Classification of Interest Rates:

1
Classification of Interest Rates Nominal rate
Periodic rate EAR (effective
annual rate)
2
What is the effective annual rate for the
following compounding frequencies if the quoted
rate is 10
3
Among other things the effective annual rate can
be used when compounding periods do not match the
frequency of the compounding periods. Example
You have inherited a 10-year annuity which pays
4000 annually. The interest rate this annuity
earns is 8 annually, compounded quarterly. What
is the present value of this annuity? ________
___________________________________________
___
4
Perpetuities Similar to an annuity in that the
cash flows are over even time periods and the
cash flows are of equal value however,
perpetuities will that cash amount for all
eternity, forever!!! PV(perputituity) PMT/I
or PMT(1/I) Lets look at how this is? Assume the
current interest rate is 10, and that we have an
instrument that will pay 1 every year. What is
the PVA if
5
Growing Perpetuities Imagine an apartment
building where the value of the apartment to the
owner is the value of the cash flows from Rent.
The owner increases the rent by 5 annually. If
one assumes that the rent will increase
indefinitely, the cash flow stream is a growing
perpetuity. How do we value this? Assume the
rent is 1000 per year (to be paid at the end of
the year) and that the relevant interest rate for
discounting is 10. _______________________
___________________________
6
Example The Sands Corp is about to pay a stock
dividend of 3.00 per share. Investors
anticipate that the annual dividend will rise by
6 per year, forever. The risk-free rate is
currently 3.5 and the market risk premium is 6.
The beat for Sands Corp is 1.5. What is the
value to the investors of the future dividends?
(This is a growing perpetuity problem!!)