MODULE 2

MONEY-TIME RELATIONSHIPS AND EQUIVALENCE

Interest and Money-Time Relationships

Interest

The amount of money earned for the use of borrowed capital is called interest. From the
borrower’s point of view, interest is the amount of money paid for the capital. For the
lender, interest is the income generated by the capital which he has lent. There are two
types of interest, simple interest and compound interest.

Principal

The amount of money used on which interest is charge

Rate of Interest

The amount earned by one unit of principal during a unit of time.

Simple Interest

Simple interest is calculated using the principal only, ignoring any interest that had been
accrued in preceding periods. In practice, simple interest is paid on short-term loans in
which time of the loan is measured in days.

The formula for simple interest is given by,

𝑰 = 𝑷𝒓𝒕

The future amount is,

𝐹 =𝑃+𝐼

𝐹 = 𝑃 + 𝑃𝑟𝑡

𝐹 = 𝑃(1 + 𝑟𝑡)

Where,
𝐼 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡

𝑃 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑟 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ

𝑟 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

𝑡 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

Ordinary and Exact Simple Interest

a. Ordinary Simple Interest  it is computed on the basis of 12 months of 30 days each

or 360 days a year.

Banker’s year:

1 𝑦𝑒𝑎𝑟 = 12 𝑚𝑜𝑛𝑡ℎ𝑠

1 𝑚𝑜𝑛𝑡ℎ = 30 𝑑𝑎𝑦𝑠 (𝑎𝑙𝑙 𝑚𝑜𝑛𝑡ℎ𝑠)

1 𝑦𝑒𝑎𝑟 = 360 𝑑𝑎𝑦𝑠

b. Exact Simple Interest  It is based on the actual number of days in a year. One year
is equivalent to 365 days for ordinary year and 366 days for leap year. A leap year is
when the month of February is 29 days, and ordinary year when February is only 28 days.
Leap year occurs every four years.

Note:

Leap years are those which are exactly divisible by 4 except century years, but those
century years that are exactly divisible by 400 are also leap years.

If d is the number of days, then ...

In ordinary simple interest,

𝑑
𝑡=
360
In exact simple interest,

𝑑
𝑡= → 𝑓𝑜𝑟 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑦𝑒𝑎𝑟
365
𝑑
𝑡= → 𝑓𝑜𝑟 𝑙𝑒𝑎𝑝 𝑦𝑒𝑎𝑟
366

Sample Problem No. 1

Determine the ordinary simple interest on P700 for 8 months and 15 days if the rate of
interest is 15%.

Solution to Problem No. 1

Let: P = P700, r = 15%, t= 8 months and 15 days, find, I =?

First let us identify the time value of the interest,

𝑑
𝑡=
360

𝑑𝑎𝑦𝑠
𝑑 = 8 𝑚𝑜𝑛𝑡ℎ𝑠 (30 ) + 15 𝑑𝑎𝑦𝑠
𝑚𝑜𝑛𝑡ℎ

𝑑 = 255 𝑑𝑎𝑦𝑠

Use the formula of the interest,

𝐼 = 𝑃𝑟𝑡

255
𝐼 = (𝑃700)(15%) ( )
360

𝑰 = 𝑷𝟕𝟒. 𝟑𝟖 → 𝑭𝒊𝒏𝒂𝒍 𝑨𝒏𝒔𝒘𝒆𝒓

Sample Problem No. 2

Determine the exact simple interest on P500 for the period from January 10 to October
28, 1996 at 16% interest.
Solution to Problem No. 2:

Let: P = P500, r = 16%, t= Jan 10 to Oct 28, 1996, find, I =?

First let us identify the number of days to be used,

𝑑
Since 1996 is a leap year, we are going to use 𝑡 = 366.

𝐽𝑎𝑛. 10 − 31 = 21 (𝑒𝑥𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝐽𝑎𝑛. 10)

𝐹𝑒𝑏𝑟𝑢𝑎𝑟𝑦 = 29 (𝑙𝑒𝑎𝑝 𝑦𝑒𝑎𝑟)

𝑀𝑎𝑟𝑐ℎ = 31

𝐴𝑝𝑟𝑖𝑙 = 30

𝑀𝑎𝑦 = 31

𝐽𝑢𝑛𝑒 = 30

𝐽𝑢𝑙𝑦 = 31

𝐴𝑢𝑔𝑢𝑠𝑡 = 31

𝑆𝑒𝑝𝑡𝑒𝑚𝑏𝑒𝑟 = 30

𝑂𝑐𝑜𝑏𝑒𝑟 28 = 28 (𝑖𝑛𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑂𝑐𝑡. 28)

𝑇𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 = 21 + 29 + 31 + 30 + 31 + 30 + 31 + 31 + 30 + 28

𝑑 = 292 𝑑𝑎𝑦𝑠

To solve for the value of interest,

𝐼 = 𝑃𝑟𝑡

292
𝐼 = (𝑃500)(16%) ( )
366

𝑰 = 𝑷𝟔𝟑. 𝟖𝟑 → 𝑭𝒊𝒏𝒂𝒍 𝑨𝒏𝒔𝒘𝒆𝒓

Sample Problem No. 3

What will be the future worth of money after 14 months if a sum of P10,000 is invested
today at a simple interest rate of 12% per year?

Solution to Problem No. 3

Let: P = P10,000, r = 12% per year, t= 14 months, find, F=?

To find for the future worth,

𝐹 = 𝑃(1 + 𝑟𝑡)

14
𝐹 = 𝑃10,000 (1 + (12%) ( ))
12

𝑭 = 𝑷𝟏𝟏, 𝟒𝟎𝟎. 𝟎𝟎 → 𝑭𝒊𝒏𝒂𝒍 𝑨𝒏𝒔𝒘𝒆𝒓

Sample Problem No. 4 (ME Board Exam April 1998)

It is the practice of almost all bank in the Philippines that when they grant a loan, the
interest for one year is automatically deducted to the principal amount upon release of
money to a borrower. Let us therefore assume that you applied for a loan with a bank and
the P80,000 was approved at an interest rate of 14% if which P11,200 was deducted and
you were given a check of P68,800.00. Since you have to pay the amount of P80,000
one year after, what will be the effective interest rate?

Solution to Problem No. 4

Let: I = (14%)(P80,000) = P11,200 P = 68,800 r =? t = 1 year

Therefore, we can use the formula of interest,

𝐼 = 𝑃𝑟𝑡

𝑃11,200 = (𝑃68,800)(𝑟)(1)

𝒓 = 𝟎. 𝟏𝟔𝟐𝟖 𝒐𝒓 𝟏𝟔. 𝟐𝟖% → 𝑭𝒊𝒏𝒂𝒍 𝑨𝒏𝒔𝒘𝒆𝒓

Sample Problem No. 5 (ME Board Exam April 1997)

P5,000 is borrowed for 75 days at 16% per annum simple interest. How much will be due
at the end of 75 days?

Solution to Problem No. 5

Let: P = P5,000, t = 75 days, r = 16% per annum

We can use the formula,

75
𝐹 = 𝑃5,000 (1 + (16%) ( ))
360

𝑭 = 𝑷𝟓, 𝟏𝟔𝟔. 𝟔𝟕 → 𝑭𝒊𝒏𝒂𝒍 𝑨𝒏𝒔𝒘𝒆𝒓

Sample Problem No. 6

A man wants to invest a sum of P50,000 in two investments. The first investment earns
a rate of interest 4 times that of the second investment. In 3 years the first investment
grows to P37,200. For 10 years, the second investment grows to P24,000.

a. Find the sum invested in each rate of interest.

b. Find the rate of interest of each.

Solution to Sample Problem No. 6

a. Find the sum invested in each rate of interest.

First investment:

𝐹1 = 𝑃37,200, 𝑃1 =?, 𝑟 = 4𝑖, 𝑡 =?

𝐹 = 𝑃(1 + 𝑟𝑡)

37,200 = 𝑃1 (1 + 4𝑖(3))
 37,200
𝑃1 = → 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 1
1 + 12𝑖

Second investment:

𝐹1 = 𝑃24,000, 𝑃1 =?, 𝑟 = 𝑖, 𝑡 = 10

𝐹 = 𝑃(1 + 𝑟𝑡)

24,000 = 𝑃1 (1 + 𝑖(10))

24,000
𝑃2 = → 𝐸𝑞𝑢𝑎𝑡𝑖𝑜𝑛 2
1 + 10𝑖

Note that the sum of the two investment is P50,000,

𝑃1 + 𝑃2 = 50,000

37,200 24,000
+ = 50,000
1 + 12𝑖 1 + 10𝑖

37,200(1 + 10𝑖) + 24000(1 + 12𝑖)

= 50,000
(1 + 10𝑖)(1 + 12𝑖)

37,200 + 372,000𝑖 + 24000 + 288,000𝑖

= 50,000
(1 + 22𝑖 + 120𝑖 2 )

37,200 + 372,000𝑖 + 24000 + 288,000𝑖 = 50,000(1 + 22𝑖 + 120𝑖 2 )

37,200 + 372,000𝑖 + 24000 + 288,000𝑖 = 50,0001 + 1,100,000𝑖 + 6,000,000𝑖 2

Combine the like terms and simplify it,

60,000𝑖 2 + 4,400𝑖 − 112 = 0

𝑖 = 0.02 𝑎𝑛𝑑 𝑖 = −0.093 (𝑎𝑏𝑠𝑢𝑟𝑑)

Therefore,

𝑖 = 0.02

Then substitute it to the equation,

 37,200
𝑃1 =
1 + 12(0.02)

𝑷𝟏 = 𝑷𝟑𝟎, 𝟎𝟎𝟎 → 𝑭𝒊𝒓𝒔𝒕 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

24,000
𝑃2 =
1 + 10(0.02)

𝑷𝟐 = 𝑷𝟐𝟎, 𝟎𝟎𝟎 → 𝑺𝒆𝒄𝒐𝒏𝒅 𝑰𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

Cash-Flow Diagrams

A cash-flow diagram is simply a graphical representation of cash flows drawn on

a time scale. Cash-flow diagram for economic analysis problems is analogous to that of
free body diagram for mechanics problems.

Receipt (positive cash flow or cash inflow)

Distribution (negative cash flow or cash outflow)

Example:

A loan of P100 at simple interest of 10% will become P150 after 5 years.

P150

0
1 2 3 4 5

P100

Cash flow diagram on the viewpoint of the lender

 P100

0
1 2 3 4 5

P150

Cash flow diagram on the viewpoint of the borrower

Compound Interest

In calculations of compound interest, the interest for an interest period is calculated on

the principal plus total amount of interest accumulated in previous periods. Thus,
compound interest means “interest on top of interest”.

Consider $1000 invested in an account of 10% per year for 3 years. The figures below
show the contrast between simple interest and compound interest.

At 10% simple interest, the $1000 investment amounted to $1300 after 3 years. Only the
principal earns interest which is $100 per year.
At 10% compounded yearly, the $1000 initial investment amounted to $1331 after 3 years. The
interest also earns an interest.

Elements of Compound Interest

1 2 3 n-1 n

Interest
Principal at
Interest Earned
Beginning of Amount at End of Period
Period During
Period
Period
1 𝑃 𝑃 (𝑖) 𝑃 + 𝑃 (𝑖) = 𝑃 (1 + 𝑖)
2 𝑃 (1 + 𝑖) 𝑃 (1 + 𝑖) (𝑖) 𝑃 (1 + 𝑖) + 𝑃 (1 + 𝑖)(𝑖) = 𝑃(1 + 𝑖)2
3 𝑃(1 + 𝑖)2 𝑃(1 + 𝑖)2 (𝑖) 𝑃(1 + 𝑖)2 + 𝑃(1 + 𝑖)2 (𝑖) = 𝑃(1 + 𝑖)3
... ... ... ...
n 𝑃(1 + 𝑖)𝑛−1 𝑃(1 + 𝑖)𝑛−1 (𝑖) 𝑃(1 + 𝑖)𝑛
Therefore, the future amount of the compounded interest may be formed into,

𝑭 = 𝑷(𝟏 + 𝒊)𝒏

Where,

𝐹 = 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 "𝑛" 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

𝑃 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ 𝑜𝑟 𝑃𝑟𝑖𝑛𝑖𝑐𝑖𝑝𝑎𝑙

i = rate of interest

𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

The quantity (𝟏 + 𝒊)𝒏 is commonly called the “single-payment compound amount

factor”.

Rates of interest

a. Nominal rate of interest  The nominal rate of interest specifies the rate of interest
and a number of interest periods in one year

𝒓
𝒊= ; 𝒏 = 𝒎𝒕
𝒎

Where,

𝑖 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑

𝑟 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟

𝑛 = 𝑡𝑜𝑡𝑎𝑙 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑖𝑛 𝑡 𝑦𝑒𝑎𝑟𝑠

𝑡 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
Example of nominal interest rate:

1. For 8% compounded annually for 5 years

𝑟
𝑖= ; 𝑛 = 𝑚𝑡
𝑚

8%
𝑖= ; 𝑛 = (1)(5)
1

𝑖 = 0.08 ; 𝑛 = 5

2. For 8% compounded semi-annually for 5 years

𝑟
𝑖= ; 𝑛 = 𝑚𝑡
𝑚

8%
𝑖= ; 𝑛 = (2)(5)
2

𝑖 = 0.04 ; 𝑛 = 10

3. For 8% compounded quarterly for 5 years

𝑟
𝑖= ; 𝑛 = 𝑚𝑡
𝑚

8%
𝑖= ; 𝑛 = (4)(5)
4

𝑖 = 0.02 ; 𝑛 = 20

4. For 8% compounded bi-monthly for 5 years

𝑟
𝑖= ; 𝑛 = 𝑚𝑡
𝑚

8%
𝑖= ; 𝑛 = (6)(5)
6

𝑖 = 0.013 ; 𝑛 = 30

5. For 8% compounded monthly for 5 years

𝑟
𝑖= ; 𝑛 = 𝑚𝑡
𝑚
 8%
𝑖= ; 𝑛 = (12)(5)
12

𝑖 = 0.00667 ; 𝑛 = 60

b. Effective rate of interest  Effective rate of interest is the actual or exact rate of
interest on the principal during one year. If P1.00 is invested at a nominal rate of 15%
compounded quarterly, after one year this will become,

𝐹 = 𝑃(1 + 𝑖)𝑛

15% 4(1)
𝐹 = 𝑃1.00 (1 + )
4

𝐹 = 𝑃1.1586

The actual interest earned is P0.1586, therefore, the rate of interest after one year is
15.86%. Hence,

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑅𝑎𝑡𝑒 (𝐸𝑅) = 𝐹 − 1

𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝑹𝒂𝒕𝒆 (𝑬𝑹) = (𝟏 + 𝒊)𝒎 − 𝟏

Sample Problem No. 7

Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?

Solution to Problem No. 7

Solution No. 1:

We can use the formula,

𝐹 = 𝑃(1 + 𝑖)𝑛

Where, F=P=1

𝐹1 = 𝑃1 (1 + 𝑖)𝑛 ; 𝐹2 = 𝑃2 (1 + 𝑖)𝑛
 𝑟 4(1) 12% 12(1)
𝐹1 = 𝑃1 (1 + ) ; 𝐹2 = 𝑃2 (1 + )
4 12

If 𝐹1 = 𝐹2 and 𝑃1 = 𝑃2 ,

𝐹1 = 𝐹2

𝑟 4(1) 12% 12(1)

𝑃1 (1 + ) = 𝑃2 (1 + )
4 12

𝑟 4(1) 12% 12(1)

(1 + ) = (1 + )
4 12

𝑟 = 0.121204

𝑜𝑟

𝒊 = 𝟏𝟐. 𝟏𝟐% → 𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒓𝒂𝒕𝒆 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒆𝒅 𝒒𝒖𝒂𝒓𝒕𝒆𝒓𝒍𝒚

Solution No. 2:

We can solve it using the formula of the effective rate,

𝐸𝑅 = (1 + 𝑖)𝑚 − 1

For two or more nominal rates to be equivalent, their corresponding effective rates must
be equal.

𝐸𝑅1 = 𝐸𝑅2

𝑟 4 12% 12
(1 + ) − 1 = (1 + ) −1
4 12

𝑟 = 0.121204

𝑜𝑟

𝒓 = 𝟏𝟐. 𝟏𝟐% → 𝒄𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒆𝒅 𝒒𝒖𝒂𝒓𝒕𝒆𝒓𝒍𝒚

Sample Problem No. 8

John borrowed P50,000 from the bank at 25% compounded semi-annually. What is the
equivalent rate of interest.

Solution to Problem No. 8

𝐸𝑅 = (1 + 𝑖)𝑚 − 1

25% 2
𝐸𝑅 = (1 + ) −1
2

𝐸𝑅 = 0.2656 𝑜𝑟

𝑬𝑹 = 𝟐𝟔. 𝟓𝟔%

Sample Problem No. 9

Find the present worth of a future payment of P300,000 to be made in 5 years with an
interest rate of 8% per annum.

Solution to Problem No. 9

Let: F = P300,000 P =? t = 5 years m = 1 (annually) i=8%

𝐹 = 𝑃(1 + 𝑖)𝑛

8% 5(1)
𝑃300,000 = 𝑃 (1 + )
1

𝑷 = 𝟐𝟎𝟒, 𝟏𝟕𝟒. 𝟗𝟓𝟗𝟏 → 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝑾𝒐𝒓𝒕𝒉

Sample Problem No. 10

How long will it take money to double itself if invested at 5% compounded annually?

Solution to Problem No. 10

Let: F = 2P P=P i = 5% compounded annually t=?

𝐹 = 𝑃(1 + 𝑖)𝑛

2𝑃 = 𝑃(1 + 5%)𝑛

2 = (1.05)𝑛

log 2 = log(1.05)𝑛

log 2 = 𝑛 log(1.05)

log 2
𝑛=
log 1.05

𝑛 = 14.20669908

𝑛 = 𝑚𝑡

14.21 = (1)(𝑡)

𝒕 ≈ 𝟏𝟒 𝒚𝒆𝒂𝒓𝒔

Sample Problem No. 11

In how many years is required for P2,000 to increase by P3,000 if interest at 12%
compounded semi-annually?

Solution to Problem No. 11

Let: F = P5000 P = P2000 i = 12% compounded semi-annually t=?

12% 2(𝑡)
5000 = 2000 (1 + )
2
 2.5 = (1.06)2𝑡

log 2 = 2𝑡 log(1.06)

log 2
2𝑡 =
log 1.06

2𝑡 = 15.72520854

𝑡 = 7.862604272 𝑜𝑟

𝒕 ≈ 𝟖 𝒚𝒆𝒂𝒓𝒔

Sample Problem No. 12

Mr. W borrowed P2,000 on Mr. Y on June 1, 1928 and P500 on June 1, 1930, agreeing
that money is worth 5% compounded annually. Mr. W paid P500 on June 1, 1931, P400
on June 1, 1932 and P700 on June 1,1933. What additional sum should Mr. W pay on
June 1, 1936 to discharge all remaining liability?

Solution to Problem No. 12

First draw a cash-flow diagram,

𝐹5
7 0 0

𝐹4
7 0 0

𝐹3

500 400 700 𝑥 7 0 0

7 0 0

1929 1930 1931 1932 1933 1934 1935 1936

1928

500

2000 𝐹2
7 0 0

𝐹1
7 0 0
Given from the cash-flow diagram,

𝐹1 + 𝐹2 = 𝑥 + 𝐹3 + 𝐹4 + 𝐹5

2000(1 + 0.05)8 + 500(1 + 0.05)6 = 𝑥 + 500(1 + 0.05)5 + 400(1 + 0.05)4 + 700(1 +

0.05)3

𝒙 = 𝑷𝟏𝟔𝟗𝟎. 𝟐𝟖

(𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑠𝑢𝑚 𝑡ℎ𝑎𝑡 ℎ𝑒 𝑠ℎ𝑜𝑢𝑙𝑑 𝑝𝑎𝑦 𝑜𝑛 𝐽𝑢𝑛𝑒 1, 1936 𝑡𝑜 𝑑𝑖𝑠𝑐ℎ𝑎𝑟𝑔𝑒 𝑎𝑙𝑙 ℎ𝑖𝑠 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠)

Sample Problem No. 13

What is the present worth of two P100 payments at the end of the 3 rd year and 4th year?
The annual interest rate is 8%.
0 1 2 3 4

100 100

𝑃1

𝑃2

𝐹 = 𝑃(1 + 𝑖)𝑛

𝑃 = 𝐹(1 + 𝑖)−𝑛

𝑃 = 𝑃1 + 𝑃2
𝑃 = 𝑃100(1 + 8%)−3 + 𝑃100(1 + 8%)−4
𝑷 = 𝑷 𝟏𝟓𝟐. 𝟖𝟗

Continuous Compounding and Discrete Payments

In discrete compounding, the interest is compounded at the end of each finite – length
period, such as a month, a quarter or a year. In continuous compounding, it is assumed
that cash payments occur once per year, but the compounding is continuous throughout
the year.
 F

1 2 3 4 mn

Formula for continuous compounding (𝑚 → ∞),

𝐹 = 𝑃(1 + 𝑖)𝑛

𝑟 𝑚𝑡
𝐹 = 𝑃 (1 + )
𝑚

𝑟
When 𝑚 → ∞, 𝑚𝑡 = ∞, and → 0. Hence,
𝑚

𝑟 𝑚𝑡
𝐹 = 𝑃 lim (1 + )
𝑚→∞ 𝑚
𝑟 𝑟
Let 𝑥 = 𝑚, when 𝑚 → ∞, 𝑥 → 0, and 𝑚 = 𝑥

𝑟
𝐹 = 𝑃 lim(1 + 𝑥)(𝑥)(𝑡)
𝑥→0

1
1 𝑥
From Calculus, lim (1 + ) = 𝑒, thus,
𝑥→∞ 𝑥

𝑭 = 𝑷𝒆𝒓𝒕 → 𝑪𝒐𝒏𝒕𝒊𝒏𝒖𝒐𝒖𝒔 𝑪𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝑭𝒐𝒓𝒎𝒖𝒍𝒂

Effective Annual Interest

𝑬𝑹 = 𝒆𝒓 − 𝟏

Where,

𝐸𝑅 = 𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑟 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑐𝑜𝑛𝑡𝑖𝑛𝑢𝑜𝑢𝑠𝑙𝑦

Sample Problem No. 14

Compare the accumulated amounts after 5 years of P1,000 invested at the rate of 10%
compounded (a) annually, (b) semi-annually, (c) quarterly, (d) monthly, (e) daily and (f)
continuously.

Solution to Problem No. 14

Using the formula,

𝐹 = 𝑃(1 + 𝑖)𝑛

(a) 𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃1000(1 + 10%)5 = 𝑷𝟏, 𝟔𝟏𝟎. 𝟓𝟏

10% 5(2)
(b) 𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃1000 (1 + ) = 𝑷𝟏, 𝟔𝟐𝟖. 𝟖𝟗
2

10% 5(4)
(c) 𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃1000 (1 + ) = 𝑷𝟏, 𝟔𝟑𝟖. 𝟔𝟐
4

10% 5(12)
(d) 𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃1000 (1 + ) = 𝑷𝟏, 𝟔𝟒𝟓. 𝟑𝟏
12

10% 5(365)
(e) 𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃1000 (1 + ) = 𝑷𝟏, 𝟔𝟒𝟖. 𝟔𝟏
365

(f) 𝐹 = 𝑃𝑒 𝑟𝑡 = (𝑃1000)(𝑒 (10%)(5) ) = 𝑷𝟏, 𝟔𝟒𝟖. 𝟕𝟐

Sample Problem No. 15

Compute the effective annual interest rate which is equivalent to 5% nominal annual
interest compounded continuously.

Solution to Problem No. 15

𝐸𝑅 = 𝑒 𝑟 − 1

𝐸𝑅 = 𝑒 5% − 1

𝐸𝑅 = 0.0513 𝑜𝑟

𝑬𝑹 = 𝟓. 𝟏𝟑%

Discount

It is the difference between the future worth and its present worth. Discount is interest
paid in advance.

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ − 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ

Rate of Discount

It is the discount on one unit of principal for one unit of time or it is defined as the ratio of
the discount to the future worth

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑=
𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ

𝐹−𝑃
𝑑=
𝐹

𝑃
𝑑 =1−
𝐹

𝑃
𝑑 = 1−
𝑃(1 + 𝑟)𝑛
 1
𝑑 =1−
(1 + 𝑟)𝑛

Where n = 1,

1
𝑑 =1−
(1 + 𝑟)1

1+𝑟−1
𝑑=
1+𝑟
𝒓
𝒅= → 𝑹𝒂𝒕𝒆 𝒐𝒇 𝑫𝒊𝒔𝒄𝒐𝒖𝒏𝒕
𝟏+𝒓

Equivalent Rate of Interest

We may derive the formula of rate of discount into the rate of interest,

𝑟
𝑑=
1+𝑟

𝑑 (1 + 𝑟) = 𝑟

𝑑 + 𝑑𝑟 = 𝑟

𝑑 = 𝑟 − 𝑑𝑟

𝑑 = 𝑟(1 − 𝑑)

𝒅
𝒓= → 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕
𝟏−𝒅

Sample Problem No. 16

A man borrowed P5,000 from a bank and agreed to pay the loan at the end of 9 months.
The bank discounted the loan and give him P4,000 in cash. (a) What was the rate of
discount? (b) What was the rate of interest? (c) What was the rate of interest for one year?
Solution to Problem No. 16

(a) What was the rate of discount?

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑=
𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ

𝑃1,000
𝑑= = 0.20 𝑜𝑟 𝟐𝟎%
𝑃5,000

(b) What was the rate of interest?

𝑑
𝑟=
1−𝑑

20%
𝑟=
1 − 20%

𝒓 = 𝟎. 𝟐𝟓 𝒐𝒓 𝟐𝟓%

Alternate Solution:

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑖=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ

𝑃1,000
𝑖= = 0.25 𝑜𝑟 𝟐𝟓%
𝑃4,000

(c) What was the rate of interest for one year?

𝐼 = 𝑃𝑟𝑡

𝐼
𝑟=
𝑃(𝑡)

𝑃1,000
𝑟= = 0.3333 𝑜𝑟 𝟑𝟑. 𝟑𝟑%
9
𝑃4000 (12)
Sample Problem No. 7

A man borrowed P2,000 from a bank and promise to pay the amount for one year. He
received only the amount of P1,920 after the bank collected an advance interest of
P80.00. What is the rate of discount and the rate of interest that the bank collected in
advance?

Solution to Problem No. 7

To solve for the rate of discount,

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑=
𝐹𝑢𝑡𝑢𝑟𝑒 𝑊𝑜𝑟𝑡ℎ

𝑃80
𝑑=
𝑃2000

𝑑 = 0.04

𝒅 = 𝟒% → 𝒓𝒂𝒕𝒆 𝒐𝒇 𝒅𝒊𝒔𝒄𝒐𝒖𝒏𝒕

To solve for the rate of interest,

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑟=
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ

80
𝑟= = 0.0417
1920

𝒓 = 𝟒. 𝟏𝟕% → 𝒓𝒂𝒕𝒆 𝒐𝒇𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕

GUIDE QUESTION 2

1. What is Interest?

2. Differentiate the simple interest and compound interest.

3. What is the difference between the discount and interest?

ANSWER FOR GUIDE QUESTIONS

1. Interest is the amount of money earned for the use of borrowed capital is called interest.
From the borrower’s point of view, interest is the amount of money paid for the capital.
For the lender, interest is the income generated by the capital which he has lent. There
are two types of interest, simple interest and compound interest.

2. Simple Interest is interest is calculated using the principal only, ignoring any interest
that had been accrued in preceding periods. In practice, simple interest is paid on short-
term loans in which time of the loan is measured in days while Compound Interest is is
calculated on the principal plus total amount of interest accumulated in previous periods.
Thus, compound interest means “interest on top of interest”.

3. Interest Rate is a rate applied to a present value to get a future value while Discount
Rate is the rate by which future value is reduced to get its present value.

KEY POINTS

Interest  The amount of money earned for the use of borrowed capital.

Principal  The amount of money used on which interest is charge

Rate of Interest  The amount earned by one unit of principal during a unit of time.
Simple Interest  It is calculated using the principal only, ignoring any interest that had
been accrued in preceding periods.

Ordinary Simple Interest  it is computed on the basis of 12 months of 30 days each

or 360 days a year.

Exact Simple Interest  It is based on the actual number of days in a year.

Compound Interest It is calculated on the principal plus total amount of interest
accumulated in previous periods. Thus, compound interest means “interest on top of
interest”.

Nominal rate of interest  The nominal rate of interest specifies the rate of interest and
a number of interest periods in one year

Effective rate of interest  Effective rate of interest is the actual or exact rate of interest
on the principal during one year. If P1.00 is invested at a nominal rate of 15%
compounded quarterly, after one year this will become,

Discount It is the difference between the future worth and its present worth. Discount
is interest paid in advance.

Rate of Discount It is the discount on one unit of principal for one unit of time or it is
defined as the ratio of the discount to the future worth

References:

Engineering Economy 3rd Edition by Hipolito B. Sta. Maria

Engineering Mathematics Volume 2 by Gillesania

Engineering Economics by Besavilla

ASSESSMENT 2

Instruction. Pick your best answer to the given question

1. Find the rate of interest if compound amount factor compounded bi-monthly for 5 years
is equal to 1.487887.

A. 7%

B. 5%

C. 8%

D. 6%

2. Compute the nominal rate for a period of 6 years for an effective rate of 8.33% if it is
compounded continuously.

A. 7%

B. 5%

C. 8%

D. 6%

3. A man loan P2000 from the bank. How long would it take in years for the amount of
the loan and interest to equal P3280 if it was made at 8% simple interest.

A. 7 years

B. 5 years

C. 8 years

D. 6 years

4. A man loan P2000 from the bank. How long would it take in years if it was made at 8%
compounded quarterly.

A. 5.25 years
B. 7.25 years

C. 6.25 years

D. 8.25 years

5. A man loan P2000 from the bank. How long would it take in years if it was made at 8%
compounded continuously.

A. 7.18 years

B. 5.18 years

C. 8.18 years

D. 6.18 years

6. P60,000 was deposited at 6% compounded quarterly, tax free for 9 years and 3
months. How much interest was earned at the end of the period?

A. P43,214.24

B. P44,086.60

C. P43.242.24

D. P44,215.60

7. P100,000 was placed in a time deposit which earned 9% compounded quarterly tax
free. After how many years would it be able to earn a total interest of P50,000?

A. 4.56 years

B. 3.45 years

C. 4.23 years

D. 3.64 years
8. Which of these gives the lowest effective rate of interest?

A. 12.35% compounded annually

B. 12.2% compounded quarterly

C. 11.9% compounded semi-annually

D. 11.6% compounded monthly

9. Fifteen years ago P1,000.00 was deposited in a bank account, and today it is worth
P2.370.00. The bank pays interest semi-annually. What was the interest rate paid on this
account?

A. 4.9%

B. 5.0%

C. 5.8%

D. 3.8%

10. The effective rate of interest of 14% compounded semi-annually is:

A. 14.49%

B. 14.94%

C. 14.36%

D. 14.88%