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Simple and compound interest; present value concept; and TVM.

1. Can you explain the difference between "simple" and "compound" interest? Please provide some of the uses of compound interest in business.
I also need to know the effects of using compound interest when evaluating future value transactions and calculations.

2. What is "present value"? What is an example of the "present value" concept? How does a single cash flow present value example differ from an annuity calculation?

3. How is a home mortgage an example of TVM? How can you show that more interest is paid at the beginning of a loan period than at the end?

Solution Preview

Simple interest is interest on the principle amount while compound interest is when your principle and any earned interest earned interest. The interest rate is applied to the original principle and any accumulated interest.
Compound interest is critical to investment growth. With simple interest, interest is paid just on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.

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 be Rs. 110/-
Thus compounding technique is use to find the future value of the investment

Use of Compounding in business:

1) Future value of Annuity

WE can also use the compounding technique to find out the future value of annuity in the following manner:

Example:
What's the future value in 10 years of $1,000 payments received at the beginning of each year for the next 10 years? A 5.625% interest rate is assumed.

Here we have to find out the compounded value of annuity
F=A*((1+r)^n-1)/r
F=Future value, A= Annuity r= rate of interest n=duration

A= 1000, r= 5.625%, n=10= ...

Solution Summary

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