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Simple and Compound Interest: Simple Interest: Petroleum Economics Tutorial

1. Simple interest is calculated on the principal only, while compound interest is calculated on both the principal and previously earned interest over time. 2. The present value of a future payment is calculated using the present worth factor, which discounts the payment to its value today using a specified interest rate. 3. The future value of a present payment is the reciprocal of the present value calculation and adds interest to the payment over time using the compound amount factor.

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113 views6 pages

Simple and Compound Interest: Simple Interest: Petroleum Economics Tutorial

1. Simple interest is calculated on the principal only, while compound interest is calculated on both the principal and previously earned interest over time. 2. The present value of a future payment is calculated using the present worth factor, which discounts the payment to its value today using a specified interest rate. 3. The future value of a present payment is the reciprocal of the present value calculation and adds interest to the payment over time using the compound amount factor.

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عفيف جبران البراشي
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Download as PDF, TXT or read online on Scribd
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‫بسم هللا الرحمن الرحيم‬

‫جامعة السودان للعلوم والتكنولوجيا‬


‫هندسة النفط والتعدين‬

Petroleum Economics
Tutorial (2)

Simple and compound interest:


Simple interest is calculated using principal only,
which earns interest over a fixed period (loan period).

Interest = (Principal) × (Number of Periods)


× (Interest Rate per Period, fraction)
Example (1):
Suppose $2,000 is borrowed at a simple interest rate of
8% per year.
Calculate (a) the principal plus interest at the end of one
year, and (b) principal and interest if the loan has to be
repaid after 90 days.
Solution:
(a) Interest = (2,000) × (1) × (0.08) = $160
[Principal + Interest] = $2,000 + $160 = $2,160 =
($2,000) × (1 + 0.08) = $2,160
(b) Principal plus interest at the end of 90 days will be
90
Principal + Interest = 2000* ( 1+ * 0.08) =2040 $
360

Compound interest is the interest accrued on both


the principal and the unpaid interest earned in the
previous periods.
𝑖
Interest = [(1 + 𝑛 )𝑡𝑚 − 1] ∗ 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝑚
𝑖
Interest+ principal = (1 + 𝑛 )𝑡𝑚 ∗ 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝑚
𝑖𝑛 =the nominal interest rate, fraction per year
m = compounding or interest periods per year (Where m =
1 for yearly compounding, m = 2 for semiannual
compounding, m = 4 for quarterly compounding, m = 12
for monthly compounding, and so on.)
t = the loan period or investment period, years
Example (2):
Suppose that $2,000 is borrowed for one year at an
interest rate of 8%. Calculate the interest at the end of the
year if the interest is compounded (a) yearly and (b)
quarterly. (c) What will be the interest at the end of three
years if the interest is compounded semi-annually?
Solution:

(a) If the interest is compounded yearly


𝑖
Interest = [(1 + 𝑛 )𝑡𝑚 − 1] ∗ 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝑚
0.08 1∗1
Interest = [(1 + ) − 1] ∗ 2000 = 160 $
1
The resulting interest is the same as that obtained in
example 1.
(b) If the interest is compounded quarterly
0.08 1∗4
Interest = [(1 + ) − 1] ∗ 2000 = 164.86 $
4

The same interest can be calculated without using


equation (2.2) as follows:
0.08
First quarter’s interest = ∗ 2000 = 40 $
4

Principal at the end of first quarter is, therefore, $2,000 +


$40 = $2,040.
0.08
Second quarter’s interest == ∗ 2040 = 40.8 $
4

Principal at the end of second quarter amounts to $2,000


+ $40 + $40.80 = $2,080.80.
0.08
Third quarter’s interest = = ∗ 2080.80 = 41.62 $
4
Similarly, the interest for the fourth quarter amounts to
$42.45. Thus, the total interest at the end of the year (for
four quarters) sums to
$164.87 = $40.00 + $40.80 + $41.62 + $42.45
the interest after three years (with semiannual
compounding) will be
0.08 3∗2
Interest = [(1 + ) − 1] ∗ 2000 = 530.64 $
2

Present value of future sum


The present value of a single sum of money, received at
some future point in time, is calculated using the
following equation:
1
𝑃𝑉 = 𝐹𝑉 [ ]
(1 + 𝑖𝑒 )𝑡
𝑃𝑉 = present value (at time zero) of future sum
𝐹𝑉 = future sum received at time t
𝑖𝑒 = effective interest rate (discount rate, fraction)
The present value of periodic cash flows is calculated
with equation
1
the term [( 𝑡 ] is referred to as the present worth
(1+𝑖𝑒 )
factor, P/F.
Example (3):
Suppose a landowner receives annual royalty payments
of $2,000, $2,200, $1,900, $2,500, and $1,500 over the
next five years. Calculate the present worth of these
payments at an interest (discount) rate of 8%.
Solution:
𝑛
1
𝑃𝑉 = ∑ 𝐹𝑉 [ ]
(1 + 𝑖𝑒 )𝑡
𝑡=1
1 1
𝑃𝑉 = 2000[ 1 ] + 2200[ ]+
(1+ 0.08) (1+ 0.08)2
1 1 1
1900[ 3 ] +2500[ 4 ] +1500[ ]
(1+ 0.08) (1+ 0.08) (1+ 0.08)5

= $1,851.85 + $1,886.15 + $1,508.28 + $1,837.57 +


$1,020.87 = $8,104.72

Example (4):
Calculate the present value of $5,000 received at the end
of the sixth year (example 3) if the interest rate is 8% per
year compounded quarterly
(i.e., m = 4).
Solution: In this example, t = 6, in = 0.08, and m = 4.
Therefore
𝑖 0.08
i= 𝑛= = 0.02
𝑚 4
t = t*m =6*4 =24
the present value is
1
𝑃𝑉 = 𝐹𝑉 [ ]
𝑖𝑛 𝑡𝑚
(1 + )
𝑚
1
𝑃𝑉 = 5000 [ 6∗4 ] = 3108.61$
0.08
(1 + 4 )
Future value of present sum
the future value of a present sum is a reciprocal of the
present value of future sum. Here, interest is added to the
cash flows

𝐹𝑉 = 𝑃𝑉 [ (1 + 𝑖𝑒 )𝑡 ]
The factor (1 + 𝑖𝑒 )𝑡 is referred to as the single payment
compound amount factor, represented by the factor F/P
in interest tables
𝑛−1

𝐹𝑉 = ∑ 𝑃𝑉 [(1 + 𝑖𝑒 )𝑡 ]
𝑡=1
Example (5):
Using the royalty payments in example (3) calculate the
future value of these payments at 8% effective interest.

Solution:
Fv = $2,000(1+ 0.08)4 + $2,200(1+ 0.08)3 + $1,900(1+
0.08)2 + $2,500(1+ 0.08)1 + $1,500(1+ 0.08)0
= $2,000(1.3605) + $2,200(1.2597) + $1,900(1.1664)
+ $2,500(1.08) + $1,500 = $11,908.50

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