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Simple and Compound Interest; Present and Future Values

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Part A: What is the difference between "simple" and "compound" interest? What are some of the uses of compound interest in business? What are some of the effects of using compound interest when evaluating future value transactions and calculations?

Part B: Describe the concepts of PV, FV, PV of an annuity, and FV of an annuity. Briefly list the different methods of solving these problems. What limitations do any of these methods have?

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Solution Summary

Interest, PV and FV are investigated.

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Simple interest is interest on the principle amount while compound interest is when interest is charged on the principle and any earned interest. The interest rate is applied to the original principle and any accumulated interest.

Time value of money always use compound interest. Thus it is used to find the present value, future value of any amount and annuity. It is used in capital budgeting to calculate the net present value of the project.

For example in case of home mortgages also the person takes loan which must be paid by him in future in installments. The present value of future installments must be equal to the loan taken. Hence time value of money plays an important role to equate the future value of installments to the amount of mortgage taken.

The effects of using compound interest is:
1) It gives accurate picture
2) It takes care of time value
3) It takes care of opportunity cost

Future Value = Present Value (1+r)^n
r= interest rate
n= time period

Future value of today's Rs 100 @10% per annum after one year will ...

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