Page 23 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes
Example: Interest on mortgages for having the use of bank's money.

Similarly, the bank pays us interest on money invested in savings accounts or certificates of
deposit because it has temporary access to our money. The amount of money that is lent or
invested is called principal. Interest is usually paid in proportion and the period of time over
which the money is used. The interest rate is typically stated as a percentage of the principal per
period of time.

Example: 18 per cent per year or 1.5 per cent per month.
Interest that is paid solely on the amount of the principal is called simple interest. Simple
interest is usually associated with loans or investments that are short-term in nature. The
computation of simple interest is based on the following formula:

Simple interest = principal × interest rate per time period × number of time period

Example: A person lends 10,000 to a corporation by purchasing a bond from the
corporation. Simple interest is computed quarterly at the rate of 3 per cent per quarter, and a
cheque for the interest is mailed each quarter to all bondholders. The bonds expire at the end of
5 years and the final cheque includes the original principal plus interest earned during the last
quarter. Compute the interest earned each quarter and the total interest which will be earned
over the 5-year life of the bonds.

Solution: In this problem, principal = 10,000, interest = 3 per cent per quarter and the period of
loan is 5 years. Since the time period for interest is a quarter of a year, we must consider 5 years
as 20 quarters. And since we are interested in the amount of interest earned over one quarter, the
period is 1 quarter. Therefore, quarterly interest equals 10,000 × 0.03 × 1 = 300

To compute total interest over the 5-year period, we multiply the per-quarter interest of 300 by
the number of quarters 20, to obtain

Total interest = 300 × 20 = 6,000
Compound Interest: Compound Interest occurs when interest earned during the previous period
itself earns interest in the next and subsequent periods. If 1000 is placed into savings account
paying 6% interest per year, interest accumulates as follows:

Principal invested in the first year 1000.00
Interest for first year ( 1000 × 0.06 × 1) 60.00
Amount available at end of first year 1060.00

Interest for second year ( 1060 × 0.06 × 1) 63.60
Amount available at end of second year 1123.60
The interest earned in the second year is greater than 60 because it is earned on the principal
plus the first year's interest. If the savings account pays 6% interest compounded quarterly, 1.5%
interest is added to the account each quarter, as follows:
Principal invested in the first year 1000.00
Interest for first quarter ( 1000 × 0.06 × 1 × 1/4) 15.00

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