1
• Cost involved in borrowing money or the reward
received when lending money is referred to as
interest
– Study, home, car loans
– Saving money at the bank, pension fund
• Calculated as a % of the amount borrowed or
invested – referred to as the interest rate
2
Basic principles and notation
• PV – Present value – amount at the beginning of the
transaction
• Term – total number of periods for which the principle is
used
– t – simple interest
– n – compound interest
• FV – Future value – amount at the end of the transaction
– FV or At for simple interest
– An for compound interest
3
Simple Interest
• Interest calculated at the end of equal interest periods on
the original principal only
i = rate of interest per annum
Interest I t P i t
t = term (years)
Future value Αt P(1 it ) I = actual interest earned
t
Αt P = amount invested
Present value = P At = amount due
1 it
4
Simple Interest - example
• R1500 is borrowed for 3 years at 9.5% p.a. simple interest.
What is the amount due at the end of the term?
• How much interest was paid?
Future value Αt P (1 it )
1500(1 0.095 3)
R1927.50
Interest paid = 1927.50 - 1500.00 = R427.50
or I t P i t 1500 0.095 3 R 472.50 5
Simple Interest - example
• How long will it take R5 700 to accumulate to R7 000, at
5.5% per annum simple interest?
Interest 7000 5700 1300
I t P i t 1300 5700 0.055 t
1300
t 4.15 years
5700 0.055
6
Simple Interest - example
• How long will it take R5 700 to accumulate to R7 000, at
5.5% per annum simple interest?
Future value Αt P (1 it )
7000 5700(1 0.055t )
7000 7000
1 0.055t 1 0.055t
5700 5700
t 4.15 years
7
Simple Interest - example
• What amount should be invested at a rate of 7.8% simple
interest, if R10 500 is needed in 30 month’s time?
30
t = =2.5
12
Αt
Present value = P
1 it
10500
R8786.10
1 0, 078(2.5) 8
Compound Interest
• At the end of each interest period the interest due is paid
over to the lender
• At the end of each interest period the interest that is due is
added to the principal. The total of the principal and interest
earned on it becomes the new principal for the next interest
period
• Compound interest refers to the interest calculated on the
total of the original principal plus interest earned in all
previous interest periods
9
Only effective rate per interest
Nominal and Effective Interest Rates
period can be used in the
• formulas for compound interest
Nominal rate - r - Note that nominal rates must
– For compound interest, first
the quoted annualtointerest
be changed raterates
effective
• Effective rate of interest per annum im
– The total amount of interest earned per annum as a
percentage per annum of the principal only
• Effective rate per interest period - i
– Percentage of interest earned in each interest period on the
amount available at the beginning of the interest period
10
Nominal and Effective Interest Rates
• Nominal rate - r
– For compound interest, the quoted annual interest rate
• Effective rate of interest per annum im
m
r m = number of
im 1 1
m compounding periods
per annum
• Effective rate per interest period - i
r
i
m
11
Nominal and Effective Interest Rates - example
• Find the effective rate of interest p.a. if the nominal rate
is 6.25% compounded monthly.
m 12
r 0.0625
im 1 1 1 1
m 12
0.06432 6.432% p.a.
• Find the effective rate per interest period if the nominal
rate is 6.25% compounded monthly.
r 0.065
i (rather do not round)
m 12 12
Nominal and Effective Interest Rates - example
• Find the effective rate of interest p.a. if the nominal rate
is 6.25% compounded quarterly.
m 4
r 0.0625
im 1 1 1 1
m 4
0.06398 6.398% pa
• Find the effective rate per interest period if the nominal
rate is 6.25% compounded quarterly.
r 0.065
i (rather do not round)
m 4 13
Nominal and Effective Interest Rates - example
• Find the nominal rate of interest p.a. if the effective rate
is 6.5% compounded semi annually
m 2
r r
im 1 1 0.065 1 1
m 2
1
r
1.065 2 1
2
r 0.06398 6.398% p.a.
14
i = rate of interest per
Compound Interest interest rate period
n = number interest
n periods
Future value = An P(1 i )
An = amount due
after n periods
An
Present value = P n
P = amount invested
(1 i ) In = interest earned in n
periods
n
Interest = I n An P P [(1 i ) 1]
15
Compound Interest - example
• What amount will be repaid if R20 000 is invested for 2
years at a rate of 11.6% p.a. compounded monthly?
0.116
i= 12
and n 24
n
Future value = An P(1 i )
24
0.116
20000 1 12
R 25 194.31 16
Compound Interest - example
• What amount should be invested to pay for a R15 000 trip
abroad, if the interest rate is 9.75% p.a. compounded quarterly?
The money will be invested for 15 months.
0.0975 15
i 4
and n = 5 quarters
3
An
Present value = P n
(1 i )
15000
R13 298.31
5
0.0975
1 4 17
Compound Interest - example
• How much must be invested for one year at a rate of
12.9% p.a. compounded semi-annually, if R869 interest
is needed at the end of that year?
0.129
i 2
, n 2 and I n 869
n
Interest = I n An P P [(1 i ) 1]
2
0.129
869 P 1 2 1
869
P 0.1332 R6524.02 18
Annuities
• Equal amount of money paid at equal time intervals
over a period of time
– Payment period – time between two payment periods
– Term of annuity – number of payment periods during the
term – n
– Regular amount paid – R
– Present value – P
– Future value – S
– Effective interest rate – i
– Nominal interest rate - r
19
Annuities
• Ordinary annuities
– First payment due in first period of the term
– Ordinary annuities certain
• Payments are made at the end of payment periods,
from first payment onwards
– Ordinary annuities due
• Payments are made at the beginning of payment
periods, from first payment onwards
• Deferred annuities
– First payment is made in some future period 20
Ordinary Annuities Certain R = periodic
payment
(1 i ) n 1
Future value = S R
i i = effective rate of
interest
i n = number of
Payment if FV is known = R S n
(1 i ) 1 interest periods
1 (1 i ) n S = future value
Present value = P R
i P = present value
i
Payment if PV is known = R P n
1 (1 i ) 21
Ordinary Annuities Certain - example
• How much will be available in an account if R250 is
deposited monthly for 10 years? The rate is 9.75% p.a.
compounded monthly.
i 0.0975
12
and n 10 12 120
(1 i ) n 1
Future value = S R
i
S 250 12
1 0.0975 120 1
R50484.41
0.0975
12
22
Ordinary Annuities Certain - example
• How much do I need to invest every six months in an account to
be able to afford a vacation of R10 000 in three years time?
Interest of 8.7% p.a. is compounded semi-annually.
i 0.087
2
and n 3 2 6
i
Payment R S n
(1 i ) 1
0.087
R 10 000 2 R1494.41
2
1 0.087 6 1
23
Ordinary Annuities Certain - example
• What will be the monthly payment on a car of R55 970?
The money needs to be repaid monthly over 4 years at
a rate of 16.45% p.a. compounded monthly.
i 0.1645
12
and n 4 12 48
i
Payment = R P n
1 (1 i )
0.1645
R 55970 12
48
R1599.13
1 1 0.1645
12 24
Ordinary Annuities Certain - example
• I can afford a payment of R350 per month on an account at a
How much
furnisher store. How much can I spend on furnisher if the store
interest
chargeswill
10%I interest
pay p.a., monthly compounded, and the
inaccount
the 24needs
months?to be settled in 24 months?
Total amount payable
i 0.10 and n 24 months
12
= 350 x 24 = R8 400.00
1 (1 i ) n
Present value = P R
R8 i 400.00
– R7 584.80
= R815.20 interest
24
1 1 0.10
P 350 12 R 7 584.80
0.10
12
Ordinary Annuities Due R = periodic
payment
i = effective rate of
(1 i ) n 1 1 i interest
Future value = S R
i n = number of
interest periods
1 (1 i ) n 1 i S = future value
Present value = P R
i P = present value
26
Ordinary Annuities Due - Example
• How much will be available in an account if R600 is
deposited at the beginning of the month for 6 years?
The rate is 6.39% p.a. compounded monthly.
i 0.0639
12
and n 6 12 72
(1 i ) n 1 1 i
Future value = S R
i
1 0.0639 72 1 1 0.0639
12 12
S 600 0.0639 R52760.94
12
27
Deferred Annuities d = number of
deferred periods
R = periodic
Present value payment
1 (1 i ) ( d n ) 1 (1 i ) d
= P R i = effective rate of
i i interest
n = number of
interest periods
P = present value
28
Deferred Annuities - example
• A student loan of R25 000 needs to be paid in full 4 years after the
student finished his studies. If the student will start repaying the
loan after three years of study, what will the monthly instalments
be if interest is charged at 8.85% p.a., monthly compounded?
i 0.085
12
, n 4 12 24 , d 3 12 36 and P 25000
1 (1 i ) ( d n ) 1 (1 i ) d
Present value = P R
i i
1 1 0.085 (3648) 1
36
0.085
1
25000 R
12 12
0.085
0.085
12 12
25000
R R 794.48
31.467 29