INVESTMENT MATHEMATICS Simple Interest and Bank Discount LEARNING COMPETENCIES % Afer studying this section, the learner is expected to: 1. Define terms involving simple interest, bank discount, and promissory note. 2, Find the simple interest, maturity value, bank discount, and proceeds. Distinguish and apply in problem solving the different concepts of time. Manipulate the simple interest formula when principal, rate or time is unknown, Compute for the effective rate of a bank discount note. Solve discounting problems on simple interest note and bank discount note before maturity.248 | Math in the Business World “Money makes money, and the money that money makes, makes more Money." ~- Benjamin Franklin Warren Buffett, 82 years old, at US$44 billion is the 2nd richest American (per Forbes Global, Sept. 2012, The Forbes 400 Richest People in America), Was a student of Benjamin Graham, the father of value investing. The Student ig known as the Sage of Omaha in investing circles. He built an empire out of Berkshire Hathaway which was originally a textile milling company. Berkshire jg Now a multinational conglomerate holding company. A Berkshire's class A share Sold for $121,775 as of May 2, 2012, making them the highest-priced shares on the New York Stock Exchange, in part because they have never had a stock and never paid a dividend, retaining corporate earnings on its balance sheet, k value has grown from $19 to $99,860, a rate of 19.8% compounded annually. Or, an overall gain of 513,055% from 1964-2011, Berkshire Hathaway stock Produced a total return of 76% from 2000-2010 versus a negative 11.3% return for the S&P 500. y Mr. Buffett’s genius in investing definitely has its foundation on the application of good investment mathematics. He was onee quoted as saying that, “Sophisticated knowledge of markets and finance is not vital or even necessary. You may, in fact, be better off knowing nothing about efficient market theory, option pricing or emerging markets. Investment students need only to know how to value a business and how to think about market prices.” He also said firmly that “if you are not willing to own a stock for 10 years, don’t even think about owning it for 10 minutes,” SIMPLE INTEREST Individuals, whether engaged in business or not, occasionally find themselves in need of funds for worthwhile purposes. One recourse they usually resort to is borrowing. On the other hand, a business or person who has excess money may want to invest this through lending. The one who invests the money is the lender or creditor and the one who owes it is the borrower of debtor. The lender, of course, expects a sum in addition to what he has lent; this is actually the interest—the income he has earned, However, on the part of the borrower, this interest is his cost for the use of money, Simply stated, interest is money paid for the use of money. Interest may be computed by cither of the two most common methods—simple or compound,Simple Interest and Bank count | 249 simple interest is an interest computed on the amount the borrower received at the time the loan is obtained and is added to that amount when the loan becomes due, ‘Thus, simple interest is computed only once for the entire time period of the loan. At the end of the time period, the borrower repays the amount originally owed plus the interest, Some lenders, however, prefer to collect the interest in advance. The interest deducted in advance is called bank discount, This is discussed in another section of this chapter. Simple interests are usually applied to loans whose time period is less than a year. Compound interest, on the other hand, means that the interest is computed more than once during the time period of the loan. Compound interest loans are generally for time periods of a year or longer, The computation of simple interest considers three factors: principal, rate and time. In this section, simple interest rate is referred to as interest rate or rate and simple interest as interest. Illustration: Luz Clarita borrowed P280,000 at a simple interest rate of 9% for one year. Compute for the simple interest and maturity value of the loan. Finding the simple interest Simple interest is the product of the principal, rate and time; or stated as a formula, Interest - Principal x Rate x Time Z - PRT The principal is the amount of deposit made by a depositor or the face amount lent to the borrower on loan date. In the illustration, the principal is P280,000. The simple interest rate expressed as a percentage, is converted to a decimal for computation purposes. Unless otherwise stated, the simple interest rate is an annual rate. In the illustration, rate is 9% or in decimal form, .09. The time is the length of time for which the money is borrowed or lent. The expressed in years or fractional part of a year is the period between the loan dat date when the loan was obtained and maturity date—the date when the loan due. In the illustration, the time is one year. The simple interest may now be computed using the formula J = PRT. Substit givens in the illustration, Interest = Principal x Rate x Time Interest = 280,000 x .09 x 1 Interest = 25,200 us, a loan of P280,000 for one year at simple interest rate of 9% will cost Luz CI 5,200 in interest.250 | Math in the Business World Finding the maturity value After one year, Luz Clarita’s loan matures and she is obliged to pay the maturity value of the loan. This formula, Maturity Value = My = The maturity value is solved as, Maturity Value Maturity Value the sum of the principal she received on loan date and the interest, In Principal + Interest P4t Principal + Interest 280,000 + 25,200 Maturity Value 305,200 Hence, on maturity date, in addition to the principal of P280,000 that Luz Clarita received when she obtained the loan, she is to pay P25,200 in interest; or a total of P305,200. The computation is on the premise that the interest has been initially computed. Maturity value may also be computed directly by Substituting the interest formula, J = PRT to [ $ in the maturity value formula, MV = P + 1, Maturity Value =) Principal ieee Maturity Value Principal + (Principal x Rate x Time) The formula below is arrived at by factoring: . Maturity Value = Principal (1 + Rate x Time) MV P(1+ RD Solving for the maturity value of Luz Clarita’s loan directly, Maturity Value Principal (1 + Rate x Time) Maturity Value 280,000 (1 + .09 x 1) Maturity Value 280,000 (1 + .09) Maturity Value 280,000 (1.09) Maturity Value = ~——-_—P395.200 The Concept of Time The time T in the simple interest formula I = PRT isthe period between the loan and the maturity date. In the previous illustration, time is exactly one year. With simple interest rate expressed as an annual rate and with the time expressed in years, th computation of interest and maturity value in the illustration is as simple as just the product of the principal, rate and time. If the time in years is not exact, say, | year and six months or 1% years, it has to converted to decimal hence it becomes 1.5 years; 2 years and 3 months or 2% becomes 2.25 years; and 3 years and 9 months or 3% years becomes 3.75 years, This, course, is being done to facilitate the computation,Simple Interest and Bank Discount 25 1 es, the time 7 may be given in months. Be it mo in °1-month period is used in converting time into a fractional fan 12. monte or ane Ue teest rate is given as an annual rate, the time should be prorated gain, since the sim jdvisable to convert the time in months to decimal form. By ote ti par d | 4 ‘months is actually converted in terms of years. For example, the time of 9 a 4 ines 75 year, 1S months or 15/12 is 1.25 years; and 30 months or 30/12 is 2.8 years, However, in instances when it would be impracticable to convert the number of month to decimal form, say, 7 months or 7/12, the fractional form may be substituted to the mple interest formula as is. other 2 sin Ifthe time 7 is given in months and only the loan date is stated, the maturity date shall coincide with the loan date. Thus, a loan obtained on June 13, 2018 payable in 4 months will mature Oct. 13, 2018. In addition; if either the loan date or maturity date does not make mention of the year, it shall be assumed that these dates fall on the same year. For example, a loan that was granted on Feb. 14, 2018 and to mature Sept. 20 would mature on Sept. 20, 2018. There are also cases when the time 7’ is.stated as a certain number of days. It follows that the year should likewise be measured in terms of the number of days. Two methods are at hand: first, the exact interest method, which uses 365 days as the time denominator: and second, the ordinary interest method, which uses 360 days. Note that the exact interest method uses 366 days in a leap year. Illustration: If Esperanza borrowed P140,000 at 7% interest for 64 days, how much would the interest be using tHe exact and ordinary interest methods? Exact Interest Method Interest = Principal x Rate x Time Interest. = 140,000 x .07 x 64/365 Interest. = — PLZ18.36 Ordinary Interest Method Interest. = Principal x Rate x Time Interest = 140,000 x .07 x 64/360 Interest = PL74222 Note that the ordinary interest method yielded a higher interest. When only the loan date and maturity date are given, the number of days may be counted as either actual time or approximate time, Actual time is determined by day excluding the loan date until the maturity date while approximate time by assuming that each month has 30 days,252 | Math in the Business World ‘i is il 8, 2018 to 20, Illustration; Count the actual time and approximate time from April 8 Sept. 2018. Actual Time Approximate Time . April (30-8) 2 April (30-8) e May 31 May a June 30 nee 5 July 3h July a August 31 one es e September 20 ae 165 days 162 days i i that what have It turns out that actual time is longer than approximate time. Bu ee 4 eee been counted so far is the time numerator. The next problem is wl sue nee to use. This, as discussed, uses either the exact interest method using eriod, or the ordinary interest method using the 360-day period. It may be deduced from the above discussions that where only the lean aay sod oat date are given, there are four possible time combinations. Applying illustration, 1. __Actualtime__—__165 3. Actual time * igs Exact interest 365 Ordinary interest 2: Approximate time ___162 4. Approximate time ___162 Exact interest pu « 365 Ordinary interest 360 Illustration: Applying the four time combinations above, compute for the interest if Esperanza was lent P122,500 at 11% interest. 1, Exact interest using actual time Interest = Principal x Rate x Time Interest = 122,500 x .11 x 165/365 Interest =i 6,091.44 2. Exact interest using approximate time Interest = Principal x Rate x Time Interest o 122,500 x .11 x 162/365 Interest = 5,980.68 3. Ordinary interest using actual time Interest = Principal x Rate x Time Interest - 122,500 x .11 x 165/360 Interest = 26,176.04Simple Interest and Bank Discount | 253 4, Ordinary interest using approximate time Principal x Rate x Time Interest faa Interest’ = 122,500 x_.11 x 162/360 Interest. = = 6,063.75 Esperanza must have realized that ordinary interest using actual time is most favorable to Iso known as the her since it yielded the highest interest. This time combination al W ‘ Banker’s Rule is being adopted by banks. For problem solving purposes, this shall be used whenever the problem is silent as to which time combination to use. Manipulating the Simple Interest Formula There may be cases when the simple interest is known yet either the principal, rate or time is not, These problems may be solved by manipulating the simple interest formula = PRT. The variable or unknown factor is isolated to one side of the equation opposite the givens. Principal is unknown Illustration: A bank loaned Anakarenina Fashion Boutique money at 8% simple interest for 90 days. If the amount of interest was P4,000, use the ordinary interest method to find the amount of principal borrowed. The principal formula may be derived by dividing both sides of the simple interest formula I = PRT by Rho P= is RT. Solving the problem, the amount borrowed from the bank is P200,000. Interest Frneinay Rate x Time Ms 4,000 Principal eee 360 Principal sane Ame Printpal =) SEARO Rate is unknown It will be noticed that the answer when an unknown rate is being solved is a decimal number. This must be converted to percent inasmuch as businesses always express. interest rates as a percentage. iustration: If Anakarenina Fashion Boutique applies for a P175,000 loan in a bank the inasest of which is PS,810 for 125 days, what interest rate is being charged? Use the ordinary interest method, ;254 | Math in the Business World The rate formula is arrived at by dividing both sides of the simple interest formula 1 = PRT by PT, or R = I + PT, Solving the problem, cs Interest, ae Principal x Time Rate a 5,810 175,000 x 125 360 5,810 ae F 60,763,888 Rate = 095616 Rate = 2.56% The bank charged an interest rate of 9.56%. Time is unknown When the time 7 is missing, a whole number in the answer represents years and the decimal represents a portion of a year. The decimal should be converted to days by multiplying it by 360 for ordinary interest or by 365 for exact interest. For example, an answer of 3 means 3 years. An answer of 3.23 means 3 years and .23 of the next year. Assuming ordinary interest, the decimal portion of the answer, .23 is multiplied by 360. This gives 82.8, which represents the number of days. The total time of the loan would be 3 years and 83 days. Note that any fraction of a day is always rounded up to the next higher day, even if it is less than .5. Any part of a day is considered to be a full day. For example, 25.1 days would round up to 26 days. Illustration: What would be the time period of Anakarenina Fashion Boutique’s loan for P266,000, at 11% ordinary interest, if the amount of interest is P10,150? Dividing both sides of the simple interest formula J = PRT by PR, the time formula T = 1 + PR isarrived at. Time E Interest. Principal x Rate Ti ES 10,150, DY 266,000 x .11 J {oso Nini Time = ~—-—«.3468899 yearsSimple Interest and Bank Discount | 255 Time . 3468899 x 360 Time == =~ 124.8 or 125 days the time period of the loan is 125 days, CC ——————————————— BANK DISCOUNT Another way of lending money is to collect the interest in advance, This interest is referred to as bank discount. A bank discount is an interest computed on the maturity value of the loan and is deducted from that amount at loan date to determine the net amount to be received by the borrower. Simply stated, the amount of loan applied for at Joan date is the maturity value of the loan. The bank discount is deducted from that amount to arrive at the proceeds—the amount the borrower is to receive. This is in contrast to simple interest, which is altogether paid with the principal at maturity date. In computing for the bank discount, three factors are being considered: maturity value, bank discount rate and time. In this section, bank discount rate is referred to as discount rate or rate and bank discount as:discount. Illustration: Mirasol availed of a P245,000 loan at 14% discount rate for 9 months. Find the bank discount and proceeds of the loan. Bank discount is the product of the maturity value, discount rate and time; or stated as a formula, Maturity value x Discount rate x Time Bank discount = = MVXRXT BD* The maturity value is the amount applied for by the borrower on Joan date. This is the same amount that the debtor is supposed to pay at maturity date. In the illustration, the maturity value is P245,000. The bank discount rate, expressed as a percentage, is converted to a decimal for computation purposes. Unless otherwise stated, the bank discount rate is an annual rate. In the illustration, the rate is 14% or in decimal form, .14. The time expressed in years or fractional part of a year, is the period betwe the loan and maturity date. In the example, time is 9 months or 9/12 or asa decimal, .75. Finding the bank discount The bank discount may now be computed using the bank discount formula, Substituting the givens in the illustration, Bank discount = Maturity value x Discount rate x Time Bank discount = 245,000 x .14 x .75 Bank discount = 25,725256 | Math in the Business World . Thus, a loan of P245,000 for one year at a bank discount rate of 14% will cost Mirasol — P25,725 in discount. Finding the proceeds On loan date, Mirasol did not receive the entire P245,000. The bank discount of P25, had to be deducted as interest in advance, The proceeds formula follows, Proceeds . Maturity value - Bank discount P = MV - BD Solving for the proceeds, Proceeds = ‘Maturity value - Bank discount Proceeds - 245,000 - 25,725 6 Proceeds = =~ P219,.275 ie Hence, on loan date, Mirasol received P219,275 as proceeds of her loan. The computation assumed that the bank discount has been initially computed, Proce: may also be computed directly by substituting the bank discount formula, BD = MV R x T to BD into the proceeds formula, P = MV - BD, Proceeds, Proceeds Maturity value - Bank discount Maturity value - (Maturity value x Rate x Time) And by factoring, the formula below is arrived at, Proceeds P wo ‘Maturity value (1 - Rate x Time) MV (1 - RT) : Solving for the proceeds of Mirasol’s loan directly, Proceeds = Maturity value (1 - Rate x Time) Proceeds 245,000 (1 - .14 x .75) Proceeds 245,000 (1 - .105) Proceeds 245,000 (.895) Proce = P219,275 PROMISSORY NOTES In the previous sections, computations involving simple interest and bank discoun loans were discussed, In actual cases, when a business or person obtains a loan, he a note evidencing his indebtedness and commitment to pay. This is actually a promiss note. A promissory note is an unconditional promise in writing made by one pers. another, signed by the maker, engaging to pay on demand, or at a fixed or determi future time, a sum certain in money to order or to bearer (Negotiable Instruments LSimple Interest and Bank Discount | 257 js document stating the details of a loan is a negotiable instrument which, when Hiperly endorsed, can be transferred or sold fo another person oF bank which is not a party to the original loan Originally, there are two parties to a promissory note—the maker who makes the promise and who signs the instrument and the payee to whom the promise is made and to whom the instrument is payable. Types of Notes promissory notes may either be interest-bearing or non-interest-bearing. Generally, there are two types of promissory notes—the simple interest note and the bank discount note. In this section, the computational concepts learned in the previous sections may be related as each type of note is analyzed. simple Interest Note ittustration: On May 13, 2018, Thaddeus Dominique applies for a Joan at Domdane Credit Union. The loan was approved for P175,000, at 12% simple interest, for 90 days. The parts of the simple interest note are discussed and identified as follows: Maker. Thaddeus Dominique. The maker is the person or business borrowing the money Payee. DomDane Credit Union. The payee is the person or business lending the money. Face Value. P175,000. The face value of the note is the principal amount borrowed. Simple Interest Rate. 12%. The annual rate of interest charged. P175,000 Quezon City, Phils. May 13, 2018 90 days after date, I promise to pay to the order of DomDane Credit Union, One Hundred Seventy Five Thousand and xx/100 Pesos for value received with simple interest at 12% per annum. Due Aug. 11, 2018 Thaddeus Dominique Term. 90 days. The time period of the note. Issue Date. May 13, 2018, The date when the note was signed and issued, Maturity Date. Aug, 11,2018. The date when maturity value is due the payee.258 | Math in the Business World ——<—$—$—<—$—$——$——— substituting the face value to Thus, the simple interest on the note, may be computed by ce it becomes 1 = FV xR the principal in the simple interest formula [= PRT, hen Tt Interest = Face value x Rate x Time Interest = 175,000 x .12 x 90/360 Interest . P5250 The maturity value is then computed as, Face value + Interest 175,000 + 5,250 180,250 deus Dominique is obliged to pay a total amount of Maturity Value Maturity Value Maturity Value e, on maturity date, Thad Hene , the maturity value of the loan. P 180, Bank Discount Note Llustration: On June 13, 2018, Theodore Daniel was granted a loan by Basic Enterprises for P225,000, payable in 75 days at 8% bank discount. The parts of the bank discount note are discussed and identified as follows: Vaker. Theodore Daniel. The maker is the person or business borrowing the money. Payee. Basic Enterprises. The payee is the person or business lending the money. Face Value. P225,000. The face value of the note is the maturity value of the loan. Bank Discount Rate, 8%, The annual rate of interest charged. P225,000 Makati City, Phils. June 13, 2018 75 days after date, I promise to pay to the order of Basic Enterprises, Two Hundred Twenty Five Thousand and xx/100 Pesos for value received with bank discount at 8% per annum. Due Aug. 27, 2018 Term. 75 days. The time period of the note. Issue Date. June 13, 2018, The date when the note was signed and issued. Maturity Date. Aug. 27,2018. The date when maturity value is due the payee.Simple interest and Bank Discount [259 us, the bank discount on the note may be computed by substituting the face value to ihe maturity value in the bank discount formula BD = MV x R x T, hence it becomes go = FVXRXT. Bank discount Face value x Discount rate x Time Bank discount . 225,000 x .08 x 75/360 Bank discount =” _—p3,750 solving for the proceeds, Proceeds Face value - Bank discount Proceeds 225,000 - 3,750 Proceeds 221,250 Hence, on loan date, Theodore Daniel received P221,250 as proceeds of the loan and is to pay P225,000—the face value of the note at maturity date. Note that in a simple interest note the face value of the note is equal to the principal. Hence, the maturity value is higher than the face value. On the other hand, in a bank discount note, the face value of the note is the maturity value. Thus, the borrower pays for the face value at maturity date. A non-interest-bearing note generally looks similar to an interest-bearing note except that a non-interest-bearing note does not make reference to an interest rate. Effective Rate of a Bank Discount Note In a simple interest note, the borrower receives the full face value, whereas with a bank discount note the borrower receives only the proceeds. Because proceeds are less than the face value, the stated discount rate is not the true or effective rate of the note. Effective interest rate is computed using the formula, Hitectita Geen i Bank discount fective interest rate Seana Illustration: What is the effective rate of a bank discount note for P350,000, at a bank discount rate of 14%, for a period of 6 months? To find the effective interest rate, the bank discount and proceeds should be computed first. The following procedures are observed: 1. Solve for the bank discount: Bank discount Face value x Discount rate x Time Bank discount 350,000 x .14 x .5 Bank discount 24,500 wud 2. Solve for the proceeds: Face value - Bank discount 350,000 - 24,500 325,500 Proceeds Proceeds Proceeds wu 4260 | Math in the Business World 3. Solve for the effective interest rate: jank Effective interest rate “eosedr k Mee 24,500 Effective interest rate ©) Sea 325,500 x 5 24,500 Effective interest rate ©) sae 162,750 Effective interest rate e +15053 or 15,05% Hence, the true or effective interest rate is 15.05%, Discounting Notes before Maturity Frequently in business, companies extend credit to their customers by accepting short- term promissory notes as payment for goods or services. These notes are usually for less than one year. Prior to the maturity date of these notes, the payee (lender) may take the note to a bank and sell it. This is a convenient way for a company or individual to cash in note at any time before maturity. This process is known as discounting a note. When a note is discounted at a bank, the original payee receives the proceeds of the discounted note, and the bank (the new payee) receives the maturity value of the note when it matures. The time used to compute the proceeds is from the date the note is discounted to the maturity date. This is known as the discount period. Discounting a Simple Interest Note . Mlustration: WES Distributors received a P1S0,000 simple interest note for S months at 12% simple interest from one of its customers. After 3 months, WES Distributors needed _ cash so it discounted the note at the PCI Bank at a discount rate of 14%. What are proceeds WES will receive from the discounted note? Before proceeds may be computed, the maturity value, time and bank discount are determined. The following procedures are observed: 1. Solve for the maturity value of the original note: Maturity Value = —_—Prineipal (1 + Rate x Time) Maturity Value 150,000 (1 + .12 x 5/12) Maturity Value 150,000 (1 + .05) Maturity Value 150,000 (1.05) Maturity Value = ——_—P1S7,500 2. Count the number of months or days of the discount period: In the illustratic discount period is 2 months—S months less the 3 months that had lapsed.Simple Interest and Bank Discount | 261 ,_ solve for the bank discount: " Bank discount ‘Bank discount Bank discount Maturity value x Discount rate x Time 157,500 x .14 x 2/12 P3,675 wo 4, Solve for the proceeds: Proceeds = ‘Maturity value - Bank discount Proceeds « 157,500 - 3,675 Proceeds = — 153,825 Thus, WES received P153,825 as proceeds from the discounted note. Discounting a Bank Discount Note Illustration: WES Distributors received a 350,000 bank discount note for 6 months from one of its customers. After 3 months, the note was discounted at the BPI Bank at a discount rate of 14%, What are the proceeds WES will receive from the discounted note? In a bank discount note, the computation of proceeds is one procedure less than that in a simple interest note since the given face value is the maturity value of the loan. The procedures follow: |. Count the number of months or days of the discount period: In the illustration, the discount period is 3 months—6 months less the 3 months that had lapsed. 2. Solve for the bank discount: Bank discount Maturity value x Discount rate x Time Bank discount 350,000 x .14 x .25 Bank discount = 12,250 3. Solve for the proceeds: Proceeds = ‘Maturity value - Bank discount Proceeds 350,000 - 12,250 Proceeds = — P337,750 Hence, WES received P337,750 as proceeds from the discounted note. The procedures involved in discounting a non-interest-bearing note are similar to those in a bank discount note. The face value of the non-interest-bearing note is the same as its maturity value; hence, same procedures are followed.