Chapter 1 Simple Interest and Discount Simple Interest (section 1.

.1) In any financial transaction, there are two parties: The lender and the borrower

Consider the following transaction: Person A lends money to person B person A is called the lender or investor person B is called the borrower or debtor

 the debtor must pay back the original amount borrowed (at some point in the future) along with a fee charged for the use of the money, called interest

Definitions/Notation P = principal = original amount borrowed = original amount invested I = interest = a dollar amount of money representing a fee or service charge paid to the lender for the use of his/her money r = rate of interest per year = ratio of the interest earned over a period of time to the principal t = length of investment (in years) S = accumulated value of P

Simple Interest Interest is calculated on the original principal only during the whole term of the investment (or loan), at the stated annual rate of interest It is calculated by means of the formula: I = Prt From the definition of S, we have: S = P+I

Combining the above two formulas, you get: S = P + I = P + Prt = P(1 + rt) S = P(1 + rt)

Note About Time The value of t must be given in years If time is given as something other than years, we make the following adjustments to t: 1. If time is given in months, then
t= number of months 12

2. If time is given in days, or if you are given actual dates, then (a) Exact Interest:
t= number of days 365

(b) Ordinary Interest:

number of days t= 360

Example 1.1.1 Using exact and ordinary interest, what will $15,000 accumulate to over 120 days at r = 7%?

Solution to 1.1.1

Example 1.1.2 You invest $5000 in a 6-month guaranteed investment certificate (GIC) paying interest at r = 4%. (a) What is the maturity value of the GIC? (b) What is the maturity value of the GIC if you invested the money on May 7, 2013?

Solution to 1.1.2

Example 1.1.3 How long will it take $1500 to earn $22.50 interest at r = 9%?

Solution to 1.1.3

Example 1.1.4 Suppose you bought some furniture for $977 and paid no interest for 90 days. However, there was a $25 administration charge to be paid up front. What interest rate were you charged for this no interest payment plan?

Solution to 1.1.4

Invoice Cash Discounts Often when a company buys supplies or merchandise from a wholesaler or retailer, they are frequently given an amount of time before they have to fully pay for the goods wholesaler/retailer will give them an invoice which stipulates how much is owed and when it has to be paid back to encourage prompt payment of invoices, the wholesaler will offer a discount on the price of the goods if the invoice is paid quickly

Typical Terms of an Invoice 2/10, n/30 This means that a 2% discount will apply to the cost of the goods if the invoice is paid in full within 10 days of the date of the invoice otherwise, the full amount is due no later than 30 days from date of invoice

Companies generally like to pay their bills as late as possible, yet need to pay them early to take advantage of the discount

What Can the Company Do?

Example 1.1.5 A merchant receives an invoice for $10,000 with terms 2/20, n/60. What is the highest rate of simple interest at which he/she can afford to borrow money at in order to take advantage of the discount? If the merchant could borrow money at r = 12%, what savings would he/she make?

Solution to 1.1.5

Discounted Value at Simple Interest (section 1.2) From section 1.1, we have the formula: S = P(1 + rt) We can rearrange this formula to obtain P in terms of S, r and t: P =
S 1 + rt

= S (1 + rt)1 P = S (1 + rt)1

Notes 1. The process of calculating P from S is called discounting at simple interest 2. P is called the discounted value or present value of S 3. The term (1 + rt)1 is called the discount factor at simple interest

Example 1.2.1 A man takes out a loan for 90 days at r = 8.5%. At the end of 90 days, he pays back $500. What was the original amount of the loan?

Solution to 1.2.1

An Application of Discounting: Promissory Notes Promissory notes are almost the same as bank loans they are written by a debtor (maker, borrower) debtor promises to pay the stated sum of money to the creditor (payee, lender) money is paid on a specified date, with or without interest

Differences Between Promissory Notes and Bank Loans 1. The lender does not have to be a financial institution 2. A note can be sold to a third party before the due date; the 3rd party becomes the payee of the note

Example of a Promissory Note

The Due Date vs. the Maturity Date In the note above, the due date is 120 days after October 17, 2012, which is February 14, 2013 in Canada, 3 days of grace are added to the due date to arrive at the legal due date OR maturity date in the note above, this would be 123 days later, February 17, 2013

Note If the term of a note is stated in months, these are calendar months, not months of 30 days If the above note had a due date of 4 months, the due date would be Feb.17/13 (123 days) and the maturity date would be Feb. 20/13 (126 days)

Procedure for Discounting Notes As mentioned, a note can be sold several times before its maturity date but how do you determine the price at which the note will sell? Each buyer will take the maturity value of the note and discount it back to the date of sale (at some interest rate) this discounted value is the price the seller of the note receives for selling the note (called the proceeds)

Two Step Procedure for Selling/Buying a Note Before Maturity 1. Determine the maturity value of the note, S 2. Determine the proceeds, P, by discounting S from the maturity date back to the date of sale, at a specified interest rate

Example 1.2.2 A promissory note, with a face value of $5000, is written by Mr. B on October 17, 2012. Mr. B agrees to pay back Mr. A in 120 days with interest at r = 9%. On January 15, 2013, Mr. A decides to sell the note to a bank which discounts the note at r = 10%. a) How much will Mr. A receive for selling the note? b)What rate of interest will the bank realize on their investment if the note is held to maturity? c) What rate of return does Mr. A realize on his initial investment?

Solution to 1.2.2

Equations of Value (section 1.3) Concept of Dated Values All financial decisions must take into account the time value of money For example,

In General $X due on a given date is equivalent, at a given simple interest rate, r, to $Y due t-years later if: Y = X(1 + rt) OR X = Y(1 + rt)1

Example 1.3.1 You owe Jim $600 7-months from now. Instead of this payment, you and Jim both agree that you will pay an equivalent amount at some other point in time. If r = 11%, what is the equivalent payment, if it is made a) 2 months from now (at the end of 2 months) b)10 months from now (at the end of 10 months)

Solution to 1.3.1

Note You should not add or subtract sums of money unless the sums are evaluated on the same date For example, suppose you owe $1000 now, $1000 in 6-months and $1000 in one year this is not the same as owing $3000 in a one-lump sum payment the size of a lump sum payment will depend on 1. the interest rate, and 2. when the amount is to be paid We have to replace all the dated values by equivalent dated values, due on the same date the sum of equivalent values is called the dated value of the set of payments

Example 1.3.2 A person owes $200 two months from now and $800 10-months from now. Instead of these two payments, it is agreed that a single payment will be made at some point in time to replace these two debts. If r = 10% , what is the equivalent single payment, if it is to be made a) now? b)at the end of 1 year? c) 5 months from now?

Solution to 1.3.2

Example 1.3.3 Kim originally owes $500 in 4 months and $500 in 8 months. Instead, she restructures her loan so that she pays $300 in one month and with another payment of $X at the end of 10 months. Determine X, using 10 months as your focal date, so that Kims proposed payments are equivalent to the original debts. The interest rate is r = 10%

Solution to 1.3.3

Note We say that two sets of payments are equivalent (at a given r) if the dated value of the sets, on any common date, are equal an equation stating that the dated values of two sets of payments are equal is called an equation of value the common date used to value the payment set is called the focal date

General Method for Equations of Value 1. Draw a good time diagram put original debts and their due dates on one side of the line put replacement payments and their due dates on other side 2. Select one (and only one) focal date accumulate or discount all dated values to this focal date (using the specified interest rate) 3. Set up an equation of value at the focal date value of debts = value of payments 4. Solve equation

Example 1.3.4 A person borrows $1000 now at 10%. He is to repay the loan with 2 payments, one at the end of 6 months and the other at the end of the year. The first payment is to be exactly twice as large as the 2nd payment. If r = 10%, determine the size of the payments, using a focal date of now.

Solution to 1.3.4