SIMPLE AND COMPOUND
INTEREST
01 MODULE 02
If you win the lotto worth $25.6M
• What are you going to do?
Two way to be paid:
1. Single Sum Payment worth $13.5 Million
2. Receive the $25.6 Millions in 30 installments over 29 Years,
First payment is received immediately and installment of
$853,333 for the next 29 Years.
This is operation of interest and the Time Value of Money
INTEREST: The Cost of Money
• What is interest rate?
- The cost of money is established and measured by interest
rate.
- A percentage that is periodically applied and added to an
amount.
• Interest
- defined as the cost of having money available for use.
The rate of Interes
• The rate of interest is usually expressed as an annual percentage
of the principal, and is influenced by the money supply, fiscal
policy, amount being borrowed, creditworthiness of the borrower,
and rate of inflation
Consider buying a refrigerator at $100.00
• You have $100 on your pocket.
• If you invest the $100, it will an annual interest rate of 6% per
annum.
• But, inflation is at 8% per annum.
Gains and Losses
Power of Money
• Earning power
is a company's ability to generate profit. Specifically, its ability to
generate profit from its operations. Investors and analysts calculate
earning power to determine whether a company is worth investing in.
Purchasing Power
is the amount of goods and services that can be purchased with a
unit of currency. For example, if one had taken one unit of currency to a
store in the 1950s, it would have been possible to buy a greater number
of items than would be the case today, indicating that the currency had a
greater purchasing power in the 1950s. Currency can be either a
commodity money, like gold or silver, or fiat money emitted by
government sanctioned agencies.
Market Interest Rate
1. The prevailing rate of interest offered on cash deposits,
determined by demand and supply of deposits and based on the
duration (the longer the duration, the higher the rate) and
amount (the higher the amount, the higher the rate) of deposits.
2. The prevailing rate of interest on loans determined by the
demand and supply of credit and based on the duration (the
longer the duration, the higher the rate) of loan and type of
security offered (the higher the quality of security, the lower the
rate).
Elements of Transaction involving Interest
1. The initial amount of money invested or borrowed – Principal (P)
2. The interest rate measures the cost or price of money and is
expressed as a percentage in a period of time – Interest Rate (i)
3. A period of time that determines the frequency interest is calculated
– interest period (n)
4. A specified length of time marks the duration of the transaction and
thereby establishes a certain number of interest periods (N)
5. A plan for receipts or disbursements (An) yields a particular cash flow
pattern over a specified length of time.
6. A future amount of money (F) results from the cumulative effects of
the interest rates over a number of interests periods.
Interest Transaction
• Principal Amount
• Interest Rate
• Interest Period
• Number of interest period
• Annuity
• Future Amount
Cash Flow Diagram
Simple Interest
• Is interest earned on only the principal amount during each
interest period.
• In other words, the interest earned during each interest period
does not earn additional interest in the remaining periods, even if
you do not withdraw the earned interest.
In General
• I = (iP)N
Total Amount at the end of N period would be,
• F = P + I = P(1+iN)
Example
If you invested $1,000 in a bank that provides 8% interest per
annum of simple interest. What is the value of the investment after
3 years?
Given:
• Principal Amount (P) = $1,000
• Interest Rate (i) = 8%
• Number of years (N) = 3 Years
• Future Value = ?
Simple Interest Formula
Compound Interest
• The interest earned in each period is calculated based on the total
amount based on the previous period.
• The total amount includes the principal amount plus the
accumulated interest that has been left in the account.
With this, Balance after the end of the second period is
𝑃 1 + 𝑖 + 𝑖 𝑃 1 + 𝑖 = 𝑃 1 + 𝑖 1 + 𝑖 = 𝑃(1 + 𝑖)2
Continuing, we can see that the balance after the 3rd period is
𝑃(1 + 𝑖)2 + 𝑖[𝑃(1 + 𝑖)2 ] = 𝑃(1 + 𝑖)3
With this,
𝐹 = 𝑃(1 + 𝑖)𝑁
Compound Interests
If you invested $1,000 in a bank that provides 8% interest per
annum of compound interest. What is the value of the investment
after 3 years?
Given:
• Principal Amount (P) = $1,000
• Interest Rate (i) = 8%
• Number of years (N) = 3 Years
• Future Value = ?
Cash Flow Diagram
The two Perspective of a Cash Flow Diagram
1. Borrowers Perspective
2. Lenders Perspective
Borrowers & Lenders Perspective
Cash Flow
Interest Transaction
Cash Flow Diagram
Comparison
ECONOMIC EQUIVALENCE
02 MODULE 02
Economic Equivalence
• If receiving $100 today is not the same as receiving $100 at any future
point, how do we measure and compare various cash flows?
• Exists between cash flows that have the same economic effect and
could therefore be traded for one another.
• Even though the amounts and timing of the cash flows may differ, the
appropriate interests' rates makes them equal.
Economic equivalence refers to the fact that any cash flow, whether
single payment or a series of payments can be converted to an
equivalent cash flow at any point in time.
Activity
Answer Key: Phase One
Answer Key: Phase Two
Answer Key: Phase Three
Discount Rate
• Finding the present worth of a future sum is simply the reverse of
compounding and is known as the discounting process.
• The factor 1/(1+i)^N is known as the single-payment present worth
factor and is designated (P/F, I, N).
• Tables have been constructed for P/F factors and for various
values of i & N.
• The interest rate i and the P/F factor are also referred to as the
discount rate and the discounting factor.
Example
Single Payment present worth factor : (Discount Factor)
Given
i = 12% (Discount Rate)
N = 5 years
F = $1,000
Find P?
P = $1,000(1+.12)^-5
= $1,000(P/F,12%,5)
= $1,000(.56740) , discounting factor
= $567.40
Activity
A zero-coupon bond is a popular variation on the bond theme for
some investors. What should be the price of an eight-year zero-
coupon bond with a face value of $1,000 if similar, nonzero-coupon
bonds are yielding 6% annual interest?
Given:
i = 6% per year
F = $1,000
N = 8 years
ANNUITY
03 MODULE 02
WHAT IS ANNUITY?
• An annuity is a series of payments made at equal intervals.
Examples of annuities are regular deposits to a savings account,
monthly home mortgage payments, monthly insurance payments
and pension payments. Annuities can be classified by the
frequency of payment dates.
• a fixed sum of money paid to someone each year, typically for the
rest of their life.
• a form of insurance or investment entitling the investor to a series
of annual sums.
ORDINARY ANNUITY
Is a series of constant cash flows that occur at the end of each
period for some fixed number of periods.
Examples : Consumer Loans, Home Mortgages
ORDINARY ANNUITY
SINKING FUND FACTOR (Find A given F, I,
and n)
CAPITAL RECOVERY FACTOR
(ANNUITY FACTOR)
ANNUITY DUE
DEFERRED ANNUITY
• An annuity where in the first payment interval does not coincide
with the first interest period. The first payment is put-off to some
later date.
PERPETUITY
• Is an annuity in which the cash flows continue forever.
PERPETUITY
• Is an annuity whose term
is INFINITE (i.e. an
annuity whose payments
continue forever)
• Present Value
(Perpetuity) = A / I
CAPITALIZED COST
• (CC) is the present worth on an investment what will last forever.
• Examples : Government Projects (Roads, Dams, Bridges, project
that possess perpetual life.
• It has an infinite analysis period.