Simple Interest

You can commonly see interest applied in two different situations: investments and debts. In both
situations, one party is a lender of money and the other is a borrower.

DEFINITION 1.1 A lender or creditor is a person or an institution that makes funds available to
those who need it. In turn, the person or institution that avails these funds from the lender is
called a borrower or debtor.

The lender charges the borrower a certain amount of money calculated based on the amount
borrower makes use of. This amount is called the interest. There are two types of interest: simple
interest and compound interest.

Simple interest depends on three factors: the principal, the interest rate, and the term or time of
the loan or investment.

DEFINITION 1.2
• The principal or present value is the original amount of money borrowed or invested,
• The interest rate, expressed in percent, dictates the increase of the principal. It may be the rate
charged by the lender or the rate of increase of the investment.
• The time or term of the loan refers to the amount of time money was borrowed or invested. It is
commonly expressed in years or per annum (per year).
• Interest is the amount calculated from the principal using the interest rate based on the time.

From this point onward, simple interest will be referred to as interest and interest
rate as rate.

The formula for finding interest is given by

I= Prt
where

I is the interest,
P is the principal,
r is the rate (in decimals), and
t is the term of the loan in years.
If the interest rate is given in percent, you need to convert it to a decimal before substituting in
the formula above. Simply move the decimal point of the given rate two places to the left. For
example, 5% is the same as 0.05 while 5.5% is equal to 0.055.
Example:

How much interest is charged when P10,000 is borrowed for 2 years at an interest
Given : P = 10,000; r = 3% or 0.03; t = 2 years
Required: I
Solution : Substitute the given variables in the formula.

I = Prt
= (P10,000)(0.03)(2)
= 600
Answer : The interest charged for borrowing P10,000 for 2 years is P600.

Normally, the borrower pays the principal and interest at the same time. The amount the
borrower pays is called the future value.

DEFINITION 1.3 The future value or maturity value is the sum of the principal and the interest it
earned.

Hence, if you denote the maturity value by F, you get

F=P+I.

Since I = Prt, you can substitute Prt for I in the equation above. Thus,

F=P + Prt.

By factoring, you get

F= P(1 + rt).

This equation shows the relationship between the principal, interest, and maturity value.

Example:
Stella borrowed P40,000 from a lending firm that charges 6% per year. How much will she pay
the lending firm after 5 years?
Given: P= 40,000; r = 6% or 0.06; t = 5 years
Required: F
Solution : The problem can be solved in two ways.

• First, find the interest charged on the loan.

I = Prt
= (40,000)(0.06)(5)
= 12,000
Then add the computed interest to the principal.
F = P+I
= 40,000 + 12,000
= 52,000

• The maturity value can be found by using equation 1.3 directly.

F= P(1 + rt)
= 40,000[1 + (0.06)(5)]
= 40,000(1.3)
= 52,000

Both methods yield the same value, which is 52,000.

Answer : Stella will have to pay 52,000 after 5 years.

Exact Interest and Ordinary Interest

Not all loan or investment terms are expressed in years. You have seen examples where the terms
of the loan or investment need to be converted to years. If the time is given in number of days,
the simple interest may be categorized into two: exact interest and ordinary interest.

DEFINITION 1.4 Exact interest is a type of simple interest that is computed assuming that there
are 365 days in a year,

Following the definition of exact interest, you can obtain the time of a loan in years (denoted by
t.) by dividing the given number of days by 365, that is
 t = number of days / 365

DEFINITION 1.5 Ordinary interest is a type of simple interest that is computed on a 360-day
period.

For ordinary interest, the time in years (denoted by t) is obtained by dividing the number of days
by 360. This assumes that there are 30 days in each month.

t = number of days / 360

Actual Time and Approximate Time

The terms of a loan can affect the amount of interest a loan or investment earns. You have seen
this when you calculated for ordinary and exact interests. Some situations in finance call for you
to know the exact duration of time a loan or investment matures.

You can find this by knowing the origin date and the maturity date.

DEFINITION 1.6 The origin date is the date when a loan or an investment is made. The maturity
date is the date when the loan is paid or the investment is terminated.

When you have to count the number of days between the origin date and the maturity date, the
time or term of a loan or an investment may be categorized as actual time or approximate time.

DEFINITION 1.7
• The actual time is the time of a loan or an investment that is obtained by counting the actual
number of days between the origin date and the maturity date based on a Julian calendar.
• The approximate time is the time of a loan or an investment that is obtained in the same manner
as actual time, but on the assumption that each month has 30 days.

In both actual time and approximate time, the origin date is normally not included in the
counting, while the maturity date is included.

Example:

Find the (a) actual time and (b) approximate time between April 15 and December 21 of
the same year.
 Given: Origin date: April 15
: Maturity date: December 21
required: actual time and approximate time

Solution (a) To find the actual time between the given dates, count the actual number of days per
month from April 15 to December 21.

Month Number of Days Per Month

April 15

May 31

June 30

July 31

August 31

September 30

October 31

November 30

December 21

Total 250
You can see from the table above that there are only 15 days and 21 days accounted for April and
December, respectively. Note that this is because of the given origin and maturity dates.

Solution (b) In finding the approximate time between the two given dates, assume that there are
approximately 30 days per month.

Month Number of Days Per Month

April 15

May 30

June 30
 July 30

August 30

September 30

October 30

November 30

December 21

Total 246

Answer : There are 250 actual days and approximately 246 days from April 15 to December 21
of the same year.

Recall that exact interest considers time based on 365 days. Ordinary interest considers time
based only on 360 days. Using actual time or approximate time as numerator to obtain the term
of the investment or loan, you can compute interest based on four possible scenarios:

• exact interest using approximate time

• ordinary interest using approximate time
• exact interest using actual time
• ordinary interest using actual time

For the first three scenarios above, you can apply the concepts that you have learned. The fourth
scenario, a combination of simple ordinary interest and actual time, is called the Bankers' rule.
This particular combination is normally used by banks worldwide since it will always produce
maximum yield for simple interest.

Example:

Ms. Hathaway borrowed P10,000 on June 25, 2012. If the maturity value is to be paid on
November 18 of the same year at 15% interest, how much should he pay given each set of
conditions below?
a. exact interest for the approximate time
b. ordinary interest for the approximate time
c. exact interest for the actual time
 d. Bankers' rule

Given: P=P10,000; 1 = 15% or 0.15

Origin date: June 25, 2012
Maturity date: November 18, 2012
Required: F
Solution : Count the number of days between June 25 and November 18 for both
approximate time and actual time.

Month Number of Days Per Month

June 30 - 25 = 5

July 30

August 30

September 30

October 30

November 18

Total 143
Hence, the approximate number of days from June 25 to November 18 is 143.

Month Number of Days Per Month

June 30 - 25 = 5

July 31

August 31

September 30

October 31

November 18

Total 146
Hence, the actual number of days from June 25 to November 18 is 146 days
 a. The maturity value using exact interest for the approximate time is then computed as

F = P(1+rt)
= 10,000[1+(0.15)(143/365)]
= 10,587.67

b. For ordinary interest using approximate time, the maturity value is

F = P(1+rt)
= 10,000[1+(0.15)(143/360)]
= 10,595.83

c. For exact interest using actual time, the maturity value is

F = P(1+rt)
= 10,000[1+(0.15)(146/365)]
= 10,600.00

d. Using Bankers’ rule, the maturity value is

F = P(1+rt)
= 10,000[1+(0.15)(146/360)]
= 10,608.33

Answer : Ms. Hathaway should pay the following maturity values for each given
a. exact interest with approximate time: P10,587.67
b. ordinary interest with approximate time: P10,595.83
c. exact interest with actual time: P10,600.00
d. Bankers' rule: P10,608.33

Simple Discount

Lending institutions such as pawnshops require collecting interest in advance on items that are
deposited to them in exchange for certain amounts of money. Interest collected on the origin date
is known as simple discount or discount interest.
DEFINITION 1.8 Simple discount, denoted by Id is the simple interest collected or deducted in
advance from the amount of a loan. The subscript d is written to distinguish simple discount
from simple interest.

In simple discount, the borrower needs to pay back the actual amount borrowed since the interest
has already been deducted in advance. Simple discount Id, depends on three factors: the maturity
value F of the loan, the discount rated, and the time or term of the loan t. In symbols, you have

Id = Fdt

DEFINITION 1.9 The money left after the simple discount is deducted from the actual amount
of the loan is referred to as the proceeds of the loan, denoted by Pr

Since the proceeds of the loan are obtained by deducting the simple discount from the maturity
value, you can calculate the proceeds using the formula

Pr = F-I

To have a more direct way of computing the proceeds,

Pr = F(1 - dt)

Example:

Alan wants to borrow P12,000 payable in 2 years at a 12% discount rate. How much will Alan
receive on the origin date? How much will he pay on the maturity date?

Given: F= 12,000; d = 12% or 0.12; t = 2 years

Required: Pr and the amount to be paid on the maturity date
Solution : The proceeds of the loan would be

Pr = F (1 - dt)
= 12,000[1 - (0.12) (2)]
= 9,120
Answer : Alan will receive 9,120 on the origin date. However, he would pay 12,000 on the
maturity date since the interest has already been deducted in advance.

Compound Amount and Compound Interest

Compound interest can be thought as "interest on interest." The rate of interest may be
compounded once, twice, or several times a year.

DEFINITION 2.1 Compound interest is interest that is computed on the sum of the original
principal of a deposit or loan and the interest accumulated. Compound interest is denoted by Ic.

Compound interest has its advantages and disadvantages. Suppose you have a bank account with
an initial principal of P50,000.00 invested at 5% interest compounded once a year.

After a year, your investment will earn P2500.00 and you will have a total of P52,500.00
in your account.

After another year, the amount of P52,500.00 will earn another 5% interest amounting to
P2625.00, thus, giving a total of P55,125.00 at the end of the second year.

Following the pattern, you will have P57,881.25 at the end of the third year, P60,775.31 at the
end of the fourth year, and so on.

The process of continuous addition of interest to the principal such as in the given example is
called compounding. While a compounding interest rate increases interest earned by an investor
over time, it can also adversely affect consumers who have debts that carry high interest rates
since compounding interest results to a higher interest which is charged to the debt or loan. This
interest is an added expense, instead of an income, on the part of the borrower.

Computing for the Total Number of Conversion Periods

When the interest rate is compounded annually, interest is computed once a year. Thus, one
conversion period is equivalent to one year.
The frequency of conversion, denoted by m, is the number of times that the interest is computed
in the span of one year. The time or the number of years of the term for compound interest is
denoted by t. Thus, the total number of conversion periods for the entire term, denoted by n, is
the product of the number of years t and the frequency of conversion m.

n = tm

The following table shows the different values of n given a particular frequency of conversion m
and time t.

Description Conversion Time (t) Frequency of Value of n

Period Conversion (m)

Annually 1 year 1 year 1 1

Semiannually 6 months 3 years 2 6

Quarterly 3 months 2 years 4 8

Monthly 1 month 5 years 12 60

The value of n (total number of conversions for the entire term) is dependent on m (frequency of
conversion). If the term t is kept constant, n increases as m increases. Similarly, n is also
dependent on t. If m is held constant, n increases as t increases.

Computing Interest Rates per Period

Now, suppose you want to know how much the interest rate per period is for compound interest
charged on a particular loan or investment. How do you get this value?

First, determine the nominal rate, or the rate charged that may be converted several times per
year, say, semiannually. This type of rate is denoted by j. For example, you are investing P36,000
for 5 years in a bank that pays 3% compounded semiannually. The nominal rate i is 3% or 0.03.

Now, to get the interest rate per period denoted by i, divide the nominal rate by the frequency of
conversion per year as follows:
 i = j/m

The following table shows the different interest rates per period given a particular nominal rate:

Description Interest Period Frequency of Nominal Rate (j) Interest Rate Per
Conversion (m) Period (i)

Annually 1 year 1 10% 0.10

Semiannually 6 months 2 12% 0.06

Quarterly 3 months 4 14% 0.035

Monthly 1 month 12 16% 0.0133

Note that the interest rate per period i are never rounded off as much as possible.

Computing Compound Amount

Most savings accounts pay interest that is compounded once or several times a year. For
example, if P10,000 is invested in a bank that pays 1.25% compounded annually, it will earn an
interest of P125 after a year. This amount will then be added to the principal. If the maturity
value remains invested for another year, the interest for the second year is computed based on the
new amount and not on the original principal. This new amount is called the compound amount.
This process is repeated in the succeeding periods until the end of the term.

DEFINITION 2.2 The accumulated value of the principal P at the end of the term
is called the compound amount, denoted by the variable F.

F = P(1 + i)n

where
F is the compound amount or accumulated value of the principal P at the end of the term,
P is the present value or original principal,
i is the interest rate per period, and
n is the total number of conversion periods.
Computing Compound Interest

You learned that compound interest is the total interest earned for the entire term. You can obtain
it by getting the difference between the compound amount F and the principal or present value P.

Ic = F - P

Future Value

e.g. what is the value of our money after 4 years

Year 1 Puts money in the bank

Year 2

Year 3

Year 4 How much money she will have after 4 years?

(FV)

Present Value

e.g. what amount of money should I put in the bank today to earn the specified future value
P= Known F= Unknown

Year 1 Puts money in the bank

Year 2

Year 3

Year 4 You know the value that you want to have at

the end of the investment period (PV)
Example to understand: 10% interest semi annually for 5 years, the future value is 500,000.

Present Value at compound interest

Present value formula: P = F ( 1 + I ) -n

Example: What is the present value of 35,000 due in 7 years and 6 months if the rate is 12%
compounded quarterly?

Given: F = 35,000 t= 7.5 years m= 4j= 12% P= ?

Solution: i= (j/m) = (0.12/4) = 0.03
n= (t)(m) = (7.5)(4) = 30
P = F ( 1 + I ) -n P = 35,000 ( 1 + 0.03 ) -30 = 14,419.54

Answer: the present value of 35,000 that is due at the end of 7.5 years is 14,419.54. this could be
interpreted as: if the investor invested 14,419.54 in an financial instrument or investment that
grows 12% compounded quarterly for 7 years and 6 months, the amount will grow to 35,000

Example: A certain principal P was invested at 6% compounded semi-annually. If this principal

amounted to 94,500 at the end of 3 years, how much was the principal?

Given: F = 94,500 t= 3 years m= 2 j= 6% P= ?

Solution: i= (j/m) = (0.06/2) = 0.03
n= (t)(m) = (3)(2) = 6
P = F ( 1 + I ) -n P = 94,500 ( 1 + 0.03 ) -6 = 79,142.26

Answer: the present value of 94,500 that is due at the end of 3 years is 79,142.26.

Ordinary Annuity
Annuity
- Series of equal payments that are made at the end of equidistant points in time, such as
monthly, quarterly, or annually.
Ordinary Annuity
 - Payments are made at the end of each period
Payment interval

- time between two consecutive payments of annuity; equivalent to 1 period.

Term

- Starts immediately and ends on the last payment interval

Periodic Rent or Periodic Payment (R)

- Size of each payment

Annuity Certain Contingent Annuity

- Called annuity - Sequence of periodic payments

- One in which payments in which the payments extend
begin and end at definite over an indeterminate length of
times time

1. Ordinary annuity- payment

made at the END of each period

2. Annuity due- payment made at

the BEGINNING of each period

3. Deferred annuity- first

payment is made at some later date

Present Value of an Ordinary Annuity (A)

A = R [ 1 – ( 1 + i ) -n/ i ]

Future Value or Amount of an Ordinary Annuity (S)

 S = R [ ( 1 + i )n – 1 / i ]

Relationship between A and S

A = S(1+i) -n
S = A(1+i) n

Example: If the prevailing worth of money is 12% interest compounded monthly,

find the present value and the amount of an annuity of P2,000 payable monthly for
10 years.
Given:

j = 0.12 R = P2,000 t = 10

n = 120 m = 12 i = 0.01

Missing:

S=? A=?

Solution:

A = R [ 1 – ( 1 + i )-n/ i ]

A = 2,000 [ 1 – ( 1 + 0.01 )-120/ 0.01 ]

= 139,401.04

S = R [ ( 1 + i )n – 1 / i ]

S = 2,000 [ ( 1 + 0.01 )120 – 1 / 0.01 ]

= 460,077.38

Answer: A = P139,401.04 S = P460,077.38

Cash Value or Cash Price

- indicates the current value of an investment in terms of today's cash, or if you

were to pay in cash for the investment today.
 Cash Price = Down Payment + A

Formula for Cash Value or Cash Price

CP = DP + A

Example: Mrs. Myrna Mendoza, a car buyer, makes a down payment of P225,000
and pays P20,794.52 at the end of each month for 5 years to discharge all principal
and interest costs at 36% interest rate compounded monthly. Find the equivalent cash
price of the car.

Given: DP = 225,000 j = 0.36 t = 5 m = 12 R= 20,94.52 n = 60 i = 0.03

Missing: CP=?

Solution:
CP = DP + A

= 225,000 + 20,794.52 [ 1 – ( 1 + 0.03 )-60/ 0.03 ]

Answer: 800,500.06

Amount of an Annuity at any time (S k)

- This is the amount that you would expect is in the annuity investment should you decide to
check the amount after a specific period.
K= number of deposits or payment made Sk = R [ ( 1 + i )k – 1 / i ]

Example: At the end of each 6 months for 7 years, ABC Printing will deposit P50,000 in a
depreciation fund to provide for the replacement of its printing machinery at the end of 7 years.
If the fund accumulates at 8% compounded semi-annually, how much is in it
(a) just after the last deposit and

(b) just after the 5th deposit?

Given:
R = 50,000 j=0.08 t=7

m=2 n=14 i=0.04

Missing:

(a) S=? (b) S5=?

(kRL)

- amount that you still have to pay right before a specified kth payment.
RL = R + RL k
k

Example: Michael bought a laptop and paid P10,000 as down payment plus P3,000
at the end of each month for a year. If money is worth 24% converted monthly,

find (a) the cash price of the laptop,(b)

Michael’s remaining liability just after his 5th installment and (c) his remaining
liability just before he pays his 7th installment.

Given:

DP = P10,000 R = P3,000 t = 1 m = 12 n = 12 i = 0.02

Missing:

(a) CP = ? (b) RL5 = ? (c) 7RL = ?

Solution:

CP = DP + A

CP = 10,000 + 3,000 [ 1 – (1.02) -12 / 0.02]

= 41,726.02
RL5 = R [ 1 – ( 1 + i ) –(n-k) / i ]
RL5 = 3,000 [ 1 – ( 1.02)-(12-5) / 0.02 ]
= 19,415.97

Solution:

(a) S = R [ ( 1 + i )n – 1 / i ]
S = 50,000 [ ( 1 + 0.04 )14 – 1 / 0.04 ]

=914,595.56

(b) S5 = R [ ( 1 + i )n – 1 / i ]

S5 = 50,000 [ ( 1 + 0.04 )5 – 1 / 0.04 ]

=270,816.13

Answer:

(a) = 914,595.56
(b) = 270,816.13

Remaining Liability after the kth Payment (RLk )

Amount that you still have to pay after you've made after a specific number of payments.
RLK = R [ 1 – ( 1 + i ) –(n-k) / i ]

Remaining Liability just before the kth Payment (kRL)

Amount that you still have to pay right before a specified kth payment.
kRL = R + RL k

Example: Michael bought a laptop and paid P10,000 as down payment plus P3,000
at the end of each month for a year. If money is worth 24% converted monthly, find
(a) the cash price of the laptop, (b) Michael’s remaining liability just after his 5th
installment and (c) his remaining liability just before he pays his 7th installment.

Given:
DP = P10,000 R = P3,000 t = 1 m = 12 n = 12 i = 0.02

Missing:

(a) CP = ? (b) RL5 = ? (c) 7RL = ?

Solution:

CP = DP + A

CP = 10,000 + 3,000 [ 1 – (1.02) -12 / 0.02]

= 41,726.02

RL5 = R [ 1 – ( 1 + i ) –(n-k) / i ]
RL5 = 3,000 [ 1 – ( 1.02)-(12-5) / 0.02 ]
= 19,415.97

Periodic Payment (R)

Given the Present Value (A)
R= A i / 1 – ( 1 + i ) -n

Given the Future Value (S)

R= S i / 1 – ( 1 + i )-n

Example: Mrs. Anonas acquired a loan of P50,000 from a credit union that charged an interest
of 16% compounded quarterly. She promised to settle her obligation by making quarterly
payments for 3 years. Find her quarterly payment.

A = P50,000 j = 0.16 t = 3

m = 4 n = 12 i = 0.04 Missing: R = ?

R= A i / 1 – ( 1 + i )-n
R= 50,000 (0.04) / 1 – ( 1 + 0.04 )-12

= 5,327.61

Example: To create a fund for the purchase of a brand new car, Frances will make equal monthly
deposits to a bank that pays [4%, m = 12] for 5 years. If she intends to buy a car that will cost her
P700,000, how much should she deposit monthly to the bank.

Given:

S = 700,000 j = 0.4 t=5 m = 12 n = 60 i = 0.0033

Missing: R = ?

R= S i / 1 – ( 1 + i )-n

R= 700,000 (0.0033) / 1 – ( 1 + 0.0033 )-60 = 10,558.23

Solving for time t (# of years)

Given the Present Value (A)

t = - log ( 1 - (Ai / R) / mlog ( 1 + i )

Given the Future Value (S)

t = - log ( 1 - (Si / R) / mlog ( 1 + i )

Annuity
- Series of equal payments that are made at the end of equidistant points in time, such as
monthly, quarterly, or annually.
Ordinary Annuity
- Payments are made at the end of each period

Annuity Due

- Payments happen at the beginning of the period

What’s difference between annuity and annuity due?

- The money remains at the bank or any invested financial instrument within the period of 4th
and 5th year
- In annuity due, the present value is looked at the beginning or the year 0
- In annuity due, A is discounted less by 1 period
- In annuity due, A increase interest by 1 more period

Present Value of an Annuity Due (Ä)

Future Value or Amount of an Annuity Due (S)

Relationship between Ä and S

Example 1: Mary Frances agrees to pay P2,000 at the beginning of every 3 months for 6 years
and 6 months for an investment paying 9% compounded quarterly. Find (a) the equivalent cash
price of the investment, (b) the investor’s remaining liability just after her 10th payment is made
and (c) her remaining liability just before the 20th payment.
Given: R = P2,000 j = 0.09 t = 6.5 m=4 n = 26 i = 0.0225

Missing: a. Ä b. RL10 c. 20RL

 Solution:

Example 2: Find the amount of an annuity due of P15,500 payable at the beginning
of every 6 months for 7 years if money is worth 11% compounded semi-annually.
Given: R = P15,500 j = 0.11 t=7 m=2 n=14 i=0.055

Missing: S

Solution:
Example 3: For 5 years, P100,000 will be deposited in a fund at the beginning of every 6 months.
If money is worth 10.5% compounded semi-annually, how much is in the fund (a) at the end of 4
½ years just after the last deposit is made, (b) at the end of 5 years? (c) What is the present value
of the fund?
Given: R = 100,000 j = 0.105 t = 5 m = 2 n = 10 i = 0.0525
Missing: a. S10 b. S c. Ä

Solution:
Periodic Payment, Given the Present Value (Ä)

Periodic Payment, Given the Future Value (S)

Business Math

Finance
- Money
- Increasing value/net worth
- Managing resources
- Budgeting
- Study of how people and businesses evaluate investments to create value and raise capital
to fund them:
- Spending
- Managing
- Budgeting
- Investing

Finance’s 3 key decisions

 1. Investing: what (long-term) investments should the firm undertake to create value
o Where we use the money
2. Financing: How should the firm raise money to fund these investments
o Where is the money from
3. Cash flow management: How can the firm best manage its cash flows as they arise
in its day-to-day operations?

The Goal of a Financial Manager

- consistent with the mission of the corporation
- maximize shareholders' wealth.

Corporate Mission and/or Goal

- pay particular attention to the shareholders
- If managers fail to pursue shareholder wealth maximization they will lose the
support of investors and lenders
Case Example: Coca-Cola’s Vision Statement

To achieve sustainable growth, Coca-Cola has established and committed towards a

vision with clear goals for: profit, people, planet, partners, and portfolio

Are there main principles that guide the overall practice of finance?

PRINCIPLE 1: Money Has a Time Value

- A dollar received today is worth more than a dollar received in the future.
PRINCIPLE 2: There is a Risk-Return Trade-of
- We won’t take on additional risk unless we expect to be compensated with
additional return
- Higher the risk, higher will be the expected return.
- Note: The expected return may not be equal to the realized rate
of return
PRINCIPLE 3: Cash Flows Are the Source of Value ("Cash is King")
 - Profit is an accounting concept and measures a business’s performance. Cash
flow is the amount of cash that can actually be taken out of the business.
- It is possible for a firm to report profits but have no cash
The Concept of "Incremental Cash Flow"

- Financial decisions in a firm should consider “incremental cash flow” i.e. the difference
between the cash flows the company will produce with the potential new investment and
what it would make without the investment.

PRINCIPLE 4: Market Prices Reflect Information

- Investors react quickly to news/information and decisions made by managers.
- Good News lead to higher stock prices; Bad News lead to lower stock prices
PRINCIPLE 5: Individuals Respond to Incentives
- Managers (as agents) respond to incentives they are given in the workplace. If their
incentives are not properly aligned with those of the firm’s stockholders (the principal) they may
not make decisions that are consistent with increasing shareholder value leading to agency costs.

The agency problems/costs can be mitigated through:

1. Compensation plans that reward managers when they act to maximize
shareholder wealth
2. Monitoring by the board of directors

3. Monitoring by financial markets (such as auditors, bankers, security analysts,

credit agencies)
4. The underperforming firms seeing their stock prices fall and face threat of being taken over
and have their management teams replaced

What is the Basic Structure of Financial Markets?

● Three Key Players in the Financial Market

● Financial Institutions
● Securities Markets

Three Key Players in the Financial Market

 - Within the financial markets, there are three principal sets of players that interact:
1. Borrowers – individuals/businesses
2. Savers – Mostly individuals
3. Financial Institutions – Financial intermediaries (banks)

The Financial Market Place: What are Financial Institutions?

Financial Intermediaries
- They help bring together those who have money (savers) and those who
need money (borrowers)
- Banks, finance companies, insurance companies, investment banks, and
investment companies

The Financial Market Place: What are Securities Markets?

Security
- a negotiable instrument that represents a financial claim. It can take the form of
ownership (stocks) or a debt agreement

Security market
- allow businesses and individual investors to trade the securities issued by public
corporations.

Security Markets Provide a Link Between the Corporation and Investors

Types of Securities
1. Debt Securities
- Firms borrow money by selling debt securities in the debt market. Debt is classified
based on maturity period
● Less than one year (issued in the money market)
● One to ten years (called Notes, issued in the capital market)
● More than 10 years (called Bonds, issued in the capital market)

2. Equity securities
- These securities represent ownership of a corporation. There are two major types of
equity securities: common stock and preferred stock
- Common stock: represents equity ownership in a corporation, provides voting rights, and
entitles the holder to profits in the form of dividends
- Preferred stock: It gives preference, relative to common stockholders, with regards to
dividends and claim on assets

Stock Markets
- a public market, venue, or space in which the stock of companies is traded. Stock markets
are classified as either organized security exchanges or the over the counter (OTC)
markets
 - Organized security exchanges physically occupy space and financial instruments are
traded on their premises.

CONCEPTS IN BUSINESS MATH

LENDER/CREDITOR- A Person or institution that makes the funds available

BORROWER- A Person or institution who avails the fund
INTEREST- a certain sum of money that the lender charges the borrower for the use of the
funds
Principal – is the sum of money borrowed or invested.
Interest Rate – is the rate charged by the lender or rate of increase of the investment.
○ Could be seen expressed in percentage
○ Could be seen expressed in decimals
Time or Term of the loan – the number of years the sum of money was borrowed or invested.
MATURITY VALUE OR FACE VALUE- the sum of
the principal and the interest

SIMPLE INTEREST: Two Categories:

EXACT(e) - uses 365 days as denominator for t

ORDINARY(o) - uses 360 days as denominator for t

- Bank typically uses ordinary

Actual time- Obtained by counting the actual number of days between the origin and maturity

Approximate time- Obtained by counting the actual number of days between origin and
maturity but with the assumption that each month has 30 days
IF QUESTION IS NOT FOR THE WHOLE YEAR-
watch out for exact/ordinary and actual/approximate
LEAPYEAR:
Ordinary- use 30 days Exact- use 29 for feb
Simple Discount - the simple interest collected or deducted in advance from the amount of loan
n-> the entire annuity

k- > number of payments

- Interest that is computed on the sum of the original principal of a deposit or loan and the
interest accumulated
- Interest earned per period is automatically reinvested to earn more interest
Frequency of conversion (m)

- Is the number of times that the interest computed for the span of 1 year
Total number of conversion periods for the entire term (n)
- Is the product of the frequency of conversion and the number of years
n= t m

Nominal rate (j)

- is the rate charged which may be converted several times per year
Interest rate per period (i)

- nominal rate divided by the frequency i= j / m

Present Value at compounded Interest

- The present value shows the value at present of an expected future value, which grew
with compound interest
- It may also be defined as the present value of a compounded amount
Annuity

- Series of equal payments that are made at the end of equidistant points in time, such as
monthly, quarterly, or annually.
Ordinary Annuity

- Payments are made at the end of each period

Payment interval

- time between two consecutive payments of annuity; equivalent to 1 period.

Term

- Starts immediately and ends on the last payment interval

Periodic Rent or Periodic Payment (R)

- Size of each payment

Ordinary annuity

- payment made at the END of each period

ANNUITY DUE
- payment made at the BEGINNING of each period

Deferred annuity
- first payment is made at some later date

Cash Value or Cash Price

- indicates the current value of an investment in terms of today's cash, or if you were to pay
in cash for the investment today.
Amount of an Annuity at any time (Sk)

- This is the amount that you would expect is in the annuity investment should you decide
to check the amount after a specific period.
K= number of deposits or payment made

Remaining Liability after the kth Payment (RLk )

- amount that you still have to pay after you've made after a specific number of payments.
Remaining liability just before the kth payment (kRL)
- amount that you still have to pay right before a specified kth payment.

Computing for nominal rate

- Know if it’s an A or S question
- Substitute everything
- It will now be a polynomial
- Proceed to formula