Page |1

Engineering Economy
Week 3 and Week 4 Module

Topic 2: Interest and Money – Time Relationships

Objectives:

1. Learn the relationships of interest earned on a borrowed capital.

2. Explain the computation of ordinary and exact simple interest on a borrowed capital and discount value.

Content:

A. Meaning of Interest

From the borrower’s viewpoint: Interest is the amount of money paid for the use of borrowed capital.
From the lender’s viewpoint: Interest is the income produced by the money that he/she has lent.

B. Simple Interest

Simple Interest is the interest on borrowed money.

Principal is the amount of money borrowed and on which interest is charged.
Rate of interest is the amount earned by one unit of principal during a unit of time.

The formula for simple interest is 𝐈 = 𝐏𝐢𝐧

Where:

I = total interest earned by the principal

P = amount of the principal
i = rate of interest expressed in decimal form
n = number of interest periods

The formula for total amount is 𝐅 = 𝐏 + 𝐈

C. Ordinary and Exact simple Interest

1. Ordinary simple interest is computed on the basis of one banker’s year, which is
1 banker’s year = 12 months, each consisting of 30 days
= 360 days

𝐏𝐢𝐝
𝐈𝐨 =
𝟑𝟔𝟎

2. Exact simple interest is based on the exact number of days, 365 days for an ordinary year and 366 days
for a leap year. The leap years are those that are exactly divisible by 4, but excluding the century years
1900, 2000, etc.
If d is the number of days in the interest period, then

𝐏𝐢𝐝
𝐈𝐞 = (𝐟𝐨𝐫 𝐨𝐫𝐝𝐢𝐧𝐚𝐫𝐲 𝐲𝐞𝐚𝐫)
𝟑𝟔𝟓

𝐏𝐢𝐝
𝐈𝐋 = (𝐟𝐨𝐫 𝐥𝐞𝐚𝐩 𝐲𝐞𝐚𝐫)
𝟑𝟔𝟔

Note:
If the problem did not specify whether it is simple ordinary interest or exact simple interest, assume
it to be an ordinary simple interest

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |2

If the problem did not specify whether it is exact ordinary year or leap year, assume it to be an ordinary
year.

D. Discount

Discount on a negotiable paper is the difference between what is worth in the future and its present
worth. Discount is interest paid in advance.

Discount = Future Worth − Present Worth

The rate of discount is the discount on one unit of principal per unit time. If d is the rate of discount,
then
𝐢
𝐝=
𝟏+𝐢

For the equivalent rate of interest (i) corresponding to a rate of interest,

𝐝
𝐢=
𝟏−𝐝

Application Problems

1. Determine the ordinary and exact simple interest on P10, 000 for 9 months and 10 days if the rate of
interest is 12%.

Given:
P = P 10, 000. 00
d = 9 months and 10 days
30 𝑑𝑎𝑦𝑠
d = 9 months ( ) + 10 days
1 𝑚𝑜𝑛𝑡ℎ
d = 280 days
i = 0.12

Required:
Ordinary interest, Io
Exact simple interest, Ie

Solution:
Pid (P 10,000.00)(0.12)(280days)
Io = Io =
360 360 days
𝐈𝐨 = 𝐏 𝟗𝟑𝟑. 𝟑𝟑

Pid (P 10,000.00)(0.12)(280days)
Ie = Ie =
365 365 days
𝐈𝐞 = 𝐏 𝟗𝟐𝟎. 𝟓𝟓

2. Determine the ordinary and exact simple interest on P5, 000 for the period from January 15 to June 20,
1993, if the rate of interest is 14%.

Given:
P = P 5, 000. 00
January – 16 days
February – 28 days (1993 is not a leap year)
March – 31 days
April – 30 days
May – 31 days
June – 20 days
d = 156 days
i = 0.14

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |3

Required:
Ordinary interest, Io
Exact simple interest, Ie

Solution:
Pid (P 5,000.00)(0.14)(156 days)
Io = Io =
360 360 days
𝐈𝐨 = 𝐏 𝟑𝟎𝟑. 𝟑𝟑
Pid (P 5,000.00)(0.14)(156days)
Ie = Ie =
365 365 days
𝐈𝐞 = 𝐏 𝟐𝟗𝟗. 𝟏𝟖
3. A man borrows P10, 000 from a loan firm. The rate of simple interest is 15%, but the interest is to be
deducted from the loan at the time the money is borrowed. At the end of one year he has to pay back
P10, 000. What is the actual rate of interest?

Given:
F = P 10, 000. 00
i = 0.15
n = 1 year

Required:
Actual Rate of Interest, ia

Solution:
F =P+I
I = 𝐹𝑖 I = (P 10,000.00)(0.15)
I = P 1,500.00
P =F−I P = P 10,000.00 − P 1,500.00
P = P 8,500.00
I = Pin
𝐼 𝑃 1,500.00
i= i=
𝑃𝑛 (𝑃 8,500.00)(1 𝑦𝑒𝑎𝑟)
𝐢 = 𝟎. 𝟏𝟕𝟔𝟓 𝐨𝐫 𝟏𝟕. 𝟔𝟓%

4. If P1, 000 accumulates to P1, 500 when invested at a simple interest for three years, what is the rate of
interest?

Given:
P = P 1,000. 00
F = P 1,500. 00
n = 15 months
i = 0.15
Required:
Actual Rate of Interest, i

Solution:
F =P+I
I=F−P I = P 1,500.00 − P 1,000.00
I = P 500.00
I = Pin
𝐼 𝑃 500.00
i= i=
𝑃𝑛 (𝑃 1,000.00)(3 𝑦𝑒𝑎𝑟𝑠)
𝐢 = 𝟎. 𝟏𝟔𝟔𝟕 𝐨𝐫 𝟏𝟔. 𝟔𝟕%

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |4

5. A loan of P 5, 000 is made for a period of 15 months, at a simple interest rate of 15%, what future amount
is due at the end of the loan period?

Given:
P = P 5,000. 00
1 𝑦𝑒𝑎𝑟
n = 15 months ( ) = 1.25 𝑦𝑒𝑎𝑟𝑠
12 𝑚𝑜𝑛𝑡ℎ𝑠
i = 0.15

Required:
Future Amount, 𝐹

Solution:
F = P ( 1 + in)
F = P 5,000.00{1 + (0.15)(1.25)}
𝐅 = 𝐏 𝟓, 𝟗𝟑𝟕. 𝟓𝟎

6. A man borrowed P 2, 000 from a bank and promise to pay the amount for one year. He received only the
amount of P 1, 920 after the bank collected an advance interest of P80. What were the rate of interest
that the bank collected in advance? What is the discount rate?

Given:
F = P 2,000. 00
P = P 1,920. 00
I = P 80.00
n = 1 𝑦𝑒𝑎𝑟

Required:
Rate of Interest, 𝑖
Discount rate, d

Solution:
𝐼 𝑃 80.00
i= i=
𝑃𝑛 (𝑃 1,920.00)(1 𝑦𝑒𝑎𝑟)
𝐢 = 𝟎. 𝟎𝟒𝟏𝟕 𝐨𝐫 𝟒. 𝟏𝟕%

𝑖 0.0417
d= d=
1+𝑖 1+0.0417

d = 0. 04 or 4%

E. 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.

1. Nominal rate of interest specifies the rate of interest and the number of interest periods per year.

𝐍𝐑
𝐢=
𝐦
Where:
I = rate of interest per interest period
NR= nominal rate of interest
m = number of compounding periods per year

2. Effective rate of interest is the actual rate of interest on the principal for one year and its equal to the
nominal rate if the interest is compounded annually, but greater than the nominal rate if the number of

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |5

interest periods per year exceeds one, such as for interest compounded semi-annually, quarterly or
monthly.

Formula Effective Rate of Interest:

𝐍𝐑 𝐦
𝐢𝐞 = [𝟏 + ] − 𝟏
𝐦

Formula Effective Rate of Interest Compounded Continuously:

𝐄𝐑 = 𝐞𝐫 − 𝟏

Application Problems

1. Find the nominal rate of interest of 8% compounded quarterly and 10% compounded semi-annually.

Solution:
NR
i=
m
8%
a. Nominal rate of interest of 8% compounded quarterly = 2%
4
10%
b. Nominal rate of interest of 10% compounded semi-annually = 5%
2

2. Determine the effective rate of interest of P1. 00 if invested at a nominal rate of 8% compounded
quarterly.

Solution:
NR m
ie = [1 + ] − 1
m

0.08 4
ie = [1 + ] = 0.0824 or 8.24%
4

3. Calculate the rate of interest per interest period and effective rate of I interest corresponding to each of
the following rates:
a. 9% compounded semi-annually
b. 9% compounded quarterly
c. 9% compounded bi-monthly
d. 9% compounded monthly

Given:
NR = 0.09
m1 = 2 (Semi-annually)
m2 = 4 (Quarterly)
m3 = 6 (Bi-monthly)
m4 = 12 (Monthly)

Required:
Interest rate per period
Effective Rate, ie

Solution:
Interest rate per interest period effective rate of interest

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |6

NR NR m
I= ie = [1 + ] − 1
m m
a. 9% compounded semi-annually
0.09 0.09 2
i = = 𝟎. 𝟎𝟒𝟓 𝒐𝒓 𝟒. 𝟓% ie = [1 + ] − 1 = 𝟎. 𝟎𝟗𝟐𝟎 𝐨𝐫 𝟗. 𝟐𝟎%
2 2
b. 9% compounded quarterly
0.09 0.09 4
in = = 𝟎. 𝟎𝟐𝟐𝟓 𝒐𝒓 𝟐. 𝟐𝟓% ie = [1 + ] − 1 = 𝟎. 𝟎𝟗𝟑𝟏 𝐨𝐫 𝟗. 𝟑𝟏%
4 4
c. 9% compounded bi-monthly
0.09 0.09 6
in = = 𝟎. 𝟎𝟏𝟓 𝒐𝒓 𝟏. 𝟓% ie = [1 + ] − 1 = 𝟎. 𝟎𝟗𝟑𝟒 𝐨𝐫 𝟗. 𝟑𝟒%
6 6
d. 9% compounded monthly
0.09 0.09 12
in = = 𝟎. 𝟎𝟎𝟕𝟓 𝒐𝒓 𝟎. 𝟕𝟓% ie = [1 + ] − 1 = 𝟎. 𝟎𝟗𝟑𝟖 𝐨𝐫 𝟗. 𝟑𝟖%
12 12

4. Which of these gives the lowest effective rate of interest?

a. 12. 35% compounded annually
b. 11. 90% compounded semi-annually
c. 12. 20% compounded quarterly
d. 11. 60% compounded monthly

Given:
i1 = 0.1235 m1 = 1 (Annually)
i2 = 0.1190 m2 = 2 (Semi-annually)
i3 = 0.1220 m3 = 4 (Quarterly)
i4 = 0.1160 m4 = 12 (Monthly)

Required:
Lowest Effective Rate, ie

Solution:
𝐍𝐑 𝐦
𝐢𝐞 = [𝟏 + ] − 𝟏
𝐦

a. 12.35% compounded annually

0.1235 1
ie = [1 + ] − 1 = 𝟎. 𝟏𝟐𝟑𝟓 𝐨𝐫 𝟏𝟐. 𝟑𝟓%
1
b. 11.90% compounded semi-annually
0.1190 2
ie = [1 + ] − 1 = 𝟎. 𝟏𝟐𝟐𝟓 𝐨𝐫 𝟏𝟐. 𝟐𝟓%
2
c. 12.20% compounded quarterly
0.1220 4
ie = [1 + ] − 1 = 𝟎. 𝟏𝟐𝟕𝟕 𝐨𝐫 𝟏𝟐. 𝟕𝟕%
4
d. 11.60% compounded monthly
0. 12
ie = [1 + ] − 1 = 𝟎. 𝟏𝟐𝟐𝟒 𝐨𝐫 𝟏𝟐. 𝟐𝟒%
12

Lowest Effective Rate is d, 𝟏𝟐. 𝟐𝟒%

F. Equivalent Rates

Two nominal rates are equivalent if they have the same effective rates.

Application Problems

1. 12 % compounded monthly to a rate compounded quarterly

(Effective rate of interest) monthly = {Effective rate of interest) quarterly

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |7

𝟎.𝟏𝟐 𝟏𝟐 𝐍𝐑 𝟒
[𝟏 + ] − 𝟏 = [𝟏 + ] -1
𝟏𝟐 𝟒

NR = 12.12% compounded quarterly

2. What nominal rate compounded semi-annually yield the same amount as 16% compounded quarterly.

(Effective rate of interest) quarterly = {Effective rate of interest) semi annually

𝟎.𝟏𝟔 𝟏𝟐 𝐍𝐑 𝟐
[𝟏 + ] − 𝟏 = [𝟏 + ] −𝟏
𝟒 𝟐

NR = 16.32 % compounded semi annually

G. Compound interest

Compound interest is the interest earned by the principal when invested at compound interest.
0 1 2 n

P F
Cash Flow
Formula:

𝐅 = 𝐏 (𝟏 + 𝐢)𝐧

𝐍𝐑 𝐦𝐭
𝐅 = 𝐏 [𝟏 + ]
𝐦
Where:
F = future amount
I = interest rate per period
n = total number of periods
P = present worth
m= number of compounding periods
t= number of years

Note: (1 + i)n = single payment compound amount factor

Derivation of Formula

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)2i P(1 + i)2(1 + i) = P(1 + i)3
n P(1 + i)n

Application Problems

1. If the sum of P12, 000 is deposited in an account earning interest at the rate of interest at the rate of 9%
compounded quarterly, what will it become at the end of 8 years?

Given:
P = P 12, 000. 00
t = 8 years
m = 4 (quarterly)
i = 0.09

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |8

Required:
Future Interest, F

Solution:
NR mt
F = P [1 + ]
m
0.09 (4)(8)
F = P 12,000.00 [1 + ]
4
𝐅 = 𝐏 𝟐𝟒, 𝟒𝟓𝟕. 𝟐𝟒

2. Mr. J. Dela Cruz borrowed money from a bank. He receives from the bank P1, 340 and promised to pay
P1, 500 at the end of 9 months. Determine the following:
a. Simple interest rate
b. The corresponding discount rate or often referred to as the “banker’s discount”
Given:
P = P 1,340. 00
F = P 1,500. 00
1 𝑦𝑒𝑎𝑟
n = 9 months ( ) = 0.75 year
12𝑚𝑜𝑛𝑡ℎ𝑠

Required:
Simple Interest Rate, 𝑖
Discount Rate, d

Solution:
a. Simple interest rate
F =P+I
I=F−P I = P 1,500.00 − P 1,340.00
I = P 160
I = Pin
𝐼 𝑃 160.00
i= i=
𝑃𝑛 (𝑃 1,340.00)(0.75 𝑦𝑒𝑎𝑟𝑠)
𝐢 = 𝟎. 𝟏𝟓𝟗𝟐 𝐨𝐫 𝟏𝟓. 𝟗𝟐%

b. The corresponding discount rate or often referred to as the “banker’s discount”

i 0.1592
d= = = 𝟎. 𝟏𝟑𝟕𝟑 𝒐𝒓 𝟏𝟑. 𝟕𝟑%
1+i 1 + 0.1592

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 Page |9

H. Continuous Compounding

The concept of continuous compounding is based on the assumption that cash payments occur once
per year but compounding is continuous throughout the year.

The basic equation for future worth of compound interest is

𝐅 = 𝐏(𝟏 + 𝐢)𝐧
But for m periods per year
𝐍𝐑 𝐦𝐭
𝐅 = 𝐏 [𝟏 + ]
𝐦

Continuous compounding single payment compound factor

𝐅 = 𝐏𝐞𝐫𝐧
Where:
P = principal
i = rate of interest
t = number of years
m = mode of payments
ern = continuous compounding compound amount factor

Note: Cash flow diagram refers to the diagram where money is projected as a function of time.

Application Problems

1. If P5, 000 shall accumulate for 10 years at 8% compounded quarterly, find the compounded interest at
the end of 10 years.

Given:
P = P 5, 000. 00
t = 10 years
m = 4 (quarterly)
i = 0.08

Required:
Compound Interest, I

Solution:
i mt
F10 = P [1 + ]
m
0.08 (4)(10)
F10 = P 5,000.00 [1 + ]
4
F10 = P 11,040.20
I=F−P
I = P 11,040.20 − P 5,000.00
𝐈 = 𝐏 𝟔, 𝟎𝟒𝟎. 𝟐𝟎

2. How many years are required for P1, 000 to increase to P2, 000 if invested at 9% per year compounded
annually, semi-annually, quarterly, monthly, daily and continuously?

Given:
P = P 1, 000. 00
F𝑛 = P 2, 000. 00
i = 0.09

Required:

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 P a g e | 10

t
Compounded annually
Semi-annually
Quarterly
Monthly
Daily
Continuously,

Solution:
NR mt
F𝑛 = P [1 + ]
m

Compounded annually
Using either analytical or numerical method, the value of n will be:
By analytical:
0.09 (1)(t)
P 2,000.00 = P 1,000.00 [1 + ]
1
𝑃 2,000.00 0.09 (1)(t)
= [1 + ]
𝑃 1,000.00 1
2 = 1.09(1)(t)
(1𝑛)log1.09 = log 2
log 2
𝑡=
log 1.09
𝒕 = 𝟖. 𝟎𝟒 𝒚𝒆𝒂𝒓𝒔
By numerical: (using shift solve)
0.09 (1)(t)
P 2,000.00 = P 1,000.00 [1 + ]
1
𝒕 = 𝟖. 𝟎𝟒 𝐲𝐞𝐚𝐫𝐬

Compounded Semi-annually
0.09 (2)(t)
P 2,000.00 = P 1,000.00 [1 + ]
2
𝒕 = 𝟕. 𝟖𝟕𝐲𝐞𝐚𝐫𝐬

Compounded Quarterly
0.09 (4)(t)
P 2,000.00 = P 1,000.00 [1 + ]
4
𝒕 = 𝟕. 𝟕𝟗𝐲𝐞𝐚𝐫𝐬

Compounded Monthly
0.09 (12)(t)
P 2,000.00 = P 1,000.00 [1 + ]
12
𝒕 = 𝟕. 𝟕𝟑𝐲𝐞𝐚𝐫𝐬

Compounded daily same to compounded continuously

0.09 (365)(t)
P 2,000.00 = P 1,000.00 [1 + ]
365
𝒕 = 𝟕. 𝟕𝟎𝐲𝐞𝐚𝐫𝐬

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

Given:
i = 0.18

Required:
Effective rate, 𝐢𝐞

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE

 P a g e | 11

Solution:
i m
ie = [1 + ] − 1
m
0.18 360
ie = [1 + ] − 1
360
𝐢𝐞 = 𝟎. 𝟏𝟗𝟕𝟐 𝐨𝐫 𝟏𝟗. 𝟕𝟐%

4. What nominal rate, compounded semi – annually, yields the same amount as 16% compounded
quarterly?
Given:
NR 4 = 0.16

Required:
Nominal rate, 𝐍𝐑𝟐

Solution:
NR m
ie = [1 + ] − 1
m

The nominal rates are equal if they have the same effective rate, then:
iquarterly = isemi−annually

0.16 4 NR 2 2
[1 + ] − 1 = [1 + ] − 1
4 2

Using either analytical or numerical method, the value of 𝐍𝐑 𝟐 will be:

𝐍𝐑𝟐 = 𝟎. 𝟏𝟔𝟑𝟐 𝐨𝐫 𝟏𝟔. 𝟑𝟐%

5. A nominal interest of 3% compounded continuously is given on the account. What is the accumulated
amount of P10, 000 after 10 years?

Given:
P = P 10, 000. 00
t = 10 years
m = 365 (quarterly)
i = 0.03

Required:
Accumulated Amount, F10

Solution:
i mt
F10 = P [1 + ]
m
0.03 (365)(10)
F10 = P 10,000.00 [1 + ]
365
𝐅𝟏𝟎 = 𝐏 𝟏𝟑, 𝟒𝟗𝟖. 𝟒𝟐

Alternative Solution:
F10 = Pern (Note: r is also the nominal rate of interest)
F10 = P 10,000e0.03(10)
𝐅𝟏𝟎 = 𝐏 𝟏𝟑, 𝟒𝟗𝟖. 𝟓𝟗

6. How long will it take the money to triple itself if invested at 10% compounded semi-annually?

Given:
P=P
F𝑛 = 3P
NR = 0.10
m=2
TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE
 P a g e | 12

Required:
t

Solution:
i mt
F𝑛 = P [1 + ]
m

Compounded semi-annually
Using either analytical or numerical method, the value of t will be:
By analytical:
0.10 (2)(t)
3P = P [1 + ]
2
3𝑃 0.10 (2)(t)
= [1 + ]
𝑃 2
(2)(t)
3= 1.05
(2𝑡)log1.05 = log 3
log 3
𝑡=
2 log 1.05
𝒕 = 𝟏𝟏. 𝟐𝟔 𝒚𝒆𝒂𝒓𝒔

By numerical: (using shift solve)

0.10 (2)(t)
3P = P [1 + ]
2
𝒕 = 𝟏𝟏. 𝟐𝟔 𝐲𝐞𝐚𝐫𝐬

References:

1. Fundamental of Engineering Economics by Chan S. Park 2004

2. Engineering Economy by Jaime R. Tiong 2002
3. Economy 10th Edition by William Sullivan 1997
4. Engineering Economy 3rd Edition by Matias Arreola 1993
5. Engineering Economy 2nd Edition by Hipolito Sta. Maria 1993
6. Engineering economics 2nd Edition by Venancio I. Besavilla Jr. 1989

TOPIC 2: INTEREST AND MONEY COMPILED BY : IRENE R. ROQUE, RCE, ME-SE