Lesson 6: Basic Long-Term Financial Concepts

Introduction:

When people need to secure funds for some purposes, one of the ways they usually
resort to is borrowing. On the other hand, the person or institution, which lends
the money would also wish to get something in return for the use of money.

What is Interest?

➢ The cost of holding money.

➢ It is the amount charged by the lenders to the borrowers/users of money \,
and usually paid at regular intervals.

Terminologies

1. Debtor or Maker – The person who borrows money for any purpose.
2. Lender – The person or institution which loans the money.
3. Interest – The payment for the use of borrowed money.
4. Principal – The capital or sum of money invested.
5. Rate of Interest – The fractional part of the principal that is paid on the loan.
6. Time or Term – The number of units of the time for which the money is
borrowed and which for the interest is calculated.
7. Final amount or Maturity Value – The sum of the principal and interest which is
accumulated at a certain time.
8. Present Value – The amount received by the borrower.

SIMPLE INTEREST

➢ the charging interest rate r based on a principal P over T number of years.

Simple Interest Formula:

I = Prt

I = Interest

P = Principal ( Initial Value )

r = Interest Rate per interest period ( Rate = % )

t = Number of interest periods ( Time )

For example, you invested PHP 10 000 for 3 years at 9% and the proceeds from the
investment will all be collected at the end of 3 years. Using a simple interest assumption,
interest will be computed as follows:

I = F – P

F = P + I

F = P + Prt

F = P (1 + rt)

SIMPLE INTEREST

Interest in which only the original principal bears interest for the entire term of
the loan.

The term or time may be stated in any of the following ways:

1. When the time is expressed in number of year(s). Our formula will be:
I = P × r × number of years
2. When the time is expressed in number of month(s):
I = P × r × ( number of months / 12 )

Ordinary Interest and Exact Interest

Ordinary Interest ( Io )

➢ Assumed that there are 360 days in a year.

Io = P × r × ( number of days / 360 )

Exact Interest ( Ie )

➢ Assumed that there are 365 days in a year.

Ie = P × r × ( number of days / 365 )

REMINDER:

• Ordinary interest is greater than exact interest.

• When interest ( Io or Ie ) is not specified in any problem it is assumed as ordinary
interest ( Io ).
ACCUMULATION AND DISCOUNTING

Accumulation is the process of determining the amount F of a given principal P due at a

specified time t.

To accumulate a principal P for t years, means to solve for F applying the formula:

F = P ( 1 + rt )

Discounting is the process of determining the present value of P of any amount due in the
future.

To discount the amount F for t years, means to solve for P applying the formula:

P = ( F / 1 + rt )

COMPOUND INTEREST

➢ The interest resulting from the periodic addition of simple interest to the principal
Compound Amount.
➢ The resulting value when the interest is periodically added to the principal and this
new sum is used as the new principal for a certain number of periods.

For example, you invested PHP 10 000 for 3 years at 9% and the proceeds from the
investment will all be collected at the end of 3 years. Using a compound interest
assumption, interest will be computed as follows:

I = F – P

End of year 1:

(10,000)(1+0.9) = Total amount at the end of that year

(10,000)(1.09) = Total amount at the end of the year

End of year 2:

((10,000)(1.09))(1.09) = Total amount at end of that year

(10,000)(1.09)2 = Total amount at end of that year

End of year 3:

((10,000)(1.09)2) (1.09) = Total amount at end of that year

(10,000)(1.09)3 = Total amount at the end of that year

Thus, (10,000)(1.09)n = Total amount at the end of the year ‘n’

P (1+i)
 Formula:

• F = P ( 1 + i )n
• I=F–P

F – final or compound amount

P – original principal

i – periodic rate ( i = r/m )

n – total number of conversion periods for the whole term ( n = tm )

I – compound interest

Interest rate (r) – Usually expressed as an annual or yearly rate, and must be changed to
the interest rate per conversion period ( periodic rate: i ) and can be found form the
relation:

i = interest rate (r) / conversion period per year (m)

i = r / m

Derivation of Formula

Compound Interest Formula:

1) I = F – P
2) F = P ( 1 + i )n
(T x m)
❖ Interest = ( P × (1 + r/m) ) – P

Compounding or Conversion Period

The time between the successive interest computations

Notations:

m – the number of conversion periods for one year

n – the total number of conversion periods for the whole investment term

Conversion Periods:

Annually m = 1

Semi-annually m = 2

Quarterly m = 4

Monthly m = 12
Total number of conversion periods form the whole term:

n = time × number of conversion periods m

n = t × m

TERM: 5 Years

Compounded annually: 5×1 n=5

Compounded semi-annually: 5×2 n = 10

Compounded quarterly: 5×4 n = 20

Compounded monthly: 5 × 12 n = 60

Effective Annual Rate (EAR)

• The effective annual rate is the actual interest actually paid or earned.
• It does not reflect the effect of compounding frequency.

EAR = ( 1 + r/m )m ) – 1

Let` s solve the EAR of our previous example where the interest rate of 8% is
compounded quarterly.

EAR = ( 1 + 0.08/4 )4 – 1

EAR = 8.24% (rounded)