Chapter 29 INTEREST AND DISCOUNTING Chapter topic list ‘Silabus reterence “{ Sephkeret —=*~*‘“*‘s ET Te GA 2 Compound interest ar 2(0) ‘8 Effective and nominal rates of interest ar2(6) 4 The concept of discounting ‘ar 2(¢) 5. The net present value (NPV) method ‘ar 2(e) 6 _Thiinteral ata ratte (RB) method ara) Introduction ‘The previous chapters intoduced = varely of quantiatve methods relevant to business analysis. This chapter extends the use of mathematics and oaks at aspect of financial analy ‘yplally undenaken ina business organisation. In general, financial mathematics deals wih problems of Inestng money, or capital. If ‘company (or an indvkduel invest) puts some captal Into an investment, a franca retum will be expected ‘The two major techniques of nancial mathematics are compounding and discounting, These fechniques are very closely rolaod to each otter. This chapter wil begin by describing ‘compounding and wil han inroduee ecounting, ‘Tho major appication of dscountng in business isin the evaluation of capital expenditure projects to decide whether they ofr a sabstctry return to tho investor. We wil be looking at {Wo methods of sing ciscouning to aporase capil expenditure projets, tha net present Value (NPV) methos andthe internal rat of return (IRR) method. 1 SIMPLE INTEREST 11 Ifa sum of money is invested for a period of time, then the amount of simple interest which accrues is equal to the number of periods x the interest rate x the amount invested, 523° BPP PublishingNowe Part F: Business mathematics Van\ ASP 42 13 4 22 “BRP Publishing 524 ‘EXAMPLE: SIMPLE INTEREST ‘What isthe terminal value after five years if an investor invests £1,000 at 10% simple interest per annum? SOLUTION Sq = £1,000 + (5% 0.1 x £1,000) = £1,500 1, for example, the sum of money is invested for 3 months and the interest rate is a rate per annum, then m= "iz = Ye. Ifthe investment period is 197 days and the rate is an annual rate, then 2 = "as. (COMPOUND INTEREST ‘Interest is normally calculated by means of compounding. Ifa sum of money, the principal, is invested at a fixed rate of interest such that the interest is added to the principal and no withdrawals are made, then the amount invested will grow by an increasing number of pounds in each successive time period, ‘because interest earned in eatlier periods will itselfearn interest in later periods. ‘Suppose, for example, thar £2,000 is invested to earn 10% interest. After one yeas, the ‘original principal plus interes will amount ro £2200. © Original investment 2000 atest inthe iret year (10%) 200 ‘Toul investment a the end of one year 2200 (2) After two vears the total investment will be £2,420. © Investment at end of one year 2200 Tere inde second year (10%) 220 ‘Toul investment atthe end oftwo years Pro} ‘The second year interest of £220 represents 10% of te original iavestment, and 10% ‘of dhe interest earned in the first year. (®) Similarly after Uhre years, the total investment will be £2,662 Investment a the end of two years 2420 Interest in the third year (10%) 242 ‘Total investment atthe end of three years 66329: Interest and discounting Notas Tay ANP 23. In the previous example, £2,000 invested at 10% per annum for three years would increase in value to +£2,000% 1.10" = £2,000 1.331 £2,662. ‘The interest earned over three years is £562. ‘Question 1 @ (©) What woul be tet valu of 5,00 vested now ws (aarti yrs, the tees rats 20% por annum; (@) after four years ithe intrest rates 15% per annum, i) ator tree year, the interest rat is 6% per annum? (b) At what annua! rate of compound interest wil £2,000 grow t6 £2,721 after four years? Answer ly) om mie staan Vi £5,000 x 1.15" = 28,748.03, (i) £5,000. 108° = 6,056.08, © 2721, = 2000%(1+9" (ent = 2.722000: ter = i,9005 = 7.08 ' 0.08 = 8%. Inflation 24 The same compounding formula can be used to predict future prices after allowing for inflavion. For exemple, if we wish to predict the ealary af an emplayee in five yours time, ‘given that he earns £8,000 now and wage inflaton is expected to be 10% per annum, the formula would be applied as follows. 8. = Pd +e? £8,000 x 1.10" £12,884.08, say, £12900. ‘Withdrawals of capital or interest 25 Ian investor takes money out ofan investment, it wil ease 1o earn interest. Thus ifn investor puts £3,000 into a bank deposit account which pays interest at 8% pet annum, 525 BPP Pubsening