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Module 7

Time Value of Money: Simple Interest

If you have enough resources especially money, what would you do

with them? You may be thinking to put them into work. Therefore
you must be aware of relationship of risk and return involved in such
activity. In this part, we will also show that the value of your money
today would not be the same as its value in the future, vice versa.

After going over this lesson you should be able to

 Know the basic concept of risk and return

 Understand the time value of money
 Solve problems about the time value of money

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7.1 Basic Concepts of Risk and Return

Risk is the variability of returns from those that are expected. This
refers to a situation in which possible future events can have
reasonable probabilities assigned while uncertainty refers to
situations in which there is no viable method of assigning
probabilities to future random events.

Return is the income received on an investment plus any change in

market price. Thus there are two components in return—the basic
component or the periodic cash flows from the investment, either
in the form of interest or dividends; and the change in the price of
the asset, commonly called as the capital gain or loss.

The risk-return tradeoff is the principle that potential return rises with
an increase in risk. This concept means that low levels of uncertainty
or risk are associated with low potential returns while high levels of
uncertainty or risk are associated with high potential returns. Thus
invested money can render higher profits only if the investor is willing
to accept the possibility of losses.

7.2 Time Value of Money

The time value of money is the idea that money available at the
present time is worth more than the same amount in the future
due to its potential earning capacity. This impacts business finance
and results from the concept of interest. Interest is a fee paid for
using another party’s money. It is a payable amount on the part of
the borrower or lendee and a receivable amount on the part of the
creditor or lender.

Time value of money deals with future value and present value.
Future value is the value of a current asset at a specified date in
the future based on an assumed rate of growth over time. On the
other hand, present value is the current worth of a future sum of
money or stream of cash flows given a specified rate of return.

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7.3 Simple Interest

This is the interest paid (earned) on the original amount, or principal,
borrowed (lent).

Formula

Is=Prt

where
Is simple interest
P principal
r interest rate
t number of years the amount is deposited or borrowed for

Example

You made a bank deposit worth Php10,000. With 5% annual interest,

how much is the total interest after 2 years?

Given
P = 10,000
r = 0.05
t=2

Is = (10,000)(0.05)(2)
Is =1,000

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7.4 Simple Interest: Future Value of a Single Sum

Future value of a present single sum of money is the amount that will
be obtained in future if the present single sum of money is invested on
a given date at the given rate of interest. The future value is the sum of
present value and the interest.

Formula

F = P(1 + rt)

where
F future value
P principal or present value
r interest rate
t number of period the amount is deposited or borrowed

Example 1

You made a bank deposit worth Php10,000 which will earn 5% annual
interest. What is the value of this money after 2 years?

Given

P = 10,000
r = 0.05
t=2

FV = 10,000[1+(0.05)(2)]
FV = 11,000

Example 2

You made a bank deposit worth Php10,000 which will earn 5% semi-
annual interest. What is the value of this money after 2 years?

Given

P = 10,000
r = 0.05
t=2x2=4

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FV = 10,000[1+(0.05)(4)]
FV = 12,000

Example 3

You made a bank deposit worth Php10,000 which will earn 5%

interest every quarter. What is the value of this money after 2 years?

Given

P = 10,000
r = 0.05
t=2x4=8

FV = 10,000[1+(0.05)(8)]
FV = 14,000

Example 4

You made a bank deposit worth Php10,000 which will earn 5%

monthly interest. What is the value of this money after 2 years?

Given

P = 10,000
r = 0.05
t = 2 x 12 = 24

FV = 10,000[1+(0.05)(24)]
FV = 22,000

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7.5 Simple Interest: Present Value of a Single Sum

Present value of a future single sum of money is the value that is
obtained when the future value is discounted at a specific given rate of
interest. In the other words present value of a single sum of money is
the amount that, if invested on a given date at a specific rate of
interest, will equate the sum of the amount invested and the interest
earned on its investment with the face value of the future single sum of
money.

Present Value of a Single Sum

P principal or present value

F future value
r interest rate
t number of periods the amount is deposited or borrowed

Example 1

You need to have Php11,000 after two years. Assuming that you will
only deposit once with a 5% annual interest, how much will you
deposit today?

Given

F = 11,000
r = 0.05
t=2

P = 11,000/[1+(0.05)(2)]

P = 10,000

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Example 2

You need to have Php12,000 after two years. Assuming that you will
only deposit once with a 5% semi-annual interest, how much will you
deposit today?

Given

F = 12,000
r = 0.05
t=2x2=4

P = 12,000/[1+(0.05)(4)]

P = 10,000

Example 3

You need to have Php14,000 after two years. Assuming that you will
only deposit once with a 5% quarterly interest, how much will you
deposit today?

Given

F = 14,000
r = 0.05
t=2x4=8

P = 14,000/[1+(0.05)(8)]

P = 10,000

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Example 4

You need to have Php22,000 after two years. Assuming that you will
only deposit once with a 5% monthly interest, how much will you
deposit today?

Given

F = 22,000
r = 0.05
t = 2 x 12 = 24

P = 22,000/[1+(0.05)(24)]

P = 10,000

7.6 Simple Interest: Formula Derivation

Example 1. When Interest Rate is Unknown

You made a bank deposit worth Php10,000. Its value after 2 years is
Php11,000. What is the annual interest rate?

Given

F = 11,000
P = 10,000
t=2

F = P(1 + rt)
F/P = 1 + rt
F/P – 1 = rt
(F/P-1)/t = r

r = (F/P-1)/t
r = [(11,000/10,000) – 1]/2
r = 0.05 or 5%

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Example 2. When the Period is Unknown

You made a bank deposit worth Php10,000 which will earn 5% annual
interest. How many years will it take for his money to have a value of
Php11,000?

Given

F = 11,000
P = 10,000
r = 0.05

F = P(1 + rt)
F/P = 1 + rt
F/P – 1 = rt
(F/P-1)/r = t

t = (F/P-1)/r
t = [(11,000/10,000) – 1]/0.05
t=2

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Glossary
Interest - is the payment from a borrower or deposit-taking financial
institution to a lender or depositor of an amount above repayment of
the principal sum at a particular rate

References
C. Paramasivan and T. Subramanian. (2005). “Financial
Management”, New Age International Ltd., Publishers.
Investopedia.com

J. Van Horne and J. Wachowics(2008). “Fundamentals of Financial

Management”, Pearson Education Limited.

KEATMX (2005), “Managerial Economics”, TVM.

S.G. Eakins (2002). “Finance: Investments, Institutions, and

Management”, Addison-Wesley Higher Education Group

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