22-04-2014, 11:24 AM
INTEREST FORMULAS AND THEIR APPLICATIONS
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INTRODUCTION:
Interest rate is the rental value of money. It represents the growth of capital per unit period. The period may be a month, a quarter, semiannual or a year. An interest rate 15% compounded annually means that for every hundred rupees invested now, an amount of Rs. 15 will be added to the account at the end of the first year. So, the total amount at the end of the first year will be Rs. 115. At the end of the second year, again 15% of Rs. 115, i.e. Rs. 17.25 will be added to the account. Hence the total amount at the end of the second year will be Rs. 132.25. The process will continue thus till the specified number of years.
INTEREST FORMULAS:
While making investment decisions, computations will be done in many ways. To simplify all these computations, it is extremely important to know how to use interest formulas more effectively. Before discussing the effective application of the interest formulas for investment-decision making, the various interest formulas are presented first.
Interest rate can be classified into simple interest rate and compound interest rate.
In simple interest, the interest is calculated, based on the initial deposit for every interest period. In this case, calculation of interest on interest is not applicable. In compound interest, the interest for the current period is computed based on the amount (principal plus interest up to the end of the previous period) at the beginning of the current period.
Equal-Payment Series Compound Amount:
In this type of investment mode, the objective is to find the future worth of n equal payments which are made at the end of every interest period till the end of the nth interest period at an interest rate of i compounded at the end of each interest period. The corresponding cash flow diagram is shown in Fig. 3.4.
Uniform Gradient Series Annual Equivalent Amount:
The objective of this mode of investment is to find the annual equivalent amount of a series with an amount A1 at the end of the first year and with an equal increment (G) at the end of each of the following n - 1 years with an interest rate i compounded annually.
Effective Interest Rate:
Let i be the nominal interest rate compounded annually. But, in practice, the compounding may occur less than a year. For example, compounding may be monthly, quarterly, or semi-annually. Compounding monthly means that the interest is computed at the end of every month. There are 12 interest periods in a year if the interest is compounded monthly. Under such situations, the formula to compute the effective interest rate, which is compounded annually.
BASES FOR COMPARISON OF ALTERNATIVES:
In most of the practical decision environments, executives will be forced to select the best alternative from a set of competing alternatives. Let us assume that an organization has a huge sum of money for potential investment and there are three different projects whose initial outlay and annual revenues during their lives are known. The executive has to select the best alternative among these three competing projects.
MAKE OR BUY DECISION
INTRODUCTION:
In the process of carrying out business activities of an organization, a component/product can be made within the organization or bought from a subcontractor. Each decision involves its own costs. So, in a given situation, the organization should evaluate each of the above make or buy alternatives and then select the alternative which results in the lowest cost. This is an important decision since it affects the productivity of the organization. In the long run, the make or buy decision is not static. The make option of a component/product may be economical today; but after some time, it may turn out to be uneconomical to make the same.
Thus, the make or buy decision should be reviewed periodically, say, every 1 to 3 years. This is mainly to cope with the changes in the level of competition and various other environmental factors.