Interest is the amount of money paid for the use of borrowed capital or the income

produced by money which has been loaned.

Simple interest

- is calculated using the principal only, ignoring any interest that had been accrued in

preceding periods. It is paid in short-term loans in which the time of the loan is

measured in days.

I = Pni

F = P + I = P + Pni = P (1 + ni)

Where: I = Interest

P = Principal or Present worth

n = Number of interest periods

i = Rate of interest per interest period

F = Accumulated amount of Future worth

a. Ordinary simple interest is computed on the basis of 12 months of 30 days each or 360

days a year.

1 interest period = 360 days

n = d/360

b. Exact simple interest is based on the exact number of days in a year, 365 days for an

ordinary year and 366 days for a leap year.

 1 interest period = 365 or 366 days

n = d/365 for normal year

n = d/366 for leap year

To determine the year whether leap year or not, one has to divide the year by 4. If it is

exactly divisible by 4, the year is said to be leap year otherwise, it will be considered just a normal

year with 365 days. However, if the year is a century year, ending with two zeros (e.g. 1700, 1800)

the year must be divided by 400 instead of 4 to determine the year whether or not a leap year.

Hence, year 1600 and 2000 are leap years.

Examples:

1. Determine the ordinary simple interest on P700 for 8 months and 15 days if the rate of

interest is 15%. (I = 74.38)

2. Determine the exact simple interest on P500 for the period from January10 to October

28, 1992 at 16% interest. (I = P63.83)

3. A P4 000 is borrowed for 75 days at 16% per annum simple interest. How much will

be due at the end of 75 days? (F = 4 133.33)

4. How long must a P40 000 note bearing 4% simple interest run to amount to P 41 350?

(n = 0.84375 years)

Cash Flow Diagrams

- is simply a graphical representation of cash flows drawn on a time scale. It is analogous

to that of free body diagram for mechanics’ problems.

Receipt (positive cash flow or cash inflow)

 Disbursement (negative cash flow or cash outflow)

Compound Interest

-the interest for an interest period is calculated on the principal plus total amount of interest

accumulated in previous periods. It means “interest on top of interest”.

F = P (1+ i)n ;F = P (F/P, i%, n) (F given P at i percent in n interest period)

P = F( 1 + i)-n ;P = F (P/F, i%, n) (P given F at i percent in n interest period)

Rates of Interest

a. Nominal rate of interest

- specifies the rate of interest and a number of interest periods in one year.

i = r/m ; where i = rate of interest per interest period

r = nominal interest rate

m =number of compounding periods per year

o If the nominal rate of interest is 10% compounded quarterly, then

i = 10%/4 = 2.5 %, the rate of interest per interest period.

b. Effective rate of interest

- is the actual or exact rate of interest on the principal during one year. If P1.00 is

invested at a nominal rate of 15% compounded quarterly, after one year this will

become, P1 (1 + 0.15/4)4 = P 1.1586

The actual interest earned is 0.1586, therefore, the rate of interest after one year is

15.86%. Hence,
 Effective rate = F1 -1 = (1 + i)m -1

Where F1 = the amount P1.00 will be after 1 year

Examples:

1. Find the nominal rate which if converted quarterly could be used instead of 12%

Compounded monthly. What is the corresponding effective rate?

Nominal rate Effective rate

r% compounded quarterly [1 + (r/4)]4 – 1

12 % compounded monthly [1 + (0.12/12)]12 – 1

[1 + (r/4)4- 1 = [1 + (0.01)]12 – 1

[1 + (r/4)] = (1.01)3 = 1.0303

r = 0.1212 or 12.12% compounded quarterly

Thus, 12% compounded monthly is equivalent to 12.12 % compounded quarterly.

Effective rate = [1 + (0.12/12)]12 – 1 = 12.68%

2. Mr. Pamolino, a chemical engineer wished to accumulate a total of P10 000 in a savings account

at the end of 10 years. If the bank pays only 4% compounded quarterly, what should be the initial

deposit? (P = 6 716.53)

3. By the conditions of a will, the sum of P25 000 is left to a girl to be held in trust by her guardian

until it amounts to P45 000. When will the girl receive the money if the fund is invested at 8%

compounded quarterly? (n = 7.42 years)

Equation of Value

- is obtained by setting the sum of the values on a certain comparison or focal date of

one set of obligations equal to the sum of the values on the same date of another set of

obligations.

Example:

Noel bought a lot worth P1 000 000 if paid in cash. On the installment basis, he paid a

down payment of P200 000; P300 000 at the end of one year; P400 000 at the end of three years

and a final payment at the end of five years. What was the final payment if interest was 20%.

Diagram showing the Cash Flow

800 000

300 000

300000 (P/F, 20%,1) 400 000

400000(P/F, 20%,3) Q
Q(P/F, 20%, 5)

Using today as a focal date, the equation of value is

P800 000 = P300 000 (P/F, 20%, 1) + P400 000 (P/F, 20%, 3) + Q(P/F, 20%, 5)

P800 000 = P300 000 (1.20)-1 + P400 000(1.20)-3 + Q(1.20)-5

P800 000 = P300 00(0.8333) + P400 000 (0.5787) + Q(0.4019)

Q = P792 560
Continuous Compounding and Discrete Payments

In discrete compounding, the interest is compounded at the end of each finite-length period,

such as month, quarter or a year.

In continuous compounding, it is assumed that cash payments occur once per year, but the

compounding is continuous throughout the year.

r = nominal rate of interest per year

r/m = rate of interest per period

m = number of interest periods per year

mn = number of interest periods in n years

F = P ( 1 + r/m) mn

Let m/r = k then m = rk, as m increases so must k

( 1 + r/m) mn = (1 + 1/k)rkn = [ ( 1 + 1/k) k] rn

The limit of ( 1 + r/m) k as k approaches infinite is e

[ ( 1 + 1/k) k] rn = er n

Thus, F = P er n

P = F e –r n
Example: Compare the accumulated amounts after 5 years of p1 000 invested at the rate of 10%

per year compounded (a) annually (b) semiannually (c) quarterly (d) monthly (e) daily and (f)

continuously.

a. F = P1 000 (1+0.10)5 = P1 610.51

b. F = P1 000 [1 + (0.10/2)]10 = P 1 628.89

c. F = P1 000 [1 + (0.10/4)]20 = P 1 638.62

d. F = P1 000 [1 + (0.10/12)]60= P 1 645.31

e. F = P1 000 [1 + (0.10/365)]1825 = P 1 648.61

f. F = Pe r n = P 1 000 (e)(0.10x5) = P1 648.72

Problems for practice

I. Answer the following problems.

1. April buys a microwave oven from a merchant who asks P1250 at the end of 60 days.

April wishes to pay immediately and the merchant offers to compute the cash price on

the assumption that money is worth 8% simple interest. What is the cash price? (P=

1233.55)

2. Geowie borrowed money from a loan shark. He receives from the loan shark an amount

of P1342 and promised to pay P1500 at the end of 3 quarters. What is the simple

interest rate? (i = 15.69%)

3. Determine the exact simple interest of P5000 invested for the period from January 15,

1996 to October 12, 1996, if the rate of interest is 18%. (I = 666.39)

4. The exact simple interest of P5000 invested from June 21, 1995 to December 25, 1995

if P100. What is the rate if interest? (i = 3.90%)

 5. What is the nominal rate compounded semi-annually, yields the same amount as 16%

compounded quarterly? (NR = 16.32%)

6. Find the nominal rate, which if converted quarterly could be used instead of 12%

compounded semi-annually. (NR = 11.83%)

7. A sum of P1000 is invested now and left for eight years at which time the principal is

withdrawn. The interest has accrued is left for another 8 years. If the effective annual

interest rate is 5%, what will be the withdrawal amount at the end of 16th year? (F =

705.42)

8. Vernelli plans to deposit P1500 in the bank now and another P3000 for the next 2 years.

If he plans to withdraw P5000 three years from after her last deposit for the purpose of

buying shoes, what will be the amount of money left in the bank after one year of his

withdrawal? Effective annual interest rate is 10%. (P= 1549.64)

9. Funds are deposited in a saving account at an interest of 8% per annum. What is the

initial amount that must be deposited to yield a total of P10 000 in 10 years. (P =

4631.93)

10. A deposit of P1000 is made in the bank account that pays 8% interest compounded

annually. Approximately how much money will be in the account after 10 years? (F =

2158.92)

II. Determination of leap year. Write L if it is leap year and N if not.

a. 1988

b. 1974

c. 1800
 d. 1973

e. 2400

Discount

Discount on a negotiable paper is the difference between the present worth (the amount

received for the paper in cash) and the worth of the paper at some time in the future (the face value

of the paper or principal) Discount is interest deducted in advance.

Discount = Future worth – Present worth

The rate of discount (d) is the discount on one unit of principal for one unit of time

(1 + i)-1

P 1. 00

d = 1 – (1 + i)-1 = discount/principal = D/P

i = d/(1-d) = interest/principal actually received = I/(Pn)

Where d = rate of discount for the period involved

i = rate of interest for the same period

Example:

A man borrowed P 5 000 from a bank and agreed to pay the loan at the end of 9 months.

The bank discounted the loan and gave him P4 000 in cash. (a) What was the rate of discount? (b)

What was the rate of interest (c) What was the rate of interest for one year?

a. d = discount/principal = P1000/P5000 = 0.20 or 20% or

d = 1- 0.80 = 0.20 or 20 %
 b. i = [d/(1-d)] = [0.20 /(1- 0.20)] = 0.25 or 25% or

i =interest/principal actually received = P1000 / P4000 = 0.25 or 25%

c. i =[ I/(Pn)] = [ 1000 / (4000(9/12))] = 0.3333 or 33.33%

Problem Exercises:

1. A price tag of P1200 is payable in 60 days but if paid within 30 days it will have a 3%

discount. Find the rate of interest. (i = 37.11%)

2. Mr. John dela Cruz borrowed money from a bank. He receives from the bank of P1340

and promised to pay P1500 at the end of 9 months

a. Simple interest rate (i = 15.92%)

b. The corresponding discount rate or often referred to as the banker’s discount.

(d = 13.73%)

3. Carlos borrowed P2000 from a bank and promised to pay the amount for one year. He

received only the amount of P1920 after the bank collected an advance interest of P80.

What were the rate of discount and the rate of interest that the bank collected in

advance? (d= 4%, i= 4.17%)