Hi Guys,
I am new to the CFA and just beginning my long journey to pass this sucker (and finance really), and I’ve come across more of an understanding problem rather than a how to solve problem.
My question is this: When solving for the Payment of a fixed term amortizing loan, such as a mortgage, I would only divide the annual interest rate (let’s say it is 10%) by 12, to get the monthly interest rate (.0083333). This rate is used to calculate the interest vs. principal payment, etc.
However when we are discounting cashflows using the Net Present Value, we cannot simply use the annual discount rate/12. For Example, let’s say we have an initial investment of $100,000. Then three monthly periods of cash flows of $25,000, $30,000, and $35,000. At the end of year 4, we sell the investment for $200,000.
To solve for NPV, the discount rate that we use (10% again) will not work if we do .10/12, as this does not include compounding. We need to use the Effective Interest Rate, which would be =1+.10)^(1/12)+1
So why do we use the effective interest rate when solving for NPV/Discounted Cash Flows, but not when we are using Rate to solve for a mortgage payment/interest expense, etc? I understand that the Effective Interest Rate over the 12 months will equal the Annual Rate, but I don’t know why it isn’t used in the mortgage example.
I’m just missing the bridge here so any help is appreciated. Thanks!