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Chapter 5 BASIC LT FINANCIAL CONCEPT

This document discusses basic concepts of simple and compound interest: - Simple interest is calculated on the original principal only, while compound interest is calculated on the principal plus previously accumulated interest. - Formulas are provided to calculate simple interest, principal, rate, and time given other variables. - Examples are given to demonstrate calculating simple interest with known and unknown principal, rate, and time. - Compound interest is defined as interest added to the principal at regular intervals, so interest earns interest over time. - An example demonstrates calculating interest compounded annually over 5 years yields more than simple interest. - More frequent compounding yields higher total interest than less frequent compounding over the same time period.

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Airon Bendaña
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2K views

Chapter 5 BASIC LT FINANCIAL CONCEPT

This document discusses basic concepts of simple and compound interest: - Simple interest is calculated on the original principal only, while compound interest is calculated on the principal plus previously accumulated interest. - Formulas are provided to calculate simple interest, principal, rate, and time given other variables. - Examples are given to demonstrate calculating simple interest with known and unknown principal, rate, and time. - Compound interest is defined as interest added to the principal at regular intervals, so interest earns interest over time. - An example demonstrates calculating interest compounded annually over 5 years yields more than simple interest. - More frequent compounding yields higher total interest than less frequent compounding over the same time period.

Uploaded by

Airon Bendaña
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 DOCX, PDF, TXT or read online on Scribd
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Chapter 5: BASIC LONG-TERM FINANCIAL CONCEPTS

INTEREST - the cost of holding money. It is the amount charged by the lenders to the borrowers/
users of money, and is usually paid at regular intervals.

A. Simple Interest – the interest is computed on the original principal during the whole time , or term of the
loan, at the stated annual rate of interest.

In any financial transaction, there are two parties involved: an investor or lender, who is lending money to someone,
and a debtor or maker, who is borrowing money from investor. The debtor must pay back the money originally
borrowed, and also the fee charged for the use of the money, called interest. Simply stated, interest is money paid
for the use of money.

From the investor’s point of view, interest is income from invested capital and from the debtor’s point of view, an
expense for the use of capital. The capital originally invested in an interest transaction is called the principal. The
sum of the principal and interest due is called the final amount or accumulated value or maturity value. Any
interest transaction can be described by the rate of interest, which is the ratio of the interest earned in one time
unit on the principal.

In early times, the principal lent and the interest paid might be tangibles (ex: grain). Now, they are most company in
the form of money. The practice of charging interest is as old as the earliest written records of humanity. Four
thousand years ago, the laws of Babylon referred to interest payments on debts.

We shall use the following notation:


P = the principal,
I = simple interest,
F = the final amount, or the accumulated value of P or the maturity value of P,
r = annual rate of simple interest,
t = time in years.

Simple interest is calculated by means of the formula


I = Prt
from the definition of the final amount F we have
F = P+I
By substituting for I = Prt, we obtain F in terms of P, r, and t:
F = P + Prt
F = P(1 + rt)

Illustration: Lucita borrowed ₱ 280,000 at a simple interest rate of 9% for one year. Compute the simple interest and
final amount (maturity value) of the loan.

Interest = Principal x Rate x Time


= ₱ 280,000 x .09 1
= ₱25,200

The final amount or Maturity Value is solves as,

Final Amount = P,rincipal + Interest


= 280,000 + 25,200
= ₱305,200

Or

Final Amount = Principal (1 + Rate x Time)


= 280,000 (1 + .09 x 1)
= ₱305,200
Hence, on maturity date, in addition to the principal of ₱280,000 that Lucita received when she obtained the
loan, she is to pay ₱25,200 in interest; or a total loan of ₱305,200.

From the formula for the simple interest, the following formulas can be derived. These formulas can be used if
the problem requires other than the interest.

To find the principal P when interest I, time t, and rate r are given
P = I ÷ rt
To find time t when principal P, interest I, and rate r are given
t = I ÷ Pr
To find the rate r when principal P when interest I, and time tare given
r = I ÷ Pt

PRINCIPAL IS UNKNOWN
Illustration: How much was borrowed by Ms. Becky if the interest she paid after 3 months at 12.5% simple interest is
₱3,000?
P = I ÷ rt
P = 3,000 ÷ (.125 x .25)
P = 3,000 ÷ .03125
P = ₱96,000

Therefore, Ms. Becky borrowed ₱96,000.

RATE IS UNKNOWN
Illustration: At what rate of interest did Mercy invest the amount of ₱23,500 for it to earn a simple interest of
₱3,525 for 3 years?
r = I ÷ Pt
r = 3,525 ÷ (23,500 x 3)
r = 3,525 ÷ 70,500
r = .05 or 5%

Therefore, Mercy invested the money at 5%.

TIME IS UNKNOWN
Illustration: How long should Dwain invest the amount of ₱90,000 to earn an interest of ₱4,500 at 7.5% simple
interest?
t = I ÷ Pr
t = 4,500 ÷ (90,000 x 0.075)
t = 4,500 ÷ 6,750
t = .6667 year or 8 months (.6667 x 12 to convert to months)
Or 240 days (.6667 x 360 days to convert to days)

When the time is given in days, there are two different varieties of simple interest in use:
1. Exact interest, where t = no. of days ÷ 365 (the year is taken as 365 days, leap year or not)
2. Ordinary interest, where t = no. of days ÷ 365 (the year is taken as 360 day)

Illustration: Lucita borrowed ₱140,000 at a simple interest at 7% for 64 days. Compute the simple interest using the
exact interest and ordinary interest methods.
Exact interest = Principal x Rate x Time
= 140,000 x .07 x 64 ÷ 365
= ₱1,718.36

Ordinary interest = Principal x Rate x Time


= 140,000 x .07 x 64 ÷ 360
= ₱1,742.22

EXERCISE:
1. Determine the maturity value of a) a ₱2,500 loan for 18 months at 12% simple interest, b) a ₱1,200 loan for 120
days at 8.5% ordinary simple interest, and c) a ₱10,000 loan for 64 days at 7% exact simple interest.
2. At what rate of simple interest will a) ₱1,000 accumulate to ₱1,420 in 2.5 years, b) money double itself in 7 years,
and c) ₱500 accumulate ₱10 interest in 2 months?
3. How many days will it take ₱1,000 to accumulate to at least ₱1,200 at 5.5% simple interest?
4. Determine the ordinary and exact interest on ₱5,000 for 90 days at 10%.
5. A student lends his friend ₱10,000 for one month. At the end of the month he asks for repayment of the ₱10,000
plus purchase of a chocolate bar worth ₱500. What simple interest rate is implied?
6. What principal will accumulate to ₱5,100 in 6 months if the simple interest rate is 9%?
7. What principal will accumulate to ₱5,800 in 120 days at 18% simple interest?
8. Determine the accumulated value of ₱1,000 over 65 days at 6% using both ordinary and exact simple interest.

B. Compound Interest - the interest in the first compounding period is added on the principal, which
will then be the basis for the interest to be computed for the next period.

Example:
Given:
Principal = ₱500,000
Rate = 8%
Time = 5 years

The interest to be earned on the first year is equal to 500,000 x .08 = 40,000. The 40,000 interest will be added to the
500,000 principal which will then be the basis for interest computation for the second year; 540,000 x .08 = 43,200,
and so on.

Principal = ₱500,000
Rate = 8%
Time = 5 years
Compounding frequency = annually
Thus,
Interest = 500,000 x (1 + (0.08/1))(5x1) – 500,000 = PHP234,664.04

Compounding Frequency - the number of times interest is computed on a certain principal in one year.
 If the investment pays annually, the interest is the same as computed above since m=1.
 If the investment pays semi-annually, the total interest will be equal to:
Interest = 500,000 x (1+(0.08/2))(5x2) – 500,000 = PHP240,122.14

EXERCISE:
Compute the interest earned over the 5 year term with PHP500,000 as principal using the following compounding
periods.
1. Quarterly: PHP242,973.70
2. Monthly: PHP244,922.85
3. Semi-monthly: PHP245,416.34
4. Daily (365 days): PHP245,879.66

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