5 years?
Obviously, Rs 1,00,000 today. This is recognized because there is TIME VALUE TO MONEY!!

Why TIME?
Why is TIME such an important element in your decision? TIME allows the opportunity to postpone consumption and earn INTEREST.

Time Value of Money

One of the fundamental principles of finance is the

concept that $1 today is more valuable than $1 a year from now. The reason for this is two-fold. First, a dollar will probably buy less goods and services in the future due to the destructive force of inflation. Second, if I have the dollar in my hand today, I can invest it and earn a a return in the form of dividends, interest or capital gains.

Time Value of Money

The best money advice anyone can ever give you is to

firmly establish this time value of money concept in your head. The key to financial prosperity is realizing the potential value of every dollar that comes into your hands. In fact, I think of cash as a seed you can either eat it (spend it) or invest it (sow it).

Time Value of Money

Lets assume you find a $20 bill on the side of the road.
You are faced with two potential uses: you can stick

the money in your tax-free retirement account or take yourself out to dinner. Its only twenty bucks! you say to yourself and opt for the dinner. In reality, you are spending far more. Using one of the time value of money formulas, we can calculate the real economic cost of not investing the cash.

Interest Rate
Interest is the manifestation of the time value of

money, and it essentially represents rent paid for use of the money. Computationally, interest is the difference between an ending amount of money and the beginning amount. If the difference is zero or negative, there is no interest.

Interest Rate
There are always two perspectives to an amount of

interest
interest paid interest earned

Interest is paid when a person or organization borrows

money (obtains a loan) and repays a larger amount. Interest is earned when a person or organization saves, invests, or lends money and obtains a return of a larger amount.

Interest Rate
Interest paid or earned is determined by using the

relation Interest = End Amount Original Amount When interest over a specific time unit is expressed as a percentage of the original amount (principal), the result is called the interest rate or rate of return (ROR). Interest rate or rate of return=(interest accrued per time unit/original amount) * 100

Interest Rate
The time unit of the interest rate is called the interest

period. By far the most common interest period used to state an interest rate is 1 year. Shorter time periods can be used, such as, 1% per month. Thus, the interest period of the interest rate should always be included. If only the rate is stated, for example, 8.5%, a 1-year interest period is assumed.

Return on investment (ROI)

The term return on investment (ROI) is used

equivalently with ROR in different industries and settings, especially where large capital funds are committed to engineering-oriented programs. The term interest rate paid is more appropriate for the borrowers perspective, while rate of return earned is better from the investors perspective. Interest rate or rate of return = (interest accrued per time unit/ original amount) * 100% Interest = end amount - original amount

Interest Rate
An employee at abc.com borrows Rs10,000 on April 1

and must repay a total of Rs 10,700 exactly 1 year later. Determine the interest amount and the interest rate paid. Interest = End Amount Original Amount Interest = Rs 10,700-10,000= Rs 700 Interest rate= ( 700/10000) *100 Interest Rate = 7%

Interest Rate
a. Calculate the amount deposited 1 year ago to have Rs

1000 now at an interest rate of 5% per year. b. Calculate the amount of interest earned during this time period.

Interest Rate
The total amount accrued (Rs 1000) is the sum of the

original deposit and the earned interest. If X is the original deposit,

Total accrued = original amount + original amount (interest rate)

Rs 1000= X+ X(0.05)= X ( 1+.05)= 1.05 X The Original deposit = Rs 1000/ 1.05=952.38

b. Interest= Rs 1000- 958.38=47.62

Simple or Compound Interest

The interest period was 1 year, and the interest amount

was calculated at the end of one period. When more than one interest period is involved (e.g., if we wanted the amount of interest owed after 3 years it is necessary to state whether the interest is accrued on a simple or compound basis from one period to the next

Simple Interest Example

Assume that you deposit $1,000 in an

account earning 7% simple interest for 2 years. What is the accumulated interest at the end of the 2nd year?

SI

= P0(i)(n) = $1,000(.07)(2) = $140

Simple Interest (FV)

What is the Future Value (FV) of the

deposit?
= P0 + SI = $1,000 + $140 = $1,140 Future Value is the value at some future time of a present amount of money, or a series of payments, evaluated at a given interest rate. FV

Simple Interest (PV)

What is the Present Value (PV) of the

previous problem?
The Present Value is simply the $1,000 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.

Why Compound Interest?

Future Value of a Single $1,000 Deposit
Future Value (U.S. Dollars)

20000 15000 10000 5000 0 1st Year 10th Year 20th Year 30th Year 10% Simple Interest 7% Compound Interest 10% Compound Interest

Future Value Single Deposit (Graphic)

Assume that you deposit $1,000 at a compound interest rate of 7% for 2 years.
0
7%

$1,000
FV2

Future Value Single Deposit (Formula)

FV1 = P0 (1+i)1 = $1,000 (1.07) = $1,070 Compound Interest You earned $70 interest on your $1,000 deposit over the first year. This is the same amount of interest you would earn under simple interest.

Future Value Single Deposit (Formula)

FV1 = P0 (1+i)1 = $1,000 (1.07) = $1,070
=

FV2 = FV1 (1+i)1 = P0 (1+i)(1+i) = $1,000(1.07)(1.07) P0 (1+i)2 = $1,000(1.07)2 = $1,144.90

You earned an EXTRA $4.90 in Year 2 with compound over simple interest.

Minimum attractive rate of return (MARR)

Engineering alternatives are evaluated upon the

prognosis that a reasonable rate of return (ROR) can be realized. A reasonable rate must be established so that the accept/reject decision can be made. The reasonable rate, called the minimum attractive rate of return (MARR), must be higher than the cost of money used to finance the alternative, as well as higher than the rate that would be expected from a bank or safe (minimal risk) investment.

MARR
For a corporation, the MARR (minimum attractive rate of

return) is always set above its cost of capital, that is, the interest rate a company must pay for capital funds needed to finance projects. If a corporation can borrow capital funds at an average of 5% per year and expects to clear at least 6% per year on a project, the minimum MARR will be 11% per year. The MARR is also referred to as the hurdle rate; that is, a financially viable projects expected ROR must meet or exceed the hurdle rate.

MARR
Note that the MARR is not a rate calculated like the

ROR; MARR is established by financial managers and is used as a criterion for accept/reject decisions. ROR MARR>Cost of Capital

Future Value
FV = pmt (1+i)n

FV = Future Value Pmt = Payment I = Rate of return you expect to earn N = Number of years To perform the calculation, we have to make a few assumptions. First, lets assume you are 30 years old (and hence 35 years away from retiring at 65). That means that the $20 can compound for 35 years. We will substitute 35 for n in the equation.

Future Value
Next, we must establish your expected rate of return.

Historically, the stock market has returned 12%. If you want to invest in bonds, your return will be lower. Assume that you invest in a combination of both and expect to earn a 10% rate of return. This will be substituted for the i variable in our equation. The pmt, or payment, is the value of the single amount you want to invest (in this case $20). Now that weve figured out the variables, the formula looks like this: FV = $20 (1+.10)35

Future Value
Enter 1.10 into your calculator (this is the sum of 1+.10).

Raise this to the 35th power. The result is 28.1024. Multiply the 28.1024 by the pmt of $20. The result ($562 and change) is the true cost of spending the $20 today (if you adjusted the $562 for inflation, it would probably work out to about $140 in todays dollars. That means your real purchasing power would increase approximately 7-fold).

Future Value
Clearly, this is enough to buy an entre at a five-star

restaurant! Armed with this knowledge, you are free to make an economic decision; namely, would you prefer to eat a $20 meal today or a $140 meal in the future. The answer is entirely personal. Once you understand this concept, however, it becomes painfully obvious that the small luxury items you think nothing of are really costing you millions and millions of dollars in future wealth.