 Capital – refers to wealth in the form of
money or property that can be used to
produce more wealth
 Time value of money – refers to “a
peso today is worth more than peso
one or more years from now because
of the interest (or profit) it can earn
2 Basic Categories of Capital:
1. Equity capital – owned by
individuals who have invested their
money or property in a business
project or venture in the hope of
receiving a profit
2. Debt capital (or borrowed capital) –
obtained from lenders (e.g., through
the sale of bonds) for investment
Fundamental reasons why return to capital in the form of interest and profit is an
essential ingredient of engineering economy studies:
1. Interest and profit pay the providers of capital for forgoing its use during the
time the capital is being used
2. Interest and profit are payments for the risk the investor takes in permitting
another person, or an organization, to use his or her capital
 2000 B.C. in Babylon – interest was paid in money for the use of grain or other
commodities that were borrowed; it was also paid in the form of grain or other
goods
 575 B.C. in Babylon – firm of international bankers existed
*Usury – charging of exorbitant (or excessive) interest rates on loans which is
prohibited in the Bible (Exodus 22:21-27)
 Middle Ages – interest taking on loans of money was generally outlawed on
scriptural grounds
 1536 – Protestant theory of usury was established by John Calvin, and it refuted the
notion that interest was unlawful
 21st century – interest is viewed as an essential and legal part of doing business
 Simple interest – when the total Formula 2:
interest earned or charged is linearly
proportional to the initial amount of F=P+I
the loan (principal) F = P + Pin
 Simple interest is not used frequently in F = P (1 + in)
modern commercial practice
where:
Formula 1:
F = total amount repaid at the end of t
I = Pin interest periods
where:
P = principal amount lent or borrowed
i = interest rate per interest period
n = number of interest periods (e.g.,
years)
Ex.: If Php 1,000 were loaned for three (b) F = ?
years at a simple interest rate of 10%
per year, (a) what would be the interest F=P+I
earned? (b) what will be the total F = 1,000 + 300
amount owed at the end of three years?
F = Php 1,300
Solution:
(a) I = ?
What if the period is not in years?
I = Pin
I = (1,000)(3)(0.10)
I = Php 300
2 Types of Simple Interest:
1. Ordinary Simple Interest
Assumption: 30 days/month (or 360
days/year)
To convert days to years,
n = no. of days/360
2. Exact Simple Interest
Based on the actual number of days
on a certain year
Case 1: Non-leap year
To convert days to years,
n = no. of days/365
Case 2: Leap year
To convert days to years,
n = no. of days/366
Ex.: Find the simple interest rate of an Ex.: What is the accumulated amount of
investment worth Php 10,000 which will money worth Php 22,500 if invested at an
earn Php 500 in 215 days. interest rate of 1.5% per annum from
February 14, 2016 to October 2, 2017?
Solution:
Solution:
i = ? (ordinary)
F=?
I = Pin
n1 = 322 days (366 – 44)
i = I/Pn
n2 = 275 days (365 – 90)
i = 500/((10,000)(215/360))
F = P(1 + in)
i = 0.0837 or 8.37%
F = 22,500(1+0.015((322/366)+(275/365)))
F = Php 23,051.21
 Compounding interest – whenever the Period (1) (2) = (1) x 10% (3) = (1) + (2)
interest charge for any interest period (a Amount Interest Amount
year, for example) is based on the Owed at Amount for Owed at End
remaining principal amount plus any Beginning Period of Period
accumulated interest charges up to the of Period
beginning of that period
Ex.: The effect of compounding of interest 1 $1,000 $100 $1,100
can be seen in the following table for 2 $1,100 $110 $1,210
$1,000 loaned for 3 periods at an interest
rate of 10% compounded each period. 3 $1,210 $121 $1,331
Formula: P = present value of money
𝐹 = 𝑃(1 + 𝑖) i = interest rate per period
but 𝑖= r = nominal/annual interest rate
and 𝑁 = 𝑚𝑛 m = number of compounding periods
N = total number of compounding periods
so 𝐹 =𝑃 1+
n = number of years
Compounding Number of
Frequency compounding Using Interest Tables for Discrete
periods (m) Compounding
Annually/Per annum 1 *(1 + 𝑖) = (𝐹 ⁄𝑃 𝑜𝑟 𝑃⁄𝐹 , 𝑖%, 𝑁)
Semiannually 2 *𝐹 = 𝑃(𝐹 ⁄𝑃 , 𝑖%, 𝑁)
where:
Quarterly 4 *𝑃 = 𝐹(𝑃⁄𝐹 , 𝑖%, 𝑁)
F = future value of money
Bimonthly 6
Monthly 12
Daily 365
Ex.: What will be the sum of money if Ex.: What will be the amount of money
Php 10,000 is invested to a bank account to be invested to accumulate a sum of
having an interest rate of 1% money worth Php 500,000 for 10 years
compounding quarterly for 10 years? with an interest rate of 10%
compounding bimonthly?
𝐹 =𝑃 1+ ( )
( )
𝑃 =𝐹 1+
.
𝐹 = 10,000 1 + ( )
.
𝑃 = 500,000 1 +
𝐹 = 𝑃ℎ𝑝 11,050.33
𝑃 = 𝑃ℎ𝑝 185,461.99
Ex.: How many years will it take to have Ex.: What is the nominal interest rate of
a sum amount of money of Php 25,000 a principal amount of Php 35,500 to
from an investment of Php 20,000 having acquire an interest amount of Php 5,250
an interest rate of 15% compounding in 7 years if compounding quarterly?
semiannually?
𝐹 =𝑃+𝐼
𝐹 =𝑃 1+ 𝐹 = 35,500 + 5,250 = Php 40,750
.
25,000 = 20,000 1 + 𝐹 =𝑃 1+
n = 1.54 𝑦𝑒𝑎𝑟𝑠 ( )
40,750 = 35,500 1 +
𝑟 = 0. 0198 𝑜𝑟 1.98%
Notation:
i = effective interest rate per interest
period
N = number of compounding periods
P = present sum of money; the
equivalent value of one or more cash
flows at a reference point in time called
the present
F = future sum of money; the equivalent
value of one or more cash flows at a
reference point in time called the future
 Cash flow (time) diagrams –
recommended for situations in which
the analyst needs to clarify or visualize
what is involved when flows of money
occur at various times
 Cash flow diagram – analogous to that
of the free-body diagram for
mechanics problems
Net cash flow = Cash inflows (receipts)
+ Cash outflows (expenditures)
Cash flow diagram conventions:
 The horizontal line is a time scale, with
progression of time moving from left to
right. The period (e.g., year, quarter,
month) labels can be applied to
intervals of time rather than to points
on the time scale.
 The cash flow diagram is dependent
on the point of view.
 Dashed arrow – indicates the quantity
to be determined
 Cash inflows = cash outflows
(balanced)

 The arrows signify cash flows and are

placed at the end of the period.
(Downward arrows represent
expenses and upward arrows
represent receipts)
Ex.: Before evaluating the economic merits of a proposed investment, the XYZ
Corporation insists that its engineers develop a cash flow diagram of the proposal.
An investment of Php 10,000 can be made that will produce uniform annual revenue
of Php 5,310 for five years and then have a market (recovery) value of Php 2,000 at
the end of year five. Annual expenses will be Php 3,000 at the end of each year for
operating and maintaining the project. Draw a cash flow diagram for the five-year
life of the project. Use the corporation’s viewpoint.

Solution:
Ex.: Xander, Emman and Ruth are 𝐶𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝐶𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
friends. They try to save money starting
January 2020 amounting Php 30,000 for
their excursion somewhere at the 𝐹 = 𝑅 1 + 0.025 ⁄
northern part of the country on January
⁄
2021 for 3 days and 2 nights. They apply 𝐹 = 1.10𝑅 1 + 0.025
for a joint bank account where they can ⁄
save their money earning at 2.5% 𝐹 = 0.50𝑅 1 + 0.025
interest rate per annum. Xander 𝐹 +𝐹 +𝐹 = 30,000
contributes half of Ruth’s contribution.
Emman, being the rich person of the 𝐹 = 𝑃ℎ𝑝 11,345.57
group, contributes 10% more of Ruth’s 𝐹 = 𝑃ℎ𝑝 12,480.13
contribution. Ruth will pay her
contribution at the end of the 3rd month. 𝐹 = 𝑃ℎ𝑝 5,672.78
Xander will pay his contribution at the
end of the 5th month and Emman will
pay his contribution at the end of the 4th
month. What must be Xander, Emman
and Ruth’s individual contributions?
 Effective interest rate (ER) – actual or Ex.: What is the actual interest rate of 2.5%
exact interest rate earned on the compounded monthly in 10 years?
principal during one year
𝐸𝑅 = 1 + −1
𝐸𝑅 = 1 + 𝑖 −1
.
but 𝑖= 𝐸𝑅 = 1 + −1
so 𝐸𝑅 = 1 + −1 𝐸𝑅 = 0.0253 𝑜𝑟 2.53%

Converting different compounding Ex.: If a certain account has an interest

interest rates: rate of 8.5% compounding semiannually,
what is its nominal interest rate if
1+𝑖 = 1+𝑖 compounded quarterly? actual interest
rate compounded quarterly?
1+ = 1+
.
1+ = 1+
𝑟 = 0.0841 𝑜𝑟 8.41%
𝑖 = 0.0210 𝑜𝑟 2.10%
 Continuous compounding assumes Ex.: What is the effective interest rate of
that cash flows occurs at discrete a 1.05% compounding continuously
intervals (e.g., once per year), but that interest rate for 25 years?
compounding is continuous
throughout the interval. 𝐸𝑅 = 𝑒 − 1
.
𝐹 = 𝑃𝑒 𝐸𝑅 = 𝑒 −1
𝐸𝑅 = 𝑒 − 1 𝐸𝑅 = 0.0106 𝑜𝑟 1.06%

Ex.: What is the future value of an Ex.: Find the number of years for a
amount of Php 4,775 if the interest rate present value to triple if the interest rate
is 5% compounding continuously for 25 is 12% compounding continuously?
years? 𝐹 = 𝑃𝑒
𝐹 = 𝑃𝑒 3𝑃 = 𝑃𝑒 ( . )
. ( )
𝐹 = 4,775𝑒 𝑛 = 9.16 𝑦𝑒𝑎𝑟𝑠
𝐹 = 𝑃ℎ𝑝 16,666.39
 Discount (D) – amount saved when paid
before the due period (counterpart of
interest)
 Discount rate (d) – discount on one unit
of principal per unit of time
Banker’s discount:
𝑑=
Equivalent interest rate:
𝑟=
Ex.: A property currently worth Php
2,000,000 is subject to a lease at a
peppercorn rent for five years. A
purchaser has paid Php1,750,000 for it.
Assuming no future growth in value, what
was the discount rate?
𝐹 =𝑃 1+𝑖
2,000,000 = 1,750,000 1 + 𝑖
𝑖 = 0.0271 𝑜𝑟 2.71% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
 General price inflation – increase in Ex.: If a company borrowed Php 100,000 to
average price paid for goods and be repaid at the end of three years at a
services bringing about a reduction in combined (market) interest rate of 11%,
the purchasing power of the monetary what is the actual amount owed at the end
unit of three years and the real interest rate to
the lender? Assume general price
 General price deflation - decrease in inflation rate of 5%.
average price paid for goods and
services bringing about an increase in a. 𝐹 = 𝑃 1 + 𝑖
the purchasing power of the monetary
unit 𝐹 = 100,000 1 + .11
𝑖 =𝑖 +𝑓+𝑖 𝑓 𝐹 = 𝑃ℎ𝑝 136,763.10
𝑖 = b. 𝑖 =
. .
where: 𝑖 =
.
= 0.0571 𝑜𝑟 5.71%
𝑖 =combined interest rate
𝑖 =real interest rate
𝑓 = inflation rate
END OF PRESENTATION