Bicol University

COLLEGE OF ENGINEERING
Legazpi City

Interest and the

MODULE 3
Time Value of Money
Overview
This module covers an introduction to the time value of money. It covers the basics of
interest calculation, and an introduction to how time and interest affect money.

Lesson Objectives
At the end of this lesson, the student should be able to:
1. Define and provide examples of the time value of money; and
2. Distinguish between simple and compound interest, and use compound interest in
engineering economic analysis.

Lesson Outline
1. Introduction
2. Simple Interest
3. Compound Interest

3.1. Introduction

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 Interest and the Time Value of Money [BES 12] Engineering Economics

Interest, to simply define, is the privilege of borrowing money. Suppose that an investor
lends money to a debtor. Then the latter must pay back the original sum loaned (the amount
borrowed) plus an interest (an additional sum earned at a particular rate). The capital
originally invested in a transaction is called the principal, and the sum of the principal plus
the interest due at any time after the investment of the principal is called the amount.
There are two main types of interest – simple and compound. These two will be
discussed in the succeeding sections.

3.2. Simple Interest

3.2.1. DEFINITION
When the total interest earned or charged is linearly proportional to the initial
amount of the loan (principal), the interest rate, and the number of interest periods
for which the principal is committed, the interest and interest rate are said to be
simple. Simple interest is calculated using the principal only (calculated only on the
original sum), ignoring any interest accrued in preceding interest periods.
The total interest, , earned or paid for years at an interest rate may be computed
using the formula
=
where, = principal amount
= number of years
= interest rate

The final amount, , which results from an investment of the principal, , can then be
computed as
= +

= +

= ( + )

If the time is expressed in months, we shall express it in years by dividing it by 12,

assuming that a year consists of 12 equal months, to obtain . If the time is given in days,
two varieties of simple interest are in use: the ordinary interest, where the year is taken
as 12 months * 30 days/month = 360 days; and the exact interest, where the exact

2 KIM ARVIN P. LEOCADI O, REE OLIVER M. PADUA, CE

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 [BES 12] Engineering Economics 3.2 Simple Interest

number of days in a year, 365 (or 366 for leap year), is used. We shall obtain by dividing
by the appropriate number of days.

EXAMPLE 1 Simple Interest

Find the ordinary and the exact interest at 10% on a Php 10,000.00 investment, and
the corresponding amounts at the end of 75 days.
SOLUTION
Ordinary interest
75
= 10,000(0.10) = .
360

= + = 10,000 + 208.33 = , .

Exact interest
75
= 10,000(0.10) = .
365

= + = 10,000 + 205.48 = , .

3.2.2. CALCULATION OF THE TIME BETWEEN DATES

In the computation of interest, we include the last day but not the first day in
computing the time between two dates. Sometimes, the time between two dates is
counted under the assumption that each month has 30 days, we shall call the result the
approximate time.

EXAMPLE 2 Actual and Approximate Times

Find the actual and approximate time between February 1, 2020 and June 28, 2021.

SOLUTION
Actual Time
Note that February 1 is the 32nd day of the year 2020. Therefore, a quick
computation of the number of days from February 1 to December 31, 2020 will be
366* – 32 = 334 days.

* Year 2020 is a leap year.

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 Interest and the Time Value of Money [BES 12] Engineering Economics

To find the number of days from January 1 to June 28, 2021, we shall count
the number of days for each month. Hence, the number of days will be equal to 31
(Jan) + 28** (Feb) + 31 (Mar) + 30 (Apr) + 31 (May) + 28 (Jun) = 179 days.
Therefore, the total number of days from February 1, 2020 to June 28, 1993
is 334 + 179 = 513 days.

Approximate Time
In finding the approximate time, we assume that each month has 30 days.
Therefore, to find the approximate number of days, we shall determine a
reference date in which we shall base our starting and ending dates. Let’s choose
January 1, 2020 as our reference. Thus,

June 28, 2021 2021 : 06 : 28

February 1, 2020 2020 : 02 : 01

0001 : 04 : 27

Therefore, the approximate time is (1 * 360) + (4 * 30) + 27 = 507 days

3.2.3. ACCUMULATION & DISCOUNT AT SIMPLE INTEREST

Every amount that is dealt with in financial transactions are dated values. This
means that the amounts are anchored on a particular point in time. In the simple interest
formula, = (1 + ), we shall call as the present value of the investment and as
the future value. We shall say that grows or accumulates to the value at the end of
years.

EXAMPLE 3 Accumulation at Simple Interest

Accumulate Php 10,000.00 for 5 years at 10% simple interest.

SOLUTION
= 10,000[1 + (0.10)(5)] = , .

EXAMPLE 4 Accumulation at Simple Interest

If Php 10,000 accumulates to Php 12,500 in 10 years, find the interest rate.
SOLUTION

** February will only have 28 days since not 2021 is not a leap year.

4 KIM ARVIN P. LEOCADI O, REE OLIVER M. PADUA, CE

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 [BES 12] Engineering Economics 3.2 Simple Interest

= (1 + )

12,500 = 10,000[1 + (5)]

= . or %

EXAMPLE 5 Accumulation at Simple Interest

If money is worth* 7.5% simple interest, find the present value of Php 23,750 which
is due at the end of 2.5 years.
SOLUTION
= (1 + )

23,750 = [1 + (0.075)(2.5)]

= , .

To discount the future value for years means to find the present value of on
a day which is years before is due. The difference between the future value and its
present value is called the discount on .
EXAMPLE 6 Discount at Simple Interest

A merchant buys a bill of goods requiring the payment of Php 15,000 at the end of
180 days. He is offered a 10% discount for cash in 30 days. What is the highest rate at
which he could afford to borrow money in order to take advantage of the discount?
SOLUTION
Cash in 30 days means payment at the end of 30 days.
The discount offered is 10% of Php 15,000,

0.10(15,000) = ,

which means that the amount payable in 30 days is

15,000 − 1,500 = ,

The highest rate, therefore, at which he could afford to borrow money in order to
take advantage of the discount is the rate at which Php 13,500 is the present value of

* This means that money can be invested at the given rate.

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Interest and the Time Value of Money [BES 12] Engineering Economics

Php 15,000 due in 150 days (the difference between the maturity date and the offered
discounted payment date, 180 – 30 = 150 days). Thus,

= (1 + )

150
15,000 = 13,500 1 +
360

= . or . %

3.2.4. SIMPLE DISCOUNT

In the previous subsections, we have considered the interest as a percentage of
the principal . However, it is sometimes convenient to have an expression expressing
as a percentage of . This percentage is called as the discount rate, . Putting into a
mathematical equation, considering as the discount on ,
=
where, = future amount
= number of years
= discount rate
which results to
= −

= −

= ( − )

EXAMPLE 7 Simple Discount

At 7.5% discount, find the present value of Php 3,000 which is due at the end of
150 days. What is the discount?
SOLUTION
150
= 3,000 1 − (0.075) = , .
360
The discount is
= − = 3,000 − 2,906.25 = .

EXAMPLE 8 Simple Discount

6 KIM ARVIN P. LEOCADI O, REE OLIVER M. PADUA, CE

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[BES 12] Engineering Economics 3.2 Simple Interest

Find the amount due at the end of 30 months whose present value is Php 45,000 at
10% simple discount.
SOLUTION
= (1 − )

30
45,000 = 1 − (0.10)
12

= ,

EXAMPLE 9 Simple Discount

Discount Php 10,000 for 15 months, and find the discount at (a) 10% simple interest
and (b) 10% simple discount.
SOLUTION
(a) at 10% simple interest,
= (1 + )
15
10,000 = 1 + (0.10)
12
= , .

The discount is
= − = 10,000 − 8,888.89 = , .

(b) at 10% simple discount,

= (1 − )
15
= 10,000 1 − (0.10)
12
= , .

The discount is
= − = 10,000 − 8,750 = , .

EXAMPLE 10 Simple Discount

What simple interest rate is equivalent to the simple discount rate 12% in
discounting an amount for (a) 1 month; (b) 3 months; and (c) 6 months?
SOLUTION

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 Interest and the Time Value of Money [BES 12] Engineering Economics

First, we find the relationship between the simple interest rate and simple discount
rate,
= (1 + ) = [ (1 − )](1 + )
1 = (1 − )(1 + )
We shall use this relationship to solve (a), (b) and (c).
(a) for 1 month,
1 1
1 = 1 − (0.12) 1+
12 12

= . %

(b) for 3 months,

3 3
1 = 1 − (0.12) 1+
12 12

= . %

(c) for 6 months,

6 6
1 = 1 − (0.12) 1+
12 12

= . %

3.3. Compound Interest

3.3.1. DEFINITION
Compound interest is the interest on a loan or investment calculated based on both
the initial principal and the accrued interest from the previous periods. In compounding,
the interest due is added to the principal and thereafter earns interest. We shall illustrate
this by an example.

EXAMPLE 11 Defining Compound Interest

K.A. Leocadio Engineering Solutions loans Php 100,000 at 5% per year compound
interest to cover the expenses of the company’s R&D project. The company shall pay the
principal and interest after 5 years. Compute the annual interest and total amount due
after 5 years.
SOLUTION
Interest, year 1 : 100,000(0.10) = Php 10,000

8 KIM ARVIN P. LEOCADI O, REE OLIVER M. PADUA, CE

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[BES 12] Engineering Economics 3.3 Compound Interest

Total due, year 1 : 100,000 + 10,000 = Php 110,000

Interest, year 2 : 110,000(0.10) = Php 11,000
Total due, year 2 : 110,000 + 11,000 = Php 121,000
Interest, year 3 : 121,000(0.10) = Php 12,100
Total due, year 3 : 121,000 + 12,100 = Php 133,100
Interest, year 4 : 133,100(0.10) = Php 13,310
Total due, year 4 : 133,100 + 13,310 = Php 146,410
Interest, year 5 : 146,410(0.10) = Php 14,641
Total due, year 5 : 146,410 + 14,461 = Php 161,051

As seen, the total amount due after 5 years is Php 161,051.

Analyzing Example 11 (the example given above), the total amount due at the end
of each year is

Year 1 : 100,000(1 + 0.10) = Php 110,000

Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10)(1 + 0.10)
Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10)2 = Php 121,000
Year 3 : 121,000(1 + 0.10) = 100,000(1 + 0.10)(1 + 0.10)(1 + 0.10)
Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10)3 = Php 133,100
and so on…

From this, we can deduce that the total amount due at the end of years is
Year : 100,000(1 + 0.10)k

Hence, we can conclude the general formula

= ( + )
where, = total due at the end of n years (future amount)
= principal amount
= number of compounding periods (number of years)
= interest rate

This general formula can be used to directly calculate the total amount due at the end of
n years without going through the intermediate steps.

EXAMPLE 11 Compound Interest

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 9

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 Interest and the Time Value of Money [BES 12] Engineering Economics

Engr. Leocadio invests Php 50,000 at a credit corporation at interest rate of 10%
compounded annually*. How much is the investment worth after 10 years?
SOLUTION
Using the derived general formula,
= 50,000(1 + 0.10)

= , .

Commonly, the compounding period may not always be annually. Sometimes, the
principal amount in compounded semi-annually, quarterly or monthly. We calculate this
by dividing the annual interest rate by a corresponding frequency factor (i.e., the number
of times the interest is compounded per year), and multiplying the number of years by
the same factor to produce the total number of times the interest is compounded. That is,
putting into a mathematical formula,

= +

where, = future amount

= principal amount
= annual interest rate
= 2 for semiannually
= 4 for quarterly
= 12 for monthly
= 52 for weekly
=365 for daily

EXAMPLE 12 Compound Interest

Dr. Quintano purchases Php 200,000 worth of corporate bonds that has an interest
rate of 12% compounded quarterly. What will be the total worth of all the corporate
bonds after 2 years?
SOLUTION
Using the derived general formula,

* This means 10% per year compound interest.

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[BES 12] Engineering Economics 3.3 Compound Interest

( )
0.12
= 200,000 1 +
4

= , .

3.3.2. DISCOUNT
In a similar theory as the simple discount, to discount an amount for
compounding periods means to find its present value P on a day which is periods before
is due. In finding the discount, we shall alter the formula = (1 + ) and replace the
interest rate, , with the discount rate, , as such
= ( + )
where, = discount rate

EXAMPLE 13 Discount

If money can be invested at 5% compounded annually, find the present value of Php
10,000 due at the end of 5 years.
SOLUTION
= 10,000(1 + 0.05)

= , .

EXAMPLE 13 Discount

Discount Php 20,000 for 5 years at 10% compounded quarterly, and find the
discount.
SOLUTION
( )
0.10
= 20,000 1 + = , .
4
The discount is
= − = 20,000 − 12,205.42 = , .

3.3.3. NOMINAL & EFFECTIVE RATES

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Interest and the Time Value of Money [BES 12] Engineering Economics

In the Sect. 3.3.1, we are introduced the interest rate divided a corresponding
frequency factor . This interest rate, describing a variety of compound interest, is called
the nominal rate. With a given nominal rate compounded times per year, the
corresponding effective rate is the rate, , which, if compounded annually, is equivalent
to the given rate. That is,
interest earned in one year
=
principal invested at the beginning of the year
or

= + −

EXAMPLE 14 Nominal vs. Effective Rates

Obtain the nominal rate which, if compounded monthly, will yield 20% effective
rate.
SOLUTION

0.20 = 1 + −1
12
= . %

Note that unless otherwise specified in a particular problem, the interest rate given
is the nominal rate.

3.3.4. INTEREST COMPOUNDED CONTINUOUSLY

Consider the compound interest formula

= 1+

If we are going to consider → ∞, then we have

= lim 1 +
→

/
= lim 1+
→

/
= lim (1 + )
→

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[BES 12] Engineering Economics 3.3 Compound Interest

Now, note that

/
= lim (1 + )
→

Therefore,
=
where, = future amount
= principal amount
= nominal interest rate
= number of years

We refer to this formula as formula for continuously compounding.

EXAMPLE 15 Continuous Compounding

Find the future worth of a Php 1 million investment if it is invested for 10 years at
an interest rate of 8% compounded continuously.
SOLUTION
( . )( )
= 1,000,000 = , , .

3.3.5. EQUIVALENT RATES

Two varieties of compound interest are equivalent if the effective rates for the two
varieties are equal.

EXAMPLE 16 Equivalent Rates

What nominal rate compounded quarterly is equivalent to 8% compounded

monthly?
SOLUTION
=

0.08
1+ −1= 1+ −1
4 12

= . %

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