Exercise-1 (Computation of simple and compound interest)

A company is considering to start a new product line. The new product line requires the installation of new machines and equipment. For this purpose, company wants to borrow money by issuing bonds of $10,000 for 12-year period. The interest on these bonds is to be paid at a rate of 8% per year.

Required:

Compute the amount of interest to be paid to bondholders over 12-year period:

1. if the simple interest is charged.
2. if the interest is compounded annually.

Solution:

(1) If interest is simple:

I = Pin

= $10,000 × 8% × 12

= $10,000 × 0.08 × 12

= $9,600

(2) If interest is compounded annually:

To compute compound interest for 12-year period, we would compute compound amount first using compound amount formula and then compute compound interest by deducting the principal amount from compound amount.

S = P(1 + i)ⁿ

= $10,000 × (1 + 8%)¹²

=$10,000 × 2.518*

= $25,180

Interest to be earned over 8-year period: $25,180 – $10,000 = $15,180

*Value of (1 + 8%)¹² from future value of $1 table: 12 periods; 8% interest rate.