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Hello
I will not be able to type the entire question from the exam kit…so can you please refer to the last 2 qns relating to capital budgeting in section A (objective test qns) from the Kaplan exam kit for the below?
Now the specific part I am confused in from those 2 questions is that a different formula had been used to calculate the rate:
This was used (1+i)^n -1 instead of (1+i/n)^n-1.According to the study text the 2nd formula is right, so why was the first one used for those 2 qns in the exam kit? Please help me understand.
I apologise for any inconvenience. Thanking you in advance.
I do not have the Kaplan Kit (only the BPP Kit).
As to which formula, it depends on what was written in the question and so you will have to state the question(s).
I assume that you have watched my free lectures on interest rates?
Ok, I am talking about the following 2 questions:
1) What is the effective annual rate of interest of 2.1% compounded every three months?
A.6.43%
B. 8.40%
C.8.67%
D. 10.87%The answer is C using the formula (1+i)^n -1
2) A bank offers different bank accounts with different interest rates:
Bank account 1 = 10% interest per year, interest calculated quarterly
Bank account 2 = 12% interest per year, interest calculated monthly
Bank account 3 = 1.2% interest per month
Bank account 4 = 3% interest per quarter
Which account gives the highest annual effective interest rate?A1
B2
C3
D4The answer is C. The formula (1+i/n)^n-1 was used for bank account 1 and 2 which is not an issue because that was the formula stated in the study text. My confusion is with bank account 3 and 4 where the other different formula ((1+i)^n -1) had been used.
Can you please explain why a different formula had been used for the above? Isn’t there supposed to be a single formula used to calculate all effective interest rates?
Thanks
The first question is telling you the quarterly rate of interest as being 2.1% and therefore the annual rate of interest is as you have written.
The second question is not telling you the quarterly or monthly interest rate – it is telling you the annual interest rate. So for the quarterly rate you divide by 4, and then use the formula. For the monthly rate you divide by 12 and then use the formula. The wording of the first two alternatives is different from the wording of the other two.
Again, have you watched the free lectures. Make sure you understand what is happening rather than simply rely on learning formulae.
Oh. So the reason for dividing an annual interest rate over the number of quarters or months is to calculate the initial quarterly or monthly interest rate that will be compounded overtime right?
Which means in the case of, eg, bank account 3 and 4 we were already given that initial interest rate so we did not have to divided it by anything.
Please correct me if I am wrong, I would really like to understand what the formula means
What you have written is correct 🙂
It just highlights how important it is to read the question really carefully because obviously the wording is very similar at just a quick read.
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