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01 Module 02 - Simple & Compound Interest

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6 views

01 Module 02 - Simple & Compound Interest

Uploaded by

Katrine Siean Batoon
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Simple &

Compound
ENGINEERING ECONOMICS – SESSION 2
Time Value of Money
If you win the lotto worth $25.6M

• What are you going to do?

• Two Way to be paid


1. Single Sum Payment worth $13.5 Million
2. Receive the $25.6 Millions in 30 installments over 29 Years,
First payment is received immediately and installment of
$853,333 for the next 29 Years.

This is operation of interest and the Time Value of Money


Interest : The Cost of Money

• What is interest rate?


- The cost of money is established and measured by
interest rate.
- A percentage that is periodically applied and added
to an amount.

Interest
- defined as the cost of having money available for use.
The rate of interest

• The rate of interest is usually expressed as an annual percentage of the


principal, and is influenced by the money supply, fiscal policy, amount being
borrowed, creditworthiness of the borrower, and rate of inflation
Consider buying a Refrigerator at $100.00

• You have $100 on your pocket.


• If you invest the $100, it will an annual interest rate of 6%
per annum.

• But, inflation is at 8% per annum.


Gains and losses
Power of money
• Earning power
- is a company's ability to generate profit. Specifically, its ability to
generate profit from its operations. Investors and analysts calculate earning
power to determine whether a company is worth investing in.
• Purchasing Power
- is the amount of goods and services that can be purchased
with a unit of currency. For example, if one had taken one unit of currency to
a store in the 1950s, it would have been possible to buy a greater number of
items than would be the case today, indicating that the currency had a
greater purchasing power in the 1950s. Currency can be either a commodity
money, like gold or silver, or fiat money emitted by government
sanctioned agencies.
Market Interest Rate

1. The prevailing rate of interest offered on cash deposits,


determined by demand and supply of deposits and based on the
duration (the longer the duration, the higher the rate) and
amount (the higher the amount, the higher the rate) of deposits.
2. The prevailing rate of interest on loans determined by the
demand and supply of credit and based on the duration (the
longer the duration, the higher the rate) of loan and type of
security offered (the higher the quality of security, the lower the
rate).
Elements of Transaction involving interest
1. The initial amount of money invested or borrowed – Principal (P)
2. The interest rate measures the cost or price of money and is expressed as a percentage in a
period of time – Interest Rate (i)
3. A period of time that determines the frequency interest is calculated – interest period (n)
4. A specified length of time marks the duration of the transaction and thereby establishes a
certain number of interest periods (N)
5. A plan for receipts or disbursements (An) yields a particular cash flow pattern over a
specified length of time.
6. A future amount of money (F) results from the cumulative effects of the interest rates over a
number of interests periods.
Interest transaction

• Principal Amount –
• Interest Rate –
• Interest Period –
• Number of interest period –
• Annuity –
• Future Amount -
Cash Flow Diagram

$29,700

Years

1 2 3 4 5

$7,712.77 $7,712.77
$7,712.77 $7,712.77 $7,712.77
Cash Flow Diagram

$29,700

Years

0
$46,158.72
Two ways for calculating interest

Simple Interest

Compound Interest
Simple Interest

• Is interest earned on only the principal amount during each interest


period.
• In other words, the interest earned during each interest period does
not earn additional interest in the remaining periods, even if you do not
withdraw the earned interest.
• In General
I = (iP)N
• Total Amount at the end of N period would be,
F = P + I = P(1+iN)
Example

• If you invested $1,000 in a bank that provides 8% interest per


annum of simple interest. What is the value of the investment after
3 years?

• Principal Amount (P) = $1,000


• Interest Rate (i) = 8%
• Number of years (N) = 3 Years
• Future Value = ?
Exact Simple Interest. If
the interest is calculated
on the basis of 365 days
a year, the result is
called "Exact simple
interest".
Ordinary simple
interest is a simple
interest that uses 360
days as the equivalent
number of days in a
year.
Compound Interest

• The interest earned in each period is calculated based on the total amount based on the
previous period.
• The total amount includes the principal amount plus the accumulated interest that has
been left in the account.
• With this, Balance after the end of the second period is
P(1+i) + i[P(1+i)] = P(1+i) (1+i) = P (1+i)2
Continuing, we can see that the balance after the 3rd period is
P(1+i) 2 + i[P(1+i) 2] = P (1+i)3
With this,

F = P(1+ i)N
Compound Interests

• If you invested $1,000 in a bank that provides 8% interest per annum of compound interest.
What is the value of the investment after 3 years?

• Principal Amount (P) = $1,000


• Interest Rate (i) = 8%
• Number of years (N) = 3 Years
• Future Value = ?
Comparison YEARS SIMPLE INTEREST COMPOUND INTEREST
END OF 1ST YEAR $1,080 $1,080.00
END OF 2ND YEAR $1,160 $1,166.40
END OF 3RD YEAR $1,240 $1,259.71
Cash Flow Diagram

The two perspective of a Cash Flow diagram

1. Borrowers Perspective
2. Lenders Perspective
Borrower & Lenders Perspective
Cash Flow
Interest transaction

• Principal Amount – $29,700


• Interest Rate – 9%
• Interest Period – 5 Years
• Number of interest period –
5 Years
• Annuity –
• Future Amount -
Compounding Interests
Cash Flow Diagram

$29,700

Years

1 2 3 4 5

$7,712.77 $7,712.77
$7,712.77 $7,712.77 $7,712.77
Cash Flow Diagram

$29,700

Years

0
$46,158.72
Comparison

Principal @30K Principal @29.7K


YEAR Option 1 Option 2 YEAR Option 1 Option 2
Year 0 $ 30,000.00 $ 30,000.00 Year 0 $ 29,700.00 $ 29,700.00
Year 1 $ 7,712.77 $ - Year 1 $ 7,712.77 $ -
Year 2 $ 7,712.77 $ - Year 2 $ 7,712.77 $ -
Year 3 $ 7,712.77 $ - Year 3 $ 7,712.77 $ -
Year 4 $ 7,712.77 $ - Year 4 $ 7,712.77 $ -
Year 5 $ 7,712.77 $ 46,158.72 Year 5 $ 7,712.77 $ 46,158.72

Interest Rates Original Actual


i 9.00% 9.00%
Principal $ 30,000 $ 30,000
Original Principal $ 29,700 $ 29,700
Actual Interest 9.39% 9.22%

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