UNIVERSITY OF SOUTHERN MINDANAO

ES 312B
Engineering Economy
 Module 3: Principles of Money-Time
Relationship
• Simple Interest
• Cash Flow Diagram
• Compound Interest
• Continuous Compounding

Principles of Money-Time Relationship 2

 Lecture 1: Simple Interest

ILO 1: By the end of the learning experience, students must be able

to:

✓Solve Simple Interest problems

Principles of Money-Time Relationship 3

Lecture 1: Simple Interest

Simple Interest 4
 Example 1:
• GreenTree Financing lent an engineering company $100,000 to retrofit an
environmentally unfriendly building. The loan is for 3 years at 10% per year
simple interest. How much money will the fi rm repay at the end of 3
years?
Solution:
The interest for each of the 3 years is:
Interest per year $100,000(0.10) = $10,000
Total interest (I) for 3 years:
I= PNi = $100,000(3)(0.10) $30,000
The amount due after 3 years is:
F = P + I = $100,000+30,000= $130,000

Simple Interest 5
 Examples
2. What will be the future worth of money after 14 months if a sum of
P10,ooo is invested today at simple interest rate of 12% per year?

Solution:
14
𝐹 = 𝑃 1 + 𝑁𝑖 = 𝑃10,000 0.12 = 𝐏 𝟏𝟏, 𝟒𝟎𝟎
12
3. If P1,000 accumulates to P1500 when invested at simple interest for
three years, what is the rate of interest?
𝐹 = 𝑃 1 + 𝑁𝑖 = 𝑃1,500 1 + 3 𝑖
𝒊 = 𝟎. 𝟏𝟔𝟔𝟔𝟕
Simple Interest 6
Lecture 1: Types of Simple Interest

Simple Interest 7
 Example 1:
• Determine the ordinary simple interest on Php 700 for 8 months and
15 days if the rate of interest is 15%?

Solution:
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 = 8 30 + 15 = 255 𝑑𝑎𝑦𝑠
255
𝐼 = 𝑃𝑁𝑖 = 700( )(0.15)
360
𝑰 = 𝑷𝒉𝒑 𝟕𝟒. 𝟑𝟖

Simple Interest 8
 Lecture 1: Types of Simple Interest

A leap year is when the month of February is 29 days, and ordinary year
when February is only 28 days. Leap year occurs every four years.

Note:
Leap years are those which are exactly divisible by 4 except century
years, but those century years that are exactly divisible by 400 are also
leap years.
Simple Interest 9
 Lecture 1: Types of Simple Interest
Example: Determine the exact simple interest on Php 500 for the
period from January 10 to October 28, 1996 at 16% interest?

292
Solution: 𝐼 = 𝑃𝑁𝑖 = 𝑃500 366
0.16
𝐼 = 𝑃ℎ𝑝 63.83

Simple Interest 10
 Lecture 1: Cash Flow Diagram

ILO 1: By the end of the learning experience, students must be able

to:

✓Draw Cash Flow Diagram

Cash Flow Diagram 11

 Lecture 2: Cash Flow Diagram
- Graphical representation of cash flows drawn on a time scale
- The diagram includes what is known, what is estimated, and what is
needed.

RECEIVE (POSITIVE CASH FLOW/ CASH INFLOW)

DISBURSEMENT (NEGATIVE CASH FLOW/ CASH OUTFLOW)

TIME SCALE
𝟎 𝟏 𝟐 𝟑 𝒏

Cash Flow Diagram 12

Lecture 2: Cash Flow Diagram

Cash Flow Diagram 13

Lecture 2: Cash Flow Diagram

Figure 2. Cash flows from perspective of borrower for loan and purchases. Cash Flow Diagram 14
 Example 1
• A loan of P100 at simple interest of 10% will become P150 after 5 years

𝑷 𝟏𝟓𝟎

Viewpoint on the Lender

𝟏 𝟐 𝟑 𝟒 𝟓
𝑷 𝟏𝟎𝟎
𝑷 𝟏𝟎𝟎
𝟓
Viewpoint on the Borrower
𝟏 𝟐 𝟑 𝟒
𝑷 𝟏𝟓𝟎 Cash Flow Diagram 15
Example 2

Cash Flow Diagram 16

 Lecture 3: Compound Interest
• It is when the interest increases based on the original principal
amount plus any accumulated interest from the beginning of the
period. To say, the new principal of the new period is the addition of
the new interest and the previous principal. This will continue until
the finished period
• Thus, compound interest means interest on top of interest.

Compound Interest 17
 Lecture 3: Compound Interest
• The effect of compounding of interest can be seen in the following
table for $1,000 loaned for three periods at an interest rate of 10%
compounded each period:

Compound Interest 18
 Lecture 3: Compound Interest
1. Future Worth, F
𝐅=𝑷 𝟏+𝒊 𝒏 where: 𝟏 + 𝒊 𝒏

2. Present Worth, P
𝑭 𝟏
𝑷= where:
𝟏+𝒊 𝒏 𝟏+𝒊 𝒏
n = no of interest period

Compound Interest 19
 Example: Future Equivalent of a Present Sum

1. Suppose that you borrow $8,000 now, promising to repay the loan principal
plus accumulated interest in four years at i = 10% per year. How much would
you repay at the end of four years?

Solution: F = 𝑃 1 + 𝑖 𝑛 = $ 8000 1 + 0.10 4 = $ 11,713

𝐹 𝐹
𝐹 = 𝑃 , 𝑖%, 𝑁 = $ 8000 , 10%, 4 = $ 8000 1.4641 = $ 11,713
𝑃 𝑃

Compound Interest 20
 Example 2:
• A student deposits $1000 in a savings account that pays interest at
the rate of 6% per year, compounded annually. If all of the money is
allowed to accumulate, how much will the student have after 12
years? Compare this with the amount that would have accumulated if
simple interest had been paid.

Solution:
𝑛 12
F=𝑃 1+𝑖 = $1000 1 + 0.06 = $20,121.20
𝐹
F = $ 10000 , 6%, 12 = $ 10000 2.0122 = $20,121.20
𝑃

Compound Interest 21
 Example 3:
• An investor (owner) has an option to purchase a tract of land that
will be worth $10,000 in six years. If the value of the land increases at
8% each year, how much should the investor be willing to pay now
for this property?
Solution:
𝐹 10,000
𝑃= = = $ 𝟔, 𝟑𝟎𝟐
1+𝑖 𝑛 1+0.08 6

𝑃
P = $10,000 , 8%, 6 = $10,000 0.6302 = $ 𝟔, 𝟑𝟎𝟐
𝐹

Compound Interest 22
 Example 4:
• A student who will inherit $5000 in three years has a savings account
that pays 5% per year, compounded annually. What is the present
worth of the student's inheritance?

• Solution:
𝐹 5,000
P= 1+𝑖 𝑛
= 1+0.05 3
= $4,319.20

𝑃
P = $5,000 , 5%, 3 = $5,000 0.8638 = $4,319.20
𝐹

Compound Interest 23
 Example 5:
• Discrete Cash-Flow Examples Illustrating Equivalence
• Using an Interest Rate of i = 10% per Year

Compound Interest 24
Nominal Interest Rate

Nominal Interest Rate 25

Nominal Interest Rate

Nominal Interest Rate 26

 The Effective Rate of Interest
• The rate the that takes compounding into account. It is the actual
annual rate considering the compounding.
𝒓 𝒎
𝐢= 𝟏 +𝒎 −𝟏

Example: 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(1.375%) = 16.5%. What is the
effective rate of interest per year being charged by the company?

The Effective Rate of Interest 27

 Example:
• Example: 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(1.375%) = 16.5%. What is the effective rate of interest
per year being charged by the company?
Solution:
The 1.375% per month would lead to a simple calculation of 𝑟 = 16.5%
which is called the nominal interest rate
𝑟 𝑚 0.165 12
i= 1+ −1= 1+ − 1 = 0.178 𝑜𝑟 17.8 %
𝑚 12

The Effective Rate of Interest 28

• While investors accept only simple interest from savings accounts,
generating compound earnings is necessary to build enough wealth to
retire.
• Avoid owing compound interest on debt in favor of debts with simple
interest such as mortgages. Prioritize investments like stocks that
enable your gains to compound over time.

The Effective Rate of Interest 29

 Lecture 4: Continuous Compounding (single
amounts)
• is a type of compound interest in which the number of periods in a
year tends to go infinite (m → ∞). As shown by the example,
continuous compounding has much higher future amount than any
compound interest

Continuous Compounding 30
 Example:
• You have Php 150,000 to invest for two years. Your bank offers 5%
interest, compounded continuously for funds in a money market
account. Assuming no additional deposits or withdrawals, how much
money will be in that account at the end of two years? What if the
interest rate was 5% compounded weekly? Compounded monthly?
Compounded quarterly? Compounded semi-annually, Compounded
annually?
Solution:
𝐹
𝐹 = 𝑃ℎ𝑝 150,000 , 5%, 2 = (𝑃ℎ𝑝 150,000)𝑒 (0.05)(2)
𝑃
𝑭 = 𝑷𝒉𝒑 𝟏𝟔𝟓, 𝟕𝟕𝟓. 𝟔𝟒
Continuous Compounding 31
Example

Continuous Compounding 32
 Example 2
• A savings bank is selling long-term savings certificates that pay
interest at the rate of 7 ½ % per year, compounded continuously. The
bank claims that the actual annual yield of these certificates is 7.79%.
What does this mean?

Solution:
The nominal interest rate is 7 ½ %
Since the interest is compounded continuously, the effective annual
interest rate is: 𝑖 = 𝑒 0.075 − 1 = 0.77885 ≈ 7.79%

Continuous Compounding 33
End of Topic

Thank you
Engr. Jean Martin, MSEnE
College of Engineering and Information Technology

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