Chapter 2: Time Value of money: Simple and Compound Interest
Learning Objectives:
• Understand the concept of Interest, simple interest and compound interest
• Apply the concept of interest in various calculations
• Applying Rule of 72
2.1 Introduction: Investment option
• Option 1: Bank Deposit: Deposit the RO 1,000 in a bank for a straightforward, low-risk option.
• Option 2: Business Venture: Invest the amount in a business venture, which could be riskier but
potentially rewarding.
• Option 3: Shares and Securities: Invest in shares and securities, which requires learning and involves
risk but can offer significant growth.
Considerations:
Option 1: Easy and low-risk, suitable for safe cash management.
Option 2 & 3: Involve risks and require learning but offer potential for higher returns.
Common choice: Banks are typically the first choice for safe money management and storage.
2.2 Interest:
• Function of Banks: Accept deposits and provide loans.
• Deposits: Money deposited is not used immediately, allowing banks to utilize these funds. Depositors
are rewarded with interest.
• Loans: Borrowers use money for a specified period and repay with interest. This arrangement is known
as "financing through loan."
• Interest Rate Margin: Banks pay lower interest on deposits and charge higher interest on loans,
creating a profit margin.
Interest Rates in Oman:
• Deposit Rates: 0.5% to 5% per annum.
• Lending Rates: 1.50% to 7% per annum, varying with financial products.
Types of Interest:
• Simple Interest
• Compound Interest
2.2.1 Simple Interest:
As the name denotes interest is simply calculated on the principal amount of money deposited or borrowed.
The formula for simple interest (I) = Principal (P) x Interest rate (r) x Time period in years (t)
=Pxrxt
• Principal refers to the amount deposited into the bank or borrowed from the bank.
• Interest rate is the rate provided or charged by the bank.
• Time period in years refers to the number of years for which the money is deposited or borrowed from the
bank.
For example you have a saving of RO 1,000 in a bank which gives interest @ 4% p.a. What will be the amount
of interest received on such deposit:
a. For 2 years
b. For 15 months
The solution will be:
4
a. P = 1,000 , r = 100 = 0.04%, t = 2
Interest received = 1,000 x 0.04 x 2 = RO 80
4
b. P = 1,000 , r = 100 = 0.04%, t = 15 months
15
Interest received = 1,000 x 0.04 x 12 = RO 60
Exercise 1:
Find out the amount of interest on a deposit of RO 5,000 for 4 years at the rate of 4% simple interest. (Ans: Total
interest = RO 800)
Exercise 2:
Calculate the amount of principal if the amount of interest received of a deposit of 5 years is RO 250 at the rate
of 5% simple interest. (Ans: RO 1000)
Exercise 3:
In a deposit of RO 4,000 fetched you an interest of RO 360 in a period of 3 years then calculate the rate of interest
on such deposit. (Ans: 3%)
Exercise 4:
If you have to make 2 different deposits as follows:
I. Bank Muscat: RO 5,000 deposit @ 5% simple interest per annum
II. Bank Ahli: RO 2,500 deposit @ 4% simple interest per annum
Suppose your target interest amount is RO 500, what will be the time period of deposit for both banks?
(Ans: Bank Muscat = 2 years, Bank Ahli = 5 years)
2.2.3 Compound Interest:
As the name suggest interest is compounded in this method. It means that interest is not only calculated on
outstanding principal amount but also on the interest accumulated from the previous period. Such compounding
of interest depends on frequency of interest being released in a period of one year. So the compounding factor i.e.
‘n’ will be considered as follows:
• Annually: n = 1
• Semi-annually: n=2
• Quarterly: n = 4
• Monthly: n = 12
• Daily: n = 365 or 366
Interest calculation using compound interest on deposits or loans will be as follows:
𝒓
Interest (I) = P (𝟏 + 𝒏)𝒏𝒕 - P
P = Principal amount of money deposited or borrowed
r = rate of interest
n = number of times interest compounded in a year
t = time period
For example: The amount of interest received with a deposit of RO 500 @ 12% compound interest for 2 years if
compounded a. Annually b. Semi-annually c. Quarterly d. Monthly will be as follows:
P = RO 500
r = 12 ÷ 100 = 0.12
t = 2 years
n = depends on number of times compounded in a year it can be
• Annually: n = 1
• Semi-annually: n=2
• Quarterly: n = 4
• Monthly: n = 12
𝒓
Formula for Interest (I) = P (𝟏 + 𝒏)𝒏𝒕 - P
𝟎.𝟏𝟐 𝟏𝒙𝟐
If compounded annually: I = 500 (𝟏 + ) - 500 = RO 127.2
𝟏
𝟎.𝟏𝟐 𝟐𝒙𝟐
If compounded semi-annually: I = 500 (𝟏 + ) - 500 = RO 131.24
𝟐
𝟎.𝟏𝟐 𝟒𝒙𝟐
If compounded quarterly: I = 500 (𝟏 + ) - 500 = RO 133.385
𝟒
𝟎.𝟏𝟐 𝟏𝟐𝒙𝟐
If compounded monthly: I = 500 (𝟏 + ) - 500 = RO 134.867
𝟏𝟐
Exercise 5:
A bank is offering a fixed deposit scheme for 5 years under the following schemes.
I. At 12%, where interest is compounded monthly
II. At 12.5% where interest is compounded annually
State which scheme is more beneficial?
Exercise 6:
In general all banks are accepting deposits @ 5% interest compounded monthly except a bank which is ready to
pay interest @ 5.25% simple interest. Suggest which option is more suitable to the customer who wishes to keep
money in the bank for a period of 4 years
Exercise 7:
Find the amount to be deposited initially, if RO 420 interest is received on such loan @10% compounded yearly
for a period of 2 years. (Ans: RO 2,000)
Exercise 8:
Ali borrowed RO 1000 from a bank for 4 years with a simple interest of 5% and invested the same with an interest
of 6% to be compounded quarterly for 4 years. How much will he be benefited with such arrangement?
2.2.4 Comparison between Simple interest and Compound interest method:
The table below gives a brief comparison on the interests calculated under both methods:
Principal amount or present value = RO 1000, Interest rate = 7%
Period/y Simple Interest Compound Interest
ears
(t) Interest received Amount received - Interest received Amount received -
𝑟
Pxrxt Future value P (1 + )𝑛𝑡 - P Future value
𝑛 𝑟
P (1 + rt) P (1 + )𝑛𝑡
𝑛
0 - 1,000 - 1,000
1 70 1,070 70 1,070
2 140 1,140 144.9 1,144.9
3 210 1,210 225.04 1,225.04
4 280 1,280 310.80 1,310.80
5 350 1,350 402.22 1,402.22
6 420 1,420 500.73 1,500.73
7 490 1,490 605.78 1,605.78
… …
From the above table one can easily conclude that considering the rate of interest to be same given an option one
should borrow with simple interest and when it comes to investing an option with compound interest is always
beneficial.
2.3 Rule of 72:
As an investor you might easily think of the time period which will allow your investment amount to double at a
given rate of interest. Though one can use the future value formula given above, there is a common tool used in
finance to estimate such time period referred to as ‘Rule of 72’.
Approximate time period as per ‘Rule of 72’ assuming given rate of interest compounded annually will be:
𝟕𝟐
= 𝑹𝒂𝒕𝒆 𝒐𝒇 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
For e.g. if the rate of interest is 8% then approximate number of years taken to double the investment will be =
𝟕𝟐
= approx.. 9 years
𝟖
Also note that there is a high estimation error with this rule when the rate of interest is very low or very high
interest rates.
Exercise 9:
How long will it take for an amount deposited with a bank to double if the interest is received @ 4.5% per
annum using Rule of 72?
Exercise 10:
If you want your investment to double in 6 years, then what should be the rate of interest or return on such
investment?
Exercise 11:
Calculate the number times your investment will double using Rule of 72 at a rate of return of 12% in 18 years?
Additional question:
1. Zubin invested some amount @ of 4 % p.a. simple interest for 3 years and received a total of RO 11,200
at the end of 3 years. He kept aside the interest amount and invested the same amount @10% compound
interest for next 4 years. If interest is compounded annually, then find the amount he received at the end
of 4 years for his second investment. Also calculate the total amount of interest received by him for both
the investments. (Ans: Principal: RO 10,000, Total interest: RO 5,841)
𝟑
2. When all banks giving interest @ 8𝟒 % compounded every 3 months, one bank comes up with a scheme
𝟏
of simple interest @ 9𝟒 % p.a.. Calculate the option that will be beneficial to the customer for an
investment of 4 years. (Ans: compound interest is a better deal than simple interest)
3. A bank offers fixed deposit for 5 years under the following schemes:
• Interest @ 15% compounded half yearly
• Interest @ 14.75% compounded quarterly.
State which scheme is more beneficial to the customer? (Ans: II better than I)
4. Find the deposited amount if RO 420 interest is received after 2 years. Interest is calculated @ 10%
compounded annually. (Ans:RO 2,000)
5. If after 36 months, Rachel got RO 2,612 for her investment at 9% compounded quarterly. Find the
amount invested by Rachel. (Ans: RO 2,000)
6. Find the principal amount if the interest amount received after 2 years is RO 832. Note that interest is
compounded annually @ 8%. (Ans: RO 5,000)
7. Sameer deposited RO 2,000 in a bank scheme which provides 10% interest compounded 4 times in a
year. How much amount will be received by him after 9 months? Also state the amount of interest
earned by him in such scheme. (Ans:RO 2,153.78 & RO 153.78)
8. How long will it take for an amount deposited with a bank to double if the interest is received @ 9% per
annum using Rule of 72? (Ans: 8 years)
9. Calculate the number times your investment will grow using Rule of 72 at a rate of return of 12% in 12
years? (Ans: 2 times)
Disclaimer:
This material has been developed to cater to the needs of students studying in UTAS in all branches. For any
further use of this material please contact Hassan Sanadi through email: [Link]@[Link]
References and additional reading:
• Introduction to Finance by RONALD W. MELICHER & EDGAR A. NORTON; EPUB: 978-1-119-
32111-8
• Fundamentals of Finance - Financial institutions and markets, personal finance, financial management
by Andrea Bennett, Jenny Parry and Carolyn Wirth ISBN: 978–0–9941325–2–9
Practice Questions:
Simple Interest:
1. Find the amount of interest received, if RO 10,000 is invested @ of 6% Simple interest per annum for a) 6
3
months b) 2 years and 6 months c) 34 years d) 200 days Ans: RO 300, RO 1500, RO 2250, RO 328.767
2. Find the rate of simple interest if RO 10,000 is to become RO 12,400 in 4 years Ans : 6%
3. If RO 1,000 amounts to RO 1,320 at simple interest in 5 years, find the rate of interest: Ans 6.4%
4. In how many years the principal will double at simple interest of 4% p.a.? Ans: 25 years
5. In how much time an investment of RO 6,000 @ 12% simple interest will fetch an interest of RO 2,160?
Ans: 3 years
6. A man invested RO 4,000 for 3 years and RO 5,000 for 5 years at the same rate of simple interest. If he
received RO 2,220 in total from such investment. Find the rate of interest. Ans: 6%
7. A person invested RO 20,000 @ of 3%, RO 30,000 @ of 6%, RO 50,000 @ of 9% simple interest for a
year. Find out the average rate of simple interest on such investment. Ans: 6.9%
Compound interest:
8. Find the amount of interest received when a sum of RO 20,000 is invested for 4 years @ 12% compounded
a) annually, b) semi-annually, c) quarterly, d) monthly Ans: RO11,470.387, RO 11,876.961, RO
12,094.129, RO 12,244.522
9. What is a better investment, at simple interest of 10% for 5 years or at quarterly compound interest of 9%
for 5 years? Ans: 9% scheme is better than 10% scheme.
10. If interest received in RO 3,972 on an investment in 3 years @ 10% compounded annually then find the
amount invested at the beginning of the period. Ans: RO 25,200
Rule of 72:
11. Dawood invested RO 2,500 into a Certificate of Deposit earning 6.5% interest. How long will it take to
double his investment? Ans: 11 years
12. Jasim has RO 5,000 that he has saved from doing odd jobs around the neighborhood. When he graduates
from college in four years, he would like to have RO 10,000 to use as a down payment on a new car. If
Jasim is going to realize his dream, what interest rate will he have to invest his money at? Ans: 18%
13. Rafael is 22 years old and would like to invest RO 2,000 into an Oman development bonds earning 7.5%
interest. How many times will Rafael’s investment double before he draws it out at age 70 and what how
much his amount will grow into by that age? Ans: 5 times, RO 64,000