Chapter 05

Introductory Mathematics & Statistics for Business
Chapter 5
Simple interest
Copyright 2010 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Croucher, Introductory Mathematics and Statistics, 5e
5-1
Learning Objectives
Understand the effect of inflation on interest rate levels Perform calculations involving simple interest Manipulate the simple interest formula Distinguish between, and calculate, flat and effective rates of interest
Estimate the effective rate of interest
5-2
5.1 Introduction
Interest denotes any income received from capital that has been invested, or the amount of money paid for the use of borrowed money The actual amount of money that has been lent or invested, or the current balance of the original amount, is called the principal (or capital). The amount of money received as interest depends on three factors: 1. The principal or capital 2. The rate of interest 3. The duration of the debt or investment
5-3
Introduction (cont)
The amount of a loan or investment before interest is added on (or a discount is taken off) is called the face value The actual interest (or return) expressed as a percentage of the price paid is called the yield. The actual rate of interest charged by lending institutions depends on many factors, including current and expected inflation rates, competition between financial institutions, the size of Australias budget deficit the amount of the principal
5-4
Introduction (cont)
The effect of inflation on the level of interest rates
According to monetary theory, price levels in general will rise if the money supply grows more quickly than the total output of the economy. Inflation may be defined as persistent increase in the general level of prices and is normally accompanied by high interest rates Those who borrow money are able to pay the higher interest rate if inflation enables them to raise their selling price to pay for it. In this way, borrowers themselves are helping to create an inflationary spiral in which inflation and interest rates continually push each other higher.
5-5
Introduction (cont)
One of the factors affecting mortgage rates of interest is the cost of goods and services. That is, inflation is going to reduce the value of the money and mortgage rates will rise Many factors affect interest rates, including high unemployment rates overseas interest rates, balance of payments figures, deregulation of the financial system, the amount held in deposits and especially government policy
5-6
5.2 Calculation of simple interest

Simple interest, is the interest calculated, based on the original principal during the entire period at the stated rate of interest.
Given P = principal R = rate of interest T = time (in years) I = total simple interest S = amount or maturity value of the principal
Simple interest:
I PR T
5-7
Calculation of simple interest (cont)

The maturity value of the principal is:
S P1 RT
What amount of principal will give a certain maturity value.
S P 1 RT
When P is calculated from S, the value of P is called the present value of S or the discounted value of S.
5-8

Example
Calculate the simple interest earned on $15 000 deposited at a rate of 1.5% per annum for a period of 4 years and 3 months
Solution
Here So T 4.25 I PR T $1500 0.015 4.25 $956.25
Hence, the total simple interest earned is $956.25.
5-9

Example
A bank customer invests $5000 for 18 months at a simple interest rate of 9.5% per annum. Find the maturity value of the principal
Solution
P= $5000, R = 0.095 and T = 1.5
S P1 RT $50001 0.095 1.5 $50001.1425 $5712.50

Hence, the maturity value of the principal is $5712.50
5-10

Example
An investor wishes to have an amount of $4000 on maturity in 5 years time. A simple interest rate of 12.0% per annum is offered. How much money should be invested now in order to achieve this aim?
Solution
S= $4000, R = 0.12 and T = 5 S P 1 RT $4000 1 0.12 5 $2500
Hence, the investor should invest $2500 now in order to have $4000 at the end of 5 years.
5-11

Minimum Monthly Balance
Many financial institutions in Australia pay simple interest based on the minimum monthly balance in an account each month. That is, if a sum of money is deposited and withdrawn during the same month, it will not attract any interest. Use
I P R T
Where P = minimum monthly balance R = rate
1 12
5-12

Example
A customer opens a savings account on 15 October 2009 with a sum of $1000. The bank pays simple interest on the account at a rate of 2.5% per annum based on the minimum monthly balance. Calculate the interest due for November
Solution
I PRT $1000 0.025 $2.08
Hence the interest due for November is $2.08
1 12
5-13
5.3 Effective rate of interest

This is an interest rate that is always based on the original principal, even though the amount of the loan is reducing. For every flat rate of interest their will be an equivalent effective rate. Its approximate value is given by:
2N R E N 1
Where: E = effective rate R = flat rate N = number of repayments
5-14
Effective rate of interest (cont)

Example
A customer takes out a $15 000 personal loan from the bank to be repaid monthly over 5 years. The bank has quoted a flat rate of interest of 9.5%. Calculate the equivalent effective rate of interest
Solution
N 5 12 60, R 0.095
E 2N R N1 2 60 0.095 60 1 0.1869
Hence, the effective rate of interest is 18.69%.

5-15

To find the flat rate of interest that is equivalent to a given effective rate
N 1 E R
2N
Where: E = effective rate R = flat rate N = number of repayments
5-16

Example
A credit union is offering home equity loans to be repaid over 20 years with monthly repayments and an effective rate of interest of 11.5%. Calculate the equivalent flat rate of interest
Solution
N 20 12 240, E 0.115
R
N 1 E
2N 240 1 0.115 2 240 0.05774
Hence, the equivalent flat rate of interest is 5.774%.
5-17
Summary
We looked at understanding the effect of inflation on interest rate levels
We perform calculations involving simple interest

Also looked at how to manipulate the simple interest formula Looked at the difference between, and calculate, flat and effective rates of interest
Lastly estimated the effective rate of interest
5-18

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Chapter 05

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Introductory Mathematics & Statistics for Business

Estimate the effective rate of interest

5.2 Calculation of simple interest

Calculation of simple interest (cont)

Calculation of simple interest (cont)

Calculation of simple interest (cont)

S P1 RT $50001 0.095 1.5 $50001.1425 $5712.50

Calculation of simple interest (cont)

Calculation of simple interest (cont)

Where P = minimum monthly balance R = rate

Calculation of simple interest (cont)

5.3 Effective rate of interest

Effective rate of interest (cont)

Hence, the effective rate of interest is 18.69%.

Effective rate of interest (cont)

Effective rate of interest (cont)

2N 240 1 0.115 2 240 0.05774

Hence, the equivalent flat rate of interest is 5.774%.

We perform calculations involving simple interest

Lastly estimated the effective rate of interest

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