UNIVERSITY OF LA SALETTE,INC

COLLEGE OF ENGINEERING AND ARCHITECTURE

SANTIAGO CITY, PHILIPPINES

Module 2: Money Time Relationships and Equivalence

Introduction
Most of us are familiar in a general way with the concept of interest. We know that money left in
a savings account earns interest so that the balance over time is greater than the sum of the deposits. We
know that borrowing to buy a car means repaying an amount over time, that it includes interest, and that
the amount paid is therefore greater than the amount borrowed. What may be unfamiliar to us is the idea
that, in the financial world, money itself is a commodity, and like other goods that are bought and sold,
money costs money.
The cost of money is established and measured by an interest rate, a percentage that is
periodically applied and added to an amount (or varying amounts) of money over a specified length of
time. When money is borrowed, the interest paid is the charge to the borrower for the use of the lender's
property; when money is loaned or invested, the interest earned is the lender's gain for providing a good
to another. Interest, then, may be defined as the cost of having money available for use. In this module,
we examine how interest operates in a free-market economy and establish a basis for understanding the
more complex interest relationships.

Learning Outcomes
At the end of this module, you are expected to
a. solve problems involving interest and the time value;
b. illustrate project alternatives by applying engineering economic principles and methods
select the most economically efficient one; and
c. calculate nominal and effective rates of interest.
Preassessment:
On the last module we tackle about economic problems which deal with immediate or present situations
and costs, in connection with this calculate the following problems. (refer to back of this module on
where to write your answers and solutions):
1. Dalisay Corporation's gross margin is 45% of sales. Operating expenses such as sales and
administration are 15% of sales. Dalisay Corporation is in 40% tax bracket What percent of
sales is their profit after taxes?
2. Jojo bought a second-hand Betamax VCR and then sold it to Rudy at a profit of 40%. Rudy
then sold the VCR to Noel at a profit of 20%. If Noel paid P 2,856 more than it cost Jojo, how
much did Jojo pay for the unit?
Lecture
Topic 1: Terminologies
Capital – refers to wealth in the form of money or property that can be used to produce more wealth.
The Concept of Time Value of Money – “Money makes money”. This is true because if we invest
money today, by tomorrow we will have accumulated more money that what we had originally invested.
And also if you borrow money today you will have to pay in the future an amount that is larger that what

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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

you have originally owed. This change in the amount of money over a given time period is called time
value of money”.
Equity capital – is owned by individuals who have invested their money or property in a business project
or venture in the hope of receiving a profit and sometimes in exchange for a share of ownership in the
company. Equity financing allows a business to obtain funds without incurring debt or having to repay a
specific amount of money at a particular time.
Debt Capital – also called borrowed capital, is represented by funds borrowed by a business that must be
repaid over a period of time, usually with interest. Debt financing can be either short-term, with full
repayment due in less than one year, or long-term, with repayment due over a period greater than one year.
Return On Capital - measures of how effectively a company uses the money (borrowed or owned)
invested in its operations.
Interest - The term "interest" is used to indicate the rent paid for the use of money. It is also used to
represent the percentage earned by an investment in a productive operation. From the lender's point of
view, the interest is the income produced by the money which he has lent. From the borrower's point of
view, interest is the amount of money paid for the use of borrowed capital. The percentage of money
charge as interest is called as interest rate.
Topic 2: Interest and the Time Value
Simple Interest
The interest is said to be simple interest if the interest to be paid is directly proportional to the
length of time the amount or principal is borrowed. The principal is the amount of money borrowed or
invested.
Total interest (I) is computed by the formula:
I = (P) (n) (i) where: P = principal amount lent or borrowed
n = number of interest period (ex. years)
i = interest rate per interest period

The total amount, F to be repaid at the end of N interest period is F = P + I of F = P[1 + (n x i)]

Two types of 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 that is used in the
preceding formulas may be calculated as
�
� = ��� where: d = number of days where the principal was invested

Exact simple interest is based on the 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

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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

interest where each month has 30 days, in the type of simple interest, the number of days in a month is
based on the actual number of days each month contains in our Gregorian calendar.
� �
� = ��� normal year � = ��� leap year

Sample Problems.

1. Suppose that P1,000 is borrowed at a simple interest rate of 18% per annum. At the end of one
year, the interest would be:
I = (P) (n) (i)
I = 1,000 (1) (0.18) = P 180

2. Michelle invested $5000.00 in mutual fund with the interest rate of 4.8%. How much interest
would she earn after 2 years?
P = $5000.00 ; i= 4.8% ; n= 2
I = (P) (n) (i)
I = ($5000.00)(4.8%)(2) = $480.00

Hence, Michelle would earn $480 after 2 years.

3. Jeff has one savings account with the interest rate of 3.3%, and one money market account with
the interest rate of 5.1% in a bank. If he deposits $1,200.00 to the savings account, and $1,800.00
to the money market account, how much money will he have after 6 years?

4. If you borrowed money from your friend with simple interest of 12%, find the present worth
of P50,000, which is due at the end of 7 months.
F = P (1 + rt)
7
50000 = � 1 + 0.12
12
P = 46,728.97

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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Notation and Cash Flow Diagrams

Notations used in formulas for compound interest formulas

i = interest rate per interest period

N = number of compounding periods
P = present sum of money; the equivalent worth of one or more cash flows at a reference
point in time called the present
F = future sum of money; the equivalent worth of one or more cash flows at a reference
point in time called the future
A = end-of-period cash flows 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

Cash Flow Diagram

 Cash flow is the difference between total cash coming (inflows or cash receipts) and total cash
going out (outflows or cash disbursements) for a given period of time. Cash flow provides a
means for planning the most effective use of your cash.
 A cash flow diagram is a picture of a financial problem that shows all cash inflows and outflows
plotted along a horizontal timeline. It is used to visualize cash flow: individual cash flows are
presented as vertical arrows along a horizontal time scale.

The cash flow diagram employs several conventions:

1. The horizontal line is a time scale, with progression of time moving from left to right divided into
equal periods such as days, months, or years.
2. The arrows signify cash flows and are placed at the end of the period. Funds that you pay out
such as savings deposits or lease payments are negative cash flows that are represented by
downward arrows Funds that you receive such as proceeds from a mortgage or withdrawals from
a saving account are positive cash flows represented by upward arrows.
3. The cash flow diagram is dependent on the point of view (e.g. lender versus borrower viewpoint).

Example: You are 40 years old and have accumulated $50,000 in your savings account. You can add
$100 at the end of each month to your account which pays an annual interest rate of 6% compounded
monthly. Will you be able to retire in 20 years?

The timeline is divided into 240 monthly periods (20

years times 12 payments per year) since the payments
are made monthly and the interest is also compounded
monthly. The $50,000 that you have now (present
value) is a negative cash outflow since you will treat it
as though you were just now depositing it into the
account. It is represented with a downward pointing
arrow with its base at the beginning of the first period.
The 240 monthly $100 deposits are also negative
outflows represented with downward pointing arrows
placed at the end of each period. Finally, you will

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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

withdraw some unknown amount (the future value) after 20 years. Represent this positive inflow with an
upward pointing arrow with its base at the very end of the last period.

This diagram was drawn from your point of view. From the bank's point of view, the present value and
the series of deposits are positive cash inflows, and the final withdrawal of the future value will be a
negative outflow.

Compound Interest

 Whenever the interest charge for any interest period is based on the remaining principal amount
plus any accumulated interest chargers up to the beginning of that period, the interest is said to be
compound.
 Compound interest calculations apply to investments where the amount of interest is calculated
on the present balance of the account.

A. Future Amount, F

F = P (1 + i)n
where: P = principal amount lent or borrowed
n = number of interest period (ex. years)
i = interest per interest period (in decimal)
(1 + i)n = single payment compound factor Cash Flow
B. Present Worth, P
�
P = (� + �)�

where: (1 + i)n = single payment present worth

factor
Nominal and Effective Rates of Interest
Rate of interest is the cost of borrowing money. It also refers to the amount earned by a unit principal
per unit time.
There are two types of rates of interest, namely the nominal rate of interest and the effective rate of
interest.
Nominal rate of interest is defined as the basic annual rate of interest while effective rate of interest is
defined as the actual or the exact rate of interest earned on the principal during a one-year period.
ER = (1 + i )m – 1 where: m = number of interest per period per year
�� ��
Or ER = � + � m – 1 i = interest per period = �
NR = nominal rate of interest
Note: i = NR is the mode of compounding is annually

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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Sample Problem.
1. For instance, if you invested $100 in a bank with an interest rate of 10% compounded annually
(once per year), then in the first year of your investment you would earn $10. If this were simple
interest, you would continue to earn $10 per year for the period of your investment. However,
since the interest is compounded, you earn interest on your interest. The amount of compound
interest for 22 the first interest period is the same as for simple interest. However, for further
interest periods, the amount of compound interest increases to an amount greater than simple
interest.
To illustrate:

From the illustration above, you can see that under simple interest payments, a yearly sum of $10
is gained through interest. For each year of the loan period, $10 is earned. However, under compound
interest payments, the yearly interest is added to the principle for the next period. This has the effect of
increasing interest earned each year for the duration of the period (note: in example above, $33.10 earned
from compound interest versus $30 earned from simple interest).

2. What rate of interest compounded annually is the same as the rate of interest of 8%
compounded quarterly?

�� 4
(1 + i)1 – 1= (1 + 4
) – 1
0.08 4
(1 + i)1 – 1= (1 + 4 ) – 1
i = 0.0824 or 8.24%
3. If P5,000 shall accumulate for 10 years at 8% compounded quarterly, then what is the compound
interest at the end of 10 years?

F = P (1 + i)n
0.08
F = 5000 ( 1 + 4 )10(4)
F = 11,040.20
Interest = F – P
Interest = 11,040 .20 – 5,000
Interest = 6, 040.20

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF REPRODUCTION, DISTRIBUTION,
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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

Summary:

Simple Interest
I = (P) (n) (i)
F = P[1 + (n x i)]

Two types of simple interest

Ordinary simple interest

�
� = ���
Exact simple interest
� �
� = ��� normal year � = ��� leap year
Compound Interest
Future Amount, F

F = P (1 + i)n
Present Worth, P
�
P = (� + �)�

Nominal and Effective Rates of Interest

ER = (1 + i )m – 1
��
Or ER = � + � m – 1

Reference:

Park, C. S. (2012). Fundamentals of Engineering Economics. Chan S. Park. Pearson Education.

Sullivan, W. G., Wicks, E. M., & Luxhoj, J. T. (2003). Engineering economy (Vol. 13). Upper Saddle
River, NJ: Prentice Hall.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF REPRODUCTION, DISTRIBUTION,
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 UNIVERSITY OF LA SALETTE,INC
COLLEGE OF ENGINEERING AND ARCHITECTURE
SANTIAGO CITY, PHILIPPINES

INSTRUCTIONS: Copy and answer the following problems. Incomplete solutions will not
be credited. Work independently. (USE THE ATTACHED ANSWER SHEET)

I. Solve the following problems that involve interest and time value.

1. A man borrowed P 20,000 from a local commercial bank which has a simple interest of
18% but the interest is to be deducted from the loan at the time that the money was
borrowed and the loan is payable at the end of one year. How much is the actual rate of
interest?
2. A deposit of P 110,000 was made for 21 days. The net interest after deducting 20%
withholding tax is P 890.36. Find the rate of return annually.
3. A man borrowed P 20,000 from a local commercial bank which has a simple interest of
16% but the interest is to be deducted from the loan at the time that the money was
borrowed and the loan is payable at the end of one year. How much is the actual rate of
interest?
II. Draw the cash flows of the following problems and apply compound interest
calculations.

4. A loan for P 50,000 is to be paid in 3 years at the amount of P 65,000. What is

the effective rate of money?
5. Find the compound amount and interest if P 2,500 is invested at 8% compounded
quarterly for 5 years and 6 months. 5.5 years

III. Calculate the following problems

6. An amount of P 10000 becomes P 1608.44 after 4 years compounded bimonthly. Find

the nominal interest.
7. What is the corresponding effective interest rate of 18% compounded semi-
quarterly?
8. Find the nominal rate, which if converted quarterly could be used instead of 12%
compounded semi-annually.

THIS MODULE IS FOR THE EXCLUSIVE USE OF THE UNIVERSITY OF LA SALETTE, INC. ANY FORM OF REPRODUCTION, DISTRIBUTION,
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