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Engineering Economy
Interest and Money Time Relationship

Interest and Money Time Relationship

This module deals with interest and money time relationships.

At the end of this module, the learner should be able to:

1. Differentiate present value from future value.
2. Calculate simple and compound interest.
3. Find the corresponding effective rate.
4. Determine the future worth of a present value or the present worth of a
future value.

Interest and Money Time Relationship

1. Interest – amount of money paid for use of borrowed capital. It also the
income produced by money which has been loaned.
2. Simple interest- It is an interest calculated using the principal only
while ignoring any interest that had been accrued in preceding periods.
It is paid on short term loans in which time of the loan is in days. The
interest period for simple interest is 360 days.
3. Exact Simple Interest – It is the interest based on exact number of days.
The interest period for this type of interest is 365 days for ordinary
year and 366 days for leap year.
4. Cash flow diagram – graphical representation of cash flows drawn on a
time scale.
5. Compound Interest – It is the interest on top of interest.
6. (1 + 𝑖)𝑛 – single payment compound amount factor.
7. (1 + 𝑖)−𝑛 – single payment present amount factor.
8. Nominal Rate of Interest – rate of interest and a number of interest
periods in one year.
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Engineering Economy
Interest and Money Time Relationship

9. Effective Rate – actual or exact rate of interest and a number of interest

periods in one year
10. Equation of Values – obtained by setting the sum of the certain values
on a certain comparison or focal date on one set of obligation equal to
the sum of the values on the same focal date and other set of obligation.
11. Discrete Compounding- interest is compounded at the end of each finite
length period such as a month, a quarter, or a year.
12. Continues Compounding – such cash payments occur per year but the
compounding is continuous throughout the year.
13. Discount- It is the difference between what is it worth in the future,
and its present worth.

Simple Interest

Simple interest is calculated using the principal only, ignoring any interest
that had been accrued in preceding periods. In practice, simple interest is paid
on short term loans in which the time of the loan is measured in days.
However, in the computation of simple interest, the formula requires
that the number of interest periods be in number of years.

𝑰 = 𝑷𝒏𝒊
𝐹 = 𝑃 + 𝐼 = 𝑃 + 𝑃𝑛𝑖
𝑭 = 𝑷 (𝟏 + 𝒏𝒊)

Where:
𝐼 = 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡
𝑃 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑟 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑𝑠
𝑖 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑
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Engineering Economy
Interest and Money Time Relationship

𝐹 = 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑟 𝑓𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ

(a) Ordinary simple interest is computed on the basis of 12 months of 30 days

each month or 360 days a year. 1 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 = 360 𝑑𝑎𝑦𝑠
(b) Exact simple interest is based on the actual or exact number of days in a
year, 365 days for an ordinary year and 366 days for a leap year. 1 interest
period = 365 or 366 day

Cash-Flow Diagrams

A cash-flow diagram is simply a graphical representation of cash flows

drawn on time scale. Cash- flow diagram for economic analysis problems is
analogous to that of free body diagram for mechanics problem.

Receipt (positive cash flow or cash inflow)

Disbursement (negative cash flow or cash outflow)

Compound Interest
𝑭 = 𝑷 (𝟏 + 𝒊)𝒏
𝑷 = 𝑭 (𝟏 + 𝒊) −𝒏
𝑤ℎ𝑒𝑟𝑒:
𝑃 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑜𝑟 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ
𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑖𝑛 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟
𝑛 = 𝑚 ∗ 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝑟
𝑖 =
𝑚
𝐹 = 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑟 𝑓𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ
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Engineering Economy
Interest and Money Time Relationship

The quantity (𝟏 + 𝒊)−𝒏 is called the "single payment present worth

factor" and is designated by the functional symbol(𝑃/𝐹, 𝑖%, 𝑛). Thus,
𝑷 = 𝑭 (𝑷/𝑭, 𝒊%, 𝒏)
The symbol P/F, i%, n is read as "P given F at i per cent in n interest
periods."

Rate of Interest:
(a) Nominal rate of interest
The nominal rate of interest specifies the rate of interest and a
number of interest periods in one year.
𝒓
𝒊=𝒎

Where: 𝑖 = 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟𝑖𝑜𝑑

𝑟 = 𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒
𝑚 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
10%
If the nominal rate of interest is 10 % compounded quarterly, then 𝑖 = =
4

2.5%, the rate of interest per interest period.

(b) Effective rate of interest
Effective rate of interest is the actual or exact rate of interest on
the principal during one year.
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 = (1 + 𝑖)𝑚 − 1
For two or more nominal rates to be equivalent, their corresponding
effective rates must be equal.

Illustrative Examples:
1. Determine the ordinary simple interest on P700 for 8 months and 15
days if the rate of interest is 15%.

Solution:
Number of days = (8) (30) +15 = 255 days
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Engineering Economy
Interest and Money Time Relationship

255
Number of years: 360

255
𝐼 = 𝑃𝑛𝑖 = 𝑃700 ∗ ∗ 0.15
360
𝑰 = 𝑷𝟕𝟒. 𝟑𝟖

2. Determine the exact and ordinary simple interest on P1200.00 for the
period from January 16, to November 26, 1992, if the rate of interest
is 24%.

Solution:
First determine the number of days in the given period
January 16 - 31 15 (excluding January 16)
February 29
March 31
April 30
May 31
June 30
July 31
August 31
September 30
October 31
November 26 (Including November 26)
Total 315 days
315
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃1200(0.24) ( ) = 𝑃252.00 𝐴𝑛𝑠.
360
315
𝐸𝑥𝑎𝑐𝑡 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃1200(0.24) ( ) = 𝑃247.87 𝐴𝑛𝑠.
366
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Engineering Economy
Interest and Money Time Relationship

3. 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.
Solution:
𝑟
𝑖=
𝑚
𝑟 = 0.08
𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦: 𝑚 = 4; 𝑛 = 2 ∗ 4 = 8
0.08
For compounded interest: 𝑖= ; 𝑛 = 2 𝑦𝑒𝑎𝑟𝑠
4

For simple interest: 𝑖 = 8%, 𝑛 = 7/12

𝐹1 = 𝑃 (1 + 𝑖)𝑛 = 𝑃1000 (1 + 0.02)8 = 𝑃1171.66

7
𝐹2 = 𝐹1 (1 + 𝑛𝑖) = 𝑃1171.66 [1 + ]
12(0.08)
𝑭𝟐 = 𝑷𝟏, 𝟐𝟐𝟔. 𝟑𝟒

4. 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 semiannually. How much should the borrower pay at
the end of 7 years?
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Engineering Economy
Interest and Money Time Relationship

Solution:
F4 = the amount at the end of four years
𝑖 = 8%; 𝑛 = 4
F1 = the amount at the end of seven years (3 years after four years)
𝑟 = 10%;
0.10
𝑖= 𝑖 = 0.05
2
𝑛 =3∗2= 6
F4 is the pesent value after after four years and F1 is the future value after 3
years.

𝐹4 = 𝑃 (1 + 𝑛𝑖) = 𝑃2, 000 [1 + (4) (0.08)] = 𝑃2, 640

𝐹1 = 𝐹4 (1 + 𝑖)𝑛 = 𝑃2, 640 (1 + 0.05)6
𝑭𝟏 = 𝑷𝟑, 𝟓𝟑𝟕. 𝟖𝟔

5. Find the nominal rate which if converted quarterly could be used

instead of 12% compounded monthly. What is the corresponding
effective rate?
Solution:
Let r = the unknown nominal rate
For two or more nominal rates to be equivalent, their corresponding
effective rates must be equal.
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Engineering Economy
Interest and Money Time Relationship

Nominal rate Effective rate

𝑟 𝑚
R% compounded quarterly (1 + ) −1
𝑚

0.12 12
12% compounded monthly (1 + ) −1
12

(1 + r/4)^4 - 1 = 1(+ 0.12) ^ - 1

𝑟 4 0.12 12
(1 + ) − 1 = (1 + ) −1
4 12

𝑟 4 0.12 12
(1 + 4) = (1 + )
12

𝑟 0.12 3
1 + = (1 + )
4 12
𝑟
1 + = (1 + 0.01)3
4

𝑟
1+ = 1.0303
4
𝑟 = 0.1212 𝑜𝑟 12.12% 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑒𝑑 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦

6. What nominal rate compounded semi – annually yields the same

amount of 16% compounded quarterly.

Solution:
𝑟 2 . 16 4
[1 + ] − 1 = [1 + ] −1
2 4

2 𝑟 2 2 . 16 4
√[1 + ] = √[1 + ]
2 4

1 + r/2 = 1.0816; r = 16.32%

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Engineering Economy
Interest and Money Time Relationship

7. Compare the accumulated amounts after 5 years of P1, 000 invested

at the rate of 10% per year compounded (a) annually, (b)
semiannually, (c) quarterly,
(d) monthly, (e) daily, and (f) continuously.

Using the formula, F = 𝑃(1 + 𝑖)𝑛

Solution:
Using the formula, F = 𝑃(1 + 𝑖)𝑛
(a) 𝐹 = 𝑃1,000(1 + 0.10) 5 = P1,610.51
0.10 10
(b) 𝐹 = 𝑃1,000 (1 + ) = 𝑃1,628.89
2

0.10 20
(c) 𝐹 = 𝑃1,000 (1 + ) =P1,638.62
4

0.10 60
(d) 𝐹 = 𝑃1,000 (1 + ) =P1,645.31
12

0.10 1825
(e) 𝐹 = 𝑃1,000 (1 + 365 ) =P1,648.61

(f) 𝐹 = 𝑃1,000(𝑒)(10𝑥5) =P1,648.72

8. A bank charges 12% simple interest on a P300.00 loan. How much will
be repaid if the loan is paid back in one lump sum after three years?

Solution:
𝐹 = 𝑃 (1 + 𝑛𝑖)
𝑃 = 300
𝑛 = 3 𝑦𝑒𝑎𝑟𝑠
𝑖 = 12%
𝐹 = 300 [1 + (3) (.12)]
𝑭 = 𝑷 𝟒𝟎𝟖
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Engineering Economy
Interest and Money Time Relationship

9. What amount will be available in eight months if P 15,000.00 is

invested now at 10% simple interest per year?

Solution:
𝑃 = 15,000.00
𝐹 = 𝑃 (1 + 𝑛𝑖)
8
𝑛 =
12
𝐹 = 15,000[1 + (8/12) 0.10]
𝑖 = 10%
𝑭 = 𝑷 𝟏𝟔, 𝟎𝟎𝟎. 𝟎𝟎

10. If you borrow money from your friend with simple interest of 12%,
find the present worth of P 20,000.00 which is due at the end of nine
months?
Solution:
𝐹 = 20,000
𝐹 = 𝑃 (1 + 𝑛𝑖)
𝐹
𝑃=
1 + 𝑛𝑖
𝑖 = 12%
9
𝑛 =
12

20, 000
𝑃 =
[1 + (9/12) (0.12)]
𝑷 = 𝑷 𝟏𝟖, 𝟑𝟒𝟖. 𝟔𝟐

11. Three years ago, an engineer opened a savings account with an initial
deposit of P200,000 he withdrew P50, 000 three months later, and
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Engineering Economy
Interest and Money Time Relationship

another P50, 000 six months after the first withdrawal. Last year, he
deposited P100, 000 and P150, 000 six months later. Find the account
balance today if interest is 10% compounded quarterly.
Solution:
F = P (1 + i) n
F = 200, 000 (1 + 0.025)12 - 50, 000 (1 + 0.025)11- 50, 000 (1 + 0.025)9
+ 100,000 (1 + 0.025)4
+ 150, 000 (1 + 0.025)2
F = 408, 905.32

The Concept of Equivalence

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.

1. A man bought a lot worth P1, 000,000 if paid in cash. On the

installment basis, he paid a down payment of P2, 000,000; 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%?

Solution
Let Q= the final payment
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Engineering Economy
Interest and Money Time Relationship

Using today as the focal date, the equation of value is

P800, 000 = P300, 000(P/F, 20%, 3) + Q (P/F, 20%, 5)
P800, 000 = P300,000(1.20)−1 + P400,000(1.20)−3 + Q(1.20)−5
P800, 000 = P300, 000(0.8333) + P400, 000(0.5787) + Q (0.4019)
𝑸 = 𝑷𝟕𝟗𝟐, 𝟓𝟔𝟎

2. Deposits of P35, 000, P48, 000, P25, 000 were made in a savings
account eight years, five years and 2 years ago, respectively. Determine
the accumulated amount in the account today if a withdrawal of 55,
000 was made 4 years ago. The applied interest rate is 11%
compounded annually.
Solution:
Let Q = the accumulated amount today
35, 000 (1 + 0.11)8 + 48, 000 (1 + 0.11)5 + 25, 000 (1 + 0.11)2
= 55,000 (1 + 0.11)4 + 𝑄
𝑸 = 𝟏𝟎𝟖, 𝟖𝟓𝟎. 𝟐𝟒
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Interest and Money Time Relationship

3. A company expects to retire an existing machine at the end of 1993

and will replace it with the new machine for the same task at an
estimated cost of P 60,000.00. The old machine is expected to be sold
for P5000.00 it is replaced to provide for replacement the company
intends to deposit the following amount in an account earning
interest at 8% compounded quarterly:
P20, 000 at the end of 1990
P15, 000 at the end of 1991
P10, 000 at the end of 1992
What additional investment amount is needed to purchase the new
machine?

Let Q be the additional amount needed at the end of 1993.

60, 000 = 20, 000 (1 + 1.02)12 + 15, 000 (1 + 1.02)8 + 17, 000
(1 + 1.02)4
+ 17, 000 (1 + 1.02)4 + 5, 000 + Q (1 + 1.02)0
Q = P1, 235.95