9/4/2021

Engineering Economics

Time Value of Money and Interest

Interests
Discounts

Engr. Vernon Degala

©2016 Slides created by Vernon Degala. ©2014 Check Point Software
1 Technologies Ltd

Time Value of Money

• Time value of money concepts are based on the effects of time on the
earning power of money. Money provides the opportunity for investment and
this opportunity translates into profit, so that a peso invested now shall earn a
return equal to the original peso plus interest sometime in the future.
• Another consideration for the time value of money concept is the change in the
purchasing power of money which is realized during periods of inflation
where the amount of goods or services that can be purchased decreases as the
purchase occurs further out into the future.

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Terminologies
• Interest (I), monetary unit – is the amount paid for the use of borrowed funds
(borrowers viewpoint) or the earnings generated by loaned capital (lenders viewpoint)
• Interest Rate (i), % - is the rate of capital growth, it is the ratio of the interest payable
or chargeable at the end of interest period and the amount of capital borrowed at the
beginning of that period.
• Interest Period (n) – is the time elapsed starting from the time capital is borrowed
to the time capital is paid. It is also the time for which the interest rate is applied.
• Principal or Present Worth (P), monetary unit – is the amount borrowed or invested
at the start of the interest period.
• Future Worth (F), monetary unit – is the amount accumulated at the end of the
interest period, it is the sum of the principal plus the interest earned for the interest
period.

𝑭 = 𝑷 + 𝑰
• Cash Flow – A term that refers to receipts (earnings, revenues) or disbursements
(payments, expenditures) of funds.

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Cash Flow Diagram

• A graphical representation of the cash transactions for a given interest period. It
is drawn with an equally segmented horizontal line representing the time scale for the
period, with the interest rate indicated on top of the line. Vertical arrows are placed
along the time scale to specify the cash flow timing, with upward arrows representing
receipts and downward arrows representing disbursements.
• Note:
– Two or more cash flows occurring in the same period may be combined into a single cash
flow.
– Cash flows are assumed to take place at the end of the period in which they occur, with the
exception of the initial cost that occurs at t=0.
– Sunk costs are expenditures incurred before t=0 and should not be considered.
– It is preferred that arrows be drawn to scale.

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Interest
• Interest is a factor that must be considered since earnings and expenditures occur at
different times. The time that funds are received or disbursed is of great consequence.
A present expenditures will not be the same as an expenditure of an identical amount in
the future, while, funds are loaned for the purpose of realizing a profit sometime in the
future.
• Simple Interest - it occurs when the interest earned is directly proportional to the
principal, the interest rate and the given interest period, it does not take into
account any interest accumulated from a preceding period.
𝐼 = 𝑃𝑖𝑛
𝐹 =𝑃+𝐼
𝐹 = 𝑃 + 𝑃𝑖𝑛
𝑭 = 𝑷 𝟏 + 𝒊𝒏
𝑷 = 𝑭 𝟏 + 𝒊𝒏 -1

• Ordinary Simple Interest – is computed on the basis of one bank year, where it is
common to consider a year to be composed of 12 months of 30 days each, or a total
of 360 days.
• Exact Simple Interest – is computed on the basis of the exact number of days for a
given year – 365 days for an ordinary year and 366 days for a leap year.
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Interest
• Compound Interest – occurs when the interest owed from the previous
interest period becomes part of the total amount owed for the succeeding
interest period. Hence, the interest earned for a given interest period is
calculated based on the principal plus the accumulated interest at the start
of the period. The sum by which the principal has increased at the end of the
interest period is called the compound interest.
• Compound Amount – is the total amount due at the end of the interest period.
It is equal to the sum of the principal and the accumulated interest.

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Nominal and Effective Interest Rates

• Nominal Interest Rate (NIR)
– It is also referred to as the annual percentage rate (APR) is used for transactions which stipulate
that interest charges are computed more often than once a year, it specifies the rate of interest
(in) and the number of interest periods per year. Thus, the interest rate period, 𝒊 = 𝒊𝒏 /𝒎
• Effective Interest Rate (EIR)
– The ratio of the actual interest earned for one year and the principal at the start of the year
expressed in percent, it therefore specifies the percentage increase in principal per annum, ie
• Relation between Nominal and Effective Interest Rate
– If P1.00 is invested for one year at a nominal rate of 12% compounded quarterly, then
in = 12%; m=4; i = 12%/4; n = 1x4
𝐹 = 𝑃(1 + 𝑖)𝑛 = P1.00(1.03)4
= P1.1255
The actual interest earned for one year (F-P) would therefore be P0.1255, which corresponds to an
EIR of 12.55%.
From this reasoning, the expression to find the effective annual interest rate is
𝒊𝒏
𝒊𝒆 = (𝟏 + )𝒎 −𝟏
𝒎

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Discrete Compounding
• It is the process of compounding interest at the end of every finite period, such
as weekly, monthly, or yearly.
Table: Comparative Table Showing the Equivalent Effective Interest Rates for Various Compounding
Periods at a Nominal Rate of 12%

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Continuous Compounding
• It is the counterpart of discrete compounding, the concept for such arises from the view that interest is earned every
day, hour, and minute. The interest earned is continuously added to the principal at the end of each infinitesimal
interest period, such that the number of compounding periods m per year is considered to be infinite.
From equation,
𝐹 =𝑃 1+𝑖 𝑛

If the NIR is given

𝑚
𝑖
= 𝑃 [(1 + 𝑛 ) 𝑖 ]𝑖𝑛𝑛 let 𝑚 = 𝑐𝑖𝑛
𝑛
𝑚
1 𝑐 𝑖 𝑛
= 𝑃 [(1 + ) ] 𝑛 If m  α then, c  α
𝑐
𝑖𝑛 𝑐 𝑖 𝑛
= 𝑃 [(1 + ) ]𝑛
𝑚
Note that
1
𝑙𝑖𝑚𝑐 → 𝛼 = (1 + )𝑐 = 𝑒
𝑐
Therefore,

𝑭 = 𝑷𝒆𝒊𝒏𝒏 where n = number of years

From the derived equation it is clear that 𝑒 𝑖𝑛𝑛 corresponds to 1 + 𝑖 𝑛 , such that the effective rate for continuous compounding may
be computed as
𝒊𝒆 = 𝒆𝒊𝒏 − 𝟏

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Equivalence
• The basic condition of equivalence is satisfied when the applied interest rate
sets the equivalent amount of receipts equal to the equivalent amount of
disbursements
– Payments may be added or subtracted directly if they occur at the same point
in time.
– Cash flows that are equivalent maybe referred to any point in time
– Two or more cash flows are equal if their equivalent values at any point in time are
equal.
– The applied interest rate for the specified time period must be reflected in
equivalence calculation.

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Inflation (i’)
• It is a condition describe by a decline in the purchasing power of money
brought about by a general increase in the prices of goods and services.
This translates to a steady decrease in the quantity of goods and services
that a fixed amount can purchase as time progresses.
• As a consequence, it is but appropriate to include in time value of money
computations the adjusted interest rate, 𝑖′, which reflects the actual or real
interest rate, 𝑖1, and the effects of the inflation rate, 𝑖2

1 + 𝑖 ′ = 1 + 𝑖1 1 + 𝑖2
𝑖 ′ = 1 + 𝑖1 1 + 𝑖2 − 1

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Discount (D)
• A discount occurs when a transaction requires that interest be paid in advance, usually at the start of the
interest period. The discount is the difference between the amount indicated on the paper (face value)
and the price at which it is sold. The discount rate, d, is the ratio of the amount of discount to the future
worth of money, computed for one interest period, such that
𝑫 = 𝑭 − 𝑷 = 𝑭𝒅𝒏

Relation between i and d

𝐹 − 𝑃 = 𝐹𝑑𝑛
𝐹 − 𝐹𝑑𝑛 = 𝑃
𝐹 1 − 𝑑𝑛 = 𝑃
𝐹 = 𝑃(1 − 𝑑𝑛)−1

Equating with equation

𝐹 = 𝑃 1 + 𝑖𝑛
𝑃
𝑃 1+𝑛 =
1 − 𝑑𝑛
1
1 − 𝑑𝑛 =
1 + 𝑖𝑛
1 1 + 𝑖𝑛 − 1 𝑖𝑛
𝑑𝑛 = 1 − = =
1 + 𝑖𝑛 1 + 𝑖𝑛 1 + 𝑖𝑛
For one interest period 𝑛 = 1 then, Note:
𝒊 𝒅 Unless otherwise specified, the use of 360 days per year shall be used
𝒅= or 𝒊 =
𝟏+𝒊 𝟏−𝒅
with ordinary simple discount.
Simple discount is seldom used for transaction periods of more than one
year.
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Let’s do this! Foundation questions

1. Determine the exact simple interest of P5000 invested for the period from January 15,
2021 to October 12, 2021 if the rate of interest is 18%.
2. If you borrowed money from your friend with simple interest of 12%, find the present
worth of P50,000.00, which is due at the end of 7 months.
3. Mr. Reyes borrowed money from the bank. He received from the bank P1,842.00 and
promised to pay P2,000.00 at the end of 10 months. Determine the simple interest
rate.
4. An ordinary simple interest rate of 8.5% per year is applied on a P50,000.00 loan
made on July 01, 2005. Find the lump sum interest to be paid on the load on June 05,
2012.
5. What will be the value of P6,000.00 four and one half years from now, if invested at
15% compounded quarterly?
6. A bank offers 0.5% effective monthly interest. What is the effective annual rate with
monthly compounding?
7. How long will an account invested at 11.5% compounded yearly be tripled?

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Let’s do this! Foundation questions

1. If the nominal interest rate is 3%, how much is P5000.00 worth in 10 years in a
continuously compounded account?
2. East Side Bank offers the following effective rates on 5 year loans: 8% for the
first two years, 10% for the third year, 11% for the fourth year, and 12% on the
fifth year. If P500000 is borrowed, determine the lump-sum amount to be paid
at the end of the loan period.
3. Determine the adjusted interest rate if the actual interest rate is 12% and the
inflation rate is 5.5%.
4. A loan of P50000 is due in 10 months at 12% interest is guaranteed by a post
dated check. Four months later the check is sold at a discount of 15%.
Determine a) the face value of the check; b) the selling price of the check.

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