ES 312b - Engineering Economy 1st Sem, S.Y.

2020-2021

MODULE 3

Principles of Money-Time Relationship (Part 1)

After completing this module, you are expected to:

1. Solve for Simple Interest problems
2. Solve for Compound Interest problems
3. Draw Cash Flow Diagram
4. Evaluate Continuous Compounding (single amounts)

A. Simple Interest
𝐈 = 𝐏𝐍𝐢
𝐅=𝐏+𝐈
𝐅 = 𝐏 (𝟏 + 𝐍𝐢)
Where:
READ (IMPORTANT!)
I = interest
P = principal amount lent or borrowed, or present worth • Page 5 to 6
N = number of interest periods
Textbook: Engineering
i = rate of interest per interest period Economy, 3rd
F = accumulated amount of future worth Ed. (Sta. Maria)
READ (IMPORTANT!)
1. Ordinary simple interest – computed based on a
fixed number of days in a month = 30 days. It • Page 109 to 110
disregards the other months with 31 days or 28-29
Textbook: Engineering
days. Thus, the number of days in a year is 360 = (30 Economy, 16th
days/months) x (12 months). Ed.

Example: Determine the ordinary simple interest on Php 500 for 9 months and
21 days if the rate of interest is 16%?

Number of days = 9(30) + 21 = 291

291
I = PNi = (Php 500) ( ) (0.16)
360
𝐈 = 𝐏𝐡𝐩 𝟔𝟒. 𝟔𝟕

2. Exact simple interest – computed based on the exact number of days in a

month. It considers the other months with 31 days or 28-29 days. Thus, the
number of days in a year will be 365 or 366 (for leap year).
Page 1 of 7
Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

Example: Determine the exact simple interest on Php 500 for the period from
January 10 to October 28, 1996 at 16% interest?
292
I = PNi = (Php 500) ( ) (0.16)
366
𝐈 = 𝐏𝐡𝐩 𝟔𝟑. 𝟖𝟑

B. Cash Flow Diagrams

Example: Before evaluating the economic merits of READ (IMPORTANT!)

a proposed investment, the XYZ Corporation insists • Page 7
that its engineers develop a cash-flow diagram of
Textbook: Engineering
the proposal. An investment of $10,000 can be made
Economy, 3rd
that will produce uniform annual revenue of $5,310
Ed. (Sta. Maria)
for five years and then have a market (recovery)
value of $2,000 at the end of year (EOY) five. Annual READ (IMPORTANT!)
expenses will be $3,000 at the end of each year for • Page 113 to 115
operating and maintaining the project. Draw a cash-
flow diagram for the five-year life of the project. Use Textbook: Engineering
Economy, 16th
the corporation’s viewpoint.
Ed.

Solution:
As shown in the figure below, the initial investment of $10,000 and annual
expenses of $3,000 are cash outflows, while annual revenues and the market value
are cash inflows.

Notice that the beginning of a given year is the end of the preceding year. For
example, the beginning of year two is the end of year one.
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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

C. Compound Interest
READ (IMPORTANT!)
𝐅 = 𝐏 (𝟏 + 𝐢 )𝐍 • Page 8 to 12

𝐅 = 𝐏 (𝐅/𝐏, 𝐢%, 𝐍) Textbook: Engineering

Economy, 3rd
𝐏 = 𝐅 (𝟏 + 𝐢)−𝐍 Ed. (Sta. Maria)
𝐏 = 𝐅 (𝐏/𝐅, 𝐢%, 𝐍) READ (IMPORTANT!)
• Page 110,117-119,
The term (𝟏 + 𝐢)𝐍 or 𝐅/𝐏, 𝐢%, 𝐍 is called the single
122-123
payment compound factor.
Textbook: Engineering
The term (𝟏 + 𝐢)−𝐍 or 𝐏/𝐅, 𝐢%, 𝐍 is called the single Economy, 16th
payment present worth factor Ed.

The i, m, and r

The symbol i, called the rate of interest per interest period, is important in
engineering economy, thus, we need to understand it. Let’s relate it to r and m.
The symbol r – represents the rate of interest per year. As we see, the
difference of the symbol r and the symbol i is that the former is fixed while the latter
depends on how many interest periods (or payment) would occur in a year.
The symbol m – represents the number of interest periods in a year. This the
number of times your interest compounds in a year or the number of times you pay
or being paid back in a year. (see table 3.1)

Therefore, the relationship of these three symbols is:

𝐫
𝐢=
𝐦
Also, the r in this relationship is called the Nominal Interest Rate.
Table 3.1. Common terms used for m
Terms m Definition
Weekly 52 There are 52 weeks in a year.
Fortnightly 26 There are 26 fortnights in a year (also bi-weekly).
Semi-monthly 24 Semi-monthly means you have to pay twice a month.
Monthly 12 You have to pay every month. 12 months in a year.
Bi-monthly 6 You pay every two months.
Quarterly 4 A quarter of a year is three months. (Quarter!)
Semi-annually 2 You pay only for twice a year.
Annually 1 You pay only each year. (Yearly)
Page 3 of 7
Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

The Effective Rate of Interest (i)

READ (IMPORTANT!)
• Page 155-157
Textbook: Engineering
Economy, 16th Ed.

𝐫 𝐦
𝐢 = (𝟏 + ) −𝟏
𝐦
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 1.375% per month would lead to a simple calculation of r = 16.5% which is called
the nominal interest rate. Creditors often advertised their interest on monthly basis
(or other periodical terms like quarterly and so on). This would seemingly result on
a lower annual interest rate. But, because you are an engineering student and you
know economy, you can really know the real interest rate the creditor is offering you.
You can then apply what you have learn on module 1, to decide on a choice.
Solution:
r m
i = (1 + ) − 1
m
0.165 12
i = (1 + ) −1
12
𝐢 = 𝟎. 𝟏𝟕𝟖 𝐨𝐫 𝟏𝟕. 𝟖%

This is higher than what the creditor is showing to you, higher by 1.3%. You
are paying an extra 1.3% interest annually if you think that the annual interest
rate you are paying is only 16.5%.

Page 4 of 7
Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

D. Continuous Compounding (single amounts)

𝐅 = 𝐏 𝒆𝐫𝐍 READ (IMPORTANT!)

𝐅 = 𝐏 (𝐅/𝐏, 𝐫%, 𝐍) • Page 160-163
𝐏 = 𝐅 𝒆−𝐫𝐍 Textbook: Engineering
Economy, 16th Ed.
𝐏 = 𝐅 (𝐏/𝐅, 𝐫%, 𝐍)

The term 𝒆𝐫𝐍 or 𝐅/𝐏, 𝐫%, 𝐍 is called the continuously compounding compound
amount factor (single cash flow) at r% nominal interest for N years.
The term 𝒆−𝐫𝐍 or 𝐏/𝐅, 𝐫%, 𝐍 is called the continuously compounding present
equivalent (single cash flow) at r% nominal interest for N years.

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?
F = Php 150,000 (F/P, 5%, 2)
F = (Php 150,000) 𝑒 (0.05)(2)
𝐅 = 𝐏𝐡𝐩 𝟏𝟔𝟓, 𝟕𝟕𝟓. 𝟔𝟒
For the interest rate of 5% not compounded continuously.

𝟎. 𝟎𝟓 𝐍
𝐅 = 𝐏𝐡𝐩 𝟏𝟓𝟎, 𝟎𝟎𝟎 (𝟏 + ) ; 𝑵 = 𝟐𝒎 (𝟐 𝒚𝒆𝒂𝒓𝒔 𝒙 𝒎)
𝐦
F Compounded m N = 2m Diff. w/ continuously
Php 165,767.67 Weekly 52 104 Php 7.97
Php 165,741.20 Monthly 12 24 Php 34.44
Php 165,672.92 Quarterly 4 8 Php 102.72
Php 165,571.93 Semi-annually 2 4 Php 203.706
Php 165,375.00 Annually 1 2 Php 400.64

Page 5 of 7
Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

SUMMARY:
It was shown here that money increases with time using the system of interests.
Simple interest is when the principal amount (capital, borrowed or lend) increases
linearly with time along with its interest rate.
Compound interest 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
To draw cash flow diagrams, the horizontal bar is the time divided by periods
(year, month, etc.). The up arrow symbolizes cash is coming in (cash in-flow) while the
down arrow symbolizes cash is going out (cash out-flow). The start of a period is the
end of the previous period.
Continuous compounding 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.

EXERCISES:
NOTE: For VLE Students – No need to answer the problems here. What you need to do
is to solve the exercises in the VLE.
The exercises here are to be DONE ONLY by students who chose the “Printed
Module” mode of delivery. The solutions to this problem are to be handwritten and
to be passed to your instructor a week after you received this printed module.
SHOW YOUR SOLUTIONS.
Problem 1: The principal amount is Php 173,248 and the rate of interest is 6.8%
1. Determine the ordinary simple interest for 8 months and 13 days
2. Determine the exact simple interest the period from February 11 to October
24, 2007. If 2008?
Problem 2: A Php 270,500 loan was originally made at 12% simple interest for 5
years. At the end of this period the loan was extended for 4 years without the interest
being paid, but the new interest rate was made 10% compounded quarterly.
1. How much should the borrower pay at the end of 9 years?
2. How much should the borrower pay if it was compounded semi-annually?

Page 6 of 7
Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

Problem 3: The company Schizo inc., is planning to buy a labor-saving device which
could potentially save Php 640,000 annually. CEO Harlem de Juan insist that they
should develop a cash-flow diagram for the proposal. The device cost Php 2 million
and its annual operating and maintenance cost (O & M) is Php 240,000. The salvage
value of the machine after 5 years is Php 1.2 million. Develop a cash-flow diagram for
the proposal.
Problem 4: You have Php 750,000 to invest for two years. Your bank offers 6.5%
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 6.5% compounded weekly?
Compounded fortnightly? Compounded semi-monthly? Compounded bi-monthly,
Compounded annually?

Page 7 of 7
Engr. Ryan James S. Olivo