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DSC1630_When to use which Formulas

The document provides guidelines for identifying and applying various financial formulas, including simple interest, compound interest, annuities, and present value calculations. Each section outlines specific conditions under which each formula should be used, along with the corresponding equations. It emphasizes the importance of understanding the context of the question to select the appropriate formula.

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maruvaashet
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
0 views

DSC1630_When to use which Formulas

The document provides guidelines for identifying and applying various financial formulas, including simple interest, compound interest, annuities, and present value calculations. Each section outlines specific conditions under which each formula should be used, along with the corresponding equations. It emphasizes the importance of understanding the context of the question to select the appropriate formula.

Uploaded by

maruvaashet
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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1 WHEN TO USE WHICH FORMULA

Below are guidelines with regard to the identification and application of formulae (i.e. when to use
which formula).

1.1 Simple Interest


You go to the bank once and the calculation is done at the end of the investment time.
The words “simple interest” must be mentioned in the question.

I = P rt
Use this formula when you want to determine the interest received/paid.

S = P (1 + rt)
Use this formula when the accumulated amount is mentioned in the question.

1.2 Simple Discount


The words “simple discount” or “discount rate” must be mentioned in the question.
P = S (1 − dt)
The relationship between simple interest and simple discount is given as:
d r
r= or d=
1 − dt 1 + rt

1.3 Compound Interest


You go to the bank once (one principle) and the calculations are done according to the number of
compounding periods. The word “compounded” must be mentioned in the question.
( )tm
jm
S =P 1+ or S = P (1 + i)n
m
jm
m
or i is the nominal interest rate per year divided by the number of compounding periods per
year.
tm = n where t is the total time expressed as years or a fraction of a year and m the
number of compounding periods in one year.

1.4 Effective Rate


Refers to the rate that you will, in effect, receive/pay in one year. Effective interest rate will be
mentioned in the question. (( )m )
jm
Jef f = 100 1+ −1
m

1
Open Rubric
1.5 Continuous Compounding
When the rate at which compounding takes place tends to be infinity, the calculations of the interest
are continuous.
( )
jm
c = m ln 1 +
m
This formula is used when a nominal interest rate with m compounded periods per year is converted
to a continuous compounding rate.

S = P ect
This formula is used when either the principal (present value) and/or the accumulated amount
(future value) are given and the interest rate is continuous.

J∞ = 100 (ec − 1)
This formula is used when the continuous rate is converted to an effective rate.
NB! Remember when a c is in the formula continuous compounding is applicable.

1.6 Convert Interest Rates

(( )m÷n )
jm
jn = n 1+ −1
m
This formula is used when you want to convert a given nominal interest rate jm compounded m
periods per year to n compounding periods per year and still get the same return.

1.7 Annuities
You go to the bank with equal amounts (payments or deposits) of money at the same time
intervals. The applicable interest rate is compounded. Remember the compound interest rate
periods must be the same as the payment periods.

1.8 Present Value

P = Ra[ n i ]
n
−1
= R (1+i)
i(1+i)n

You use this formula when the balance in the account, at the end of the time, is zero or you are
asked to calculate the present value or it is given.

2
1.9 Future Value

S = Rs[n i ]
n
= R (1+i)i −1
You use this formula when, at the end of the time, there is a balance in the account or you are
asked to calculate the future value or it is given.

1.10 Annuity Due


Payments are made at the beginning of the periods.
P = (1 + i) Ra n i
S = (1 + i) Rs n i
Use this formula when the words “begin, start immediately or in advance” are mentioned
in the sentence. Multiply the formulae with (1 + i) and use n in the formulae as the number of
payments made.

1.11 Increasing Annuity

( )
Q nQ
S = R+ sn i −
i i
The original payment R is increased yearly with the same amount Q.
n (n − 1)
A = nR + Q
2
The formula represents the actual amount paid for an increasing annuity where n is the number of
payments made.

1.12 Perpetuity

R
P =
i
You will receive the payment R indefinitely.

1.13 Deferred Annuity


With a deferred annuity, you are unable to start to repay your debt immediately. Your first
payment is a number of payment intervals after the end of the first interest period.
First calculate the present value of the payments made and then discount this amount back to
now by using compound interest. Do not confuse the word “discount” with “simple discount rate”.
“Discount back” is just another term for “moving back”. A deferred annuity can also apply in a
future value annuity situation.
3
1.14 Amortisation
Use the present value formula for annuities and determine the payment.
P = Ra[ n i ]
n
−1
= R (1+i)
i(1+i)n

P
R = (1+i)n −1
[ i(1+i)n ]

1.15 Sinking Fund


Use the future value formula for annuities and determine the payment.
S = Rs[n i ]
n
= R (1+i)i −1
R = (1+i)Sn −1
[ i ]

1.16 Stocks

P = da n z + 100 (1 + z)−n
d is the half yearly coupon payments, z the half yearly interest rate and n the number of outstanding
coupons.

1.17 Net Present Value

N P V = P Vin − Iout

1.18 Profitability Index

Present value of cash inflows


PI =
Present value of cash outflows
OR
NPV + Outlays (initial investment)
PI =
Outlays (initial investment)

1.19 Handling Of The Data


Use your calculator to do the calculations.
NB: Please read your questions in the examination attentively before answering them.
I hope these guidelines will help you to better understand the application of the formulae (i.e. when
to use which formula).

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