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Suppose that $1000 is borrowed at a simple interest rate of 12% per annum. At the end of one year, the interest owed would be I = $1000(1)(0.12) = $120 The principal plus the interest would be $1120 and would be due at the end of one year. A simple-interest loan can be made for any period of time. Interest and principal become due only at the end of the time period. When it is necessary to calculate the interest due for a fraction of year, it is common to represent that fraction as the ratio of the number of days in the loan 2 to the total days in a year.
For example, on a loan of $1000 at an interest rate of 12% per annum, for a period March 1 to May 20, the interest due on May 20 along with the principal sum of $1000 would be
0.12($1000) (81 / 365) = $26.63
Compound Interest:
When a loan is made for several interest periods, interest is calculated and payable at the end of each interest period. There are a number of loan repayment plans. These range from paying the interest when it is due to 3 accumulating the interest until the loan is due.
For example, the payments on a 4-year loan of $1000 at 16% interest per annum, payable when due, would be calculated as shown. Yr Amount owed at beginning of yr
1 2 3 4 $1000 $1000 $1000 $1000
Amount Amount to owed at be paid by end of yr the borrower at end of yr $1160 $160 $1160 $160 $1160 $160 $1160 $160
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If the borrower does not pay the interest earned at the end of each period and is charged interest on the total amount owed (principal plus interest), the interest is said to be compounded. The interest owed in the previous year becomes part of the total amount owed for this year. This years interest charge includes interest that has been earned on previous interest charges. For example, a loan of $1000 at 16% interest compounded annually for a 4-year period will produce the results shown.
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yr
Amount ($) Interest ($) Amount ($) Amount owed at to be added owed at ($) paid by beginning of to loan at end of yr borrower yr (A) end of yr at end of (A+B) (B) yr 1000.00 1160.00 1345.60 1560.90 1000 X 0.16 1000(1.16) =160 =1160 1160 x 0.16 1000(1.16)2 =185 =1345.60 $ 00.00 00.00 00.00 1810.64
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1 2 3 4
Similarly, disbursements during a period are represented by a downward arrow (a decrease in cash). These arrows are then placed on a time scale that spans all time periods covered by the proposed investment.
Note: Since there are two parties to every transaction, it is important to note that the cash flow directions in cash flow diagrams depend upon the point of view taken.
Net cash flow is the arithmetic sum of the receipts (+) and the disbursements (-) that occur at the same point in time.
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(Semi-annually)
Every quarter 4 times a year: (Quarterly)
1% per month
12% per year, compounded monthly