COURSE CODE: EM 5 UNITS: 3

COURSE DESCRIPTION: ENGINEERING ECONOMICS NO. OF HRS: 3

LESSON 2: MONEY-TIME RELATIONSHIPS AND EQUIVALENCE
I. INTEREST AND THE TIME VALUE OF MONEY

MONEY
Medium of Exchange
 Means of payment for goods or services;
 What sellers accept and buyers pay;
Store of Value
 A way to transport buying power from one-time period to another;
Unit of Account
 A precise measurement of value or worth;
 Allows for tabulating debits and credits;

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

KINDS OF CAPITAL
 EQUITY CAPITAL is that owned by individuals who have invested their money or property in a
business project or venture in the hope of receiving a profit.
 DEBT CAPITAL, often called borrowed capital, is obtained from lenders (e.g., through the sale
of bonds) for investment.

INTEREST
 It is the manifestation of the time value of money.
 The fee that a borrower pays to a lender for the use of his or her money.
 Difference between an ending amount of money and a beginning amount of money.
(investment) 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 𝒄𝒖𝒓𝒓𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 – 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒗𝒂𝒍𝒖𝒆
(loans) 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒘𝒆𝒅 𝒏𝒐𝒘 – 𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
NOTE: original amount = principal

INTEREST RATE
 The percentage of money being borrowed that is paid to the lender on some time basis.
 Interest paid over a time period expressed as a percentage of principal
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒑𝒂𝒊𝒅 𝒑𝒆𝒓 𝒕𝒊𝒎𝒆 𝒖𝒏𝒊𝒕
𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 (%) = 𝒐𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒂𝒎𝒐𝒖𝒏𝒕
𝒙 𝟏𝟎𝟎%
𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒂𝒄𝒄𝒓𝒖𝒆𝒅 𝒑𝒆𝒓 𝒕𝒊𝒎𝒆 𝒖𝒏𝒊𝒕
𝑹𝒂𝒕𝒆 𝒐𝒇 𝑹𝒆𝒕𝒖𝒓𝒏 (%) = 𝒑𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍
𝒙 𝟏𝟎𝟎%

HOW INTEREST RATE IS DETERMINED

Prepared by: Engr.JRLdR Page 1 of 5

COURSE CODE: EM 5 UNITS: 3
COURSE DESCRIPTION: ENGINEERING ECONOMICS NO. OF HRS: 3
LESSON 2: MONEY-TIME RELATIONSHIPS AND EQUIVALENCE
NOTATIONS
The notations which are used in various interest formula are as follows:
 P – principal amount
 i – interest rate (it may be compounded monthly, quarterly, semiannually or annually)
 n – number of interest periods
 F – future amount at the end of year n
 A – equal amount deposited at the end of every interest period
 G – uniform amount which will be added/subtracted period after period to/from the amount
of deposit A1 at the end of period 1

SIMPLE INTEREST
 In simple interest, the interest is calculated, based on the initial deposit for every interest
period.
 In this case, calculation of interest on interest is not applicable. This means that the interest
charges grow in linear function over a period of time.
 This is usually used for short-term loans where the period of the loan is measured in days
rather than years.

Simple interest can be calculated using the formula:

I = Pin where: P = principal / loan
I = interest
i = interest rate
n = period

The future amount of the principal may be calculated by adding the interest (I) to the principal (P)
F=P+I
F = P + Pin
Thus, F = P (1 + in)

TYPES OF SIMPLE INTEREST

There are two types of simple interest namely, ordinary simple interest and exact simple interest.

 Ordinary simple interest – is based on one banker’s year. A banker year is composed of 12
months of 30 days each which is equivalent to a total of 360 days in a year. The value of n that
is used in the preceding formula may be calculated as
𝒅
n= where: d = number of days the principal was invested
𝟑𝟔𝟎

 Exact simple interest – is based on exact number of days in a given year. A normal year has
365 days while a leap year (which occurs once every 4 years) has 366 days. Unlike the ordinary
simple interest where each month has a 30 days, in this type of interest, the number of days
in a month is based on the actual number of days each month contains in or Gregorian
calendar.
Determine if the year is a leap year. Divisible by 4 or 400 (century year)
The value of n to be used in the preceding formula are as follows
𝒅 𝒅
n = 𝟑𝟔𝟓 for normal year n = 𝟑𝟔𝟔 for leap year

Prepared by: Engr.JRLdR Page 2 of 5

COURSE CODE: EM 5 UNITS: 3
COURSE DESCRIPTION: ENGINEERING ECONOMICS NO. OF HRS: 3
LESSON 2: MONEY-TIME RELATIONSHIPS AND EQUIVALENCE
COMPOUND INTEREST
 In compound interest, the interest for the current period is computed based on the amount
(principal plus interest up to the end of the previous period) at the beginning of the current
period.
 This means that aside from the principal, the interest now earns interest as well. Thus the
interest charges grow exponentially over a period of time.
 This is frequently used in commercial practice than simple interest, more especially if it is a
longer period which spans for more than a year.

The future amount of the principal may be derived by the following:

PERIOD PRINCIPAL INTEREST TOTAL AMOUNT

1 P Pi P + P i = P (1 + i)
2 P (1 + i) P (1 + i) i P (1 + i) (1 + i) = P (1 + i)²
3 P (1 + i)² P (1 + i)² i P (1 + i)² (1 + i) = P (1 + i)³
n P (1 + i)ⁿ

The tabulation shows that the future amount (total amount) is just the value P (1 + i) with an exponent
which is numerically equal to the period. It is based on the principle of geometric progression.

Future Amount, F:
F = P (1 + i) ⁿ where: P = principal
i = interest per period (in decimal)
n = number of interest periods
(1 + i) = single payment compound amount factor
Present Worth, P:
𝐅 𝟏
P= where: = single payment present worth factor
(𝟏+𝐢)𝐧 (𝟏+𝒊)𝒏

TIME VALUE OF MONEY

 Money has a time value
 A peso today is worth more than a peso tomorrow
 Failure to pay the bills results in additional charge termed
 Time has a special relationship with money and that relationship brings forth this inevitable
product: Interest

• FV = the future value of money

• PV = the present value
• i = the interest rate or other return that can be
earned on the money
• t = the number of years to take into consideration
• n = the number of compounding periods of
interest per year

Prepared by: Engr.JRLdR Page 3 of 5

 COURSE CODE: EM 5 UNITS: 3
COURSE DESCRIPTION: ENGINEERING ECONOMICS NO. OF HRS: 3
LESSON 2: MONEY-TIME RELATIONSHIPS AND EQUIVALENCE

II. THE CONCEPT OF EQUIVALENCE

ECONOMIC EQUIVALENCE
 Established when we are indifferent between a future payment, or a series of future
payments, and a present sum of money.

 Considers the comparison of alternative options, or proposals, by reducing them to an

equivalent basis, depending on:
o interest rate;
o amounts of money involved;
o timing of the affected monetary receipts and/or expenditures;
o manner in which the interest, or profit on invested capital is paid and the initial capital
is recovered.

 Two sums of money at two different points in time can be made economically equivalent if:
o We consider an interest rate, and
o The number of time periods between the two sums

 Equality in terms of Economic Value

o ₱ 15,000 now is economically equivalent to ₱ 16,500 one year from now IF the
interest rate is 10%/year.

III. CASH FLOWS

CASH FLOWS
In this method of comparison, the cash flows of each alternative will be reduced to time zero by
assuming an interest rate i. Then, depending on the type of decision, the best alternative will be
selected by comparing the present worth amounts of the alternatives.

The sign of various amounts at different points in time in a cash flow diagram is to be decided based
on the type of the decision problem.

CASH FLOW DIAGRAM POSITIVE (+) NEGATIVE (-)

Cost dominated cash Costs (outflows) Profit, revenue, salvage value

flow diagram (all inflows)

Revenue/profit- Profit, revenue, salvage value Costs (outflows)

dominated cash flow (all inflows to an organization)
diagram

 In decision, to select the alternative with minimum cost, select alternative with the least
present worth amount.
 If decision is to select the alternative with maximum profit, then the alternative with the
maximum present worth will be selected.

Prepared by: Engr.JRLdR Page 4 of 5

COURSE CODE: EM 5 UNITS: 3
COURSE DESCRIPTION: ENGINEERING ECONOMICS NO. OF HRS: 3
LESSON 2: MONEY-TIME RELATIONSHIPS AND EQUIVALENCE

TABLE NOTATION
 i = effective interest rate per interest period
 N = number of compounding periods (e.g., years)
 P = present sum of money; the equivalent value of one or more cash flows at the present time
reference point
 F = future sum of money; the equivalent value of one or more cash flows at a future time
reference point
 A = end-of-period cash flows (or equivalent end-of- period values) in a uniform series
continuing for a specified number of periods, starting at the end of the first period and
continuing through the last period
 G = uniform gradient amounts -- used if cash flows increase by a constant amount in each
period

CASH FLOW DIAGRAM

SAMPLE CASH FLOW DIAGRAM

1. Time scale with progression of time moving from left to right; the numbers represent time
periods (ex. years, months, quarters, etc.) and may be presented within a time interval or at
the end of a time interval.
2. Present expense (cash outflow) of ₱ 8,000 for lender.
3. Annual income (cash inflow) of ₱ 2,524 for lender.
4. Interest rate of loan.
5. Dashed-arrow line indicates amount to be determined.

Prepared by: Engr.JRLdR Page 5 of 5