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Lesson 1 - Interest and Time Value of Money - IE 112
Lesson 1 - Interest and Time Value of Money - IE 112
Lesson 1 - Interest and Time Value of Money - IE 112
CHAPTER 2
MONEY-TIME RELATIONSHIPS AND
EQUIVALENCE
TOPIC OUTLINE
LEARNING OUTCOMES
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The cash flow is fundamental to every economic study. Cash flows occur in
many configurations and amounts—isolated single values, series that are uniform,
and series that increase or decrease by constant amounts or constant percentages.
This chapter develops derivations for all the commonly used engineering economy
factors that take the time value of money into account.
Interest is the amount of money paid for the use of borrowed capital or the
income produced by money which has been loaned.
The time value of money seems like a sophisticated concept, yet it is one that
you grapple with every day. Should you buy something today or save your money
and buy it later? Here is a simple example of how your buying behavior can have
varying results: Pretend you have Php 5, 000 and you want to buy a Php 5, 000
refrigerator for your dorm room. If you buy it now, you end up broke. But if you invest
your money at 6% annual interest, then in a year you can still buy the refrigerator, and
you will have Php 300 left over. However, if the price of the refrigerator increases at
an annual rate of 8% due to inflation, then you will not have enough money (you will
be Php 100 short) to buy the refrigerator a year from now. In that case, you probably
are better off buying the refrigerator now. If the inflation rate is running at only 4%,
then you will have Php 100 left over if you buy the refrigerator a year from now
Clearly, the rate at which you earn interest should be higher than the inflation
rate in order to make any economic sense of the delayed purchase. In other words,
in an inflationary economy, your purchasing power will continue to decrease as you
further delay the purchase of the refrigerator. In order to make up this future loss in
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purchasing power, the rate at which you earn interest should be sufficiently larger
than the anticipated inflation rate. After all. time, like money, is a finite resource. There
are only 24 hours in a day, so time has to be budgeted, too. What this example
illustrates is that we must connect earning power and purchasing power to the
concept of time.
The way interest operates reflects the fact that money has a time value. This is
why amounts of interest depend on lengths of time; interest rates. for example, are
typically given in terms of a percentage per year. We may define the principle of the
time value of money as follows: The economic value of a sum depends on when the
sum is received. Because money has both earning power and purchasing power over
time (i.e., it can be put to work, earning more money for its owner). a dollar received
today has a greater value than a dollar received at some future time. When we deal
with large amounts of money, long periods of time, or high interest rates, the change
in the value of a sum of money over time becomes extremely significant.
Simple Interest
Simple interest is calculated using 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.
𝑰 = 𝑷𝒏𝒊
𝐹 = 𝑃 + 𝐼 = 𝑃 + 𝑃𝑛𝑖
𝑭 = 𝑷(𝟏 + 𝒏𝒊)
Where:
I = interest
P = principal or present worth
n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future worth
Ordinary simple interest is computed on the basis of 12 months of 30 days each or 360
days a year.
Exact simple interest is based on the exact number of days a year, 365 days for an
ordinary year and 366 days for a leap year.
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ILLUSTRATIVE PROBLEMS
1. Supposed you deposit Php 1, 000 in a bank savings account that pays interest
at a rate of 8% per year. Assume that you don’t withdraw the interest earned
at the end of each period (year), but instead let it accumulate. How much
would you have at the end of year three with simple interest?
Solution
𝐹 = 𝑃(1 + 𝑛𝑖)
𝐹 = 1000[1 + (3)(0.08)]
𝑭 = 𝑷𝒉𝒑 𝟏, 𝟐𝟒𝟎. 𝟎𝟎
2. Determine the ordinary simple interest on Php 700 for 8 months and 15 days if
the rate of interest is 15%.
Solution
255
𝐼 = 𝑃𝑛𝑖 = (700) (0.15)
360
𝑰 = 𝑷𝒉𝒑 𝟕𝟒. 𝟑𝟖
3. Determine the exact simple interest on Php 500 for the period from January 10
to October 28, 1996 at 16% interest.
Solution
292
𝐼 = 𝑃𝑛𝑖 = (500) (0.16)
366
𝑰 = 𝑷𝒉𝒑 𝟔𝟑. 𝟖𝟑
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4. What will be the future worth of money after 15 months, if a sum of Php 10,
000.00 is invested today at a simple interest rate of 12% per year?
Solution
𝐹 = 𝑃(1 + 𝑛𝑖)
15
𝐹 = 10, 000 1 + (0.12)
12
Receipt (positive cash flow or cash inflow). Cash inflows are the receipts,
revenues, incomes, and savings generated by project and business activity. A
plus sign indicates a cash inflow.
Disbursement (negative cash flow or cash outflow). Cash outflows are costs,
disbursements, expenses, and taxes caused by projects and business Cash flow
activity. A negative or minus sign indicates a cash outflow. When a project
involves only costs, the minus sign may be omitted for some techniques, such
as benefit/cost analysis.
A loan of Php 100.00 at simple interest of 10% will become Php 150.00 after 5
years.
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COMPOUND INTEREST
In compound interest, the interest earned by the principal at the end of each
interest period (compounding period) is added to the principal. The sum (principal +
interest) will earn another interest in the next compounding period.
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𝒓 𝒎𝒕
𝑭 = 𝑷(𝟏 + 𝒊)𝒏 𝒐𝒓 𝑭 = 𝑷(𝟏 + )
𝒎
Where:
F = P(F/P, i%, n)
𝒏
𝑷 = 𝑭(𝟏 + 𝒊)
The quantity (1+i)-n is commonly called the “single payment present worth factor”
and is designated by the functional symbol P/F, i%,n. Thus,
P = F(P/F, i%, n)
Rates of Interest
𝒓
𝒊=
𝒎
0.15
𝑃ℎ𝑝 1.00(1 + ) = 𝑃ℎ𝑝 1.1586
4
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The actual interest earned is Php 0.1586, therefore, the rate of interest after
one year is 15.86%. Hence,
ILLUSTRATIVE PROBLEMS
1. Supposed you deposit Php 1, 000 in a bank savings account that pays interest
at a rate of 8% per year. Assume that you don’t withdraw the interest earned
at the end of each period (year), but instead let it accumulate. How much
would you have at the end of year three with compound interest?
Solution
𝐹 = 𝑃(1 + 𝑖)
𝐹 = 1000(1 + 0.08)
2. Find the nominal rate which if converted quarterly could be used instead of
12% compounded monthly. What is the corresponding effective rate?
Solution
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𝑟
(1 + ) − 1
4
0.12
(1 + ) −1
12
𝑟 0.12
(1 + ) − 1 = (1 + ) −1
4 12
3. Suppose that the interest rate is 10% per year, compounded annually. What is
the minimum amount of money that would have to be invested for a two-
year period in order to earn Php 15, 000.00 in interest?
Solution
𝑃 = 𝐹(1 + 𝑖)
Solution
𝐹 = 𝑃(1 + 𝑖)
𝑟
𝑜𝑟 𝐹 = 𝑃(1 + )
𝑚
Given:
P = Php 3, 000.00
r = 5%
m = 4 (quarterly)
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t = 5 (years)
0.05 ( )
𝐹 = 3, 000(1 + )
4
5. A Php 200, 000.00 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
semiannually. How much should the borrower pay at the end of 7 years?
Solution
For the first four years, the simple interest is 8%. Compute for F 4 using simple interest
formula
𝐹 = 𝑃(1 + 𝑛𝑖)
𝐹 = 200, 000[1 + (4)(0.08)]
𝐹 = 𝑃ℎ𝑝 264, 000.00
For the last 3 years, use compound interest at 10% compounded semiannually.
𝐹 = 𝐹 (1 + 𝑖)
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EXERCISES 02
Direction: Solve the following problems. Show complete and neat solution.
1. Find the principal of a loan in which the interest rate is 1.5% per month,
payable monthly, and in which the borrower has just made the first
monthly interest payment of Php 2, 500.00. (ans. Php 166, 666.667)
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2. How much money will be required four years from today to repay a Php
100, 000.00 loan that is made today (a) at 8% interest, compounded
annually? (b) at 8% simple interest? (ans. Php 136, 048.896, Php 132, 000)
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3. A person lends Php 100, 000.00 for five years at 10% per annum simple
interest; then the entire proceeds are invested for 10 years at 9% per year,
compounded annually. How much money will the person have at the end
of the entire 15-year period? (ans. Php 355, 104.55)
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