Chapter Five Interest and Investment Cost

Chapter Two
Interest and Investment Cost
2.1 Introduction
Interest: is the money returned to the owners of capital for use of their
capital. This would mean that any profit obtained through the uses of
capital could be considered as interest.
Rate of interest: is the amount of interest earned by a unit of principle in
a unit of time. The time unit is usually taken as one year.

2.2 Types Of Interest

2.2.1 Simple Interest
The amount of capital on which interest is paid is designated as the
principle. The simplest form of interest requires compensation payment at
a constant interest rate based only on the original principle.
I=P*i*n … (1
Where;
I ; the amount of simple interest.
P; represents the principle.
i; the interest rate based on the length of one interest period.
n; the number of time units or interest period.
The principle must be repaid eventually, therefore; the entire amount (S)
of principle plus simple interest due after (n) interest period is;
S=P+I=P+Pin …(2
∴ S = P (1 + i n) …(3

M.Sc. Narjes Ibrahem Khaled

2.2.2 Ordinary & Exact Simple Interest
The time unit used to determine the number of interest periods is usually
"one year", and the interest rate is expressed on a year basis. When an
interest period of less than one year is involved, the ordinary way to
determine simple interest is to assume the year consists of twelve
30 – day months, or 360 days. The exact method accounts for the fact that
there are 365 days in normal year. Thus, if the interest rate is expressed
on the regular yearly basis and (d) represents the number of days in
an interest period, the following relationships apply:
d
Ordinary simple interest = P * i * …(4
360
d
Exact simple interest = P * i * … (5
365
Ordinary interest is commonly accepted in business practices unless there
is a particular reason to use the exact value.
2.2.3 Compound Interest
In the payment of simple interest, it makes no difference whether the
interest is paid at the end of each time unit or after any number of time
units. The same total amount of money is paid during a given length of
time, no matter which method is used. Under these conditions, there is no
incentive to pay the interest until the end of the total loan period.
Interest, like all negotiable capital, has a time value. If the interest were
paid at the end of each time unit, the receiver could put this money to use
for earning additional returns. Compound interest takes this factor in to
account by stipulating that interest is due regularly at the end of each
interest period. If payment is not made, the amount due is add to the
principle, and interest is charged on this converted principle during the
following time unit.

M.Sc. Narjes Ibrahem Khaled

The compound amount due after any discrete number of interest periods
can be determined as follows:
Principle at start Interest earned Compound amount (S)
period
of period during period at end of period
1 P Pi P + P i = P (1 + i)
P (1 + i) + P (1 + i) (i)
2 P (1 + i) P (1 + i) (i)
= P (1 + i)2
P (1 + i)2 + P (1 + i)2 (i)
2 2
3 P (1 + i) P (1 + i) (i)
= P (1 + i)3
4 P (1 + i)n – 1 P (1 + i)n – 1 (i) P (1 + i)n

Therefore; the total amount of principle plus compound interest due

after n interest periods and designated as (S).
S = P (1 + i)n …(6
The term (1 + i)n is commonly referred to as the discrete single –
payment compound – amount factor.
Example// It is desired to borrow 1000$ to meet a financial obligation.
This money can be borrowed from a loan agency at a monthly interest
rate of 2%. Determine the followings:
1) The total amount of principle plus simple interest due after 2 years if
no intermediate payments are made?
2) The total amount of principle plus compound interest due after 2 years
if no intermediate payments are made?
Solution//
1) Length of one interest period = 1 month
Number of interest period in 2 years = 24
For simple interest, the total amount due after n periods at periodic
interest rate i is :

M.Sc. Narjes Ibrahem Khaled

S = P (1 + i n)
P; initial principle = 1000$ i; 0.02 as monthly basis
N; 24 interest periods in 2 years.
S = 1000 (1 + 0.02 * 24) = 1480$
2) For compound interest, the total amount due after n periods at periodic
interest rate i is :
S = P (1 + i)n
S = 1000 (1 + 0.02)24 = 1608$
2.3 Nominal And Effective Interest Rate
Nominal interest rate (r) : is the interest stored as an annual rate but
compound in other time period.
Effective interest rate (ieff) : is the higher interest because of the effect of
compounding in other time periods.
If nominal interest rates are quoted, it is possible to determine the
effective interest rate by proceeding from equation below.
S = P (1 + i)n …(6
In this equation, S represents the total amount of principle plus interest
due after n period at the periodic interest rate i. Let r be the be the
nominal interest rate under conditions where there are m conversations or
interest periods per year.
r
Then the interest rate based on the length of one interest period is , and
m
the amount S after 1 year is;
r
S1 = P (1 + ) …(7
m
Designating the effective interest rate as (ieff) , the amount S after 1 year
can be expressed in an alternate form as:
S = P (1 + ieff) …(8

M.Sc. Narjes Ibrahem Khaled

By equating equation 7&8, the following equation can be obtained from
the effective interest rate in terms of nominal interest rate and the
number of periods per year.
r
P (1 + )m = P (1 + ieff)
m
r
Effective annual interest rate = (ieff) = (1 + )m - 1 …(9
m
r
Nominal annual interest rate = m * =r …(10
m
Example// For the final exam, determine:
3) The nominal interest rate when the interest is compounded monthly?
4) The effective interest rate when the interest is compounded monthly?
Solution//
3) Nominal interest rate = interest rate * interest periods in 1 year
= 2% * 12 = 24% per year compounded monthly.
4) Number of interest periods per year = m = 12
Nominal interest rate = r = 24%
r
Effective interest rate = (ieff) = (1 + )m - 1
m
0.24
= (1 + )12 - 1 = 26.8%
12

2.4 Continuous Interest

In discrete compound interest the payment are charged at periodic
intervals, where the interval represent a finite length of time. Although
the base time interval is usually 1 year, shorter periods can be used such
as 1 month, 1 day or one hour or one second. The extreme case, of
course, is when the time interval becomes infinitesimally small so that the
interest is compounded continuously. In this case cost or income due to
interest flows regularly.

M.Sc. Narjes Ibrahem Khaled

To determine basic continuous interest. Equation 7, 8 & 9; represent the
basic expressions from which continuous interest relationship can be
developed. The symbol r represent the nominal interest rate with m
interest periods per year.
If the interest is compounded continuously, m approaches infinity, and
eq. (7) can be written as;
S1 = P Limm 𝐿𝑖𝑚
𝑚

M.Sc. Narjes Ibrahem Khaled