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Hello Tutor. Thank you for hard work you do for us.
I watched lecture and read all forum but i cant understand the example 1 in chapter 5. My question is why we not simple multiply 4/96 by 6. Can you please explain in simple way what is reason of using compound percent calculation.Suppose you put $100 in the bank earning 1% a month. At the end of 1 month you would earn $1. If you left that in the bank you would then have $101, and so at the end of the second month you would have $102.10, and so on. So at the end of the year, you would end up having earned more than simply 12 x $1.
Obviously this is a different situation, but the principle is exactly the same.
For more, watch the Paper F2 lectures on interest 🙂
Thanks for reply. I watched all lectures and it is the first reason of my exam passes). Thank you and opentution team for this videos. But in this example we dont use money by puting it in the bank. And if we do so why we dont use average percent rate. I cant imagine it in real life so it thats why i cant undersand using compound rate in this example. Sorry for asking the same guestion but i really cant make it clear for me
Giving the discount means we receive money earlier and it is exactly the same as if we had borrowed the money (instead of waiting an extra 2 months) and effectively paying interest at 4/96 for those two months.
If we want to be able to compare with overdraft borrowing at 20% per year, then we need to work out the equivalent annual cost.
Offering the discount is effectively borrowing money and paying interest. You will remember from F2 that borrowing using a credit card with 1% monthly interest is not equivalent to paying 12 x 1% = 12% a year.
This is exactly the same. With the credit card, we are not saying that they will actually pay that much interest a year – it depends on whether or not they leave the amount outstanding for the year – but the equivalent annual cost is calculated in the same way for exactly the same reasons.
If we imagine that offering or getting discount is credit card then we borrow 96 usd and pay 4.17 percent first period then we borrow another 96 usd and pay 4.17 percent for 96 usd and pay 4.17 percent for first 4.17 percent which was calculated in first period? Is it right? If yes it is acumulating the percent amount to the principal amount. is it relevant to our case when we only give discount once and not need to acumulate it. Sorry for taking a lot time of you tutor
We are only accumulating it because we are asked for the effective annual cost.
It is the same with a credit card – if you pay off the first periods interest then it does not compound, but the effective annual cost is simply finding what the equivalent interest rate per year would be (because we need that to compare with the overdraft rate per year).
What you could do to make the decision (which might have made you happier) is effectively do it backwards and work out the interest for 2 months equivalent to the annual overdraft interest, and then compare that with the 2 month cost of the discount. However that would be messier (it would mean taking a 6th root), but more importantly is not what the question would actually be asking for.
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