Simple Interest is an easy method of calculating the interest for a loan/principal amount.

Simple
interest is a concept that is used in many sectors such as banking, finance, automobile, and so on.
When you make a payment for a loan, first it goes to the monthly interest and the remaining goes
towards the principal amount. Simple Interest (S.I) is the method of calculating the interest
amount for some principal amount of money. But in the real world, money is not free to borrow.
You often have to borrow money from banks in the form of a loan. During payback, apart from
the loan amount, you pay some more money that depends on the loan amount as well as the time
for which you borrow. This is called simple interest.

Simple Interest Formula

The formula for simple interest helps you find the interest amount if the principal amount, rate of
interest and time periods are given.

Simple interest formula is given as:

SI=PTR100
Where SI = simple interest

P = principal

R = interest rate (in percentage)

T = time duration (in years)

In order to calculate the total amount, the following formula is used:

Amount (A) = Principal (P) + Interest (I)

Where,

Amount (A) is the total money paid back at the end of the time period for which it was
borrowed.

The total amount formula in case of simple interest can also be written as:

A = P(1 + RT)

Here,

A = Total amount after the given time period

P = Principal amount or the initial loan amount

R = Rate of interest (per annum)

T = Time (in yea

Compound interest on the other hand, is an interest computed for a minimum of two periods whereby
the previous interests produce another interest for subsequent or next periods. Here both the principal and
previous interests bring additional interests.

Compound Interest Formula

FVn = PV (1 + i)n
Where:
FVn = Future value at the end of n periods
PV = Present Value, or the principal amount
i = Interest rate per period
n= Number of periods
Or
FVn = PV (FVIF i, n)
Where:
(FVIF i, n) = The future value interest factor for i and n

Difference Between Simple Interest and Compound Interest

There is another type of interest called compound interest. The major difference between simple
and compound interest is that simple interest is based on the principal amount of a deposit or a
loan whereas compound interest is based on the principal amount and interest that accumulates in
every period of time. Let’s see one simple example to understand the concept of simple interest.

When we have discussed both simple and compound interest, in financial management we are
largely interested in compound interest. So in the sections that follow we shall discuss the
concepts and techniques of the time value of money in the context of compound interest.
The interest rate paid to lenders depends on the factors mentioned above. The size of the interest
rate depends on the following factors:
(a) The rate of return expected to be earned on the invested capital. If the borrower expects
to earn higher return from invested capital, they will be ready to pay higher interest rates.
On the other hand, when there are investment opportunities with higher expected returns,
lenders will have options to invest their money; hence they seek higher rates.
 (b) The lenders (savers) preference of current versus future consumptions. Lenders with
desperate needs for current consumption require higher rates to give it up. On the other
hand, those with higher needs for future consumption (such as retirement) require lower
interest rates.
(c) The riskiness of the loan. When the borrower is assumed to have higher probability of
default, lenders require higher interest rates.
(d) The expected future rate of inflation. As repeatedly discussed in this chapter, inflation erodes
the purchasing power of money and when expecting it lenders (savers) charge an interest they
believe would compensate them for the decline in value of their money.

Q2. An annuity is a series of equal periodic rents (receipts, payments, withdrawals, or deposits)
made at fixed intervals for a specified number of periods. For a series of cash flows to be an
annuity four conditions should be fulfilled.
1. The cash flows must be equal.
2. The interval between any two cash flows must be fixed.
3. The interest rate applied for each period must be constant.
4. Interest should be compounded in same manner during each period.
If any one of these conditions is missing, the cash flows cannot be an annuity.
Basically, there are two types of annuities namely ordinary annuity and annuity due. Broadly
speaking, however, annuities are classified into three types:
i) Ordinary Annuity,
ii) Annuity Due, and
iii) Deferred Annuity

(i) Future Value of an Ordinary Annuity:

An ordinary annuity is an annuity for which the cash flows occur at the end of each period.
Therefore, the future value of an ordinary annuity is the amount computed at the period when
exactly the final (nth) cash flow is made. Graphically, future value of an ordinary annuity can
be represented as follows:
0 1 2 ------------------ n

PMT1 PMT2 ----------------------- PMT n

The future value is computed at point n where PMT n is made.

[ ]
n
(1+i) − 1
FVA n = PMT
i
Where:
 FVA n = Future value of an ordinary annuity
PMT = Periodic payment
i = Interest rate per period
n = Number of periods
Or
FVA n = PMT (FVIFA i, n)
Where:
(FVIFA i, n) = the future value interest factor for an annuity
Example
You need to accumulate Br. 250,000 to acquire a car. To do so, you plan to make equal monthly
deposits for 5 years. The first payment is made a month from today, in a bank account which
pays 12 percent interest, compounded monthly. How much should you deposit every month to
reach your goal?
Given: FVA n = Br. 250,000; i = 12%  12 = 1%; n = 5 x 12 = 60 months; PMT =?
FVA n = PMT (FVIFA i, n)
 Br. 250,000 = PMT (FVIFA, %, 60)
 Br. 250,000 = PMT (81.670)
 PMT = Br. 250,000/81.670
 PMT = Birr 3,061

(ii) Future Value of an Annuity Due:

An annuity due is an annuity for which the payments occur at the beginning of each period.
Therefore, the future value of an annuity due is computed exactly one period after the final
payment is made. Graphically, this can be depicted as:
0 1 2 --------------------- n

PMT1 PMT2 PMT3 ----------------------- PMT n + 1

The future value of an annuity due is computed at point n where PMT n + 1 is made
FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
Or

Example:
= PMT
[ ]
(1+i)n − 1
i (1 + i)
Assume example 1 for ordinary annuity except that the payments are made at the beginning
instead of end of each year. How much is the terminal (future value) of the deposits at the end of
the fifth year?
 FVA n (Annuity due) = PMT (FVIFA i, n) (1 + i)
 FVA 5 = 3,000 (FVIFA 12%, 5) (1 + 12%)
 FVA 5 = 3,000 (6.35284736) (1.12)
 FVA 5 = Birr 21, 345.57

Comparing Future Values

For the same number of periods, same discount rate, and same amount of money involved; which
one, ordinary annuity or annuity due, always will have greater future value?
Key: Annuity due will always have greater future value as the last cash flow earns interest for
annuity due; but not for ordinary annuity.

(iii) Future Value of Deferred Annuity:

Deferred annuity is an annuity for which the amount is computed two or more period after the
final payment is made. When the amount of an ordinary annuity remains on deposit for a
number of periods beyond the final rent, the arrangement is known as a deferred annuity. When
the amount of an ordinary annuity continues to earn interest for one additional period, we have
an annuity due situation, when the amount of an ordinary annuity continues to earn interest for
more than one additional period, we have a deferred annuity situation.

0 1 2 -------------------n -------------- (n + x)
PMT1 PMT2 PMT n

The future value of a deferred annuity is computed at point n + x

FVA n (Deferred annuity) = PMT (FVIFA i, n) (1 + i)x
Where x = the number of periods after the final payment; and x  2.
Example: Ebise has a savings account in which she had been depositing Br. 3,000 every year on
January 1, starting in 1999. Her account earns 10% interest compounded annually. The last
deposit Ebise made was on January 1, 2008. How much money will she have on December 31,
2012? (No deposits were made after January1, 2008).
January 1:

1999 2000 2001 02 03 04 05 06 07 08 09 2010 11 12

3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000 3,000

The future value is computed on December 31, 2012 (or January 1, 2013).
Given: PMT = Br. 3,000; i = 10%; n = 10; x = 5
FVA n (Deferred annuity) = PMT (FVIFA i, n) (1 + i)x
= Br. 3,000 (FVIFA 10%, 10) (1.10)5
= Br. 3,000 (15.937) (1.6105)
= Br. 76, 999.62
A. Future Value of Uneven Cash Flows
Uneven cash flow stream is a series of cash flows in which the amount varies from one period to
another. The future value of an uneven cash flow stream is computed by summing up the future
value of each payment.
Example: Find the future value of Br. 1,000, Br. 3,000, Br. 4,000, Br. 1,200, and Br. 900
deposited at the end of every year starting year 1 through year 5. The appropriate interest rate is
8% compounded annually. Assume the future value is computed at the end of year 5.

0 1 2 3 4 5

1,000 3,000 4,000 1,200 900

FVIF8%, 4 Br. 1,000 (1.3605) = Br. 1,360.50
FVIF8%, 3 Br. 3,000 (1.2597) = 3,779.10
FVIF8%, 2 Br. 4,000 (1.1664) = 4,665.60
FVIF8%, 1 Br. 1,200 (1.0800) = 1,296.00
Br. 900 (1.0000) = 900.00
FV = Br. 12,001.20

Q3. The payback period method is criticized for not considering the time value of money,
which is the concept that money received in the future is worth less than money received
today. However, this limitation can be overcome by using the discounted payback period
method.
The discounted payback period method adjusts the cash flows by discounting them to their
present value using an appropriate discount rate. By incorporating the time value of money,
this method provides a more accurate measure of the profitability of an investment.
While the discounted payback period method addresses the limitation of not considering the
time value of money, it still has some drawbacks. It does not provide a clear indication of the
 profitability of an investment compared to a specific benchmark or hurdle rate. Additionally,
it does not consider cash flows beyond the payback period.
On the other hand, the net present value (NPV) method takes into account the time value of
money by discounting all cash flows to their present value and subtracting the initial
investment. It provides a more comprehensive measure of the profitability of an investment
and considers cash flows throughout the project's life.
In conclusion, while the payback period method can be improved by using the discounted
payback period method, the NPV method is generally considered more preferable due to its
ability to consider the time value of money and provide a more comprehensive evaluation of an
investment's profitability

Limitations of the Payback Period Criterion

The payback criterion measures the time required for a project to break even. However, this
criterion in capital budgeting has the following limitations:
1. Ignore cash flow after payback period, hence, cannot measure of profitability
2. The maximum acceptable cutoff payback period is subjective decision
3. It ignores the time value of money
4. Finally, the rule is biased against long-term projects.
5. It is one of the misleading evaluations of capital budgeting

Advantages of the Payback Period Criterion

While being a poor criterion to measure profitability, the payback period gives a rough indication
of the liquidity of a project. The payback period was among the first capital-budgeting criteria to
be widely accepted. It continues to be in common use even today for the following reasons:
It is easy to calculate and simple to understand.
Pay-back method provides further improvement over the accounting rate return
Pay-back method reduces the possibility of loss on account of obsolescence
It favors projects that “pay back quickly” and contributes to the firm’s overall liquidity.
Q4. Managers may prefer to use the Internal Rate of Return (IRR) method over the Net Present
Value (NPV) method for discounted cash flow evaluations due to several reasons:

Simplicity: The IRR method provides a single percentage rate of return, which is easier for
managers to understand and communicate compared to the NPV method, which requires
calculating the present value of cash flows.

Intuitive decision-making: The IRR method focuses on the rate of return generated by an
investment, which aligns with managers' intuition of evaluating projects based on their
profitability. Managers may find it more intuitive to compare projects based on their IRRs rather
than the absolute dollar value of NPV.
Emphasis on liquidity: The IRR method considers the time value of money and the cash flow
timing, which is important for managers who prioritize liquidity and cash flow management. By
focusing on the rate of return, the IRR method highlights the speed at which an investment
generates cash flows.

Considers reinvestment: The IRR method implicitly assumes that cash flows generated by an
investment are reinvested at the same rate of return. This assumption may align with managers'
expectations of reinvesting cash flows into similar projects, making the IRR method more
appealing.

Psychological bias: The IRR method often yields higher rates of return compared to the cost of
capital, which can be psychologically appealing to managers. This bias towards higher rates of
return may influence their preference for the IRR method.

There are a few reasons why companies might use the internal rate of return (IRR) as a measure
to evaluate projects rather than net present value (NPV).

First, the IRR takes into account the time value of money, which means that it adjusts for the fact
that a dollar received in the future is worth less than a dollar received today. This can make the
IRR a more accurate measure of an investment's profitability, especially when comparing
investments with different time horizons.

Second, the IRR is easy to understand and communicate to stakeholders, which can be especially
useful for presenting investment opportunities to executives or board members who may not
have a strong financial background.

Third, the IRR can be used to compare the expected returns of different investments, which can
be helpful for making decisions about which projects to pursue.

However, it's important to note that the IRR has some limitations as a measure of investment
performance. For example, it does not take into account the size of the investment or the risk
involved, which can make it difficult to compare investments with very different risk profiles. In
addition, the IRR can produce multiple answers for a single investment, which can make it
difficult to interpret in some cases. For these reasons, many companies will use a combination of
measures, such as the NPV and IRR, to evaluate investment opportunities.

However, it is important to note that the IRR method has limitations, such as potential multiple
IRRs, inability to handle mutually exclusive projects, and reliance on accurate cash flow
estimates. Therefore, managers should consider using both the IRR and NPV methods together
to make more informed investment decisions.
Q5 Excessively high levels of borrowing can have several adverse effects on a business and its
ability to be effectively managed. Here are some ways in which excessive borrowing can impact
managers and the business:

Financial burden: High levels of borrowing result in increased interest payments and debt
servicing costs. This can strain the company's cash flow and limit its ability to invest in growth
opportunities, research and development, or other essential activities. Managers may find it
challenging to allocate resources effectively and make strategic decisions due to limited financial
flexibility.

Increased risk: Excessive borrowing increases the company's financial risk. If the business is
unable to generate sufficient cash flow to meet its debt obligations, it may face default or
bankruptcy. Managers must navigate the increased risk and uncertainty associated with high debt
levels, which can hinder their ability to make long-term plans and investments.

Reduced profitability: High levels of borrowing can lead to higher interest expenses, which
directly impact the company's profitability. Managers may need to allocate a significant portion
of the company's earnings towards debt repayment, leaving fewer resources available for
reinvestment or distribution to shareholders. This can limit the company's ability to generate
profits and grow over time.

Limited access to additional funding: Excessive borrowing can negatively impact the company's
creditworthiness and make it more challenging to secure additional funding in the future. This
can restrict the company's ability to obtain loans or issue bonds, limiting its options for financing
growth or managing unforeseen events.

Loss of control: In some cases, excessive borrowing may require the company to seek external
financing from investors or lenders. This can result in dilution of ownership or the need to give
up control to external parties. Managers may face pressure from these stakeholders, impacting
their ability to make independent decisions and pursue long-term strategies.

To mitigate these risks, managers should carefully assess the company's borrowing needs,
maintain a balanced capital structure, and ensure that borrowing is aligned with the company's
growth plans and cash flow capabilities. Regular monitoring of debt levels and proactive debt
management strategies are essential to avoid the adverse effects of excessive borrowing.