Page 24 - DMGT405_FINANCIAL%20MANAGEMENT
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Financial Management



                      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
                                       Amount available at end of first quarter         1015.00





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