Interest

and
Time Value of
Money
ESci 131n - Engineering Economy
objective
Understand the time value of
money and be able to Solve
problems in Interest
CAPITAL
• wealth in the form of
money or property that
can be used to produce
more wealth

(ex. Money for people, machines,

materials, energy and other things
needed in the operation of an
organization)
Two basic categories
Debt Capital
Equity Capital
(Borrowed capital)

• owned by individuals who • owned by individuals who

have invested their money or have invested their money or
property in a business property in a business
project or venture in the project or venture in the
hope of receiving profit hope of receiving profit
INTEREST
• is the amount of money earned by a given capital.
From the borrowers’ viewpoint, interest is the amount of
money paid for the use of a borrowed capital
From the lender’s viewpoint, it is the income generated by
the capital that was lent

• is the difference in the ending amount of money & the

beginning or original amount.
INTEREST RATE - is the interest paid over a specific
period of time expressed in terms of percentage

Ordinary Simple Interest Exact Simple Interest

*** The interest is computed on the
basis of one banker’s year
1 banker’s year = 12 months
1 month = 30 days
1 year= 360 days
*** The interest is based on the exact
number of days of the year;
365 days for ordinary year
366 days for leap year (every four
years for years that is exactly divisible
by four, except century marks (1800,
1900, etc.) but not including those that
are exactly divisible by 400 (2000, 2400,
etc.)

interest period
ELEMENTS OF SIMPLE INTEREST

• F=P+I
• P = principal or present worth
(amount borrowed or invested)

𝐼 = 𝑃𝑟𝑡 • I = interest earned

• F = future worth (amount to be
paid or amount accumulated)

•𝐹 = 𝑃 + 𝑃𝑟𝑡 • r = simple interest rate (per year)

• t = time in years or fraction of a
•𝐹 = 𝑃(1 + 𝑟𝑡) year
 Why Pay Interest?
• Creditors or lender of money demands Interest because he has taken pains
in saving money, has suffered inconveniences in postponing his needs and
has taken risk of bad debts.
• If he will not get Interest or some advantage of Interest he may loose
interest in saving money or he may not be ready to bear inconveniences.
• Then, the formation of capital in the market will stop.
• Therefore, it can be said that the debtor’s give Interest to creditors as capital
has productivity and creditors demand interest as the lender of money has
taken risk and has faced inconveniences, so he must get some reward for the
pains of inconvenience and risk.
 Simple interest
Sample Problems
• Sample 01. Find the interest on P 6800.00 for 3 years at 11% simple interest.
Ans. P 2,244.00
• Sample 02. Mary buys a television set from a merchant who offer P 25,000.00 at the
end of 60 days. Mary wishes to pay immediately and the merchant offers to
compute the required amount on the assumption that money is worth 14% simple
interest. What is the required amount?
Ans. P 24,429.97
• Sample 03. If P 16,000 earns P 480 in 9 months, what is the annual rate of interest?
Ans. 4 %
• Sample 04. Time deposit money of P 110,000.00 for 31 days earns P 890.39 on maturity
date after deducting the 20 % withholding tax on interest income. Find the rate of
interest per annum
Ans. 11.75%
 COMPOUND INTEREST
• The interest is computed every end of each interest
period (compounding period), and the interest earned
for that period is added to the principal (interest plus
principal)
• In calculations of compound interest, the interest for an
interest period is calculated on the principal plus the
total amount of interest accumulated in previous
periods.
• Compound interest is “interest on top of interest”.
ELEMENTS OF COMPOUND INTEREST
• P= principal or present worth amount borrowed or invested)
Future worth of P
• F= future worth or compound amount (amount to be paid or
After n periods, the compound amount accumulated)
amount of F is;
𝒏 • i = effective interest per compounding period (per interest period)

𝐹 =𝑃 𝟏+𝒊 • i=r/m; Where: r = nominal interest rate

m =number of compounding per year

• n = total number of compoundings

𝐹
Present worth of F • n=tm Where: t = number of years of investment

𝑃= 𝑛
• I= interest earned

1+𝑖 •
I= F- P

t = time in years or fraction of a year

• ER = effective interest
Rate of interest
Nominal Rate of Interest
Effective Rate of Interest
(nominal annual rate)
• specifies the rate of interest in
one year without adjustment
for the full effect of
compounding. An interest
• is the actual or the exact rate
rate is called nominal if the
of interest on the principal
frequency of compounding
during one year.
(e.g. a month) is not identical
to the basic time unit in
which the nominal rate is
quoted (normally a year)
Values of i and n
The following examples show how to get the values of I and n.
Nominal interest rate, r = 15%
Number of years of investment, t = 6 years
Compounded annually (m= 1)
Compounded semi-annually ( m=2)
Compounded quarterly ( m=4)
Compounded monthly ( m=12)
Compounded bi- monthly ( m= 6)
CONTINUOUS COMPOUNDING

The future worth of P at an

• Interest may be interest rate of r compounded
continuously for t years is;
compounded daily,
hourly, per minute,
etc. As a limit, interest
may be considered to 𝐹 = 𝑃𝑒 𝑟𝑡
be compounded an
infinite number of
times per year (m→∞)
 Compound interest
Sample Problems
• Sample 01. Accumulate P 5000.00 for 10 years at 8% compounded quarterly
ANS. P 11, 040.20.
• Sample 02. How long will it take for an investment to double its amount if invested
at an interest rate of 6% compounded bi-monthly?
ANS. 11.61 years say 12 years

• Sample 03. A man has a will of P 650,000.00 from his father. If his father deposited
an amount of P 450,000.00 in a trust fund earning 8% compounded annually, after
how many tears will the man receive his will?
ANS. 4.78 years
• Sample 04. Jane borrowed P 10,000.00 from a bank with 18% interest per annum,
what is the total amount to be repaid at the end of one year?
ANS. P 11, 800.00
 Continuous compounding
Sample Problems
• Sample 01. The nominal interest rate is 4%. How much is my P10, 000.00 worth in
ten years in a continuously compounded account?
ANS. P 14, 918.25
• Sample 02. If nominal interest rate is 3 %. How much is P 5,000.00 worth in 10
years in a continuously compounded account?
ANS. P 6749.30
DISCOUNT

• Discount, D is interest • rate of discount, d

paid in advance

d = (Discount)/(Future
D = Future Worth – Present Worth)
Worth
Nominal & Effective
Rates of Interest
Equivalent Nominal Rates
CASH FLOW DIAGRAMS
Cash flow diagrams may be drawn to help visualize and simplify
problems having diverse receipts and disbursements.

Conventions used in a cash flow diagram;

• The horizontal axis (time) is marked off in equal increments, one per
period, up to the duration or horizon of the project.
• All disbursements and receipts (cash flows) 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.
• To or more transfers in the same period placed end-to-end may be
combined into one.
• Expenses incurred before t = 0 are called sunk cost and are not
relevant to the problem.
• Receipts and disbursement are represented by arrows on opposite
sides of the horizontal time axis.
END of presentation…