Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.

1(week1 notes)

CH. 1- SIMPLE INTEREST & SIMPLE DISCOUNT

Topics
1.1 Simple Interest
1.2 Discounted Value at Simple Interest
1.3 Equations of Value
1.4 Partial Payments
1.5 Simple Discount at a Discount Rate

1.1 Simple Interest

Simple versus Compound Interest- what is the difference?
a) Simple Interest- Amount of interest earned depends only on the initial principal and
NOT on interest earned in prior periods (interest earned is not reinvested)
b) Compound Interest- Amount of interest earned depends on the initial principal and on
previously earned interest(interest earns interest, or interest is reinvested)

When is simple interest used?

short term loans (and usually less than 1 year)
o Certificates of Deposit
o short term loans
o Crediting monthly interest on bank accounts

Notation and Formulas

P = principal or proceeds

I = simple interest earned

S = the accumulated or maturity value of P

r = rate of interest per year

Two Key Formulas:

I=Prt

S=P+I

t= time in years

S=P(1+rt)

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Two Key Formulas:

I=Prt

S=P+I

S=P(1+rt)

Note
1.

(1+rt) is referred to as the accumulation factor(or function) using simple interest

2.

Determination of t

t in the formula is expressed as number of years(integer)

If t is given to you in months use t/12

If t is given to you in days, can have exact or ordinary interest

a) Exact Interest(Canadian & use unless specified otherwise), t= days/365
b) Ordinary Interest or Bankers Rule(U.S.) use t=days/360

Example 1
Find the accumulated value (maturity value) of a $2,000 loan at 7% simple interest for
(a) 2 years
(b) 18 months

Example 2
At what rate of simple interest will $1,000 double itself in 12 years?

Example 3
How long will it take $10,000 to earn $600 interest if simple interest is at 9%?

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 4 (& use of table at back of text to get day count)
Find the exact and ordinary simple interest earned on $1,000 from Jan. 15 to May 15th 2005 at a
simple interest rate of 7.5%.

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 5
What interest rate is earned if $2,500 accumulates $137 interest in 200 days using exact
interest?

What are Demand Loans?

Payment in full or in part may be requested at any time by the lender

Interest is based on unpaid balance and is usually payable monthly
to figure out total interest paid, should set up a table that include interest cost by
period(need entries every time a payment is made or interest rate changes-Ex. 6)
In practice interest rates are usually not fixed but fluctuate with market conditions

Example 6(Demand Loan)

You borrow $1,000 on a demand loan on Sept 1st, 2004. Interest is charged on the last day of
each month and is calculated on the outstanding balance at 8%. You make payments of $150
on October 15th, $400 on November 25th, and the balance on December 20th. Calculate the
interest payments required and the total interest paid.

Interest Period

# days

Balance

Rate

Interest

Total for Sept

Total for Oct.
Total for Nov.
Total for Dec.
TOTAL INTEREST
PAID

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

What are Invoice Cash Discounts?

Wholesalers and Manufacturers offer cash discounts for payments in advance of the
final due date.
2/10, n/30 means 2% discount if paid within 10 days, otherwise full amount is due in 30
days
A retailer or merchant can borrower money to take advantage of the discount and repay
the loan on the due date
He is neutral if the discount equals the cost of borrowing
o assuming the loan would be repaid on the day the invoice is due, the interest the
merchant should be willing to pay on the loan should not exceed the cash
discount

Example 7(Invoice Cash Discounts)

You purchase $5,000 of goods on terms on 4/20 n/60.
(a) What is the highest interest rate at which you should borrow money to take advantage of the
discount?
(b) How much do you save if you can borrow money at a simple interest rate of 18%?

Example 8
An individual expects to receive a check for $5,000 on May 1st. On March 10th, one of his
friends offers him 85% of the check amount in cash (and this friend would then receive the
check proceeds on May 1st). What annual rate of simple interest does the friend earn?

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

1.2 Discounted Value at Simple Interest

(A) Definitions
From 1.1 recall that

S = P(1+rt)

Rearranging, gives

P= S/(1+rt) or

P = S(1+rt)-1

Notes:
a) P is called the present value or the discounted value of S
b) (1 +rt) -1 is called the simple interest discount factor(or discount function)
c) For a given rate r (S P) has two different interpretations;
(i)

interest I on P which when added to P gives S (P+I=S), or

(ii)

discount D on S which when subtracted from S gives P (S-P=D)

Example 1
What is the discounted or present value of $2,650 due at the end of 6 months if the simple
interest rate is 12%? What is the simple discount?

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

(B) Promissory Notes

Written promise by a debtor (called the maker of the note) to pay to the creditor (called the payee
of the note) a sum of money, with or without interest, on a specified date
Promissory Note Example:
$1,000.00

Toronto, September 1, 2005

Ninety days after date, I promise to pay to the order of Mrs. X

one thousand and 00/100 dollars
for value received with interest at 8% per annum
(signed) XXXXX
Promissory Note Components Include
(i)
Face Value is the amount of money specified on the note ($1,000)
(ii)
Term of the note is the period specified(90 days)
if term is stated in months, use calendar months, not a 30 day month
(iii)
Due Date of the note is November 30th, 2005 (90 days after September 1, 2005)
(iv)
Legal Due Date or Maturity Date of the note is the due date plus 3 days grace in
Canada (December 3, 2005)
(v)
Maturity Value of the note is the value at the maturity date
Further Comments on Promissory Notes:
These notes differ from banks in that
lender doesnt have to be a financial institution, and
note can be sold to a 3rd party before the due date (3rd party becomes the payee of note)
When the note is paid, interest is only calculated to the date note is actually paid (i.e. due date or
maturity date, or somewhere in between)
Discounting Promissory Notes

these notes can be sold before the maturity date

buyer discounts maturity value from the maturity date to the sale date. Seller receives
the proceeds

If note is sold before the maturity date, then need to

(i)
determine the maturity value S (based on legal due date= maturity date)
(ii)
Determine P(proceeds) by discounting S from the maturity date back to the
date of sale

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 2
A 90-day note for $800 bears interest at 10% and is sold 60 days before maturity to a bank that
uses 12% simple interest.
a) What are the proceeds?
b) What rate of interest did the seller of the note earn?
c) What rate of interest does the bank earn if the note is paid on the due date?

Example 3
A 60-day non-interest bearing note for $1,000 is sold after 10 days. The interest rate used for
discounting is 9%. What are the proceeds of this note?

Example 4
A 120-day note for $1,000 bears interest at 7%. It can be sold immediately to a finance
company that uses r=6% for discounting. What is the investors(seller of the note) profit?

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

1.3 Equations of Value

fundamental course concept/technique

objective is to properly equate two different sets of payments

will build upon what weve been working with earlier, but will now look at valuing payments
on any date(not just a beginning amount(P) or ending amount(S))
in class Example

Concepts
money has time value
every sum of money has an associated date(dated values)

Equivalence definition(Single payment amounts)

$ X due on a given date is equivalent at a given simple interest rate to $Y due t years later if
Y=X(1+rt)

OR

X=Y(1+rt) -1

Example 1
Liz takes a loan out from Ann and agrees to pay off this loan with $500 in six months time. Find
the equivalent loan payment amount at a simple interest rate of 6% if instead Anna wants this
same loan paid off with one payment;
a) in 4 months
b) in 1 year

Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

When there is more than one payment: 2 sets of payments are equivalent at a
given rate of interest if the dated value of the sets on any common date are
equal

the dated value of the set of payments is the sum of equivalent values (cannot add values
on different dates)
the equation of value (or equation of equivalence) is the equation stating that the dated
values of the two sets of payments are equal on a common date
the focal date is the comparison date or the valuation date. It is the specific point in time
used to compare dated values of sets of payments
STEPS TO CONSTRUCT AN EQUATION OF VALUE
1. Draw a good time diagram with payments and dates. Its best to show payments made and
payments received(or equivalent payment sets) on separate sides of the time diagram
2. Select a focal date and bring all dated values to the focal date at the given interest rate
(we will see that different focal dates will give different values for simple interest, but
not for compound interest).
3. Set up the equation of value at the focal date (Dated value of payments made = Dated value
of payments received).
4. Solve the equation of value (for the unknown variable)
Example 2
(a) Find the equivalent payment($X) in 6 months for; $200 due in 3 months and $800 due in 9
months. Use a focal date of 6 months from now and assume a simple interest rate of 8%.
(b) What is the equivalent payment($X) if the focal date is 3 months from now?

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 3
You have two options available in repaying a loan. You can pay $200 at the end of 5 months
and $300 at the end of 10 months or you can pay $X at the end of 3 months and $2X at the end
of 6 months. Find X if interest is at 12% and the focal date is at the end of 6 months.

Example 4
Peter agrees to pay John $1,000 at the end of 1 year and $3,000 at the end of 5 years if John
gives him $500 today, $X and the end of 2 years and $2X at the end of 3 years. Find X if
interest is at 7% and the focal date is at t = 1year.

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

1.4 Partial Payments

when a debt is paid off by a series of partial payments, there are two common ways to credit
interest on short term transactions
1. Merchants Rule
2. Declining Balance Method

1. Merchants Rule

How it works
Entire debt and each partial payment earn interest to the final settlement date
Balance due on the final date is the accumulated value of the debt less the accumulated
value of the partial payments
Use an equation of value using a focal date of the final date(with this method you will
always be accumulating)

Example 1 (Merchants Rule)

On August 1st, Joan borrowed $1,200 at 10%. She paid $200 on September 15th and $700 on
November 1st. What is the balance due on January 30th using the Merchants Rule?

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

2. Declining Balance Method

How it works
Interest on the unpaid balance of the debt is calculated at each payment date
If Payment > interest due, excess reduces the outstanding debt.
If payment < interest due, it is carried forward without interest until the next payment
date
process is repeated at each payment date
Balance due on the final date is the outstanding balance after the last partial payment,
accumulated to the final due date

Example 2 (work with Ex. 1 with Declining Balance rule)

On August 1st, Joan borrowed $1,200 at 10%. She paid $200 on September 15th and $700 on
November 1st. What is the balance due on January 30th using the Declining Balance method?

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 3
A loan of $2,000 taken out on January 1st is repaid by the following partial payments (or
installments): $20 on Feb. 1st, $600 on Mar.1st and $100 on April 1st . What is the balance due
on May 1st if the interest rate is 15%? Use the declining balance method.

Example 4
A debt of $500 is paid off by the following payments according to the Merchants Rule:
$100 in 30 days, 200 in 60 days, and a final payment of $208.49 in 80 days. What simple
interest rate was used?

Example 5(may be used an extra practice question - solution is $3,694.02)

A debt of $5000 taken out on April 1 is repaid by the following payments: $1,000 on May 15th,
$500 on July 1st, $50 on August 15th, and the remainder on Sept. 30th. Find the amount of the
last payment under the declining balance method using a simple interest rate of 12%.

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

1.5 Simple Discount at a Discount Rate

(A) Paying interest in advance and Simple discount rates
Accumulating and discounting using a discount rate
Simple Interest versus Simple Discount

(B) Promissory Notes using a discount rate

(C )Equivalent rates of Simple Interest and Simple Discount

(A) Paying Interest in Advance

If interest is paid in advance, it is called simple discount, D

e.g. a short term loan is taken out, the interest is calculated and deducted in advance
consider the example when $100 is borrowed at a 6% simple discount rate
The amount of simple discount is $6 ($ 100 x0.06) and this is paid for in advance.
This is also referred to as paying the interest in advance

when borrowing at a rate of discount of 6% for one year, you pay for the use of the
money upfront ($6) , so you would in fact only have the use of ($100- $6) = $94 for
the year and you would then pay back $100 at the end of the year

Notation and definitions

d the rate of simple discount
D is the amount of simple discount

D= Sdt (in our example, S=100, d=.06 and t=1, and D =$6))

when working with simple discount, consider P as the actual cash amount lent out(also
referred to as net loan amount)

P = S D = S- Sdt P = S(1-dt)

(1-dt) is the discount factor (discount function) for simple rates of

discount(d)

if we know P, then we can find S

S= P(1-dt)-1

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

(1-dt) -1 is the accumulation factor(or accumulation function) for simple

rates of discount(d)

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Simple interest versus simple discount

with simple interest pay for the use of the money at the end (I=Prt)
actual loan amount here would be P, and S= (P +I)
with simple discount pay for the use of money at the beginning (D=Sdt)
loan amount here would be S, but actual cash amount received by the
borrower (some would call this the net loan amount ) would be net of D, or
P=(S-D)
use EOV techniques to solve for problems involving either simple interest or simple
discount and just ensure that you use the appropriate accumulation factor or discount
factor
general rule; discount factor is reciprocal of the accumulation factor and
vice-versa

Simple Interest versus Simple Discount

Simple Interest Simple Discount
Rate
r
Amount of Simple Interest/Discount I=Prt

d
D=Sdt

Accumulation Factor(function)
Discount Factor (function)

(1-dt)-1
(1-dt)

(1+rt)
(1+rt)-1

Example 1
Judy borrows $1,000 for 9 months at a simple discount rate of 7.5%. What is the
discount and how much money does she receive up front?

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 2
What size of loan should you ask for if you want to receive $2,500 cash for 7 months at
an 8% simple discount rate?

Example 3
How many days will it take $1,000 to accumulate to $1,100 at a simple discount rate of
12%?

(B) Promissory Notes Sold at a Discount from the Maturity Value

Sometimes these notes are sold at a rate of discount(d)

Process is similar to that covered in 1.2 but need to use the simple discount factors
Calculate the maturity Value S (note that S is usually based on simple interest, use
S=P(1+rt)
Get the proceeds P by discount the maturity value S at the specified discount rate from
the maturity date back to the date of sale (Proceeds=S(1-dt))
best illustrated by example!

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 4
A 90-day promissory note for $1,500 bears 10% simple interest. After 30 days it is sold to a
bank that charges a simple discount rate of 12%
a) How much does the bank pay for the note?
b) What simple interest rate did the original owner of the note actually earn?
c) If the note is actually paid on the due date, what discount rate will the bank have
realized?

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Intersession2007- Zima-Brown-Kopp Lecture Notes Ch.1(week1 notes)

Example 5
A non-interest bearing note with a face value of $3,000 is due in 60 days.
It is immediately sold to a finance company that discounts it at a discount rate equal to
d.
Find d if the proceeds of the note are $2,958.58.

(C) Equivalent rates

To solve for equivalent rates, just need to equate the
corresponding accumulation or discount factors
we will actually use this concept frequently in this course!
Example 6(Equivalent rates)
What is the equivalent simple interest rate to the simple discount rate of 6% over 6
months?

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