Theory of interest – Week 1

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Example: Single investments. Semester content:

Notes: PV and FV cannot both be positive/negative, they always must have - Simple interest – solve mathematically – 2%
different signs to determine if it is money in/out. - Compound interest – solve on calculator – 90%
- Discount (d) – solve mathematically – 5%
- Taking money out of account (-) & putting/getting money in the account
- Force of interest - solve mathematically – 3%
(˖).
- Use i = 10 (I/YR) on calculator for 10% interest annually.

Notation for equations:

1.) 0 years 10 years (i= 10% annual) K – Capital amount (PV).
-PV ˖FV
S – Accumulated amount (FV).
15 000 ?
i – Effective interest.
Calculator steps: calculate FV
15 000 +/- PV 10 I/YR 10 N FV i(m) - Nominal interest per year (I/YN).

m – How many times per year will you earn interest (P/YR).

Example: Repaying a loan. n – How many years.

2.) PV FV N – How many interest periods (N = n x m).

3 000 000 -payment -payment -payment 0
Interest: 7% annual & monthly payments to repay entire loan in 10 years time.
Simple interest formula:
What are the monthly payments R...?
S = K + (K∙i)∙n
Note:” i” and “n” must be in the same “period” so
Calculator steps: calculate PMT either both in years or months.
3 000 000 PV 0 FV 120 N 7 I/YR 12 P/YR
Compound interest formula:
Press PMT for answer.
𝒎×𝒏
Remember to “clear all” your calculator after each calculation. ⅈ(𝒎)
S = K (𝟏 + )
𝒎
 PAGE 1
WEEK 2 – More calculations using PV and FV
Example: Interest = End amount – Beginning amount
What if we have FV and need PV?
-Calculate the amount of interest I’ll have at the 5th year, if I invest R5000 at 12%
-We use the “V” notation. compounded half-yearly for 7 years.

K= 𝒔𝒗𝒎×𝒏
ⅈ(𝒎)
Method: (End of year 5 interest) – (Beginning of year 5 interest (year 4 end))

𝒎
0.12 2×5 0.12 2×4
= (5000 (1 + ) ) - (5000 (1 + ) )
2 2
Tips:
[ M] to store to memory and [RM] to recall the value (Store first answer on memory to
-Word problem uses “interest” = Compound interest recall it when you have the second answer).
Value in front of a bracket “x” (1+...) = PV Calculator steps:
Value in front of a “V” = FV 5000 + /- PV 0 PMT 12 I/YR 2 P/YR (same for both equations)
For end of year 5: 5 xP/YR FV
For end of year 4: 4 xP/YR FV

i – Simple interest
Example: Interest rate changes during term
i (m)
– Compound interest 12000 1. 2 ?
..
“m” = how many times you will get interest
i = 9% 6y i(2) = 10%
e.g. m = 4 = quarterly interest.
11 years in total, for the first 6 years = 9% anually and 5 years at 10% compounded half-
yearly. PV = R12000.
0.09 1×6 0.10 2×5
= (12000 (1 + ) ) - (1 + )
1 2

Insert info of equation 1 equation 2

1. Find FV equation 1, then press + /- to get calculator out of financial mode then…
2. Press PV, to save the FV as the PV for the second part of the calculation.
3. Enter equation 2 info and get the FV, which will be the final answer.
 PAGE 2

Example: Adding/Withdrawals from account: Example: Interest rate changes during term (backwards)
How much did you withdraw/add if you have the ? 2. 1. 8000
beginning and end amount?
i = 11% 2y i(2) = 14%
A D
What is the initial investment if you have R8000 after 5 years?
B C
Step 1: Start with R8000 as FV and 1. info in calculator.
Step 1: Work out A – B (PV = A, FV = B)
Step 2: Press + /- to get calculator out of financial mode then press FV, to save the new FV
Step 2: Work out C – D (PV= C, FV = D) value for part 2.
Step 3: C – B = Withdrawl/added amount Step 3: Enter info 2. into calculator and change interest rate to find PV.

Example: Adding/Withdrawals from account:

15000 ? i(2) = 14%

3.5 years Withdraw R5000 4.5 years Example: Numerous payments over time – Cash price
2000 4000 7000

0.15 2×3.9 0⋅15 2×4⋅5 You bought an item for which you paid R2000 on the day and then 2
= (15000 (1 + ) − 5000) x (1 + )
2 2 years later R4000 and a further R5000 after 5 years. Find the cash price
of the item if the interest rate = 16% compounded.
Step 1: Start with 15000 PV and find FV for the 3.5 years.
Calculator steps: 1.) 4000 FV 0 PMT 16 I/YR 1 P/YR 2 N
Step 2: Minus 5000 and that answer is your new PV for part 2 for the equation.
(save 1st PV to memory)
2.) 7000 FV 5 N and find 2nd PV.
3.) Add 1st PV + 2nd PV + 2000 = ANS
 Section 2: Nominal & Effective rates
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Nominal interest rate: Cannot be used as is in calculations. A way interest
rate is quoted in transactions. If nominal rate is 10% and you start with R100, i – Effective interest p/year.
you will not earn R10 interest, and you will not have R110 in the future. It will
be around R10, but it may be more, or it may be less, depending on m’s value. i(m) - Nominal interest p/year, compounded m times (I/YR).

Effective interest rate: Can be used as is in calculations. If effective rate is ⅈ (𝑚)

- Effective interest p/period.
10% and you start with R100, you will earn R10 interest in that period, i.e. 𝑚

have R110 in the future.

How to change between interest rates: nominal to nominal

i(2) = 10% - Can’t use Monthly interest to quarterly interest (m=12 to k=4) @ 14% interest.

0.1 Calculator steps:

(1 + 2
) - Can use [ 0.1 = I/YR & 2 = P/YR]
1.) 14 shift NOM% 12 shift P/YR shift EFF%
2.) 4 shift P/YR shift NOM%
Effective to Nominal interest: vice versa
Example: Find the (a.) effective quarterly rate of interest as well as the
e.g. i = 0.15 to i(2) = ?
(b.) i(4) p.u.p.a that corresponds to an effective rate of interest of 9%
Calculator steps: per six months.

1.) 2 shift P/YR 15 shift EFF% shift NOM% 18 NOM% 2 P/YR EFF% then, 4 P/YR NOM% (a.)
divide by 4 (b.)

Example: You bought an item for R30,000 and sold it two years later for R38 500. Find the following respective rates
of interest that he earned with this investment.
a. Effective annual rate of interest.
b. Effective rate of interest per six months.
c. Nominal annual rates of interest compounded 2 times per year.
d. i(4) p.u.p.a

Calculator steps: a.) 30000 +/- PV 0 PMT 38500 FV 2 N 1 P/YR I/YR

b.) 30000 +/- PV 0 PMT 38500 FV 4 N 2 P/YR I/YR devide by 2 =
c.) 30000 +/- PV 0 PMT 38500 FV 4 N 2 P/YR I/YR
d.) 30000 +/- PV 0 PMT 38500 FV 8 N 4 P/YR I/YR
 WEEK 3: Continuous compounding (small section in test).
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Continuous compounding / force of interest: When interest is compounded continuously: Change from force of interests to normal
m = 1, m = 2, m = 3, m = … 𝑺 = 𝑲ⅇ𝒓×𝒏 compound interest rate:
𝒎
ⅈ(∞) = r (force of interest) 𝒓 ⅈ(𝒎)
ⅇ = (𝟏 + )
𝒎

Example: Interest is compounded continuously at a force of 8% p.a. Find the Example: Find the future value of R 2500 after 1 year (360
corresponding effective annual rate of interest (1.) as well as the corresponding days) if the interest is:
annual rate of interest compounded 4 times per year (2).
a.) 18% p.a. compounded daily.
(1.) Step 1: Take r = 0.08 to i b.) 18% p.a. compounded continuously.
Step 2: Calculator 0.08 shift ex = 1,0833
Step 3: (1 + i) = 1,0833 0.18 360
a.) 𝑆 = 2500 (1 + )
i=0,0833 360

(2.) Calculator steps: b.) 𝑆 = 25000.18

𝑒
8.33 EFF% 4 P/YR NOM%

Example: Investments/stocks = Find r

Example: Calculate the force of interest (r) that correspond to: *use Casio calculator
An investor buys a stock for R356 and 1 year later he
(a.) An annual effective rate of interest of 0.12 p.u.p.a.
sells the stock for R405. What was the annual interest
Important: In = loge and Ine = 1 rate he earned?

0.12 1
405 = 356ⅇ 𝑟×1
(a.) 𝑙𝑜𝑔[ⅇr ] = [(1 + ) ]𝑙𝑜𝑔
1 405
In [ⅇ ] = In [1.12]
r 𝑙𝑛[ⅇ 𝑟 ] = 𝑙𝑛 [ ]
356
r = 1.12 𝑟 = 0.13
 Section 2: Equivalent amounts (Borrow = Pay)
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Move money forward in time/ adding interest: PV – FV

Example: Borrowed & Pay
𝑚×𝑛
ⅈ (𝑚) 0y 14 years
(1 + )
𝑚
50000 25000 (1/2 y) 70000 (2y) ¼ X 10000 (7y) X X
Move money backwards / taking interest away: FV – PV
ⅈ(4) = 0.09 5 years ⅈ(3) = 0.085
𝑣ⅈ𝑚×𝑛
(𝑚)
𝑚
Tip: Move all the money to the interest rate change (5years).
Concept: 50000 + 70000 + 10000 = 25000 + ¼ X + X + X (excluding interest)
(Borrow = Pay)

4×5 4×3 4×4.5 4×1.5

ⅈ (0.09) ⅈ (0.09) 3×2 ⅈ (0.09) ⅈ (0.09) 3×5 3×9
50 000 (1 + ) + 70 000 (1 + ) + 10 000 𝑣0.085/3 = 25 000 (1 + ) + ¼ X (1 + ) + X 𝑣0.085/3 + X 𝑣0.085/3
4 4 4 4

Step 1: Write the equation in Borrowed = Pay terms as shown above.

Step 2: Separate sides where numbers and “X’s” are on separate sides of “=”, so that you can take out “X” and simplify.
Step 3: Enter the info into your calculator one by one. (“V” notation = find PV & normal notation = find FV)
Step 4: Solve X
 Week 4 – Interest paid in Advance: Discounting PAGE 1

2 ways it can be asked: Word problem or Discount rate is given.

Loan Amount: 𝑅10 000 (FV) (PV = Loan – Interest) (Interest rate of 10% 𝑝ⅇ𝑟 𝑦ⅇ𝑎𝑟)
Interest: 𝑅10 000 × 0.10=𝑅1000 (Time: 1 year)

Interest is usually paid at the end of the term; you get the loan at the beginning of the year and after one year you’ll pay 𝑅11000 (Loan plus interest) (𝐼𝑛𝑡
𝑖𝑠 𝑏𝑎𝑠ⅇ𝑑 𝑜𝑛 𝐾).

𝐾=𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 & 𝑆=𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡+𝐼𝑛𝑡ⅇ𝑟ⅇ𝑠𝑡

𝐾=𝑅10000 & 𝑆=𝑅10000+𝑅1000=𝑅11000

Some cases, interest is paid at the beginning of the term; as soon as you get the loan at the beginning of the year you immediately pay 𝑅1000, i.e. you
leave the bank with only 𝑅9000, and after one year you pay back the loan of 𝑅10000.
𝐾=𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡 −𝐼𝑛𝑡ⅇ𝑟ⅇ𝑠t & 𝑆=𝐿𝑜𝑎𝑛 𝐴𝑚𝑜𝑢𝑛𝑡
𝐾=𝑅10000−𝑅1000=𝑅9000 & 𝑆=𝑅10000

Interest Amount = Loan x Rate 𝐿𝑜𝑎𝑛 = 𝑅10000 𝑇𝑖𝑚ⅇ = 1 𝑦ⅇ𝑎𝑟 𝐼𝑛𝑡ⅇ𝑟ⅇ𝑠𝑡 𝑟𝑎𝑡ⅇ = 10%
Rate = Interest amount (divide by) Loan. “Normal” interest (interest paid in arrears): 𝐾 = 10000; 𝑚 = 1; 𝑁 = 1; 𝑖 = 0.10
𝑚×𝑛
ⅈ (𝑚)
𝑆 = 𝐾 (1 + )
𝑚

Discount (interest paid in advance): 𝑆 = 10000; 𝑚 = 1; 𝑁 = 1; 𝒅 = 0.10

𝑫 ≡ 𝐼𝑛𝑡ⅇ𝑟ⅇ𝑠𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑤ℎⅇ𝑛 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑎𝑑𝑣𝑎𝑛𝑐ⅇ
𝒅 𝑫 ⅈ(𝒎) 𝑫
= ; = 𝑲 ; 𝑫 = 𝑺 − 𝑲 → 𝐵𝑦 ℎ𝑎𝑛𝑑
𝒎 𝑺 𝒎
 PAGE 2

Example:
a.) Find the annual rate of discount which corresponds to an annual rate of interest of 15% p.a.
Changing interest rates when m = fraction:
b.) Find the annual rate of interest which corresponds to an annual rate of discount of 15%.
𝑚
ⅈ (𝑚)
c.) Find the effective annual rate of interest which corresponds to the rate of discount of 4% per quarter. (1 + 𝑖) = (1 + )
𝑚

𝐷
a.) 𝑑 = = 0,15/1,15 = 0.130
𝑆
𝐷
b.) 𝑖 = 𝐾 = 0.15/0.85 = 0.176
ⅈ (4)
c.) = 4/96 = 0.041 then, 4/96 x 4 =16.66 NOM% 4 P/YR EFF%
4

Example: B borrows R10 000 from A for three months at a prepaid rate of Example: A bill with a face value of R3 500 (= S) (FV) is discounted one
interest of 13%. Find the discount and the effective rate of interest at month prior to maturity at a bank which uses a discounting rate of 11%
which A earns interest per quarter and per annum. p.a. (a.) Find the discounted value of the bull and the discount. (b.) Find
the annual nominal as well as effective rates of interest for the bank in
S=10000, d=0.13, 3 months = 4 periods; m = 4
this transaction.
d D
= a.)S=3500, d=0.11, 1 months = m = 12
m S
0.13 D d D
= =
4 10000 m S

D = 325 thus, K = 9675 0.11 D

=
12 3500

D = 32.08 thus, discounted value = K = 3467.92

i(4) = D/K ⅈ (12)
b.) = 32.08/ 3467.92
12
i(4) = (325/9675) x 4 x 100 (NOM%) 4 P/YR Eff%
i(12) = 32.08/ 3467.92 x 12 NOM% 12 P/YR EFF%
 Week 5 - Annuities PAGE 1

Example: Payments are all the same amount, 8 years with 8 payments. Simple annuities – Annuities where the payment periods
are the same as the interest periods. P/YR = m
0 1 2 3 4 5 6 7 8
Ordinary Annuity (Annuity in Arrears – 𝑠, 𝑎 )
-Payment at the end of each period
Step 1: Move all amounts to point 8, like in Week 3, page 2.
Annuity-due (Annuity in Advance – 𝑠̈ , 𝑎̈ ) (Beg)
PMT = Recurring payment (P).
-Payment at beginning of period
P/YR = NEW!! = Number payments in a year = m
Deferred Annuity
- If i(4) with payments each month, CAN NOT WORK!
-First payment is a few months later.
Must change i(4 ) to i(12) with EFF% and NOM% on Hp calculator
Perpetuity
-Annuity that never ends.

Looking for FV:

S = P(1 + i)7 + P(1 + i)6 + P(1 + i)5 + P(1 + i)4 + P(1 + i)3 + P(1 + i)2 + P(1 + i)1 + P Annuity-due (Annuity in Advance – 𝑠̈ , 𝑎̈ )

S = PsN|
̅̅̅i Looking for FV:

S = Ps i (m) 𝑆 = 𝑃𝑠̈ ̅̅̅

𝑁|𝑖
̅̅̅
N|
m

Looking for PV:

𝑆 = 𝑃𝑠̈ (𝑚)
𝑖
̅̅̅
𝑁|
𝑚

K= Pvi1 + Pvi2 + Pvi3 + Pvi4 + Pvi5 + Pvi6 + Pvi7 + Pvi8 Looking for PV:
K = Pa̅̅̅
N|i 𝐾 = 𝑃𝑎̈ 𝑁|
̅̅̅𝑖
K = Pa (m)
̅̅̅i
N| 𝐾 = 𝑃𝑎̈ ̅̅̅𝑖(𝑚)
m
𝑁| 𝑚
Deferred Annuity -First payment is a few months later. Week 6- Continue Annuities PAGE 2

0 8 Example: You invest R1500 at the end of each month in a savings account
Start payments at 4 months earning interest at a rate of 15% p.a. compounded monthly. How much will be
in the account at the end of the 5th year?
𝑆 = 𝑃𝑠5|
̅𝑖
FV = 1500 s ̅̅̅̅̅̅̅̅̅
5 x 12|
0.15
12
𝟑
𝐾 = (𝑃𝑎5|
̅ 𝑖 )𝒗𝒊
Calculator steps: 0 PV 1500 +/- PMT 15 I/YR 12 P/YR 60 N FV
or
𝟒
𝐾 = (𝑃𝑎̈ 5|
̅ 𝑖 ) 𝒗𝒊

(can also look at this problem like an annuity in advance) 𝑎 = PV at period 0

𝑎̈ = PV at period 1 (1st payment)

PV PV FV FV
 PAGE 3

Example: When interest rates change

For a period of eight years, you paid at the end of the month R900 into a bank account. Initially the rate of interest was 15% p.a. compounded monthly
but since the beginning of the fourth year the rate was increased to 18% p.a. compounded monthly find the accumulated amount in your account at the
end of the 8th year.
0 1 2 3 4 5 6 7 8

PV i(12) = 0.15 900 s ̅̅̅̅̅̅̅̅̅

3 x 12|
0.15 FV PV i(12) = 0.18 900 s ̅̅̅̅̅̅̅̅̅
5 x 12|
0.18 FV
12 12

Calculator steps:
0 PV 900 +/- PMT 15 I/YR 12 P/YR 36 N FV
Then save the FV as PV: +/- PV 18 I/YR 12 P/YR 60 N FV

Example: Repaying a loan

Repay a R50 000 loan at 14% p.a. for 10 years. Deposit X amount at the end of every six months in a savings account that earns 30% interest
compounded half yearly. Find X so that the accumulated amount in the savings account will be just enough to repay the loan plus interest at the end of
the 10th year.
1. Amount due at the end of 10th year = 50000 ( 1 + 0,14) 10 = R 185 361,07
Calculator: 50000 +/- PV 0 PMT 14 I/YR 1 P/YR 10 N FV
2. Find X: 20 N 0 PV 13 I/YR 2 P/YR PMT

Example: Change in types of payments – Quarterly to Annual.

3 N changes to 12 N
 PAGE 4

Example: The future value of an annuity due.

You withdraw at the beginning of each year R2500 from a fund with an initial value of R15 000 which earns interest at an effective
rate of 15% p.a. What balance will be left in the fund at the end of the 8th year?

Calculator steps: 15 000 +/- PV shift BEG/END 2500 PMT (withdrawals = opposite sign of PV) 15 I/YR
1 P/YR 8 N FV

Week 7 – Everlasting Annuity / Perpetuity

𝑷 𝑖 (𝑚)
𝐾 = (𝑃𝑎̅̅̅̅𝑖(𝑚) )→→→ 𝑲 = 𝒊(𝒎) 𝑃=𝐾 *Payment = Interest earned
𝑚
∞| 𝑚
𝒎 Example: 2.)

𝑷 𝑖 (𝑚) Donation: K = 2500 + 2500/(0.16/12) = R190 000

𝐾 = (𝑃𝑎̈ 𝑖(𝑚) )→→→ 𝑲 = 𝑷 + 𝒊(𝒎) 𝑃 = (𝐾 − 𝑃) *Perpetuity in advance
̅̅̅̅
∞| 𝑚
𝑚 𝒎 *Remeber the time priod of “P” and “m” has to be the same!!
*Remember there is no FV

Example: 1.) How much can be paid for a capital asset which will generate a yearly income of R130 000 at the end of each year if money is
worth 15% p.a.?
K = 130 000/0.15 = R86 6666.67

2.) How much should a person donate towards a charity fund so that the fund can contribute R2 500 each month to welfare with the 1st
R2500 immediately? The fund will earn interest at a rate of 16% p.a. compounded monthly.
 Week 8 – Complex Annuities PAGE 1
Steps:

1) Get the payment period (𝑃/𝑌𝑅), i.e., how many payments will be made in a year.
2) Get the interests period (𝑚), i.e., how many times in a year will interest be
compounded/added.

3) If 𝑃/𝑌𝑅 ≠ 𝑚 → change 𝑚 (𝑢𝑠𝑖𝑛𝑔 𝑁𝑂𝑀%, 𝐸𝐹𝐹%, 𝑃/𝑌𝑅)

4) Continue, as in the previous sections, with the “new” interest rate.

Example: An amount of R5000 is deposited at the end of each year for a term of 8 years in a savings account that earns interest at a rate of 16% p.a.
compounded 4 times per year. Find the future value and present value of this annuity.

Step 1: 𝑃/𝑌𝑅 ≠ 𝑚
16 NOM% 4 P/YR EFF% = i = 16, 985 856%
Step 2: 16, 985 856% I/YR 1 P/YR 5000 +/- PMT 8 N 0 PV FV
Step 3: 0 FV PV = R21 045,22

Example: At the beginning of the first year a parent wants to deposit enough money in his savings account that earns interest at a rate of 15% p.a.
compounded monthly with which he can pay for his child’s studies. If the child will study for 4 years and R4000 will be needed in the beginning of
every 3 months how much should it deposit in the beginning?
1. 15 NOM% 12 P/YR EFF%
2. 4 P/YR NOM% = 15.18828…
3. 4000 PMT 4 shift xP/YR 15 I/YR 0 FV shift BEG/END PV

Example: A capital asset which generates an income of R50 000 at the end of each half year is bought. Find the present value of this asset if
the rate of interest is a.) 50% per annum compounded annually and b.) 15% per annum compounded quarterly.
𝑖 (2)
a.) 15 EFF% 2 P/YR NOM% = 14.476105% (can’t use), but 0.144… (can use) THEN, K(PV) = 50000 / = R690 793.51
2
(2)
b.) 15 NOM% 4 P/YR EFF% = 15,865 = i 2 P/YR NOM% =15,28125 = 𝑖
𝑖 (2)
THEN, K(PV) = 50000 / = R654 396,73
2