Republic of The Philippines Nueva Vizcaya State University Bayombong, Nueva Vizcaya

Republic of the Philippines
NUEVA VIZCAYA STATE UNIVERSITY

Bayombong, Nueva Vizcaya
INSTRUCTIONAL MODULE
IM No.: ENG ECON – 1STSEM-2020-2012
COLLEGE OF ENGINEEERING
DEGREE PROGRAM BSCE COURSE NO. ENG ECON

SPECIALIZATION SE/CEM/TE/WRE COURSE TITLE ENGINEERING ECONOMICS
YEAR LEVEL 2nd Year TIME FRAME 6 WK NO. 3-5 IM NO. 2
I. UNIT TITLE/CHAPTER TITLE

3. Principles of Money-time Relationships
II. LESSON TITLE

3.1. Terminologies
3.2. Notation and Cash Flow
3.3. Interest Formulas for Discrete Cash Flows
3.4. Nominal and Effective Interest Rate
3.5. Economic Equivalence
III. LESSON OVERVIEW

This chapter introduces the different concepts of money-time relationship which
contains the 5 variables: present value, future value, number of periods, interest rates,
and payment amount. It discusses the concept of capital and interest including solving
problems and applications on engineering economics; the use of cash flow diagrams
and interest tables. Also, applying single payment, uniform series, and combinations
of these factors in calculating time-money relationship and equivalence; nominal from
effective interest rates; and continuous compounding and discrete cash flows.
IV. DESIRED LEARNING OUTCOMES

At the end of the topic, the students should be able to:
1. Discuss the different terminologies of the principles of money-time relationship.
2. Solve problems on simple and compound interest.
3. Understand the use of cash flow diagrams and interest tables.
4. Apply single payment, uniform series, and combinations of these factors in
calculating time-money relationship and equivalence.
5. Differentiate nominal from effective interest rates.
6. Solve problems involving continuous compounding and discrete cash flows.
V. LESSON CONTENT
A. PRINCIPLES OF MONEY-TIME RELATIONSHIPS
1. TERMINOLOGIES
• Capital – refers to wealth in the form of money or property that can be used to
produce more wealth.
• The Concept of Time Value of Money – “Money makes money”. This is true
because if we invest money today, by tomorrow we will have accumulated more
money that what we had originally invested. And also, if you borrow money today
you will have to pay in the future an amount that is larger than what you have
originally owed. This change in the amount of money over a given time period is
called time value of money”.
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• Equity capital – is owned by individuals who have invested their money or property
in a business project or venture in the hope of receiving a profit and sometimes in
exchange for a share of ownership in the company. Equity financing allows a
business to obtain funds without incurring debt or having to repay a specific
amount of money at a particular time.
• Debt Capital – also called borrowed capital, is represented by funds borrowed by
a business that must be repaid over a period of time, usually with interest. Debt
financing can be either short-term, with full repayment due in less than one year,
or long-term, with repayment due over a period greater than one year.
• Return on Capital - measures of how effectively a company uses the money
(borrowed or owned) invested in its operations.
• Interest - The term "interest" is used to indicate the rent paid for the use of money.
It is also used to represent the percentage earned by an investment in a productive
operation. From the lender's point of view, the interest is the income produced by
the money which he has lent. From the borrower's point of view, interest is the
amount of money paid for the use of borrowed capital. The percentage of money
charge as interest is called as interest rate.
• Simple Interest - The interest is said to be simple interest if the interest to be paid
is directly proportional to the length of time the amount or principal is borrowed.
The principal is the amount of money borrowed or invested.
Total interest (I) is computed by the formula:
I = (P) (n) (i)

where: P = principal amount lent or borrowed
n = number of interest period (ex. years)
i = interest rate per interest period
The total amount , F to be repaid at the end of N interest period is

F = P + I of F = P[1 + (n x i)]
Sample Problems.
1. Suppose that P1,000 is borrowed at a simple interest rate of 18% per annum. At the
end of one year, the interest would be:
I= (P) (n) (i)

I = 1,000 (1) (0.18) = P 180
2. Michelle invested $5000.00 in mutual fund with the interest rate of 4.8%. How much
interest would she earn after 2 years?
P = $5000.00 ; i= 4.8% ; n= 2
I= (P) (n) (i)
I = ($5000.00)(4.8%)(2) = $480.00
Hence, Michelle would earn $480 after 2 years.
3. Jeff has one savings account with the interest rate of 3.3%, and one money market
account with the interest rate of 5.1% in a bank. If he deposits $1,200.00 to the savings
account, and $1,800.00 to the money market account, how much money will he have
after 6 years?
Given:
Savings account: P = $1,200.00; i = 3.3% n= 6
Money market account: P = $1,800.00; i = 5.1% n = 6
Solution:
I = ($1,200.00) (3.3%) (6)] I = ($1,800.00)[1+(5.1%)(6)]
I = 237.60 = ($1,800.00)(1.306)
= $2,350.80
F=P+I Total amount:

F = $1,200.00 + 237.60 $1437.60 + $2350.80 = $3,788.40
F = $1,437.60
Hence, Jeff will have $3,788.40 after 6 years.
Compound Interest
Whenever the interest charge for any interest period is based on the remaining
principal amount plus any accumulated interest chargers up to the beginning of that
period, the interest is said to be compound.
Compound interest calculations apply to investments where the amount of interest is

calculated on the present balance of the account.
Sample Problem.
For instance, if you invested $100 in a bank with an interest rate of 10% compounded
annually (once per year), then in the first year of your investment you would earn $10. If
this were simple interest, you would continue to earn $10 per year for the period of your
investment. However, since the interest is compounded, you earn interest on your interest.
The amount of compound interest for the first interest period is the same as for simple
interest. However, for further interest periods, the amount of compound interest increases
to an amount greater than simple interest.
To illustrate:
Simple Interest Compound

Interest
Year 1 $100 * 10% = $100 * 10% =
$10 $10
Year 2 $100 * 10% = $110 * 10% =
$10 $11
Year 3 $100 * 10% = $121 * 10% =
$10 $12.10
Total Interest $30 $33.10
From the illustration above, you can see that under simple interest payments, a yearly
sum of $10 is gained through interest. For each year of the loan period, $10 is earned.
However, under compound interest payments, the yearly interest is added to the principle
for the next period. This has the effect of increasing interest earned each year for the
duration of the period (note: in example above, $33.10 earned from compound interest
versus $30 earned from simple interest).
B. NOTATION AND CASH FLOW DIAGRAMS
1. Notations used in formulas for compound interest formulas
i = interest rate per interest period

N = number of compounding periods
P = present sum of money; the equivalent worth of one or more cash flows
at a reference point in time called the present
F = future sum of money; the equivalent worth of one or more cash flows at
a reference point in time called the future
A = end-of-period cash flows in a uniform series continuing for a specified
number of periods; starting at the end of the first period and
continuing through the last period
2. Cash Flow Diagram

Cash flow is the difference between total cash coming (inflows or cash receipts)
and total cash going out (outflows or cash disbursements) for a given period of time.
Cash flow provides a means for planning the most effective use of your cash.
A cash flow diagram is a picture of a financial problem that shows all cash inflows
and outflows plotted along a horizontal time line. It is used to visualize cash flow:
individual cash flows are presented as vertical arrows along a horizontal time scale.
The cash flow diagram employs several conventions:
1. The horizontal line is a time scale, with progression of time moving from left to
right divided into equal periods such as days, months, or years.
2. The arrows signify cash flows and are placed at the end of the period. Funds
that you pay out such as savings deposits or lease payments are negative cash
flows that are represented by downward arrows Funds that you receive such as
proceeds from a mortgage or withdrawals from a saving account are positive
cash flows represented by upward arrows.
3. The cash flow diagram is dependent on the point of view (e.g. lender versus
borrower viewpoint).
Example: You are 40 years old and have accumulated $50,000 in your savings account.
You can add $100 at the end of each month to your account which pays an annual interest
rate of 6% compounded monthly. Will you be able to retire in 20 years?
The time line is divided into 240 monthly periods (20 years times 12 payments per
year) since the payments are made monthly and the interest is also compounded
monthly. The $50,000 that you have now (present value) is a negative cash outflow
since you will treat it as though you were just now depositing it into the account. It is
represented with a downward pointing arrow with its base at the beginning of the first
period. The 240 monthly $100 deposits are also negative outflows represented with
downward pointing arrows placed at the end of each period. Finally, you will withdraw
some unknown amount (the future value) after 20 years. Represent this positive inflow
with an upward pointing arrow with its base at the very end of the last period.
This diagram was drawn from your point of view. From the bank's point of view,
the present value and the series of deposits are positive cash inflows, and the final
withdrawal of the future value will be a negative outflow.
C. INTEREST FORMULAS FOR DISCRETE CASH FLOWS
1. Single Cash Flows / Payments
Figure shows a cash flow diagram involving a present single sum, P and a future
single sum F, separated by N periods with interest at i% per period. The dashed arrow
indicates the quantity to be determined.
Finding F When Given P
F = P(1 + i)N
The quantity (1+i)N is commonly called the single payment compound amount
factor. The functional symbol of (1+i)N is (F/P, i%, N). Therefore, the equation can be
expressed as
F = P (F/P, i%, N)
where the factor in parentheses is read “find F given P at i% interest per
period for N interest periods.”
Problem. Find the compound amount of PHP 1 000 in 4 years at 8% interest

compounded annually.
F = P(1 + i)N
F = 1 000 × (1 + 0.08)4
= 1 000 × 1.3605
= PHP 1,360.5
Finding P When Given F
P = F (1 / 1 + i) N
= F(1+i%) -N
The quantity (1+i)-N is called the single payment present worth factor. The
functional symbol for this factor is (P/F, i%, N). Hence
P = F (P/F, i%, N)
Problem. How much should be invested now (at present time) at 8% compound interest
per year, in order to receive PHP 1360.5 within 4 years; or what is the present equivalent
worth of PHP 1 360.5 to be received four years in the future?
P = 1,360.5 x (1/1+.08)-4
= 1,360.5 × (1/1.3605)
= 1 360.5 × 0.73503
= PHP 1,000
2. Uniform Series
Uniform series mean uniform amount of money, A, occurring at the end of

each period for n periods with interest at i% per period. A uniform series is often
called annuity.
Annuity - is a bunch of structured payments or equal payments made

regularly, like every month or every week.
Other assumptions:
1. P (present worth) occurs at one interest period before the first A.

2. F (future worth) occurs at the same time as the last and n interest
periods after P.
3. A (annual worth) occurs at the end of periods 1 through N, inclusive.
Figure shows a general cash flow diagram relating uniform series (ordinary
annuity) to the present equivalent and future equivalent values.
Finding F When Given A
The quantity {[(1 + i)N – 1] / i} is called the uniform series compound amount factor.
The functional symbol for this factor is (F/A, i%, N). Hence,
F = A (F/A, i%, N)
Problem. Example: If you deposit $10,000 in a bank every year for 18 years at
interest rate 8%. Then this amount becomes
F = 10,000 x {[(1 + 0.08)18 – 1] / 0.08]}

= $374; 502:
What this amount will be if the interest rate is 10%? What if N = 20?
Finding P When Given A
The equation in bracket is called the uniform series present worth factor. And the
functional symbol for this factor is (P/A, i%, N). Therefore:
P = A (P/A, i%, N)
Problem. If a certain machine undergoes a major overhaul now, its output can be
increased by 20% - which translates into additional cash flow of $20,000 at the end of each
year for five years. If i = 15% per year, how much can we afford to invest to overhaul this
machine?
P = 20,000 x {[(1 + 0.15)5 – 1] / 0.15 (1 + 0.15)5

= $20,000 (3.3522)
= $67,044
Problem. You are running a bank. A customer agrees to pay you $100,000 each
year with annual interest rate of 10% for 5 years. How much money will you lend to him?
P = 100,000 x (P/A, i%, N)

= $379,080
Finding A When Given F
This is the relation for finding the amount, A, of a uniform series of cash flows
occurring at the end of N interest periods that would be equivalent to its future
equivalent value occurring at the end of the last period. The quantity in bracket is
called the sinking fund factor and the functional symbol for this factor is (A/F, i%, N).
Hence, A = F (A/F, i%, N)
Problem. How much do you need to invest every year in a bank with an interest rate
of 8% in order to yield $1 million in 30 year?
A = 1,000,000 x (A/F, 8%; 30)
= $8,827
How much this will be if the interest rate is 10%?
Problem. An enterprising student is planning to have personal savings totaling
$1,000,000 when she retires at age 65. She is now 20 years old. If the annual interest rate
will average 7% over the next 45 years on her savings account, what equal end-of-year
amount must she save to accomplish her goal.
A = $1,000,000 (A/F, 7%, 45)

= $1,000,000 (0.0035) = $3,500
Finding A When Given P
The quantity in bracket is called the capital recovery factor and the functional
symbol for this factor is (A/P, i%, N). Therefore,
A = P (A/P, i%, N)
Problem. Example: You want to buy an apartment at the price of 4 million Hong
Kong dollars. You will do this with a mortgage from a bank at the annual interest rate 8% for
30 years. What is your annual payment?
A = 4,000,000 (A/P, 8%, 30)

= $355,200 ($29,600 per month).
What if the interest rate is 6%?
What if the mortgage is for 20 years? 10 years?
Table 1. Discrete Compounding Interest Factors and Symbols
To Given: Factor by which to Factor Name Factor

Find: multiply “Given” Functional
Symbol
For Single Cash Flow
F P (1 + i)N Single payment compound
amount (F/P, i%, N)
P F 1 / (1 + i)N Single payment present (P/F, i%, N)

worth
For annuities)
Uniform [(1 + i)N – 1] / i Uniform series compound (F/A, i%, N)
A
series ( amount
F
P [(1 + i)N – 1] / i(1 + Uniform series present
A (P/A, i%, N)
N
i) worth
A F i / [(1 + i) – 1]
N
Sinking Fund (A/F, i%, N)
A P i(1 + i) / [(1 + i) – Capital recovery
N N (A/P, i%, N)
1]
**INTEREST FORMULAS FOR DISCRETE COMPOUNDING AND DISCRETE CASH FLOWS
Discrete Compounding – it means that the interest is compounded at the end of

each finite length period, such as month or a year. The formulas also assume discrete
(lump-sum) cash flows spaced at the end of equal time intervals of a cash flow diagram.
D. DEFERRED ANNUITIES (Uniform Series)
Ordinary Annuity – is one where the equal payments are made at the end of each
payment period starting from the first period.
Deferred Annuity – is one where the payment of the first amount is deferred a certain
number of periods after the first.
Time Present
0 1 2 J -1 J J J J J N-1 N
+ + + +
Perio
d
i=
%
If the annuity is deferred J periods (J<N), the entire framed ordinary annuity has
been forward from “time present”, or “time 0”, by J periods. Since the annuity deferred
for J periods, the first payment is made at the end of period (J + 1), assuming that all
periods involved are equal in length.
The present equivalent at the end of period J of an annuity with cash flow of amount
A is A (P/A, i%, N-J). The present equivalent of the single amount A (P/A, i%, N-J) as
of time 0 will then be
A (P/A, i%, N-J) (P/F, i%, J)
Problem. Suppose that a father, on the day his son is born wishes to determine what
lump amount would have to be paid into an account bearing interest of 12% per year to
provide withdrawals of PHP 2,000 on each of the son’s 18th, 19th, 20th, and 21st
birthdays.
A = PHP 2,000
1 2 1 1 1 2 2
7 8 9 0 1
i = 12%
P1 = 1
7
Po = ? F7
Solution: N = 21 ; J = 17
P17 = A (P/A, 12%, 4) P0 = F17(P/F, 12%, 17)

= PHP 2,000 (3.0373) = PHP 6,074.60 (0.1456)
= PHP 6,074.60 = PHP 884.46
E. NOMINAL AND EFFECTIVE INTEREST RATES
1. Terminologies
Nominal Interest Rate - Nominal means "in name only". This is sometimes called
the quoted rate or basic annual interest. It is the stated rate of interest applied to
your investment.
Periodic Rate - The amount of interest you are charged each period, like every
month.
Effective interest rate - the actual annual interest rate that accrues, after taking
into consideration the effects of compounding (when compounding occurs more
than once per year). The rate that you actually get charged on an annual basis.
Remember you are paying interest on interest.
In compound interest problems there are three kinds of rates associated with
them namely:
1. Periodic Rate (i)

➢ It is the rate used to compute compound interest factors, and it is equal to
interest rate (r) divided by the conversion period (m).
2. Nominal Rate (J)
➢ The stated annual rate of interest when the conversion period is other than
a year.
3. Effective Rate (e)
➢ The annual interest rate of interest when the conversion period is one year,
the rate actually earned in a year.
NOMINAL RATE
It is the rate quoted when interest is compounded more than once a year. It is
denoted by (J) and the number of times per year this rate is compounded or the
frequency of conversion is represented by (m). In any investment problem, if the
rate is not specified as nominal or effective, it is assumed the given rate is nominal.
To determine the nominal rate (J) if effective rate (e) is given, apply;
𝟏
𝑱 = 𝒎 [(𝟏 + 𝒆)𝒎 − 𝟏]
Where: J = nominal rate e = effective rate m = conversion period
EFFECTIVE RATE
To determine the effective rate (e) when the nominal rate (J) is given, apply;
𝑱 𝒎
𝒆 = [(𝟏 + ) − 𝟏]
𝒎
Where: e = effective rate J = nominal rate m = conversion period per year
Note:
a. When interest is compounded annually, the effective rate is equal to the
nominal rate, but when it is compounded more than once a year, the
effective rate is higher than the nominal rate.
b. When comparing two different rates compounded at different conversion
periods per year (m), we compute their respective effective rates.
To illustrate: Consider a principal amount of PHP 1,000 to be invested for three years at
a nominal rate of 12% compounded semi-annually. The interest earned during the first six
months would be: PHP 1,000 x (0.12/2) = PHP 60
The interest earned during the second six months would be

PHP 1,060 x (0.12/2) = 63.60
Then total interest earned during the year is

PHP 60.00 + PHP 63.20 = PHP 123.60
The effective annual interest rate for the entire year is

(PHP 123.60 / PHP 1,000) X 100 = 12.36%
The relationship between effective annual interest, i, and nominal interest r, is
i = (1 + r/M)M – 1
where
M is the number of compounding periods per year
r is expressed in decimal.
Problem: A credit card company charges an interest rate of 1.375 per month on the
unpaid balance of all accounts. The annual interest rate they claim is 12 x 1.375% =
16.5%. What is the effective rate of interest per year being charged by the company?
i = (1 + 0.165/12)12 – 1
= 0.1781 or 17.81% per year
2. Interest Problems with Compounding More Often Than Once Per Year
Single Amounts
If a nominal interest rate is quoted and the number of compounding periods per year
and number of years are known, any problem involving future amounts, annual, or present
equivalent values can be calculated by straightforward use of equations F = P (1 + i)N and
i = (1 + r/M)M – 1 respectively.
Problem. Suppose that a PHP 100 lump-sum amount is invested for 10 years at a nominal
rate of 6% compounded quarterly. How much is it worth at the end of the tenth year?
Solution: There are 4 compounding periods per year, or a total of 4 x 10 = 40 periods. The
interest rate per interest period is 6%/4 = 1.5%.
F = P (F/P, 1.5%, 40)

= PHP 100.00 (1.015)40
= PHP 100.00 (1.814)
= PHP 181.40
Other solution:
Using i = (1 + r/M)M – 1
i = (1 + 6/10)10 – 1
i = 6.14%
F = P (F/P, 6.14%, 10)
= $100.00 (1.0614)10
= $181.40
Problem. At a certain interest rate compounded semi-annually, PHP 2,000 will amount to
PHP 6,500 in 10 years. What is the amount at the end of 15 years?
Solution: Solve first for the interest

For 10 years: F = P (1+i)N N = 10 (2) = 20 periods
6,500 = 2,000 (1+i)20
3.25 = (1+i)20
3.251/20 = 1+i
1.06 = 1+i
i = 1.06 – 1
i = 0.06 or 6%
For 15 years: F = 2,000 (1.06)30

F = 11,486.98
3. Interest Problems with Cash Flows Less Often Than Compounding Periods
Problem. Suppose that there exists a series of 10 end-of-year receipts of PHP 1,000 each,
and it is desired to compute their equivalent worth as one of the tenth year is the nominal
interest rate is 12% compounded quarterly.
Solution.
Interest = 12/4 = 3% per quarter, but the uniform series cash flows do not occur
at the end of each quarter.
1st Procedure: Compute an equivalent cash flow for the time interval that
corresponds to the stated compounding frequency.
A = F(A/F,3%,4)
= $1,000 (0.2390)
= $239 at the end of each quarter is equivalent to $1,000 at the end of each year.
Therefore, the future equivalent at the end of 10th quarter is: N = 10(4) = 40 periods
F = A(F/A,3%,40)
= $239 (75.4012) = $18,021
2nd Procedure:
Get the effective interest rate:

i = (1+r/M)M -1
= (1+12/4)4 – 1
= 0.1255 or 12.55%
F = A (F/A, 12.55%,10)
= $1,000 (F/A, 12.55, 10)
= $18,022
F. ECONOMIC EQUIVALENCE
In economic analysis, "equivalence" means " the state of being equal in value."
The concept is primarily applied in the comparison of different cash flows. As we know
from earlier chapters, money changes value with time; therefore, one of the main factors
when considering equivalence is to determine at which point(s) in time the money
transactions occur. A second factor is the specific amounts of money involved in the
transactions. Finally, the interest rate at which the equivalence is evaluated must also be
considered.
Problem. Bob, an engineering student, has just received his salary for a summer job.
After living expenses and entertainment, he has left $1000, which he plans to save for a
down payment on a new car. His father wants to borrow Bob's $1000, and promises to
return $1060 one year from now. According to his father, that is what Bob would receive
if he put the money in his bank savings account, which pays an effective annual interest
rate of 6 %. What should Bob do?
Solution:
If Bob's only alternatives are lending the money or depositing it in his current
savings account, both courses of action are indeed equivalent. That is, either would
provide Bob, one year from now, with $1060 in return for his decision to forego using
his $1000 today. Given this equivalence, Bob's decision would be based on factors
external to engineering economics (e.g., the degree to which he trusts his father).
However, if Bob had a different savings option-say, a savings certificate with a

guaranteed 9% annual yield-the equivalent value of his assets one year from now
would be $1090. In this case, the lending and savings alternatives are no longer
equivalent, and Bob has the problem of explaining this to his father.
In Example 6.1, (F/P, 6%, 1) served as t h e equivalencing factor. In general, all

the compounding and discounting factors presented in earlier chapters are
equivalencing factors.
Equivalence is not always directly apparent. Cash flows that have very different
structures (i.e., different amounts being transacted at different points in time) may be
equivalent at a certain interest rate.
Problem. A company which produces and markets microcomputers has just

introduced a new line which is expected to sell for $10000 per system. Owing to market
conditions, the company is being forced to offer financial incentives to potential customers.
The company has decided to charge an interest rate of 10% , compounded yearly, and to
give customers three options.
Option 1: Pay in four equal yearly installments of
A = $10 000(A/P, 10%, 4 ) = $10 000(0.3155)= $3155
Option 2: Pay the interest each year, and the principal (and interest) at the end of the
fourth year. This means paying $1000 ($10 000 x 0.10) at the end of years 1, 2, and 3, and
$11 000 at the end of year 4.
Option 3: Make a single payment of
F = $10 000(FIP, l o % ,4)

= $10 OOO(1.4641)
= $14 641
at the end of year 4.
Which option is best for a customer? for the company?
As summarized in Table 6-1, the three payment plans offered a customer are quite
different in structure. However, if 10% is the "appropriate" interest rate for his economic
evaluations, all three plans are equivalent: each provides him with a microcomputer worth
$10 000 and gives him 4 years to repay at a 10% interest rate, compounded yearly. From the
company's point of view, similar reasoning applies: at low interest, all plans are equivalent
because all result in the sale of a $10 000 item, and the money is recovered over a 4 year
period.
Table 6-1
End of Year Payment
Option 1 Option 2 Option 3

1 $3155 $1000 $0
2 3155 1 000 0
3 3155 1000 0
4 3155 11 000 14 641
Problem. Are the financing plans of problem above still equivalent if the evaluation is
made at the end of year 4?
Yes; at the end of year 4, all plans have an equivalent value of $14641 (up to
roundoff errors) when the same interest rate (10%) is used to make the evaluations.
Option 1 (equal payments):
F = $3155(F/A, lo%, 4)
= $3155(4.641)
= $14 642
Option 2 (amortization of interest):

More generally, we can say that options 1 and 3 must be equivalent at
the end of year 4, since they are obviously equivalent at the end of year 0; and
that options 2 and 3 are equivalent, on the basis of the relation derived in
Problem 3.3(a). Thus, all three options are equivalent, to the customer and to
the company, provided the two parties use the same interest rate.
1. THE COST OF CAPITAL

From Example 6.4 it is seen that the relative evaluation of cash flows depends
critically on the "appropriate" or "pertinent" interest rate used in the calculations.
Unfortunately, the interest rate that determines the time value of money is not usually
known, nor is it easy to determine. It stands to reason, though, that if money is to be
invested in a project, the project's cash flow equivalent value should be calculated at
an interest rate that exceeds the rate incurred in raising the initial capital. The extra
percentage points are justified in terms of risks associated with the specific project and
with long-term commitment of funds, and in terms of a profit margin required t o get
involved in the economic activity. Thus, a mining company considering diversification
into plastics would use a higher interest rate to evaluate such a project than it would
use for a new mining project, because of the risk of entering a new venture with
unknown market factors and for which no experience is available.
There are several means for a company to raise money for a project. It may
borrow from a bank at a specified interest rate; it may reinvest profits from other
projects instead of distributing them to the owners or shareholders; it may sell stock,
thereby increasing the number of owners (and decreasing the equity of each
stockholder); and it may borrow from the public through the issue of bonds. Almost
always, a combination of methods is employed, and one-way to measure the cost of
capital is to calculate a weighted average of the costs of funds acquired from all
sources.
2. STOCK VALUATION
Stock represents a share of ownership in a company. Its equivalent-value

calculation presents practical difficulties of estimating future dividends and selling
price, which are affected not only by the company's performance but also by the overall
situation of the economy and of the stock market.
Problem. ABC Corporation's stock, which currently sells for $50 per share, has been
paying a $3 annual dividend per share and increasing in value at an average rate of
5% per year, over the last 5 years. It is expected that the company's stock will maintain
this performance over the next 5 years. (a) What is the company's cost of the capital
raised through the selling of this stock? (b) Is this stock a good buy for an investor who
expects a 9% return on his investments?
(a) From the company's point of view, it will receive $50 per share today and would
have to pay
to buy it back 5 years from now. In addition, it must pay a yearly dividend of $3
per share. The equation of value at time 0 for this cash flow is therefore
where 1% is the cost of capital for money raised through the sale of this stock,
assuming the forecast dividends and selling price are accurate. The solution for
i must be found by a trial-and-error approach:
for i = 10% $3(3.7907)+ $63.81(0.62092)= $50.99

for i = 11% $3(3.6958)+ $63.81(0.59345)= $48.96
Thus, by linear interpolation,
(b) For a customer who wants to make 9% on his investments, the value of his
expected receipts from this share is given by
P = $3(P/A,9%, 5)+ $63.81(P/F,9%,5)

= $3(3.8896)+ $63.81(0.64993)
=$53.14
Since the expected value of the share exceeds the asked price, it is expedient
for him to buy it; if he does so, he should not only recover his $50 investment and the
9% he expects yearly, but he should gain an extra $3.14 (year 0 money) in the
transaction.
Alternatively, since we infer from (a) that the company expects the stock to yield
10.49% to an investor, the investor ought to buy it, if requires only 9% and if he agrees
with the company as to the stock's future performance.
3. BOND VALUATION
A bond is an economic instrument which has a face value guaranteed to be

paid to the bondholder by the issuing company when the instrument reaches maturity.
In addition, the bond-holder usually receives periodic dividends at a specified interest
rate. Bonds are transacted on the market, and their value depends on the size and
timing of the dividends, the duration before maturity, and the rate of return desired by
the bond purchaser. The company's cost of the capital raised through bonds will
depend on their acceptability to the public.
Problem. Taboy Corporation has decided to sell $1000 bonds which will pay
semiannual dividends of $20 (2% per period) and will mature in 5 years. The bonds
are sold at $830, but after brokers' fees and other expenses the company ends up
receiving $760. (a) What is the company's cost of the capital raised through the sale
of these bonds? (b) Is the bond a good buy for an investor who expects a 9% return
on his investments?
(a) From the company's point of view, it will receive $760 per bond today and will
have to pay $1000 (the face value) 5 years hence, plus a $20 semiannual
dividend. The equation of value at time 0 for this cash flow is
where 10 periods are used because dividends are paid twice a year and the
bond matures in 5 years, and where i% is the cost of capital, effective per 6-
month period. Solving by trial and error:
for i = 5% $20(7.7216)+ $1000(0.61392)= $768.35

for i = 6% $20(8.1108)+ $1000(0.55840)= $720.62
and linear interpolation gives
The company's cost of capital for money raised through the sale of these bonds is, on
a yearly basis, given by (4.3) as
(6) From the investor's point of view, he will pay $830 today to receive $20 every 6
months and $1000 in 5 years. He expects an effective rate of 9% a year on his
investments, or
per 6-month period. Hence the equivalent value at time 0 of his expected receipts is
This value represents the maximum amount the investor can bid for this bond,
if he requires an effective annual yield of 9% on his investments. Since the market
value today ($830) exceeds this maximum amount, he should look for another
business opportunity which could give him his required 9% return.
Notice that we could not conclude from (a) that the investor could realize 10.62%
(>9%); for, in effect, part of that 10.62% goes to the brokers.
4. FAIR MARKET VALUE
The concept of equivalence, as applied in the foregoing examples, may be used

to determine the actual cost of a loan, the maximum amount a person or company can
bid on a desired property or equipment, and, in general, in the determination of the
"fair market value" of an asset.
Problem. An engineering firm has turned to Friendly Shark, Inc., to borrow $30000
needed for a short-term (2-year) project, attracted by an advertisement announcing an
interest rate of 12% per year. Friendly Shark's loan statement indicates the following:
Interest: ($30 000) (1% per month) (24 months) = $ 7 200

Loan 30 000
Total $37 200
Monthly installment = $37 200 / 24 = $1550
What is the actual cost of borrowing money from Friendly Shark, Inc.?
The engineering firm receives $30 000 immediately and must pay back $1550
per month over a 24-month period. The monthly interest rate i which makes these flows
equivalent satisfies
Now,
(P/A, 1.5%, 24) = 20.030
(P/A, 2.0%, 24) = 18.914.
Hence, by interpolation,
or, on an annual basis,
which is rather different from the advertised rate.
VI. LEARNING ACTIVITIES

Additional Information on Principles of Money-Time Relationships
• https://www.youtube.com/watch?v=IkcGTLL9Yss
• https://www.youtube.com/watch?v=u63ltTnXB8g
• https://docs.google.com/document/d/1txT7PkWuxtFRCD37pkRk1owx1Zawrr5
aipoV2v_sJfM/edit?usp=sharing (For Annuities)
•
VII. EVALUATION (Note: Not to be included in the student’s copy of the IM)
VIII. ASSIGNMENT
Answer the following questions in a HANDWRITTEN FORM using the format and
attach it in the designated ASSIGNMENT tab in our Google Classroom.
4
1. Accumulate P 10,100 for 8 mos. At 10 % simple interest.
5
2. Find the compound amount and interest if P 15, 400 is invested for at 5 ½ % compounded
semi-annually for 5 years and 8 mos.
3. Find the present value of deferred annuity of P 900 every 3 months for 5 years that is
deferred 3 year, if money is worth 10% compounded quarterly.
4. Machine X will produce cost savings of $5000 per year for four years; machine Y will
produce cost savings of $4000 per year for five years. If the interest rate is 1O0h,
compound annually, are these two machines economically equivalent in terms of the
present value of their cost savings?
5. In a series of quarterly payments of P 5,700 each, the first payment is due at the end
of 5 years and the last at the end of 10 years and 9 months. If money is worth 6%
compounded quarterly, find the present value of the deferred annuity.
6. Find the present value of a deferred annuity of P 4,800 every six months for 7 years,
if the first payment is made 4 years, and money is worth 11% compounded semi-
annually.
7. What nominal rate compounded monthly, will yield the effective rate 4%?
8. A series of quarterly payments of $1000 for 25 years is economically equivalent to
what present sum, if the quarterly payments are invested at an annual rate of 8%,
compounded quarterly?
9. An engineer deposits $1000 in a savings account at the end of each year. If the bank
pays interest at the rate of 6% per year, compounded quarterly, how much money will
have accumulated in the account after 5 years?
10. Mr. Patdo borrowed P 15,800 for 9 m0s. from Ms. Jawo who charged 11⅛% simple
discount. How much money did Mr. Patdo received?
IX. REFERENCES
ARREOLA, M. Engineering Economy. Second Edition. Manila: KEN, Inc.
BESAVILLA, V. I. 1989. Engineering Economics. Cebu City Philippines: VIB Publishers.
CUARESMA, F.D. 1995-2000. Handouts in Engineering Economy.
CUARESMA, F.D. 2002. Economics of Precision Irrigation Systems. Paper delivered

during the Training on Precision Irrigation Systems for High Productivity and Efficient
Water Management, 4-6 Sept. 2002.
SULLIVAN, William G., Bontadelli James A, and Wicks, Elin M.. 2000. Engineering
Economy. 11th Edition. McMillan Pub. Co., New York: (recommended text book)
KASNER, E. Essentials of Engineering Economy. New York: Mc. Graw-Hill Book Co.
RIGGS, J.L., D.D. BEDWORTH., and S.U. RANDHAWA, S.U.1998. 4th Ed. Engineering
Economics . New York: Mc Graw-Hill.
STA. MARIA, H. Engineering Economy Reviewer. Third Edition.
SEPULVEDA, J., SOUDER, W., GOTTFRIED, S.. Theory and Problems of Engineering
Economics. McGraw-Hill Companies:USA. 1984
THUESEN, G.J. and W.J. FABRICKY, W. J. Engineering Economy. New Jersey: Prentice
Hall, Inc. 1989.
Websites:
www.toolkit.cch.com/text/P06_6500.asp CCH Business Owner's Toolkit
http://www.investopedia.com/terms/
www.eng.auburn.edu/~park/cee.html

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Republic of the Philippines

NUEVA VIZCAYA STATE UNIVERSITY

IM No.: ENG ECON – 1STSEM-2020-2012

DEGREE PROGRAM BSCE COURSE NO. ENG ECON

I. UNIT TITLE/CHAPTER TITLE

II. LESSON TITLE

III. LESSON OVERVIEW

IV. DESIRED LEARNING OUTCOMES

Total interest (I) is computed by the formula:

I = (P) (n) (i)

The total amount , F to be repaid at the end of N interest period is

I= (P) (n) (i)

Hence, Michelle would earn $480 after 2 years.

F=P+I Total amount:

Compound interest calculations apply to investments where the amount of interest is

Simple Interest Compound

B. NOTATION AND CASH FLOW DIAGRAMS

1. Notations used in formulas for compound interest formulas

i = interest rate per interest period

2. Cash Flow Diagram

C. INTEREST FORMULAS FOR DISCRETE CASH FLOWS

1. Single Cash Flows / Payments

Finding F When Given P

Problem. Find the compound amount of PHP 1 000 in 4 years at 8% interest

Finding P When Given F

Uniform series mean uniform amount of money, A, occurring at the end of

Annuity - is a bunch of structured payments or equal payments made

1. P (present worth) occurs at one interest period before the first A.

Finding F When Given A

F = 10,000 x {[(1 + 0.08)18 – 1] / 0.08]}

Finding P When Given A

P = 20,000 x {[(1 + 0.15)5 – 1] / 0.15 (1 + 0.15)5

P = 100,000 x (P/A, i%, N)

Finding A When Given F

A = $1,000,000 (A/F, 7%, 45)

Finding A When Given P

A = 4,000,000 (A/P, 8%, 30)

Table 1. Discrete Compounding Interest Factors and Symbols

To Given: Factor by which to Factor Name Factor

P F 1 / (1 + i)N Single payment present (P/F, i%, N)

Discrete Compounding – it means that the interest is compounded at the end of

D. DEFERRED ANNUITIES (Uniform Series)

A (P/A, i%, N-J) (P/F, i%, J)

P17 = A (P/A, 12%, 4) P0 = F17(P/F, 12%, 17)

E. NOMINAL AND EFFECTIVE INTEREST RATES

1. Periodic Rate (i)

Where: J = nominal rate e = effective rate m = conversion period

Where: e = effective rate J = nominal rate m = conversion period per year

The interest earned during the second six months would be

Then total interest earned during the year is

The effective annual interest rate for the entire year is

The relationship between effective annual interest, i, and nominal interest r, is

F = P (F/P, 1.5%, 40)

Solution: Solve first for the interest

For 15 years: F = 2,000 (1.06)30

Get the effective interest rate:

However, if Bob had a different savings option-say, a savings certificate with a

In Example 6.1, (F/P, 6%, 1) served as t h e equivalencing factor. In general, all

Problem. A company which produces and markets microcomputers has just

Option 1: Pay in four equal yearly installments of

A = $10 000(A/P, 10%, 4 ) = $10 000(0.3155)= $3155

Option 3: Make a single payment of

F = $10 000(FIP, l o % ,4)