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The amount of money earned for the use of borrowed capital is called interest. From the borrowers point

of view, interest is the amount of money paid for the capital. For the lender, interest is the income

generated by the capital which he has lent.

There are two types of interest, simple interest and compound interest.

Simple interest

In simple interest, only the original principal bears interest and the interest to be paid varies directly with

time.

The formula for simple interest is given by I=Prt

The future amount is F=P+I

F=P+Prt

F=P(1+rt)

Where

I = interest

P = principal, present amount, capital

F = future amount, maturity value

r = rate of simple interest expressed in decimal form

t = time in years, term in years

Ordinary and Exact Simple Interest

In an instance when the time t is given in number of days, the fractional part of the year will be computed

with a denominator of 360 or 365 or 366. With ordinary simple interest, the denominator is 360 and in

exact simple interest, the denominator is either 365 or 366. We can therefore conclude that ordinary

interest is greater than exact interest.

Note: When simple interest (ordinary or exact is not specified in any problem, it is assumed as ordinary.

Ordinary simple interest is computed on the basis of bankers year.

Bankers year

1 year = 12 months

1 month = 30 days (all months)

1 year = 360 days

Exact simple interest is based on the actual number of days in a year. One year is equivalent to 365

days for ordinary year and 366 days for leap year. A leap year is when the month of February is 29 days,

and ordinary year when February is only 28 days. Leap year occurs every four years.

Note: Leap years are those which are exactly divisible by 4 except century years, but those century years

that are exactly divisible by 400 are also leap years.

If d is the number of days, then

In ordinary simple interest

t= d / 360

in exact simple interest

t=d/365 (for ordinary year)

t=d/366 (for leap year)

COMPOUNT INTEREST

In compound interest, the interest earned by the principal at the end of each interest period (compounding

period) is added to principal. The sum (principal + interest) will earn another interest in the next

compounding period.

Elements of Compound Interest

P = principal, present amount

F = future amount, compound amount

i=interest rate per compounding period

r=nominal annual interest rate

n=total number of compounding in t years

t=number of years

m=number of compounding per year

i= r/m and n=mt

Future amount,

F = P(1+i)

n

or F = P ( 1 + r/m)

mt

The factor (1+i)

n

is called single-payment compound-amount factor and is denoted by (F/P, I, n).

Present amount,

P= F / (1+i)

n

The factor 1/(1+i)

n

is called single-payment present-worth factor and is denoted by (P/F, I, n)

ANNUITIES AND CAPITALIZED COST

Annuity

An annuity is a series of equal payments made at equal intervals of time. Financial activities like

installment payments, monthly rentals, life-insurance premium, monthly retirement benefits, are family

examples of annuity.

Annuity can be certain or uncertain. In annuity certain, the specific amount of payments are set to begin

and end at a specific length of time. A good example of annuity certain is the monthly payments of a car

loan where the amount and number of payments are known. In annuity uncertain, the annuitant may be

paid according to certain event. Example of annuity uncertain is life and accident insurance. In this

example, the start of payment is now known and the amount of payment is dependent to which event.

Annuity certain can be classified into two, simple annuity and general annuity. In simple annuity, the

payment period is the same as the interest period, which means that if the payment is made monthly the

conversion of money also occurs monthly. In general annuity, the payment period is not the same as the

interest period. There are many situations where the payment for example is made quarterly but the

money compounds in another period, say monthly.

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