Chapter 1, AS 2053, section 570/571

Chapter 1
Simple Interest and Simple Discount
Section 1.1 Accumulated Value at Simple Interest
Actuarial Science 2053 (skip Demand Loans in page 6)

Section 1.2 Discounted Value at Simple Interest

Section 1.3 Equations of Value
Section 270/271 Section 1.4 Partial Payments
Instructor: Xing Jiang
Section 1.5 Simple Discount at a Discount Rate

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Definitions/Notation
Section 1.1 Accumulated Value at Simple Interest
P = principal
Consider the following transaction:
= original amount borrowed
Person A lends money to person B
= original amount invested
 person A is called the “lender” or “investor”
 person B is called the “borrower” or “debtor”
t = length of investment (in years)
Example:
1. You deposit your money into a saving account in TD bank.
I = interest
2. You borrow a loan from a financial company to buy a new car.
= a dollar amount of money, representing a fee or service charge
3. You buy a Treasure Bill from Bank of Canada.
paid to the lender for the use of his/her money
The debtor must pay back the original amount borrowed (at
r = rate of interest per year
some point in the future) along with a fee ( or rent) charged for
= ratio of the interest earned over a period of time to the principal
the use of the money, called interest
S = accumulated value of P, or the maturity value of P.
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Chapter 1, AS 2053, section 570/571

Simple Interest
Interest is calculated on the original principal only during the Combining the above two formulas, we have:
whole term of the investment (or loan), at the stated annual rate of
interest S  P  (1  r  t )
The factor (1  r  t ) is called an accumulation factor at a
It is calculated by means of the formula: simple interest rate r.
Note About Time
I  P r  t
From the definition of S, we have: The value of t must be in years

S  PI If time is given as something other than years, we make the

following adjustments to t:
When is simple interest used?
Borrow or invest money for a short term transaction (usually less If time is given in months, then
than 1 year) number of months
t
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If time is given in days, or if you are given actual dates, then Example 1.1.1
Using exact and ordinary interest, what will $1000 accumulate to
(a) Exact Interest over 120 days at r = 7%?
The year is taken as 365 days (leap year or not)

number of days
t
365
(b) Ordinary Interest: (or Banker’s Rule, in U.S. and international
business transactions)
number of days
t
Note: 360
In this textbook, exact interest is used all the time unless
specified otherwise.

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Chapter 1, AS 2053, section 570/571

If you are given

actual dates, you
need to count
number of days
given interest.

You can find the

table in the last
page of your
textbook.

Note: The ordinary interest is always greater than the exact

interest. It brings increased money to the lender.

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Note: The most common practice is to count the starting date,

but not the ending date. (That means you cannot count both
Example 1.1.3
ends!!!)
You invest $5000 in a 6-month guaranteed investment certificate
To determine the number of days of your investment between
(GIC) paying interest at r = 4%.
two dates, all you have to do is to subtract the two values you
(a) What is the maturity value of the GIC?
obtain from the table in the previous page.
(b) What is the maturity value of the GIC, if you invested
Example 1.1.2 the money on May 7, 2019? (similar to example 1 (b) in page 4
Find how many actual days of your investment between the of textbook)
following two dates to calculate interest?
a) From April 7, 2018 to September 25, 2018
b) How about April 7, 2018 to September 25, 2019?

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Chapter 1, AS 2053, section 570/571

Example 1.1.4
How long will it take $1500 to earn $22.50 interest at r = 9%? Example 1.1.5 (in textbook, Page 5, example 5)
A deposit of $1500 is made into a fund on March 18. The
fund earns simple interest at 5%. On August 5, the interest
rate changes to 4.5%. How much is in the fund on October
23?

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Example 1.1.6
Suppose you bought some furniture for $977 and paid “no
interest for 90 days”. However, there was a $25
administration charge to be paid up front and you need to pay
the full price of $977 at the due day. What interest rate were
you equivalently charged for this “no interest” payment plan?

Note: Skip Demand Loans (textbook page 6, example 6)

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Chapter 1, AS 2053, section 570/571

Typical Terms of an Invoice (for example)

Invoice Cash Discounts 2/10, n/30
This means that a 2% discount will apply to the cost of the
Often when a company buys supplies or merchandise from a goods if the invoice is paid in full within 10 days of the date of
wholesaler or retailer, they are frequently given an amount of time the invoice, otherwise, the full amount is due no later than 30
before they have to fully pay for the goods days from date of invoice

 wholesaler /retailer will give them an “invoice” which stipulates What is going to happen in practice?
how much is owed and when it has to be paid back Suppose you have the following options to pay the invoice
1. To be paid on due day (full price)
 to encourage prompt payment of invoices, the wholesaler will 2. To take the discount, paid within 10 days
offer a discount on the price of the goods if the invoice is paid Question: If you don’t have money to get the discount, what you
quickly can do, if you still want to get this discount?
You can borrow money from third party to take advantage of the
discount and repay the loan on the due date to the third party.
However, the total interest you paid should be less than the
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cash discount you want to take.

Example 1.1.7 Section 1.2 Discounted Value at Simple Interest

A merchant receives an invoice for a motor boat for $4000
with term 4/30, n/100.
From section 1.1, we have the formula:
A)If the merchant could borrow money (from third party) at
r =25%, would he save some money? S  P  (1  r  t )
B) How about r =20% for question A) ?
C) (similar to textbook, page 7, example 7) We can rearrange this formula to obtain P in terms of S, r
What is the highest simple rate at which he can afford to
and t:
borrow money (from third party ) in order to take
advantage of the discount? P  S  (1  r  t ) 1

How to explain this formula?

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Chapter 1, AS 2053, section 570/571

Notes
Promissory Notes (discount notes)
1. The process of calculating P from S is called
 they are written by a debtor (maker of the note, borrower)
discounting at simple interest r
 debtor promises to pay the stated sum of money to the
2. P is called the discounted value or present value of S
creditor (payee, lender)
3. The term (1  r  t ) 1 is called the discount factor at
 money is paid on a specified date, with or without interest
simple interest r

Example 1.2.1 2019

A man takes out a loan for 90 days at r = 8.5%. At the end of 90
days, he pays back $500. What was the original amount of the
loan?

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2019
A promissory note may be sold one or several times
before its maturity.
How do you determine the “price” at which the note
will be sold?
Components of promissory note include Each buyer will take the maturity value of the note and
• Face Value is the amount of money specified on the note ($2,000) discount it back to the date of sale (at some interest rate).
• Term of the note is the period specified (60 days)
This discounted value is the price, which the seller of the
• Due Date of the note is 60 days after Sep 1, 2019
(That is October 31, 2019) note receives for selling the note (called the “proceeds”).
• Legal Due Date or Maturity Date is the due date plus 3 days
grace in Canada (Nov 3, 2019) Question?: what is the maturity value?
• Maturity Value of the note is the value at the maturity date

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Chapter 1, AS 2053, section 570/571

Example 1.2.2
Note: the maturity value can be face value or accumulate value. It The note described in the beginning of this section is sold by Mr. A
will depend on the fact that the notes is an interest-bearing note or on October 1, 2019 to a bank that discounts notes at 9.5% simple
a noninterest-bearing. (Very important!!!) interest rate.
a. How much money would Mr. A received for the note?
Two Step Procedure for Selling/Buying a Note Before Maturity b. What rate of interest will the bank realize on its investment, if it
1. Determine the maturity value of the note, S holds the note till maturity?
For an interest-bearing note, maturity value is the accumulate c. What rate of interest will the bank realize if the note is paid off in
full in exactly 60 days?
value and for a noninterest-bearing note, maturity value is the
d. What rate of interest will Mr. A realize on his investment, when he
face value.
sells the note on October 1, 2019?
2. Determine the proceeds, P, by discounting S from the maturity
date back to the date of sale, at a specified interest rate.

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Example 1.2.3 Example 1.2.4

A 120-day note for $1,000 bears interest at 7%. It can be sold A 60-day non-interest bearing note for $1,000 is sold after 10
immediately to a finance company that uses 6% for discounting. days. The interest rate used for discounting is 9%. What are
What is the investor’s profit? the proceeds of this note?

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Chapter 1, AS 2053, section 570/571

Example 1.2.5 (Example 4, page 12 in textbook) Example 1.2.6 (modified from Example 4, page 12 in
On April 21, a retailer buys goods amounting to $5000. If textbook)
he pays cash he will get a 4% cash discount. To take On April 21, a retailer buys goods amounting to $5000. If
advantage of this cash discount, he signs a 90 day he pays cash he will get a 4% cash discount. To take
noninterest-bearing note at his bank that discounts notes at advantage of this cash discount, he signs a 90 day interest-
an interest rate of 9%. What should be the face value of this bearing note at his bank that discounts notes at an interest
note to give him the exact amount needed to pay cash for the rate of 9%. What should be the face value of this note to
goods? give him the exact amount needed to pay cash for the goods?
and how much he need to pay to the bank, if he hold the
notes until maturity?

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Treasure Bills (or T-bills) Example 1.2.6

An investor bought a 91-day (a multiple of 7) T-bill to yield
1. Treasure Bills are popular short-term (less than 1 year ) and 3.45%.
low-risk securities issued by the Federal Government of a) What was the price paid by the investor if the face value
Canada . was $5000?
2. Treasure Bills are issued in denominations (face value). b) The investor sold the T-bill 40 days later to another
investor who wishes to yield 3.10%. What price did the T-
3. There is no interest rate stated on a T-bill. Instead, to bill sell for?
determine the purchase price of a T-bill, you need to c) What rate of return did the original investor earn on his
discount the face value to the date of sale at an interest rate investment?
that is determined by market conditions. They are basically
promissory notes issued by the government. We don’t need
to plus 3 days of grace for T-bills.

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Chapter 1, AS 2053, section 570/571

Section 1.3 Equations of Value

Example 1.3.1
Concept of Dated Values You owe Jim $600 7-months from now. Instead of this payment,
you and Jim both agree that you will pay an equivalent amount at
For example: some other point in time. If r = 11% ( or we say that “if money
is worth 11%” ), what is the equivalent payment, if it is made
All financial decisions must take into account the time value of
money 1) 2 months from now (at the end of 2 months)
2) 10 months from now (at the end of 10 months)

In General
$X due on a given date is equivalent, at a given simple interest rate,
r, to $Y due t-years later if:

Y  X  (1  r  t ) or X  Y  (1  r  t ) 1
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Example 1.3.2
Note A person owes $200 two months from now and $800 10-
You should not add or subtract sums of money unless the sums are months from now. Instead of these two payments, it is
evaluated on the same date agreed that a single payment will be made at some point in
For example: time to replace these two debts. If r = 10% , what is the
Suppose you owe $1000 now, $1000 in 6-months and $1000 in equivalent single payment, if it is to be made
one year 1) now?
 this is not the same as owing $3000 in a one-lump sum payment 2) at the end of 1 year?
 the size of a lump sum payment will depend on 3) 5 months from now?
1). the interest rate, and
2). when the amount is to be paid
We have to replace all the dated values by equivalent dated values,
due on the same date.
The sum of equivalent values is called the dated value of the set
of payments
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Note Example 1.3.3

We say that two sets of payments are equivalent (at a given r) if the Kim originally owes $500 in 4 months and $500 in 8 months.
dated value of the sets, on any common date, are equal Instead, she restructures her loan so that she pays $300 in one
 an equation stating that the dated values of two sets of month and with another payment of $X at the end of 10 months.
payments are equal is called an equation of value Determine X, using 10 months as your focal date, so that Kim’s
 the common date used to value the payment set is called the proposed payments are equivalent to the original debts. The
focal date or comparison date or the valuation date. interest rate is r = 10%

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Example 1.3.4
General Method for Equations of Value
A person borrows $1000 now at 10%. He is to repay the loan with 2
1. Draw a good time diagram payments, one at the end of 6 months and the other at the end of the
put original debts and their due dates on one side of the line put year. The first payment is to be exactly twice as large as the 2nd
replacement payments and their due dates on other side payment. If r = 10%, determine the size of the payments, using a
2. Select one (and only one) focal date focal date of now.
accumulate or discount all dated values to this focal date (using
the specified interest rate)
3. Set up an equation of value at the focal date

value of debts = value of payments

4. Solve equation

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Chapter 1, AS 2053, section 570/571

Example 1.3.5
Example 1.3.6 (modified from Exercise 1.3.8)
Andrew owes Nicola $500 due in 3 months with interest at 6%
How about in Example 1.3.4, if we choose other date as a focal date,
and $200 due in 6 months with interest at 5%. If Nicola accepts
for example, using 10 months as your focal date? Do they have the $300 now, how much will Andrew be required to repay at the
same answer as Ex 1.3.4?
end of 1 year, provided they agree to use an interest rate of 10%
and a focal date at the end of 1 year?

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Section 1.4 Partial Payments

Method II – Merchant’s Rule
When a person borrows money, they can pay back the loan, with The idea here is to write out an equation of value, with the
interest, in one of two ways: final due date as the focal date.
1. With a single payment on the due date
2. With a series of partial payments during the whole term of the
loan Example 1.4.1
A man borrows $2000 on June 1, 2018. He pays back $800 on
August 17, $400 on November 20 and $500 on February 2, 2019.
Methods to Handle Partial Payments
What is the balance due on April 18, 2019, which will fully
discharge (pay off) the loan, if r = 12%?
Method I – Declining Balance Method or the United Sates Rule
(common business practice)

Method II – Merchant’s Rule

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Example 1.4.2 Method I – Declining Balance Method (common business practice)

A debt of $500 is paid off by the following payments according
to the Merchant’s Rule: $100 in 30 days, 200 in 60 days, and a Under this method, you calculate the outstanding balance of the
final payment of $208.49 in 80 days. What simple interest rate loan after each payment has been made.
was used?
Example 1.4.3
Using Method I (Example 1.4.1)
A man borrows $2000 on June 1, 2018. He pays back $800 on
August 17, $400 on November 20 and $500 on February 2, 2019.
What is the balance due on April 18, 2019, which will fully
discharge (pay off) the loan, if r = 12%?

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Note
[Link] declining balance method leads to higher final balance. Section 1.5 Simple Discount
2. Under the declining balance method, if a partial payment is less
than the interest due, that payment is NOT applied to the Recall (section 1.1):
outstanding balance, but is instead carried forward to the next A simple interest rate, r, is applied to the principal P and results
payment date. in the formula I  P  r  t , which is paid at the end of the term t.

The following example illustrates this point (similar with example 3 In section 1.5:
in page 22 of textbook): A simple discount rate, d, is applied to the final amount S and
Example 1.4.4 results in the formula (which means that the interest charged
Mrs. Smith borrows $2000 on April 4. She pays back $300 on April based on the final amount S, rather than on the present value)
30, $15 on July 2 and $600 on August 15. If r = 8%, what is the D  S  d t
balance outstanding on September 4? Using Method Declining where,
Balance Method. D = simple discount on an amount S, interest in advance, which
are deducted from S and paid up front)
d = simple discount rate
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Chapter 1, AS 2053, section 570/571

Note Example 1.5.1

The charge for some short term loans (called discounted loans) is What is the actual loan given out if $1000 is due at the end of 9
based on the final amount due, rather than on the original amount months, given the lending rate is a simple discount rate of d = 9%?
borrowed, P If the borrower actually wishes to receive $1000, what size of loan
Present Value
P= SD should he ask for?
= S  S  d t
= S  (1  d  t ) P  S  (1  d  t )
The term (1  d  t ) is called the discount factor under simple
discount
Accumulated Value
S  P  (1  d  t ) 1
1
(1  d  t ) is called the accumulation factor under simple
discount d 49 50

Example 1.5.2
Equivalent rates of interest
Calculate the discount value of $1000 due in 1 year:
a) At a simple interest rate of 10%. • Two rates are equivalent if they have the same effect on money
b) At a simple discount rate of 10%. over the same period of time.
• To solve for equivalent rates, just need to equate
the corresponding accumulation or discount factors.
• For simple rate of interest and discount, the equivalent
rate are dependent on the period of time.

Example 1.5.3
What is the equivalent simple interest rate to the simple discount
rate of 6% over 6 months?

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Chapter 1, AS 2053, section 570/571

Note
Example 1.5.5
Simple discount is sometimes used to determine the proceeds of a
A non-interest bearing note with a face value of $3,000 is
promissory note sold before maturity
due in 60 days. It is immediately sold to a finance
Example 1.5.4 company that discounts it at a discount rate equal to d.
On May 9, 2020, Smith borrows $3000 from Jones and signs a Find d if the proceeds of the note are $2,958.58.
promissory note due in 6 months at r = 8%. On July 30, Jones
sells the note to Brown who discounts the note at a simple
discount rate of d = 9%.
1) What price does Jones received for selling the note?
2) What discount rate does Brown earn, if the note is held to
maturity?
3) What discount rate does Brown earn, if the note is actually paid
on the due date?

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