FINANCIAL MANAGEMENT

TA : R a n i a E l G h o n e m y

Section 10

Discounted cash Flow Valuation

Chapter 5

part (2)
Stated interest rate: the interest rate expressed in terms of the interest
payment made each period.

Effective annual rate: the interest rate expressed as if it were compounded

once per year.

Annual percentage rate: the interest rate charged per period multiplied by
number of periods per year.
If Hassan wants to deposit 500,000 EGP in a bank but he is confused
which bank to choose, so he found the following:

Has interest rate 13% compounded Semiannually

Has interest rate 12.5 % compounded Quarterly

Has interest rate 14% compounded Annually

Has interest rate 12% compounded Daily

 o Effective annual rate (EAR) : the interest rate expressed as if it were
compounded once per year.

 EAR = -1 OR  EAR = -1

m is the number of times that the interest is compounded

o Annual percentage rate (APR) : the interest rate charged per period multiplied
by number of periods per year.

 APR =
example, if a credit card charges 1% interest per month, multiplying it by 12 gives a
nominal APR of 12% per year.

o Stated ( Quoted ) interest rate : the interest rate expressed in terms of the
interest payment made each period.
 So, lets get the EAR to know the interest rate expressed as if it were compounded once
per year for each bank .

 EAR = -1

  13.4%

  13.1%

  14%

  12.7 %

• As a saver I’ll choose to put my money in NBE Bank

• As a borrower I’ll choose to take a loan from HSBC bank
 Types of Loans

Interest Only
Pure Discount Loan Amortized loans
Loan

The Loan is repaid as one The Interest is paid each The Loan is repaid in parts
lump sum at the end of the period . over time.
loan
The principle amount is
(Principle + Interest ) paid at some point in the
future ( end of the loan).

Interest principle Interest principle Interest principle

All paid at the end Each at the paid each period

period end
1- Pure Discount Loans R= 10%

0 1 2 3

$25,000 25,000 + 2,500

Principle Interest

2. Interest-Only loans R= 10%

0 1 2 3

$25,000 $2,500 $2,500 $25,000 + $2,500

Interest Principle Interest

3. Amortization loan

0 1 2 3

$25,000 $9,000 $9,000 $9,000

Interest Principle
Example 14 : (From End Of Chapter 5 Questions)

Calculating EAR. First National Bank charges 10.9 percent compounded

monthly on its business loans. First United Bank charges 11.1 percent
compounded semiannually. As a potential borrower, which bank would you go
to for a new loan ?

  SOLUTION
 For discrete compounding, to find the EAR, we use the equation:

 EAR = [1 + (APR / m)]m – 1

 
So, for each bank, the EAR is:
 
First National: EAR = [1 + ( ) ]12 – 1 = 0.1146 or 11.46 %
 
First United: EAR =– 1 = 0.11408 or 11.408%
 
For a borrower, First United would be preferred since the EAR of the
loan is lower.
• Notice that the higher APR does not necessarily mean the higher EAR.
• The number of compounding periods within a year will also affect the EAR.
Example 15 : (From End Of Chapter 5 Questions)

Calculating APR. Magnus Credit Corp. wants to earn an effective annual return
on its consumer loans of 17 percent per year. The bank uses daily compounding
on its loans. What interest rate is the bank required by law to report to potential
borrowers? Explain why this rate is misleading to an uninformed borrower

  SOLUTION

The reported rate is the APR, so we need to convert the EAR to an APR as follows:
 
EAR = [1 + (APR / m)]m – 1
 
APR = m [ (1 + EAR )1/m – 1 ]

APR = 365[(1 + 17% ) 1/365 – 1] = 0.157 or 15.7%

This is deceptive because the borrower is actually paying annualized interest of 17% per
year, not the 15.7% reported on the loan contract.
 Example 17 : (From End Of Chapter 5 Questions)
Calculating Future Values. Bucher Credit Bank is offering 4.7 percent compounded
daily on its savings accounts. If you deposit $3,650 today, how much will you have
in the account in 5 years? In 10 years? In 20 years?

  SOLUTION
  this problem, we simply need to find the FV of a lump sum using the equation:
For
 
FV = PV(1 + r)t
 
It is important to note that compounding occurs daily.
To account for this, we will divide the interest rate by 365 (the number of days in a year,
ignoring leap year), and multiply the number of periods by 365. Doing so, we get:
 
FV in 5 years = = $ 4,616.8

FV in 10 years = = $ 5,839.8
 
FV in 20 years = = $ 9343.4
Example 18 : (From End Of Chapter 5 Questions)
Calculating Present Values. An investment will pay you $65,000 in nine years. If
the appropriate discount rate is 5.5 percent compounded daily, what is the present
value?

  SOLUTION

  this problem, we simply need to find the PV of a lump sum using the equation:
For
 
PV = FV / (1 + r)t
 
It is important to note that compounding occurs on a daily basis. To account for this, we
will divide the interest rate by 365 (the number of days in a year, ignoring leap year), and
multiply the number of periods by 365. Doing so, we get:
 
PV = $65,000 / [(1 + )9(365)]

PV = $ 39,623.6
Example 19 : (From End Of Chapter 5 Questions)
EAR versus APR. Ricky Ripov’s Pawn Shop charges an interest rate of 13.7
percent per month on loans to its customers. Like all lenders, Ricky must report an
APR to consumers. What rate should the shop report? What is the effective annual
rate?
  SOLUTION
 
 The APR is simply the interest rate per period times the number of periods in a year. In
this case, the interest rate is 13.7% per month, and there are 12 months in a year, so we
get:
 
APR = 12(13.7% ) = 1.644 = 164.4%
 
To find the EAR, we use the EAR formula:
 
EAR = [1 + (APR / m)]m – 1
 
EAR = (1 + )12 – 1 = 3.6679 or 366.79 

Notice that we didn’t need to divide the APR by the number of compounding periods per
year. We do this division to get the interest rate per period, but in this problem we are
already given the interest rate per period.
 Example 55 : (From End Of Chapter 5 Questions)

Amortization with Equal Payments. Prepare an amortization schedule for a three-

year loan of $75,000. The interest rate is 8 percent per year, and the loan calls for
equal annual payments. How much interest is paid in the third year? How much
total interest is paid over the life of the loan?
  SOLUTION
 
The payment for a loan repaid with equal payments is the annuity payment with the loan
value as the PV of the annuity. So, the loan payment will be:
 
 PVA = C ({1 – [1/(1 + r)t]} / r ) = C

$75,000 = C

$75,000 = C 2.577 C = $ 29, 102.5

The interest payment is the beginning balance times the interest rate for the period, and the
principal payment is the total payment minus the interest payment. The ending balance is
the beginning balance minus the principal payment. The ending balance for a period is the
beginning balance for the next period. The amortization table for an equal payment is:
 Total Payment Beg. Balance
– -
Beg. Balance x IR Interest payment Principal payment
Beginning Total Interest Principal Ending
Year Payment Payment Payment Balance
Balance
29,102.5 - 6, 000= 75,000.00
75,000 x 8%=
1 $75,000.00 $ 29, 102.5 - 23, 103.25=
$6, 000 $51,897.5
$23, 103.25
2 $51,897.5 $ 29, 102.5 4, 151.8 24,950.7 26,946.8
3 26,946.8 $ 29, 102.5 2,155.7 26,946.8 0
$87,307.5 $12,307.5 75,000.75

In the third year, $2,155.7 of interest is paid.

 

Total interest over life of the loan = $6, 000 + 4, 151.8 + 2,155.7

= $12,307.5