THE TIME VALUE OF

MONEY

Department of Industrial Engineering

Capital
Capital refers to wealth in the form of money
or property that can be used to produce more
wealth.
Simple Interest
When the total interest earned or charged is
linearly proportional to the initial amount of
the loan (principal), the interest rate, and the
number of interest periods for which the
principal is committed, the interest and
interest rate are said to be simple.
Simple Interest
The total interest, I, earned or paid may be
computed using

where P =principal amount lent or borrowed

i = interest rate per interest period
n = number of interest periods
Simple Interest
The total amount F to be repaid is equal to the sum of
the principal (P) and the total interest (I):

= + = ( + )
Simple Interest
Ordinary Simple Interest
computed on the basis of one bankers year,
which is:
= 12 months, each consisting of 30 days
= 360 days

Exact Simple Interest

computed on the basis of the exact number of
days, 365 for an ordinary year and 366 days for a
leap year
Simple Interest
If d is the number of days in the interest period, then

=


( ) =

( ) =

Example 1
Determine the ordinary simple interest on
P700 for 8 months and 15 days if the rate of
interest is 15%.
Example 2
Determine the exact simple interest on P500
for the period from January 10 to October 28,
1996 at 16% interest.
Example 3
What will be the future worth of money after
14 months, if a sum of P10,000 is invested
today at a simple interest rate of 12% per
year?
Cash-Flow Diagrams
A cash-flow diagram is a graphical
representation of cash flows drawn on a
time scale.

Receipt (positive cash flow or cash inflow)

Disbursement (negative cash flow or cash
outflow)
Cash-Flow Diagrams
Eg: A loan of P100 at simple interest of 10%
will become P150 after 5 years.
Cash-Flow Diagrams
Eg: A loan of P100 at simple interest of 10%
will become P150 after 5 years.
Cash-Flow Diagrams
Eg: A loan of P100 at simple interest of 10%
will become P150 after 5 years.
Compound Interest
Whenever the interest charge for any interest
period is based on the remaining principal
amount plus any accumulated interest
charges up to the beginning of that period,
the interest is said to be compound.

Interest on top of interest

Compound Interest
Future Worth (F)

F=P(F/P, i%, n)
= 1+

The quantity 1 + is the single payment

compound amount factor and is designated by
F/P, i%, n.
Compound Interest
Present Worth (P)

P=F(P/F, i%, n)

= 1+

=
1+

The quantity 1 + is the single payment

present worth factor and is designated by P/F, i%,
n.
Rates of Interest

Nominal rate of interest

Effective rate of interest

Rates on Interest
Nominal Rate of Interest

The nominal rate of interest specifies the rate of

interest and a number of interest periods in one
year.

=

Where: i = rate of interest per interest period
r = nominal interest rate
m = number of compounding periods per
year
Rates on Interest
Nominal Rate of Interest

If the nominal rate of interest is 10%

compounded quarterly, then
i = 10%/4 = 2.5%
the rate of interest per interest period

If the nominal rate of interest is 10%

compounded monthly, then
i = 10%/12 = 0.8333%
the rate of interest per interest period
Rates on Interest
Effective Rate of Interest

Effective rate of interest is the actual or exact rate

of interest on the principal during one year.

= 1 + 1
Rates on Interest
Effective Rate of Interest

If P1.00 in invested at a nominal rate of 15%

compounded quarterly, after 1 year, its future
worth is

0.15 4
F = 1 1 + = 1.1586
4

The actual interest earned is P0.1586,

therefore the rate of interest after one year is
15.86%
Example 4
Find the nominal rate which if converted
quarterly could be used instead of 12%
compounded monthly. What is the
corresponding effective rate?
Example 5
Find the amount at the end of two years and
seven months if P1000 is invested at 8%
compounded quarterly using simple interest
for anytime less than a year interest period.
Example 6
A P2000 loan was originally made at 8%
simple interest for 4 years. At the end of this
period the loan was extended for 3 years,
without the interest being paid, but the new
interest rate was made 10% compounded
semi-annually. How much should the
borrower pay at the end of 7 years?
Example 7
If you have to invest, which is better: 12%
compounded semi-annually or 12%
compounded monthly?
Example 8
What payment amount 15 years from now is
equivalent to a payment of Php 3,500 five
years from now, if interest is 11% and is
compounded [a] semi-annually and [b]
monthly?
Equation of Value
An equation of value is obtained by setting
the sum of the values on a certain
comparison or focal date of one set of
obligations equal to the sum of the values on
the same date of another set of obligations.
Example 9
A man bought a lot worth P1,000,000 if paid
in cash. On installment basis, he paid a down
payment of P200,000; P300,000 at the end
of one year; P400,000 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%?
Assignment
1. A company that manufactures special types of machines
made an investment 10 years ago that is now worth Php
10,300,000. How much was the initial investment at an
interest rate of 15% per year (a) simple interest and (b)
compound interest?
2. Find the nominal rate compounded monthly which is
equivalent to 10% compounded quarterly. What is the
corresponding effective rate?
3. You borrowed Php 15,000 for the period from January 15,
2012 to October 12, 2012 at the rate of 18%. You were
charged an exact simple interest of Php 1,900. Is the interest
charged to you fair?
Continuous Compounding
In discrete compounding, the interest is
compounded at the end of each finite-length
period.

In continuous compounding, it is assumed

that cash payments occur once per year, but
the compounding is continuous throughout
the year.
Continuous Compounding

= 1+

Let m/r=k, then m=rk, as m increases so must k

1 1
1+ = 1+ = 1+

Continuous Compounding

The limit of 1 + as k approaches infinite is e


1
1+ =

Thus,
=
=
Example

What is the accumulated amount after 3

years of P1,000 invested at the rate of 8%
per year compounded continuously?
Example

How many years are required for your money

to triple if it is invested at 9% compounded
[a] annually, [b] semi-annually, [c] quarterly,
and [d] continuously?
Discount

Interest deducted in advance

Difference on what is worth in the future and

its present worth

Discount = Future Worth Present Worth

Discount

The rate of discount is the discount on one unit of

principal per unit of time.

If d is the rate of discount, then

= 1 (/, %, 1)
= 1 (1 + )1
1
=1
1+
Discount

=
1+

=
1
Example

Mr. J. Dela Cruz borrowed money from a

bank. He received from the bank P1,342 and
promise to pay P1,500 at the end of 9
months. Determine the following:
Rate of discount (Bankers discount)

Rate of interest

Rate of interest for one year

Example
A man borrows Php 10 000 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 Php 10 000.
What is the actual rate of interest?
Inflation
Inflation is the increase in the prices of goods
and services from one year to another, thus
decreasing the purchasing power of money.
Inflation

= 1 +

Where: PC = present cost of a commodity

FC = future cost of the same commodity
f = annual inflation rate
n = number of years
Example
A certain product presently costs P500. if
inflation rate is at the rate of 6% per year,
what will be the cost of this product in 4
years?
Inflation

In an inflationary economy, the buying power of

money decreases as costs increase. Thus,

=
1+

where F is the future worth, measured in todays

pesos, of a present amount P.
Inflation

If interest is being compounded at the same time

that inflation is occurring, the future worth will be

1+ 1+
=
=
1+ 1+
Example
In year zero, you invest P10,000 in a 15%
security for 5 years. During that time, the
average annual inflation is 6%. How much, in
terms of year zero pesos will be in the
account at maturity?
Seatwork
Fifteen years ago, P1,000 was deposited in a
bank account, and today it is worth P2,370.
the bank pays interest semi annually. What
was the interest rate paid in this account?
Seatwork
A man borrowed P20,000 from a local
commercial bank which has a simple interest
of 16% but the interest is to be deducted
from the loan at the time the money was
borrowed and the loan is payable at the end
of one year. How much is the actual rate of
interest?
Seatwork
What payment X 10 years from now is
equivalent to a payment of Php 10 000 six
years from now, if interest is 15%
compounded [a] annually, and [b] monthly?
Seatwork
You wish to have Php 1 500 000 ten years
from now. What amount should you invest
now if it will earn interest of 8% compounded
annually during the first 5 years and 12%
compounded quarterly during the next 5
years?