CHAPTER 1
• CONTENTS
1.1 The Concept of Interest
1.2 Simple Interest
1.3 Compound Interest
1.4 Some Practical Illustrations
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1.1 THE CONCEPT OF INTEREST
Borrowing: When you borrow money, you pay back the principal amount (the original
amount borrowed) plus interest.
Investing: When you invest money, you earn interest on your initial investment.
• Interest is the extra money paid or earned on a principal amount over time
• Interest may be regarded as a reward paid by one person or organization (the
borrower) for the use of an asset, referred to as capital, belonging to another person
or organization (the lender)
• The additional amount of money charged for borrowing money or the additional
amount of money earned on an investment.
Interest is the money that is paid for use of money.
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1.1 THE CONCEPT OF INTEREST
An investor who had opened a saving account some time ago with an initial deposit
of £100, and who would expect to withdraw more than £100 if he were now to close
the account. Suppose, for example, that he receives £106 on closing his account.
• This extra amount is called the “INTEREST”=£6
• The original amount borrowed is known as the “PRINCIPAL” or “CAPITAL” = £100
• The sum of both Principal and the interest is known as “Repayment AMOUNT”=
£106
Interest = Repayment amount – Principal
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1.2. Simple Interest
• Simple interest is calculated on the original principal amount throughout the
entire time period.
• Example: Compute simple interest on $100 invested at 6% per year for 3
years.
• 1 st year interest is $6.00 =100*6%
• 2 nd year interest is $6.00 =100*6%
• 3 rd year interest is $6.00 =100*6%
• Total interest earned: $18.00 =100*6%*3
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1.2. Simple Interest
• Formula for Simple Interest:
I= Interest
=Principal/Capital
i= interest rate
n= number of periods
Note, it is important that “n” and “i” match. If periods are expressed in terms of number of
monthly payments, the interest rate must be expressed in terms of the interest rate per month.
For example, if i is annual interest rate, then n must be time in years
EXAMPLE 1.1: $100 is invested for two years in a bank, earning a simple interest rate of 9% per
annum. Determine the simple interest earned….
Solution:
• C=$100; i=0,09; n=2
• I= C*n*i=100*0,09*2=$18
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• Note that
• if the annual rate of interest is 15%, then i = 0,15 per annum;
• if the annual rate of interest is 8%, then i = 0,08 per annum; and so on.
• EXAMPLE 1.2: $1000 is invested for 5 years, at a simple interest rate of 10%
per annum. Calculate the repayment amount after 5 years
Solution ?
• EXAMPLE 1.3: If you borrow $1,000 at a 5% annual interest rate for 2 years,
the simple interest would be: Interest = 1000 × 5% × 2= $100 ???
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• EXAMPLE 1.4 : A $1,000 investment earns a simple interest rate of 10% per annum for 3
years and 6 months. Calculate the total amount paid to the investor at the end of the
investment period.
• Solution:
• C = $1,000
• I = 0.1
• n = 3 + 6/12 = 3.5
• The amount paid to the investor when the account is closed will be
• = Captial + Interest= + I = (1+i*n)= 1000(1+0.1*3.5) = $1,350
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• Note that, we have assumed that 3 months and 10 months are periods of 1/4 and
10/12 of 1 year, respectively.
• For short-term transactions (i.e., duration less than 1 year), it is usual to allow for
the actual number of days an account is held, so, for example, two 6-month
periods are not necessarily regarded as being of equal length. In this case “Simple
Interest Formula” becomes
• where m is the duration of the account, measured in days, and i is the annual
rate of interest.
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• EXAMPLE 1.5: Suppose that $860 is deposited in a savings account that pays
simple interest at the rate of 5.375% per annum. Find the amount finally
withdrawn if the account is closed after
• (a) 6 months,
• (b) 10 months,
• (c) 1 year.
Solution?
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Solution
• The interest rate is given as a per annum value; therefore, n must be measured in
years.
• By letting n = 6/12, 8/12, and 1 with C =860 and i =0.05375, we obtain the
answers (a) £883.11; (b) £898.52; (c) £906.23.
• In each case we have given the answer to two decimal places of one pound,
rounded down. This is quite common in commercial practice.
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1.3. COMPOUND INTEREST
• Compound interest is calculated on the principal amount and the
accumulated interest from previous periods.
• Compound interest can be thought of as “interest on interest”
• Compound interest make a deposit or loan grow at a faster rate than simple
interest
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Example 1.6
• Suppose you decide to invest the initial $100 for 3 years with interest earned and
credited to your account annually (annual compounding). Calculate the total
interest earned.
o At the end of the first year, your account will have $110
Principal is $100, interest is $100*10% = $10
o At the end of the second year, your account will have $121
Principal is $110, interest is $110*10% = $11
o The amount at the end of the third year will be $133,1
Principal is $121, interest is $121*10% = $12,1
• Total interest earned: $10+$11+$12,1= $33,1
• Total interest earned: $33,1 = $100 (1+ 10% )^3 – 100 (why)
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• Quiz :
If you deposit $100 into a savings account with a 5% interest rate, you
will earn $...? in interest on the initial deposit by the end of the first
year.
At the beginning of the second year, your balance will be $105. As
another year passes, you will earn interest on the full amount, which
is… ???
The total balance at the end of the second year will be $ … ???, and the
compound interest refers to the additional $… ???
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1.3. COMPOUND INTEREST
Formula for Compound Interest
• A principal amount of invested under compound interest at a rate of i per annum for n years
will accumulate to
• = Principal amount (or Capital)
• = Total amount after n years
• i = Annual interest rate (or rate of interest per annum)
• n =Time in years (or number of years the capital is invested)
The payment consists of a return of the initial deposit , together with accumulated interest
(i.e., interest which, if n > 1, has itself earned further interest) of amount
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1.3. COMPOUND INTEREST
Formula for Compound Interest
Solution:
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Comparing simple and compound interest
Simple Interest Compound Interest
Interest is calculated only on the principal Interest is calculated on both the
amount. principal amount and the accumulated
interest
Interest earned is not reinvested. Interest earned during the previous
Therefore, it is not used in interest period is added to the principal.
calculations for following periods.
For short-term loans, simple interest is For long-term loans, compound interest
used. is used.
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Exercises
Suppose that £100 is deposited in a savings account. Construct a table to show the
accumulated amount of the account after 5, 10, 20, and 40 years on the
assumption that compound interest is paid at the rate of
• (a) 4% per annum,
• (b) 8% per annum.
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1.4 SOME PRACTICAL ILLUSTRATIONS
• One of the most important applications of compound interest lies in the analysis and
evaluation of investments, particularly fixed-interest securities.
• For example, assume that any one of the following series of payments may be purchased for
£1.000 by an investor who is not liable to tax:
i. Income of £120 per annum payable in arrears at yearly intervals for 8 years, together with
a payment of £1.000 at the end of 8 years;
ii. Income of £90 per annum payable in arrears at yearly intervals for 8 years, together with a
payment of £1.300 at the end of 8 years;
iii. A series of eight payments, each of amount £180, payable annually in arrear
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• SUMMARY
• Interest is the reward paid by the borrower for the use of money, referred to
as capital or principal, belonging to the lender.
• Under the action of simple interest, interest is paid only on the principal
amount and previously earned interest does not earn interest itself.
• Under the action of compound interest, interest is paid on previously earned
interest.
• Compound interest is used in practice for all but very short-term investments.
