BASIC CONCEPTS

Interest is a fee that is charged for the use of someone else's money. The size of the fee will
depend upon the total amount of money borrowed and the length of time over which it is
borrowed.
Simple Interest
Simple interest is defined as a fixed percentage of the principal (the amount of money
borrowed), multiplied by the life of the loan_ Thus,

Pin

Compound Interest
When interest is compounded, the total time period is subdivided into several interest
periods (e_g_, one year, three months, one month_ Interest is credited at the end of each interest
period, and is allowed to accumulate from one interest period to the next,

F = P(1 +
Inflation
National economies frequently experience inflation, in which the cost of goods and
services increases from one year to the next.
P
F=
(1 +f

If interest is being compounded at the same time that inflation is occurring, then
P(1 + On
F=
(1+

Composite Interest Rate,

t—f
0=
1+f

Problem 1. What is the annual rate of simple interest if $265 is earned in four months on an
investment of $15000?

Problem 2. How many years will be required for an investment of $3000 to increase to $4081.47 at an
interest rate of 8% per year, compounded annually?
Problem 3. Compare the interest earned from an investment of $1000 for 15 years at 10% per
annum simple interest, with the amount of interest that could be earned if these funds were
invested for 15 years at 10% per year, compounded annually.
Problem 4. Suppose that a person invests $3000 at 10% per year, compounded annually, for 8
years. Will this effectively protect the purchasing power of the original principal, given an annual
inflation rate of 8%? If so, by how much?
ANNUAL COMPOUNDING

Single Payment, Compound Amount Factor

(1 + On
COMPOUND
= P(1 +}
INTEREST Single Payment, Present-Worth Factor
1
(1 + On

Uniform Series, Compound-Amount Factor

(1 + On — 1
i
F= A[(I- + i)n — 11
[ i
Uniform Series, Sinking-Fund Factor
i
(1 + On — 1
ANNUITY
Uniform Series, Present-Worth Factor
(1 + On — 1

[(1 + On — 11 (1 + On (i)
P=A
1 (1 + On(i) I Uniform Series, Capital-Recovery Factor
(1 + On(i)
(1 + On — 1

Gradient Series Factor

GRADIENT A = G[1 1 n
Li (i. + in)n — 11 i (1 + On — 1

Problem 5. A woman deposits $2000 in a savings account that pays interest at 8% per year,
compounded annually. If all the money is allowed to accumulate, how much will she have at the
end of (a) 10 years? (b) 15 years?

Problem 6_ A man has deposited $50 000 in a retirement income plan with a local hank This
bank pays 9% per year, compounded annually, on such deposits. What is the maximum amount the
man can withdraw at the end of each year and still have the funds last for 12 years?

Problem 7. A father wants to set aside money for his 5-year-old son's future college education.
Money can be deposited in a bank account that pays 8% per year, compounded annually. What
equal deposits should be made by the father, on his son's 6th through 17th birthdays, in order to
provide $5000 on the son's 18th, 19th, 20th, and 21st birthdays?

Problem 8. Mr. Jones is planning a 20-year retirement; he wants to withdraw $6000 at the end of
the first year, and then to increase the withdrawals by $800 each year to offset inflation. How
much money should he have in his savings account at the start of his retirement, if the bank pays 9%
per year, compounded annually, on his savings?

Problem 9. Suppose that a certain savings is expected to be $10M at the end of year 3 and to
increase $1M each year until the end of year 7. If the minimum attractive rate of return (MARK) is
20%, what is the present equivalent (at the beginning of year 1) and the future equivalent (at the
end of year 7).
PERIODIC COMPOUNDING
Many financial transactions require that interest be compounded more often than once a
year (e.g., quarterly, monthly, daily, etc.).
The nominal interest rate, T. is expressed on an annual basis; this is the rate that is
normally quoted when describing an interest-bearing transaction.

The effective interest rate, i, is the rate that corresponds to the actual interest period.

The effective interest rate is obtained by dividing the nominal interest rate by m, the
number of interest periods per year.
r
=—
(per per fod)

Problem 10. A bank advertises that it pays interest at the rate of 10% per year, compounded
quarterly. What effective interest rate is the bank paying?

Problem 11. A bank pays interest at the rate of 6% per year, compounded monthly. If a person
deposits $2500 in a savings account at the bank how much money will accumulate by the end of
2 years?

Problem 12. A man plans to buy a $150,000 house, He wants to make a dawn payment of
$30,000 and to take out a 30-year mortgage for the remaining $120,000, at 10% per year,
compounded monthly. How much must he repay each month?

Problem 13. How much money must be deposited in a savings account each month to
accumulate $10 000 at the end of 5 years, if the bank pays interest at the rate of 6% per year,
compounded (a) monthly? (b) semiannually? (c) quarterly? (d) daily?

CONTINUOUS COMPOUNDING
Continuous compounding can be thought of as a limiting case of the multiple-
°will:Founding.
F = pert

Problem 14. Determine the nominal interest rate corresponding to an effective interest rate of
10% per year, compounded continuously,

Problem 15. Mr. Smith is planning his retirement. He has decided that he will need $12,000 per
year to live on, in addition to his other retirement income from Social Security and a private
pension plan. How much money should he plan to have in the bank at the start of his retirement, if
the bank pays 10% per year, compounded continuously, and if Mr. Smith wants to make 12
annual withdrawals of $12,000 each?
DEPRECIATION
Depreciation is the decrease in the value of physical property with the passage of time.

Symbols for different depreciation method

It
= useful life of the property in years
FC = theoriginal cost (first cost)
5V = the value at the end of the life, the salvage/scrap value dk
= the annual cost of depreciation
RYA = the book value at the end of k years Dk
= depreciation up to age k years

Method ordepreciatioa

A. Straight Line Method (LM)

This Method assumes that the loss in value is directly proportional to the age of the
property,

Annual depreciation Total Depreciation Book Value

FC — 5V FC — SV
4= n Dk = 37 X k Bilk = FC — Dk

B. Sinking Fund Method (SFM)

This method assumes that a sinking fund is established in which funds will accumulate for
replacement.
Annual depreciation
I otai iepreciation Book Value
1 (1
4= (Fe — SV)1(1 ±(ii)):1 _ ii Dk = (FC — 510 + i s — 11
BVk = Fr — Dk
(1 + fr — 1 1

C, Surf~-of-the-Years'-Digit Method (SoYD)

SOYD is an accelerated depredation method; more depreciation occurs early in the
asset's life than in its later life.

Annual depreciation Total Depreciation _ Book Value

(FC — Sif)(k)(27i — k + 1)
2 (FC — SV)(n— k +1) 19 4
ilk = (n)(1 + n) Blik = PC — Dk
(n)(1 + n)

D. Declining Balance Method (DBM)

In this method, sometimes called the constant percentage method or the Matheson
Formula, it is assumed that the annual cost of depreciation, is a fixed percentage of the salvage value
at the beginning of the year.
Book Value

Bvk FC(1— R)k= where R =1 —

_
FC
Annual depreciation

dk = Bier_t — BlIk
Total Depreciation

.0k = FC — Blik
E. Double Declining Balance Method (DDBM)
This method is very similar to the declining balance method except that the rate of
depreciation R is replaced by 2/n.

Book Value Annual depreciation Total Depreciation

2
BVk = FC(I. — R)k where R = — dk = BVk_l — BVk Dk = FC — Bilk
n

Problem 16. An electronic balance costs P90,000 and has an estimated salvage value of P8,000 at
the end of its 5 years life time. What would be the book value after three years? Use i = 10%