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Interest And

Investment
Costs

Interest
The price paid for the use of borrowed
money.
When money is borrowed, interest is
typically paid to the lender as a
percentage of the principal, the amount
owed to the lender.
The percentage of the principal that is paid
as a fee over a certain period of time
(typically one month or year) is called the
interest rate.

Types of Interest
1. Simple Interest
Compensation demanded = x
Principal Amount = P
i=Rate of Interest = Compensation demanded /
Principal Amount
Interest periods = n
Z = Amount of simple interest
Z=Pin
. The principal must be repaid eventually; therefore,
the entire amount S of principal plus simple
interest due after n interest periods is
S = P + Z = P(l + in)

Ordinary and Exact Simple


Interest

Compound
Interest Compound interest arises when interest
is added to the principal, so that, from that moment
on, the interest that has been added also earns
interest. This addition of interest to the principal is
called compounding.

Compound Interest

The term (1 + i)n is commonly referred to as the


discrete single-payment compound-amount
factor.

Nominal And Effective Interest


Rates

Comparison
among
total
amounts
accumulated
with
simple
interest,
discrete
compound
interest,
and
continuous
compound
nominal
interest

Continue.

Example 1 Applications of
different types of interest
It is desired to borrow $1000 to meet a financial
obligation. This money can be borrowed from a
loan agency at a monthly interest rate of 2
percent. Determine the following:
(a) The total amount of principal plus simple interest due
after 2 years if no intermediate payments are made.
(b) The total amount of principal plus compounded interest
due after 2 years if no intermediate payments are made.
(c) The nominal interest rate when the interest is
compounded monthly.
(d) The effective interest rate when the interest is
compounded monthly

Continuous Interest:
When time interval for interest accumulation
is usually taken as one year, shorter time
periods can also be taken.

When the time interval becomes


infinitesimally small so that the
interest
is
compounded
continuously.

Example 2 Calculations with continuous


interest compounding.
For the case of a nominal annual interest rate
of 20.00 percent, determine:
(a) The total amount to which one dollar of initial
principal would accumulate after one 365day year
with day compounding.
(b) The total amount to which one dollar of initial
principal would accumulate after one year with
continuous compounding.
(c) The effective annual interest rate if compounding
is continuous.

Present Worth
The present worth (or present value)
of a future amount is the present principal
which must be deposited at a given
interest rate to yield the desired amount at
some future date.
The factor l/(l + i) is commonly referred to as the
discrete single-payment present-worth factor.
For the case of continuous interest compounding

Discount
The difference between the indicated
future value and the present worth (or
present value) is known as the
discount.

Example 4 Determination of present


worth and discount
A bond has a maturity value of $1000 and is paying
discrete compound interest at an effective annual
rate of 3 percent. Determine the following at a time
four years before the bond reaches maturity value:
(a) Present worth.
(b) Discount.
(c) Discrete compound rate of effective interest which
will be received by a
purchaser if the bond were obtained for $700.
(d) Repeat part (a) for the case where the nominal
bond interest is 3 percent
compounded continuously.

Annuities
An annuity is a series of equal
payments occurring at equal time
intervals.
Payments of this type can be used to
pay off a debt, accumulate a desired
amount of capital, or receive a lump
sum of capital that is due in periodic
installments as in some life-insurance.

Ordinary Annuity
The common type of annuity involves payments
which occur at the end of each interest
period. This is known as an ordinary annuity.
An annuity term is the time from the beginning
of the first payment period to the end of the last
payment period.
The amount of an annuity is the sum of all the
payments plus interest if allowed to accumulate
at a definite rate of interest from the time of
initial payment to the end of the annuity term.

Relation between Amount of Ordinary


Annuity and the Periodic Payments

The term [(l + i) - l]/i is commonly designated as


the discrete uniform series compoundamount factor or the series compoundamount factor

Continuous Cash Flow and Interest


Compounding

Present Worth of an Annuity


The present worth of un annuity is
defined as the principal which would have to
be invested at the present time at
compound interest rate i to yield a total
amount at the end of the annuity term equal
to the amount of the annuity.

Example 5 Application of annuities in


determining amount of depreciation with
discrete interest compounding.
A piece of equipment has an initial installed value of
$12,000. It is estimated that its useful life period
will be 10 years and its scrap value at the end of
the useful life will be $2000. The depreciation will
be charged as a wst by making equal charges each
year, the first payment being made at the end of
the first year. The depreciation fund will be
accumulated at an annual interest rate of 6 percent.
At the end of the life period, enough money must
have been accumulated to account for the decrease
in equipment value. Determine the yearly cost due
to depreciation under these conditions.

Example 6 Application of annuities


in
determining
amount
of
depreciation with continuous cash
flow and interest compounding.
Repeat Example 5 with continuous
cash flow and nominal annual interest
of 6 percent compounded continuously.

Special Types of Annuities


Annuity Due:
One special form of an annuity requires that
payments be made at the beginning of each period
instead of at the end of each period. This is known
as an annuity due.

Deferred Annuity:
An annuity in which the first payment is due after a
definite number of years is called a deferred annuity

Perpetuities And Capitalized


Costs
A perpetuity is an annuity in which the
periodic payments continue
indefinitely.

COSTS DUE TO INTEREST ON


INVESTMENT
Money, or any other negotiable type
of capital, has a time value. When a
business concern invests money, it
expects to receive a return during
the time the money is tied up in the
investment. The amount of return
demanded usually is related to the
degree of risk that the entire
investment might be lost.