ENGGECON – Lesson 2: Interest and Money-Time Relationships

 Simple Interest

Capital refers to wealth in the form of money or property that can be used to produce
more wealth.

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.

The total interest, I, earned or paid may be computed using

𝑰=𝑷𝒊𝐧

Where: P =principal amount lent or borrowed

i = interest rate per interest period
n = number of interest periods

The total amount F to be repaid is equal to the sum of the principal (P) and the total interest
(I):

𝑭 = 𝑷 + 𝑰 = 𝑷(𝟏 + 𝒊 𝒏)

 Ordinary Simple Interest

- computed on the basis of one banker’s year, which is:
one banker’s year = 12 months, each consisting of 30 days
= 360 days

 Exact Simple Interest

- computed on the basis of the exact number of days, 365 for an ordinary year and
366 days for a leap year

If d is the number of days in the interest period, then

𝑑
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 𝑖
360
𝑑
𝐸𝑥𝑎𝑐𝑡 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑦𝑒𝑎𝑟) = 𝑃 𝑖
365
𝑑
𝐸𝑥𝑎𝑐𝑡 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡(𝑙𝑒𝑎𝑝 𝑦𝑒𝑎𝑟) = 𝑃 𝑖
366
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

Sample Problems:
1. Determine the interest and future worth of P900 for 10 months and 12 days if the rate
of interest is 13%.
2. Determine the interest and future worth of P2500 for the period from February 10 to
July 15, 2003 at 14% interest.
3. Determine the interest and future worth of P1200 for the period from January 14 to
October 29, 1996 at 15% interest.

Cash-Flow Diagrams

A cash-flow diagram is a graphical representation of cash flows drawn on a time scale.

Receipt (positive cash flow or cash inflow)
Disbursement (negative cash flow or cash outflow)

 Compound Interest

Whenever the interest charge for any interest period is based on the remaining
principal amount plus any accumulated interest charges up to the beginning of that period,
the interest is said to be compound.

F=P(F/P, i%, n)

𝑭 = 𝑷(𝟏 + 𝒊)𝒏

The quantity (1 + 𝑖)𝑛 is the “single payment compound amount factor” and is
designated by F/P, i%, n.

P=F(P/F, i%, n)

𝑃 = 𝐹(1 + 𝑖)−𝑛

𝑭
𝑷=
(𝟏 + 𝒊)𝒏

The quantity (1 + 𝑖)−𝑛 is the “single payment present worth factor” and is designated
by P/F, i%, n.
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

 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=
𝒎

Where: i = rate of interest per interest period

r = nominal interest rate
m = number of compounding periods per year

Sample Problems:
1. Find the nominal rate which if converted semiannually could be used instead of 15%
compounded monthly. What is the corresponding effective rate?
2. Find the amount at the end of seven years and five months if P10,000 is invested at 9%
compounded quarterly and using simple interest for anytime less than a year interest
period.
3. A P20,000 loan was originally made at 10% simple interest for 5 years. At the end of
this period the loan was extended for 4 years, without the interest being paid, but the
new interest rate was made 12% compounded bimonthly. How much should the
borrower pay at the end of 9 years?
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

 Effective Rate of Interest

Effective rate of interest is the actual or exact rate of interest on the principal
during one year.

𝑬𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒓𝒂𝒕𝒆 = (𝟏 + 𝒊)𝒎 − 𝟏

Interest Principal at Interest Earned during Amount at End of Period

Period Beginning of Period Period
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

Find the amount at the end of five years and four months if P8,000 is invested at 10%
compounded quarterly using simple interest for anytime less than a year interest period.
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

A P10,000 loan was originally made at 8% simple interest for 2 years. At the end of this period
the loan was extended for 4 years, without the interest being paid, but the new interest rate
was made 12% compounded bimonthly. How much should the borrower pay at the end of 6
years?
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

Equation of Value

An equation of value is obtained by setting the sum of the values on a certain

comparison or focal date of one set of obligations equal to the sum of the values on the same
date of another set of obligations.

A man bought a lot worth P1,500,000 if paid in cash. On installment basis, he paid a down
payment of P500,000; P200,000 at the end of two years; P400,000 at the end of three years
and a final payment at the end of five years. What was the final payment if interest was 15%?
ENGGECON – Lesson 2: Interest and Money-Time Relationships
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

 Continuous Compounding

In discrete compounding, the interest is compounded at the end of each finite-

length period. In continuous compounding, it is assumed that cash payments occur
once per year, but the compounding is continuous throughout the year.

𝑟 𝑚𝑛
𝐹 = 𝑃 (1 + )
𝑚

Let m/r=k, then m=rk, as m increases so must k

𝑟𝑛
𝑟 𝑚𝑛 1 𝑟𝑘𝑛 1 𝑘
(1 + ) = (1 + ) = [(1 + ) ]
𝑚 𝑘 𝑘

𝑟 𝑚𝑛
𝐹 = 𝑃 (1 + )
𝑚

Let m/r=k, then m=rk, as m increases so must k

𝑟𝑛
𝑟 𝑚𝑛 1 𝑟𝑘𝑛 1 𝑘
(1 + ) = (1 + ) = [(1 + ) ]
𝑚 𝑘 𝑘

𝑟 𝑘
The limit of (1 + ) as k approaches infinite is e
𝑚
𝑟𝑛
1 𝑘
[(1 + ) ] = 𝑒 𝑟𝑛
𝑘
Thus,
𝑭 = 𝑷𝒆𝒓𝒏
𝑷 = 𝑭𝒆−𝒓𝒏
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

What is the accumulated amount after 5 years of P6,000 invested at the rate of 9% per year
compounded continuously?

How many years are required for your money to triple if it is invested at 14% compounded [a]
annually, [b] semi-annually, [c] quarterly, and [d] continuously?
ENGGECON – Lesson 2: Interest and Money-Time Relationships
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

Discount

- Interest deducted in advance

- Difference on what is worth in the future and its present worth

Discount = Future Worth – Present Worth

The rate of discount is the discount on one unit of principal per unit of time.

If d is the rate of discount, then

𝑑 = 1 − (𝑃/𝐹, 𝑖%, 1)
𝑑 = 1 − (1 + 𝑖)−1
1
𝑑 =1−
1+𝑖
𝒊
𝒅=
𝟏+𝒊
𝒅
𝒊=
𝟏−𝒅
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

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 gave 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?
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

Inflation

Inflation is the increase in the prices of goods and services from one year to another,
thus decreasing the purchasing power of money.

𝑭𝑪 = 𝑷𝑪(𝟏 + 𝒇)𝒏

Where: PC = present cost of a commodity

FC = future cost of the same commodity
f = annual inflation rate
n = number of years

A certain product presently costs P1500. If inflation rate is at the rate of 8% per year, what
will be the cost of this product in 5 years?
 ENGGECON – Lesson 2: Interest and Money-Time Relationships

In an inflationary economy, the buying power of money decreases as costs increase. Thus,

𝑃
𝐹=
(1 + 𝑓)𝑛

where F is the future worth, measured in today’s pesos, of a present amount P.

If interest is being compounded at the same time that inflation is occurring, the future worth
will be

𝑷(𝟏 + 𝒊)𝒏 𝟏+𝒊 𝒏

𝑭= = 𝑷( )
(𝟏 + 𝒇)𝒏 𝟏+𝒇

In year zero, you invest P30,000 in a 14% security for 7 years. During that time, the average
annual inflation is 6%. How much, in terms of year zero pesos will be in the account at
maturity?
 ENGGECON – Lesson 3: Annuities

ANNUITIES

An annuity is a series of equal payments occurring at equal periods of time.

Annuities occur in the following instances:

 Payment of a debt by a series of equal payments at equal intervals of time.
 Accumulation of a certain amount by setting equal amounts periodically.
 Substitution of a series of equal amounts periodically in lieu of a lump sum at
retirement of an individual.

Classification of Annuities:
 Ordinary annuity
 Deferred annuity
 Annuity due
 Perpetuity

 Ordinary Annuity

An ordinary annuity is one where the payments are made at the end of each period.

Finding P when A is given

0 1 2 3 n-1 n

A A A A A
A(P/F, i%, 1)
A(P/F, i%, 2)
A(P/F, i%, 3)
A(P/F, i%, n-1)
A(P/F, i%, n)

𝑃 = 𝐴(𝑃/𝐹, 𝑖%, 1) + 𝐴(𝑃/𝐹, 𝑖%, 2) + ⋯ + 𝐴(𝑃/𝐹, 𝑖%, 𝑛 − 1) + 𝐴(𝑃/𝐹, 𝑖%, 𝑛)

 ENGGECON – Lesson 3: Annuities

P=A(P/A, i%, n)

𝟏 − (𝟏 + 𝒊)−𝒏 (𝟏 + 𝒊)𝒏 − 𝟏
𝑷 = 𝑨[ ] = 𝑨[ ]
𝒊 𝒊 (𝟏 + 𝒊)𝒏

The quantity in brackets is called the “uniform series present worth factor” and is
designated by the functional symbol P/A, i%, n.

Finding F when A is given

F

0 1 2 3 n-1 n

A A A A A
A(F/P, i%, 1)
A(F/P, i%, n-3)
A(F/P, i%, n-2)
A(F/P, i%, n-1)

𝐹 = 𝐴 + 𝐴(𝐹/𝑃, 𝑖%, 1) + 𝐴(𝐹/𝑃, 𝑖%, 2) + ⋯ + 𝐴(𝐹/𝑃, 𝑖%, 𝑛 − 2) + 𝐴(𝐹/𝑃, 𝑖%, 𝑛 − 1)

F=A(F/A, i%, n)

(𝟏 + 𝒊)𝒏 − 𝟏
𝑭 = 𝑨[ ]
𝒊

The quantity in bracket is called the “uniform series compound amount factor” and is
designated by the functional symbol F/A, i%, n.
 ENGGECON – Lesson 3: Annuities

Finding A when P is given

A=P(A/P, i%, n)

𝒊
𝑨 = 𝑷[ ]
𝟏 − (𝟏 + 𝒊)−𝒏

The quantity in bracket is called the “capital recovery factor” and is designated by the
functional symbol A/P, i%, n.

Finding A when F is given

A=F(A/F, i%, n)

𝒊
𝑨 = 𝑭[ ]
(𝟏 + 𝒊)𝒏 − 𝟏

The quantity in the bracket is called the “sinking fund factor” and is designated by the
functional symbol A/F, i%, n.

The relation between A/P, i%, n and A/F, i%, n

(A/F, i%, n) + i = (A/P, i%, n)

Thus,
sinking fund factor + i = capital recovery factor
 ENGGECON – Lesson 3: Annuities

What are the present worth and future worth of P800 deposited at the end of every month
for 5 years if the interest rate is 12% compounded quarterly?
 ENGGECON – Lesson 3: Annuities

A steam boiler is purchased on the basis of guaranteed performance. However, initial tests
indicate that the operating cost will be P400 more per year than guaranteed. If the expected
life is 25 years and money is worth 10%, what deduction from the purchase price would
compensate the buyer for the additional operating cost?
 ENGGECON – Lesson 3: Annuities

A one-bagger concrete mixer can be purchased with a down payment of P8,000 and equal
installments of P600 each paid at the end of every month for the next 12 months. If money
is worth 14% compounded monthly, determine the equivalent cash price of the mixer.
 ENGGECON – Lesson 3: Annuities

What amount of money invested today at 16% interest can provide the following
scholarships: P40,000 at the end of each year for 5 years; P50,000 for the next 8 years and
P60,000 thereafter?