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ie (1i)m 1
03-1
12
12.80%
12.70%
12.60%
Effective Interest Rate
ie1 1 12%
1 12.68%
12
4
ie2 1 12% 1 12.55%
4
2
ie3 1 12% 1 12.36%
2
12.50%
12.40%
12.30%
12.20%
12.10%
12.00%
11.90%
0
10
15
20
25
30
35
40
45
Continuous Compounding
Continuous compounding means the number of periods increase
infinitely. Effective interest rate is;
i e e im 1
See corresponding continuous compounding interest factor equations.
03-2
F Peim n P F / P, im , n
F Peim (365) n
F Peim (12)n
F Peimn
03-3
approximated by
Real interest rate Nominal rate - inflation
03-4
Example
Gas price is 50 per liter today. Expect prices to appreciate by 4% p.a. for
the next five years. If inflation is 6% p.a. Calculate the nominal and real
fuel cost per year if your annual demand is 2 million liters. Determine the
PV of your costs if nominal discount rate is 12%.
Year
Nominal
cost/liter
Real
cost/liter
Nominal cost
(m$)
Real cost
(m$)
0.50
0.50
1.00
1.00
0.52
0.49
1.04
0.98
0.54
0.48
1.08
0.96
0.56
0.47
1.12
0.94
0.58
0.46
1.17
0.93
0.61
0.45
1.22
0.91
03-5
Nominal
cost (m$)
Year
Real
cost
(m$)
PV of
Nominal
Cost(m$)
PV of Real
Cost(m$)
1.00
1.00
1.04
0.98
0.93
0.93
1.08
0.96
0.86
0.86
1.12
0.94
0.80
0.80
1.17
0.93
0.74
0.74
1.22
0.91
0.69
0.69
5.03
5.03
PV
Nominal cash
flows are
discounted with
nominal discount
rate and real
cash flows are
discounted with
real rates.
03-6
CFt
t
t 1 1 RRR
RRR - rate of return
NPV I 0
03-7
PI
PV (Cash inflow)
I 0 (Cash Outflow)
PV
1
I0
PV I0
NPV 0
PV I0 0
IRR internal rate of return, NPV = 0
Solve for simple eqns
Guess and test
Goal seek in Excel
03-8
Project B
500
100
300
50
NPV
200
50
PI
1.67
2.0
03-9
03-10