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Business Finance Week 7 Basic Long-Term Financial Concepts

AJ Santos took out a 150,000 peso loan from a bank at 10% interest over 5 years to purchase new equipment. There are two types of interest rates - simple interest and compound interest. Using simple interest, AJ would pay a total of 45,000 pesos in interest and 195,000 pesos total. However, banks typically use compound interest which calculates interest on previous interest amounts too, resulting in a higher total payment. The document explains how to calculate loan balances and payments under compound interest using formulas.

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Jessa Gallardo
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345 views

Business Finance Week 7 Basic Long-Term Financial Concepts

AJ Santos took out a 150,000 peso loan from a bank at 10% interest over 5 years to purchase new equipment. There are two types of interest rates - simple interest and compound interest. Using simple interest, AJ would pay a total of 45,000 pesos in interest and 195,000 pesos total. However, banks typically use compound interest which calculates interest on previous interest amounts too, resulting in a higher total payment. The document explains how to calculate loan balances and payments under compound interest using formulas.

Uploaded by

Jessa Gallardo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Basic Long-Term

Financial Concepts
Opening Case
AJ Santos is a small business owner that wanted to
purchase a new piece of equipment to be used in
operations. The new equipment would cost him
150,000 pesos, an amount which would require him to
obtain external financing from a bank payable in five
years. Upon applying for a loan, he notices that the
bank is charging an interest of 10%. He now wonders
why the bank is charging interest. He also wonders if
there are different types of interest rates. AJ then
computed his interest for the entire five years to be
15,000.
Question:

1. Is AJ correct in computing the interest?


2. How much should AJ pay in total and would the
equipment be worth the payment?
Simple Interest Rates Versus
Compound Interest Rates
 The banker explained that there are two types of
interest that would be used to determine the
amount of interest that you are going to pay. The
first type of interest is called the simple interest
rate while the second is called the compound
interest rate.
Simple Interest Rates
 Assuming the bank would charge simple interest on
the loan, we need to pay exactly 10% for every year
that the loan is outstanding. The interest can be
computed by using the formula below:
I=PxRxT
Where:
I = interest
P= principal
R= interest rate
T = time
If the term of the loan is three years, the total interest to
be paid over the term of the loan would be computed by
this:

The banker explains that using simple interest rates,


you would have to pay total interest of 45,000 pesos
together with the principal of 150,000 pesos for a total
maturity value of 195,000 pesos.
Compound Interest Rates
 However, most banks do not charge a simple interest
rate. The reason is because it would then become
more profitable for the bank to loan the 150,000
pesos to you every year and then the loan the
interest received at the end of one year of 15,000 to
another person. By not receiving immediately the
15,000 pesos interest each year, the bank would then
have an opportunity cost with regard the interest.
To illustrate the concept, consider the
following:
Year Unpaid Balance, Interest for the Unpaid Balance,
Beginning year Ending
0 (start of loan) 150,000
1 150,000 150,000 x 10% 165,000
=15,000
2 165,000 165,000 x 10% 181,500
=16,500
3 (end od loan) 181,500 181,500 x 10% 199,650
=18,150
However, can you imagine yourself doing the
table provided above for 50 years?
 Inorder to compute the total amount payable
quickly, we may use the formula below:

FV = P x (1 + r) T
Where:
FV = future value of the loan (unpaid balance at the
end)
P = principal
r = interest rate for one time period
T = number of time periods
 Let’s apply the formula to our example, shall we?

The principal of the loan is 150,000 pesos with an


interest rate of 10% and a term or time of 3 years, we
compute the future value as follows:
PEMDAS
FV = 150,000 x (1 + 0.10)3
FV = 150,000 X 1.331
FV = 199,650
 We can also easily compute the unpaid balance at the
end of year 2 by using the same formula like this :

150,000 x (1 + 0.10)2 = 181,500

Now, you can easily compute for the total amount


payable for a 50-year loan of 150,000 pesos at an
annual rate of 10%.
Using the same example of a principal of 150,000
pesos; interest rate of 10% and term of three years, let
us compute for the future value of the loan by
applying the formula as shown below:

FV = P x (1 + r)r
FV = 150,000 x (1+0.10/4)3x4
FV = 150,000 x 1.3449 (rounded)
FV = 201,735 (rounded)
Notice that even with the same interest rate, the future
value of the loan increased from 199,650 to 201,735 if
we choose to have a rate that is compounded quarterly.
As such, the 12% compounded annually cannot be
easily compared to a 12% loan compounded quarterly.
 In order to be able to compare interest rates that are
compounded differently, we need to compute the
effective annual interest rate (EAR) of the loan:

EAR = (1 + r/m)m - 1

Where:
EAR = effective annual interest rate
m = number of times compounded quarterly.
 Applying the formula above, let us solve the EAR of
our previous example where the interest rate of 12%
is compounded quarterly.

EAR = (1 + 0.10/4)4 – 1
EAR = 10.38% (rounded)

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