Interest and Money-Time Relationships

Interest
- is the amount of money paid for the use of borrowed capital or the income produced by
money which has been loaned.

A. 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.

I = Pin
F = P + I =P + Pin
F = P (1 + i n)

Where: I = interest
P = principal or present worth
n = number of interest periods (no. of years)
i = rate of interest per interest period
F = accumulated amount or future worth

a) Ordinary Simple Interest is computed in the basis of 12 months of 30 days each

or 360 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

For leap year:

Use the rule 400 = if the year ends in “00”
Use the rule 4 = if the year does not end in “00”
(“divide the year to 400 or 4 and if the answer is whole number,
then it is a leap year but if not, then it is not a leap year”)
 Ex. Year 2000 =˃ 2000/400 = 5 (therefore year 2000 is leap year)
Year 1987 =˃ 1987/4 = 496.75 (therefore year 1987 is not a leap year)
Example Problems:
1. Determine the ordinary simple interest on ₱700.00 for 8 months and 15 days if the rate
of interest is 15%.

Solution:
Given:
I=?
P = ₱700.00
n = 8 months and 15 days
i = 15%

No. of days = (8) (30) + 15 = 255 days

I = Pin = (₱700) (255/360) (0.15) = ₱74.38

2. Determine the exact simple interest on ₱500.00 for the period from January 10 to
October 28, 1996 at 16% interest.

Solution:
Given:
I=?
P = ₱500.00
i = 16%

n = January 10 – 31 = 21 days (excluding Jan. 10)

February = 29 ( 1996/4 = 499 )
March = 31
April = 30
May = 31
June = 30
July = 31
August = 31
September = 30
October = 28 (including Oct. 28)
___________
292 days

( 1996/4 = 499 therefore 1996 is a leap year )

 Exact Simple Interest = (₱500) (292/366) (0.16) = ₱63.83
3. What will be the future worth of money after 14 months, if a sum of ₱10,000 is
invested today at a simple interest rate of 12% per year?

Solution:
Given:
I=?
P = ₱10,000
n = 14 months
i = 12% per year
F=?

F = P ( 1 + in ) = (10,000) {1 + (14/12)(0.12)}

F = ₱11,400.00

Cash Flow Diagrams

- A cash-flow diagram is simply a graphical representation of cash flows drawn on a time
scale. Cash-flow diagram for economic analysis problem is analogous to that of free body
diagram for mechanic problems.
Conventions used in Cash Flow Diagram:
1. The horizontal (time) axis is marked off in equal increments, one period up to the
duration of horizon of the project.
2. All disbursements and receipts (cash flow) are assumed to take place at the end of the
year in which they occur. This is known as the year-end convention. The exception of
the year-end convention is the initial cost (purchase cost) which occur at t = 0.
3. Two or more transfer in the same period placed end-to-end maybe combined into one.
4. Expenses incurred before t = 0 are called sunk cost and are not relevant to the problem.
5. Receipts and disbursements are represented by arrows on opposite sides of the
horizontal (time) axis.

↑ (arrow up) = receipt (positive cash flow or cash in-flow)

 ↓ (arrow down) = disbursement (negative cash flow or cash outflow)

Example:
A loan of $1000.00 at simple interest of 10% will become $1500.00 after 5 years.
Consider the lender and the borrower’s point of view in the following cash flow diagram.

B. Compound Interest

- is defined as the interest of loan or principal which is based not only on the original
amount of the loan or principal but the amount of loan or principal plus the previous
accumulated interest. 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.

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

Period Principal Interest Total Amount

1 P Pi P + Pi = 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‾¹ P ( 1+i )ⁿ‾¹(i) P ( 1 + i )ⁿ

a. Future Amount, (F)

F = P (1+i)ⁿ
Where: P = Principal amount
i = interest per period
n = number of interest periods

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

F = P (F/P, i%, n)
The symbol F/P, i%, n is read as “F given P at i percent in
n interest periods”.

F = P (1+i)ⁿ‾¹

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

P = F (P/F, i%, n)
The symbol P/F, i%, n is read as “P given F at i% in n interest periods”.

b. Present Worth, P

P = F / (1 + i) ⁿ

Rates of Interest
a. Nominal Rate of Interest (NR)
The nominal rate of interest specifies the rate of interest and a number of interest
periods in one year. (% per year compounded quarterly, semi-annually, etc.)

i = NR/m where: i = rate of interest per interest period

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

If the nominal rate of interest is 10% compounded quarterly,

then,
i = 10% / 4 = 2.5%, the rate of interest per interest period.

b. Effective Rate of Interest (ER)

Effective rate of interest is the actual or exact rate of interest on the principal
during one year. (% per year compounded yearly)

If ₱1.00 is invested at a nominal rate of 15% compounded quarterly, after one year
this will become,

₱1.00 ( 1 + 0.15/4 )⁴ = ₱1.1586

The actual interest earned is ₱0.1586, therefore, the rate of interest after one year
15.86%. Hence,

Effective rate = F₁ - 1 = ( 1 + i )ᵐ - 1

Where:
F₁ = the amount of ₱1.00 will be after one year

Example Problems:
1. Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?

Solution:
Let NR = the unknown nominal rate

For two or more nominal rates to be equivalent, their corresponding effective rates must
be equal.

Nominal rate Effective rate

NR % compounded quarterly ( 1 + NR/4 )⁴ - 1

12% compounded monthly ( 1 + 0.12/12 )¹² - 1

 ( 1 + NR/4 )⁴ - 1 = ( 1 + 0.01 )¹² - 1
1 + NR/4 = ( 1.01 )³ = 1.0303

NR = 0.1212 or 12.12% compounded quarterly

2. What is the effective rate corresponding to 18% compounded daily? Take 1 year is equal
to 360 days.

Solution:
Given: ER = ?
NR = 18%
n = 360 days (compounded daily)

ER = ( 1 + i )ⁿ - 1
ER = ( 1 + 0.18/360)³⁶° - 1
ER = 19.72%

3. The amount of ₱50,000 was deposited in the bank earning an interest of 7.5% per annum.
Determine the total amount at the end of 5 years, if the principal and interest were not
withdrawn during the period.

Solution:
Given: P = 50,000
i = 7.5%
n = 5 years

F = P ( 1 + i )ⁿ
F = 50,000 ( 1 + 0.075 )⁵
F = 71,781.47

C. Continuously Compound Interest

- The concept of continuous compounding is based on the assumption that cash payment
occurs once per year but compounding is continuous throughout the year.
- The basic equation for future worth of continuously compound interest is given by the
formula,

F=Peͬⁿ

Where: F = future worth

 P = present worth
r = nominal rate of continuously compound interest
n = number of years
e = 2.718281828 (constant and direct from calculator)
- The present worth of continuously compound interest is given by the formula,

P=F/eͬⁿ

Discount
- The difference between the present worth (the amount received for the paper in cash) and
the worth of the paper at some time in the future ( the face value of the paper or the
principal).
- It is the interest paid in advance.

Discount = Future worth – Present worth

Rate of Discount is the discount on one unit of principal for one unit of time.

d=I/1+i

where; I = interest
d = rate of discount
i = interest rate

Example Problem:
1. Compare the accumulated amounts after 5 years of 1,000 invested at the rate of 10% per
year compounded a) annually b) semi-annually c) quarterly, d) monthly, e) daily, and f)
compounded continuously.

Solution:
Using the formulas, F = P ( 1 + i )ⁿ , F= P e ͬ ⁿ

a. F = ₱1,000 ( 1 + 0.10 )⁵ = ₱1,610.51

b. F = ₱1,000 ( 1 + 0.10 / 2 ) ¹⁰ = ₱1,628.89
c. F = ₱1,000 ( 1 + 0.10 / 4 ) ²⁰ = ₱1,638.62
d. F = ₱1,000 ( 1 + 0.10 / 12 ) ⁶⁰ = ₱1,645.31
e. F = ₱1,000 ( 1 + 0.10 / 365 )¹⁸²⁵ = ₱1,648.61

f. F= P e ͬ ⁿ = (1000) (e) ⁰٠¹⁰⁕⁵ = ₱1,648.72