THE TIME VALUE OF MONEY

Learning Objectives:

At the end of this chapter, students should be able to understand the

following:
- Simple and Compound Interest;

- Present Worth (P) and Future Worth (F) relations;

- Discount and Rate of Discount;

2
- Importance of Equation of Value
0 TABLE OF CONTENTS
0 Table of Contents ........................................................................................................ 2
1 Definitions ..................................................................................................................... 3
2 Simple Interest .............................................................................................................. 3
2.1 Sample Problems .................................................................................................. 3
3 Cash Flow Diagram ..................................................................................................... 5
4 Compound Interest ..................................................................................................... 6
5 Rate of Interest............................................................................................................. 7
5.1 Nominal rate of interest........................................................................................ 7
5.2 Effective rate of interest ....................................................................................... 7
5.3 Continuously Compounded Interest .................................................................. 7
5.4 Sample Problems .................................................................................................. 8
6 Equation of Values .................................................................................................... 10
6.1 Sample Problem ................................................................................................. 10
7 Discount...................................................................................................................... 11
7.1 Sample Problems ................................................................................................ 11
8 Practice Problems...................................................................................................... 12
1 DEFINITIONS
engineering economy – it deals with the use and application of economic principles
in the analysis of engineering decisions.

money – it is a measure of wealth

interest – it is the amount paid for the use of borrowed capital

2 SIMPLE INTEREST
Simple Interest is the interest earned by the principal alone over a given period of
time usually counted in number of days, months or in years.

a. Ordinary Simple Interest

Basis: 30 days / month

360 days / year

12 months / year

b. Exact Simple Interest

Basis: 365 days / year

366 days / leap year

Formulas:
=
= +
= +

= ( + )

where,

= interest

= rate of interest per interest period

= number of interest period

= principal or present worth

= accumulated amount or future worth

2.1 SAMPLE PROBLEMS

1. What is the interest of ₱8,600 after 4 years at 12% simple interest rate?

Solution:
Use, =
 where,
= 8600
= 12% = 0.12
=4
hence,
= 8600(0.12)(4) = ₱ ,

2. ₱5,000 will become how much after one year at simple interest of 15%?
Solution:
Use,
= (1 + )
where,
= ₱ 5000
= 15% = 0.15
=1
hence,
= 5000[1 + (0.15)(1)]
= ₱ ,

3. A man deposited ₱10,000 in a bank at 10% per annum for 3 years, 8 months
and 25 days. Find the ordinary simple interest.
Solution:
Use,
=
where,
= 10% = 0.10
8 ℎ 25
=3 + +
12 ℎ 360
= 3.7361
hence,
= 10000(0.10)(3.7361)
= 3736.11
≈ ₱ , .

4. What is the exact simple interest of ₱1,500 for the period from January 10 to
October 28, 1980, at 15% rate of interest.
Solution:
Use,
= (1 + )
where,
= 1500
= 15% = 0.15
= 10 28, 1980
January 10  21
February  29 (leap year)
March  31
April  30
 May  31
June  30
July  31
August  31
September  30
October 28  28

hence,
292
= 1500 1 + 0.15
366
= 1679.508197 ≈ ₱ .

3 CASH FLOW DIAGRAM

Cash Flow Diagram (CFD) is a graphical representation of cash flows drawn on a
time scale.

Example:

A loan of ₱200 at a simple interest of 25% will become ₱450 after 5 years.
4 COMPOUND INTEREST
In calculations of compound interest, the interest for an interest period is
calculated on the principal plus total amount of interest accumulated in previous
periods. Thus, compound interest means “the interest on top of interest”.

Principal at
Interest Interest Earned
Beginning of Amount at End of Period
Period During Period
Period

1 + = (1 + )

(1 + ) + (1 + )
2 (1 + ) (1 + )
= (1 + )
(1 + ) + (1 + )
3 (1 + ) (1 + )
= (1 + )

… … … …

(1 + ) + (1 + )
(1 + ) (1 + )
= (1 + )

= ( + )

where
= Amount at the end of period
= Principal amount
= interest rate, %
= payment period

Other notation:

(1 + ) → “single payment compound amount factor” ( , %, ) → can be read

as “F given P at i% in n interest period”

∴ = , %,

also:

= (1 + ) → / ℎ

(1 + ) → “single payment present worth factor” ( , %, ) → can be read as “P

given F at i% in n interest period”

∴ = , %,
5 RATE OF INTEREST

5.1 NOMINAL RATE OF INTEREST

- Specifies rate of interest and a number of interest periods in one year

where
= rate of interest per interest period
= nominal rate of interest
= number of compounding periods per year.

As a consequence:

= 1+

= 1+

annual → =1
semiannual → =2
quarterly → =4
bimonthly → =6
monthly → = 12
daily → = 365

5.2 EFFECTIVE RATE OF INTEREST

- Actual interest rate of an investment in one year or the interest rate for any
compounding that will give the same accumulation as computed
compounded annually.
. . = (1 + ) − 1

. .= 1 + −1

5.3 CONTINUOUSLY COMPOUNDED INTEREST

Recall the exponential Law of Change in the Differential Equations:

In monetary values
=
=
= =
= ,
We will get:
=
= −1

5.4 SAMPLE PROBLEMS

1. What is the equivalent nominal interest rate compounded quarterly of 12%
compounded semi-annually?
Solution:
Given: Compounding Compounding
Quarterly Semiannually
=? =?
=4 =2

Equating effective rate of interest:

0.12
. .= 1 + −1→ 1+ −1 = 1+ −1
4 2
= 0.1182520564 ≈ . %

2. A bank charges 1.5% per month on credit card. Find (a) the nominal rate of
interest compounded monthly (b) the effective rate of interest (c) the
equivalent nominal rate of interest which is compounded quarterly.

Solution:
a)
=
where,
= 1.5% ℎ
= 12
=?
hence,
1.5 =
12
= %

b)
. = (1 + ) − 1
. . = 0.1956181715 ≈ . %

c) 1.5% per month to ___ % compounded quarterly

. .( ) = . .( ℎ )
1+ − 1 = (1 + 0.015) −1
4
solve for r,
= 0.1827135 ≈ . %
3. A bank advertises 9.5% account that yields 9.84% annually. Find how often is
the interest compounded?

Solution:
= 9.5%
. = 9.84%
=?
Use:
. .= 1 + −1
0.095
0.0984 = 1 + −1
Solve for:
= 3.876381712 ≈ 4
∴ 9.5%

4. In 1906, an original painting of Picasso has a market price of ₱600 and in 1995
its price has increased to ₱29,000,000. What is the rate of interest of the
painting?
Solution:
Use
= (1 + )
where,
= 29000000
= 600
= 1995 − 1906 = 89
hence,
29,000,000 = 600(1 + )
= 0.1288389495 ≈ . %

5. If ₱10,000 is invested at 12% interest compounded monthly, find the 1st year
interest.
Solution:
= 12% ℎ ( = 12)
12
= =
12
= 1% ℎ
= −
where,
= (1 + )
= 100,000
= 0.01
=1 = 12 ℎ
hence,
= 100,000(1 + 0.01) 2 = 112,682.503
= 112,682.50 − 100,000
= , .
6 EQUATION OF VALUES
It is the equation formed in setting one set of obligations equal to another set of
obligations brought to any point in a cashflow diagram known as the focal date or
comparison date or reference point.

6.1 SAMPLE PROBLEM

1. A man bought a lot worth ₱1,000,000 if paid in cash. On the installment basis,
he paid a downpayment of ₱200,000; ₱300,000 at the end of one year,
₱400,000 at the end of three years and a final payment at the end of five years.
What was the final payment if interest was 20%.

Solution:

Setting the focal date to 0;

ℎ = ℎ
₱1,000,000 = ₱200,000 + ₱300,000(1 + 0.2) + ₱400,000(1 + .02) + (1 + 0.2)
=₱ , .
7 DISCOUNT
Discount, in a negotiable paper, it is the difference between the future worth and
the present worth. It is also the interest paid in advance.

By that definition,

= −

where,
= discount amount
= discount rate per period

therefore:
−
=

− (1 + ) (1 − (1 + ) ) 1
= = =1−
1+
1+ 1 1+ −1
= − =
1+ 1+ 1+

=
+

or

=
1−
or

The rate of discount is the discount on one unit of principal for one unit of time.

7.1 SAMPLE PROBLEMS

1. Mary made a loan from his employer an amount of ₱100,000 with a rate of
simple interest of 20%, but the interest was deducted from the loan when the
money was borrowed. If at the end of one year, Mary has to pay the full
amount of ₱100,000, determine the actual rate of interest.
Given: = 20%, = ₱100,000, =?

Solution 1:
0.20
= = = 0.25 ≈ %
1− 1 − 0.20
Solution 2:
= = ₱100,000(0.20) = ₱20,000
= − = ₱100,000 − ₱20,000 = ₱80,000
 ₱20,000
= = = 0.25 ≈ %
₱80,000

2. What is the corresponding rate of interest for 18% simple discount rate?
Solution:
Use:
=
1−
where
= 18% = 0.18
hence,
0.18
= = 0.21951219512 ≈ 0.2195 . %
1 − 0.18

8 PRACTICE PROBLEMS
1. A man wishes to accumulate ₱3,722 after 5 years, 8 months and 28 days. How
much should be deposited by the man in a bank if the ordinary simple interest
is 15% per annum?
2. A man deposited ₱2,000 in a bank at the rate of 15% per annum from March
21, 1996 to October 25, 1997. Find the exact simple interest.
3. A bank charges 1.5% per month on a loan. Find the equivalent nominal rate of
interest.
4. A financing company charges 1.5% per month on a loan. Find the equivalent
effective rate of interest.
5. A nominal rate of 12% compounded monthly is equal to an effective rate of
____.
6. Convert 16% compounded semi-annually to equivalent nominal rate which is
compounded daily.
7. Find the accumulated amount of ₱1,000 after 5 years when deposited in a
bank at a rate of 16% compounded monthly.
8. How long in years will a certain sum of money to triple its amount when
deposited at a rate of 12% compounded annually?
9. How much should be deposited in a bank at a rate of 12% compounded
continuously for 5 years if its accumulated amount is ₱9,110.60?
10. An effective rate of interest, which is 12.75%, is equivalent to what percent if
compounded continuously.
11. How much is expected to be received by a man that makes a loan of ₱851.06,
which is payable at once, if the bank gave him a discount of 6%.
12. Find the cash price of a generator which was bought in installment basis that
requires a down payment of ₱50,000 and payment of ₱30,000 after 1 year,
₱40,000 after 2 years and a final payment of ₱76,374.34 after 4 years at a rate
of 15% per annum.
13. A man made a loan of ₱100,000 at a rate of 15% per annum and promise to
pay it according to the following manner, ₱30,000 at the end of 1st year,
 unknown payment at the end of 2nd year and a final payment of ₱76,374.38
at the end of 4th year. Find the unknown payment made by the man.
14. Find the present worth of the following payments, ₱5,000 after 1 year, ₱4,000
after 2 years, ₱8,000 after 4 years at a rate of 12% per annum.
15. Find the amount of the following payments at the end of 5th year, ₱3,000 at
the end of 1st year, ₱4,500 at the end of 2nd year and ₱6,000 at the end of 4th
year if money worth 12% per annum.
16. How many years will it take for a certain sum of money to triple its amount when
deposited at a rate of 12% compounded continuously?
17. A bank is advertising 9.5% accounts that yield 9.84% annually. How often is the
interest compounded?
18. A man borrows ₱2,000 for 6 years at 8%. At the end of 6 years, he renews the
loan for the amount due plus ₱2,000 more for two years at 8%. What is the lump
sum due?
19. You deposit ₱1,000 into a 9% account today. At the end of two years, you will
deposit another ₱3,000. In five years, you plan a ₱4,000 purchase. How much
is left in the account one year after the purchase?
20. Consider a business which involves the investment of ₱100,000 now and
₱100,000 at the end of one year. Revenue of ₱150,000 will be generated at the
end of years 1 and 2. What is the net present value of this business if the
effective annual interest rate is 10%?