Multiple Choice
Which of the following best completes the statement: 'The cost of _____ can be observed because it is the interest rate the firm must pay on new loans.'?
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10. Time Value of Money
Time Value of Money Equations
Multiple Choice
Which term best describes interest that is calculated on both the original principal and any interest that has already been earned?
A
Compound interest
B
Discounted interest
C
Simple interest
D
Nominal interest
Verified step by step guidance1
Understand the concept of interest: Interest is the cost of borrowing money or the return on investment for lending money. It can be calculated in different ways depending on the type of interest.
Learn about simple interest: Simple interest is calculated only on the original principal amount. The formula for simple interest is \( I = P \cdot r \cdot t \), where \( P \) is the principal, \( r \) is the interest rate, and \( t \) is the time period.
Understand compound interest: Compound interest is calculated on the original principal and also on any interest that has been earned in previous periods. The formula for compound interest is \( A = P \cdot (1 + r)^t \), where \( A \) is the total amount, \( P \) is the principal, \( r \) is the interest rate, and \( t \) is the number of compounding periods.
Compare the terms: Discounted interest refers to interest that is deducted upfront from the principal amount. Nominal interest is the stated interest rate without considering compounding. Compound interest involves earning interest on both the principal and previously earned interest, which matches the description in the question.
Conclude that the correct term is compound interest, as it best describes the scenario where interest is calculated on both the original principal and any interest already earned.
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