Computation of simple interest

The total interest. I. earned or paid may be computed using the formula below.

I-Pin where:

I = total interest earned by the principal

P = amount of principal or present worth

i = rate of interest

N = number of interest periods

F-P+I-P (1+in) F = 2 accumulated amount or future worth

The total amount repaid at the end of 'n interest periods is P+I.

If $5,000 were loaned for five years at a simple interest rate of 7% per year, the interest earned would
be

I= $5,000 x 5 x 0.07 = $1,750

So, the total amount repaid at the end of five years would be the original amount ($5,000) plus the
interest ($1,750), or $6,750.

Types of Simple Interest:

Ordinary Simple Interest - computed on the basis of one banker's year (12 months, each consisting of 30
days or 360 days a year)

Exact Simple Interest - based on the exact number of days, 365 for ordinary year & 36 for leap year.

Note: Leap years are those which are exactly divisible by 4, except century years such as 1900,2000, etc.
Example: Determine Ordinary & Exact Simple Interest of P500 from Jan 10-Oct 28, 1996 at 16% interest.

Solution:

Jan 10-31-21 days (excluding Jan 10)

Feb-29 June-30 Oct-28

Mar 31 July – 31 Total Days: 292

April -30 Aug -31 (P)(i)(n)

May-31 Sept -30

I (ordinary)-P500 x 0.16 x 292/360 = P64.89

(Exact)-P500 x 0.16 x 292/366 = P63.83

Compound Interest:
• interest on top of interest
• occurs when interest earned by the principal is not paid at the end of the interest period, thus
considered as added principal & therefore will also earned interest for the succeeding periods.

F = P(1 + i) -P(F/P.1%,n)

Example 1: A loan of $1,000 is made at an interest of 12% for 5 years. The interest is due at the end of
each year with the principal is due at the end of the fifth year. The following table shows the resulting
payment schedule:

Principal (P) = $1000.00

Interest Rate (i) = 0.12
Number of years or periods (n) = 5
Year Amount at Interest at end Owed amount Payment
start of year of year at
end of year
1 $1000.00 $120.00 $1120.00 $120.00

2 $1000.00 $120.00 $1120.00 $120.00

3 $1000.00 $120.00 $1120.00 $120.00

4 $1000.00 $120.00 $1120.00 $120.00

5 $1000.00 $120.00 $1120.00 $120.00

Example 2: A loan of $1,000 is made at an interest of 12% for 5 years. The principal and interest are due
at the end of the fifth year. The following table shows the resulting payment schedule:

Principal (P) = $1000.00

Interest Rate (i) = 0.12
Number of years or periods (n) = 5
Year Amount at Interest at Owed Payment
start of year end of year amount at
end of year
1 $1000 $120 $1000 $0
2 $1120 $134 $1120 $0
3 $1254.40 $150.53 $1254.40 $0
4 $1404.93 $168.59 $1573.52 $0
5 $1573.52 $188.52 $1762.34 $1762.34

Compound interest reflects both the remaining principal and any accumulated interest. For $1,000
at 10%....

Period (1) (2) (3)

Amount owed at =(1)x10% =(1)+(2)
beginning of Interest amount Amount owed at
period for period end of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

Compound interest is commonly used in personal and

professional financial transactions.

We can apply compound interest formulas to "move" cash flows along the cash flow diagram.

Using the standard notation, we find that a present amount, P, can grow into a future amount, F, in N
time periods at interest rate i according to the formula below.

F = P * (1 + i) ^ N
In a similar way we can find P given F by

P = F * (1 + i) ^ (- N)
It is common to use standard notation for interest factors.

(1 + i) ^ N = (F / P, i, N)
This is also known as the single payment compound amount factor. The term on the right is read "F
given P at i% interest per period for N interest periods."

(1 + i) ^ (- N) = (P / F, i, N)
is called the single payment present worth factor.

We can use these to find economically equivalent values at different points in

time.
$2,500 at time zero is equivalent to how much after six years if the interest rate is
8% per year?
F = $2,500 (F/P,8%, 6) = $2,500(1.5869) = $3,967
(1 + i) ^ N = (1+0.08) ^6 = 1.5869(2,500) = 3,967
$2,500(1+0.08) ^6 = $3,967
$3,000 at the end of year seven is equivalent to how much today (time zero) if the
interest rate is 6% per year?
P=$3,000 (P/F,6%, 7) = $3,000(0.6651) = $1,995
(1 + i) ^ (- N) = (1+0.06) ^-7 = 0.6651(3,000) = 1,995
Economic equivalence allows us to compare alternatives
on a common basis.
• Each alternative can be reduced to an equivalent basis dependent on
- interest rate,
- amount of money involved, and
-timing of monetary receipts or expenses.
• Using these elements, we can "move" cash flows so that we can compare
them at particular points in time.
We need some tools to find economic equivalence.

Notation used in formulas for compound interest

calculations.
- i = effective interest rate per interest period
- n = number of compounding (interest) periods
- P = present sum of money; equivalent value of one or more cash flows at
a reference point in time; the present
- F = future sum of money; equivalent value of one or more cash flows at a
reference point in time; the future
- A = end-of-period cash flows in a uniform series continuing for a certain
number of periods, starting at the end of the first period and continuing
through the last.

Nominal and effective interest rates.

• More often than not, the time between successive compounding, or the
interest period, is less than one year (e.g., daily, monthly, quarterly).
 • The annual rate is known as a nominal rate.
• A nominal rate of 12%, compounded monthly, means an interest of 1%
(12%/12) would accrue each month, and the annual rate would be
effectively somewhat greater than 12%.
• The more frequent the compounding the greater the effective interest.

The effect of more frequent compounding can be easily

determined.
Let r be the nominal, annual interest rate and M the number of compounding
periods per year. We can find, i, the effective interest by using the formula below.
i = (1 + r/M) ^ M – 1

Finding effective interest rates.

For an 18% nominal rate, compounded quarterly, the effective interest is.
i= (1+ 0.18/4) ^4 - 1 = 19.25%

For a 7% nominal rate, compounded monthly, the effective interest is.

i= (1+ 0.07/12) ^12-1= 7.23%

Interest can be compounded continuously.

• Interest is typically compounded at the end of discrete periods.
• In most companies’ cash is always flowing, and should be immediately put
to use.
• We can allow compounding to occur
• continuously throughout the period.
• The effect of this compared to discrete
• compounding is small in most cases.
We can use the effective interest formula to derive the interest factors.
i = (1 + r/M) ^ M - 1
As the number of compounding periods gets larger (M gets larger), we find that
i=e^r–1
Continuous compounding interest factors.

The other factors can be found from these.