MODULE 3:

Present Economy Studies

Money-Time Relationships and Equivalence

a. Interest and the Time Value of Money

b. The concept of equivalence

c. Cash flows

Money-Time Relationships and Equivalence

A. Meaning of Interest:
(From the viewpoint of the borrower)
Interest is the amount of money paid for the use of borrowed capital.

(From the lender)

Interest is the income produced by the money which he has lent.

B. Simple Interest
-interest on borrowed money if the interest to be paid is directly proportional to the length of time the
amount or principal is borrowed.

Principal
-the amount of money borrowed and on which interest is charged.

Rate of Interest
-the amount earned by one unit of principal during a unit of time.

Formula for the Simple Interest:

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 Total amount F to be repaid,
F = P + I = P(1 + in)

Examples:
1. If P1, 000 accumulates to P1, 500 when invested at a simple interest for three years, what is the
rate of interest?
2. You loan from a loan firm an amount of P100, 000 with a rate of simple interest of 20% but the
interest was deducted from the loan at the time the money was borrowed. If at the end of one year,
you have to pay full amount of P100, 000. What is the actual rate of interest?

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C. Ordinary and Exact Simple Interest

Ordinary simple interest

- Computed on the basis of one banker’s year.
- 1 banker’s year = 12 months, each consisting of 30 days = 360 days

Exact Simple Interest

- based on the exact number of days.

- 365 days for an ordinary year

- 366 days for a leap year

Leap year – are those which are exactly divisible by 4, but excluding the century years such as the
years 1900, 2000, etc.

𝑑
Ordinary Simple Interest = Pi 360

𝑑
𝑃𝑖 365
Exact Simple Interest = { 𝑑
𝑃𝑖 366

Where d = number of days in the interest period

Examples:

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

2. Determine the ordinary and exact simple interest on P5, 000 for the period from January 15 to June
20, 1983, if the rate of simple interest is 14%.

D. Compound Interest

-the interest earned by the principal is not paid at the end of each interest period, but is
considered as added to the principal, and therefore will also earn interest for the succeeding periods.
The interest earned by the principal when invested at compound interest is much more than that
earned by the same principal when invested at simple interest for the same number of periods.

Using the same terms applied in simple interest, the total amount due after n periods for the
compound interest is given:

F = 𝑃(1 + 𝑖)𝑛

Which is derived from the equation, I = Pin.

(1 + 𝑖)𝑛 – “Single Payment Compound Amount Factor or SPCAF”

- designated by SPCAF = (F/P, i%,n)

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Examples:
1. The amount of P20, 000 was deposited in a bank earning an interest of 6.5% per annum.
Determine the total amount at the end of 7 years if the principal and interest were not withdrawn
during this period.
2. A loan for P50,000 is to be paid in 3 years at the amount of P65,000. What is the effective rate of
money?
3. Find the present worth of a future payment of P80,000 to be made in six (6) years with an interest
of 12% compounded annually.

E. Continuous Compounding

Single Payment Compound Amount Factor:

𝑟
F = 𝑃(1 + )𝑚𝑛 where: r = nominal annual interest rate
𝑚

m = number of interest periods each year

i = interest rate per interest period

= r/m

Continuous Compounding Single Payment Compound Amount Formula:

F = P𝑒 𝑟𝑛

F. Nominal Rate of Interest

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

Thus, a nominal rate of interest of 8% compounded quarterly means that there are 4 interest periods
each year, the rate per period being 8%/4 = 2%.

i = 0.02.

G. Effective Rate of Interest

Effective Rate of Interest- the actual rate of interest on the principal for one year. It is equal to the
nominal rate if the interest is compounded annually, but greater than that nominal rate if the number
of interest periods per year exceeds one, such as for interest compounded semi-annually, quarterly or
monthly. To make this clear, imagine P1.00 to be invested at the nominal rate of8% compounded
quarterly.

This amount will become after one year,

P1(1 + 0.02)4 = P1(1.0824) = P1.0824

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