M.

Raashid, Chemical Engineering

1
Economics
M.Raashid, Chemical Engineering
2
Economics
❑ Interest is the cost of borrowed money, or the earnings on
money loaned.
❑ Principal refers to the original amount (or the remaining
unpaid amount of original loan).
❑ Interest rate is defined as the amount of money earned
by, or paid on, a unit of principal in a unit of time,
expressed as a fraction or percentage per year.
❑ Simple Interest vs Compound Interest
❑ Simple Interest:

❑ Where N is the number of years (or time periods) and F is total amount payable
after N years (or time periods) 3
❑ Compound Interest:

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Nominal Interest Rate vs Effective Interest Rate:
❑ Traditionally, the length of the discrete interest period is
taken as 1 year, and the interest rate i is based on 1 year.
❑ However, in modern banking, time periods other than one
year are becoming very common. Even though the actual
interest period is not 1 year, the interest rate is often
expressed on an annual basis.
❑ An interest rate stated as an annual rate but compounded
other than annually is designated a nominal interest rate.
❑ The actual annual return (effective interest rate) is higher
because of the effect of compounding.
❑ The effective interest rate is the rate which, when
compounded once per year, gives the same amount of
money at the end of 1 year, as does the nominal rate r
(divided by m) compounded m times per year. 5
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❑ P = 1000$, i = 0.02, N=24, F =1480 $

❑ P= 1000$, i=0.02,N = 24, F= 1608.44 $

❑ r = 0.02x12= 0.24 or 24%

❑ r= 0.24, m=12, ieff = 0.2682 or 26.82%

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Continuous Interest:
❑ An extreme of compounding when time period becomes
so short (approaches zero). In other words, m approaches
infinity.

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❑ Common Data: P=1$, r=0.2, N=1
❑ Part a:
❑ m=1, F=1.2 $, ieff=0.2 or 20%
❑ Part b:
❑ m=12, ieff=0.2194 or 21.94%, F= 1.2194$
❑ Part c:
❑ F= 1.2214, ieff = 0.2214 or 22.14% 9
M.Raashid, Chemical Engineering
10
Economics
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Excel
File

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❑ In general, more frequent the payments, the less the total
interest paid. (Payment is assumed to be at end of period)
❑ At end of last payment, remaining principal should be zero.
This serves as a check for correctness of calculations.
❑ Last loan installment can be calculated from difference to
rectify the errors in rounding off earlier installments.
❑ The same calculation is provided in Excel with PMT
function supported by IPMT and PPMT functions.
❑ Remaining principal calculations are needed to be done in
case any borrower opts for early settlement.
❑ Loan Amount is linked with income of the borrower minus
expenses of the borrower and in case of loan against asset:
value of asset (should be within loan return power of the
borrower) and minimum ownership policy (Ranges from
15%-30% depending on bank policy). 13
❑ Interest Rate is linked with central bank rates such as
KIBOR in Pakistan that is published by State bank of
Pakistan under the directions of the Government.
❑ Currently KIBOR is 7% and it is revised from time to time
depending on Government policies. It is often kept close
to inflation as per normal practice and IMF demand. At
present, inflation rate is predicted to be around 7-8% for
next financial year.
❑ Loan borrowed 'against assets such as car/house has lower
interest rate as compared to a loan not backed by assets.
Amount charged by banks (Spread) in Pakistan is generally
3-5% above KIBOR for loan borrowed against assets such
Car/house and 6-10% above KIBOR for personal loans.
❑ For borrowing against assets, insurance is normally made
mandatory to banks to protect their investment. 14
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