ENGINEERING

ECONOMY

COURSE CODE: BES211

LEC: 3 Units
INTEREST AND
MONEY TIME
RELATIONSHIP
INTEREST
INTEREST IS THE
AMOUNT OF MONEY
PAID FOR THE USE OF
BORROWED CAPITAL OR
THE INCOME PRODUCED
BY MONEY WHICH HAS
BEEN LOANED.
INTEREST
 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 the time of the
loan is measured in days.

where: I = interest
I = Pni P = principal or present worth
F = P + I = P + Pni n = number of interest period
i = rate of interest per interest period
F = P (1 + ni) F = accumulated amount or future amount

a. ORDINARY SIMPLE INTEREST is computed on the basis of 12 months of 30 days each or 360 days a year.

1 interest period = 360 days

b. EXACT SIMPLE INTEREST is based on the exact number of days in a year, 365 days for an ordinary year and
366 days for a leap year.
1 interest period = 365 or 366 days
Example Problem:
1. Determine the ordinary simple interest on P700 for 8 months and 15 days if the rate of interest is 15%.
Given:
P = P700
n = 8 months & 15 days
i = 15%
Asked:
I = Ord. Simple Interest

Solution:

Number of Days = (8) (30) + 15 = 255 days

I = PnI = P700 x x 0.15

I = P74.375
Example Problem:
2. Determine the exact simple interest on P500 for the period from January 10 to October 28, 1996 at
16% interest.
Given:
P = P500
n = Jan. 10 – Oct. 28, 1996 Exact Simple Interest
i = 16%
I = PnI = P500 x x 0.16
Asked:
I = Exact Simple Interest

Solution: Month Number of Days I = P63.825

Number of Days Jan. 10-31 21 (excluding Jan. 10)

Note:
1996 Leap Year February 29

March 31

April 30

May 31

June 30

July 31

August 31

September 30

October 28 (including Oct. 28)

Total 292 Days
Example Problem:
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?
Given:
P = P10,000
n = 14 months
i = 12% per year
Asked:
F = accumulated amount
or future amount
Solution:

Number of Days = 14 x 30 = 420 days

F = P (1 + ni) based on Days in a year based on Months in a year

F = P10,000 1 + 0.12
or F = P10,000 1 + 0.12

F = P11,400 F = P11,400
CASH-FLOW
 Cash-Flow Diagram

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) disbursement (negative cash flow or cash outflow)

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

Cash flow diagram on the viewpoint of the lender Cash flow diagram on the viewpoint of the borrower
COMPOUND
INTEREST
 Compound Interest

In calculation 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”.

Compound Interest (Borrower’s Viewpoint)

 Compound Interest

Compound Interest (Borrower’s Viewpoint)

Interest F=P
Interest Principal at Earned
Period Beginning of During Amount at End of Period
Period Period The quantity (1 + i) is commonly called
the “single payment compound factor”
1 P Pi P + Pi = P(1 + i) and is designated by the functional symbol
2 P (1 + i) P (1 + i) i P (1 + i) + P (1 + i) i = P (1 + i) F/P , i% , n.

Thus
3 P (1 + i) P (1 + i) i P (1 + i) + P (1 + i) I = P (1 + i)
F = P F/P . i% . )
. . . . . . . . . . . .

n P (1 + i) P (1 + i) i P (1 + i) The symbol F/P . i% . n is read as “F given P

at i percent in n interest periods”.
 Compound Interest

P=F
F= P(1+i)
The quantity (1 + i) is called the “single
payment present worth factor” and is
designated by the functional symbol P/F ,
i% , n.
Thus P= F(1+i)

P=F /F . i% . ) Where:
F = future amount, compound amount
The symbol P/F . i% . n is read as “P given F P = principal, present amount
at i percent in n interest periods”. I = interest rate per compounding period
n = Number of period
 Compound Interest

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.

where:
i = rate of interest per interest period
r = nominal interest rate
m = number of compounding periods per year
Interest can be compounded
• Annually m= 1
• Semi- annually m= 2
• Quarterly m= 4
• Monthly m= 12
𝟏𝟎%
If the Nominal Rate of Interest is 10% compounded quarterly, then i = = 2.5% , the rate of interest per
𝟒
interest period
 Compound Interest

Rates of Interest
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,

The actual interest earned is P0.1586, therefore, the rate of

interest after one year is 15.86%
Hence,
Effective rate =
where:
F = the amount of P1.00 will be after 1 year. Effective Rate of Interest
 Compound Interest

Rates of Interest
b. Effective Rate of Interest Effective rate = F − 1 = 1 + i −1
Since, r
i=
m
Thus
𝐫 𝐦
𝐢𝐞𝐟𝐟 = 𝟏+ −𝟏
𝐦

where:

Effective Rate of Interest

𝐢𝐞𝐟𝐟 = Effective rate of Interest
r = nominal interest rate
m = number of compounding periods per year
Compound Interest

where:
F= P(1+i)𝐧 F = Future amount, Compound amount
P = Principal, Present amount
i = Interest rate per compounding period
𝐧 n = Number of period
P= F(1+i)
where:
r = nominal interest rate
m = frequency of conversion
t = time in years
Compound Interest

F= P(1+i) Accumulation Factor/ Single Payment

Compound Amount Factor

P= F(1+i) Discount Factor/ Single Payment

Present Worth Factor

Frequency conversion (m) Example:

“an investment of 16%
Interest can be compounded compounded quarterly for 5 years”
• Annually m= 1 r 0.16
• Semi- annually m= 2 i= = = 0.04
m 4
• Quarterly m= 4
• Monthly m= 12 n = mt = 5(4) = 20
Example Problem:
1. Find the nominal rate which if converted quarterly could be used instead of 12% compounded monthly.
What is the corresponding effective rate?
Take Note!
Solution:
For two or more NOMINAL RATES to be EQUIVALENT,
Let r = the unknown nominal rate their corresponding EFFECTIVE RATES must be EQUAL.

Nominal Rate Effective Rate

r
r% compounded quarterly 𝐢𝐞𝐟𝐟 = 1 + −1
4
0.12
12% compounded monthly 𝐢𝐞𝐟𝐟 = 1 + −1
12
Equating the two:
r 0.12
1+ −1 = 1+ −1
4 12

0.12
r=4𝑥 1+ −1+1 −1
12
Example Problem:
2. Find the amount at the end of two years and seven months if P1000 is invested at 8% compounded
quarterly using simple interest for anytime less than a year interest period.
Solution: 𝐫 𝟖%
For compound interest: 𝐢= = = 𝟐% 𝐧 = 𝐦𝐭 = 𝟒 𝟐 = 𝟖
𝐦 𝟒
𝟕
For simple interest: 𝐢 = 𝟖% 𝐧=
𝟏𝟐
𝐅𝟐
𝐅𝟏

0 1 2 2 yrs. – 7 mons.
compound simple
interest interest

P1.00

𝐅𝟏 = 𝐏 (𝟏 + 𝐢 )𝐧 = 𝐏𝟏𝟎𝟎𝟎(𝟏 + 𝟎. 𝟎𝟐 )𝟖 = 𝐏 𝟏, 𝟏𝟕𝟏. 𝟔𝟔

𝟕
𝐅𝟐 = 𝐅𝟏 𝟏 + 𝐧𝐢 = 𝐏𝟏𝟏𝟕𝟏. 𝟔𝟔 𝟏 + 𝟎. 𝟎𝟖
𝟏𝟐
Example Problem:
3. A P2,000 loan was originally made at 8% simple interest for 4 years. At the end of this period the loan
was extended for 3 years, without the interest being paid, but the new interest rate was made 10%
compounded semi-annually. How much should the borrower pay at the end of 7 years?