TOPIC 2 PRINCIPLES OF

MONEY-TIME RELATIONSHIP
 EQUITY CAPITAL AND DEBT CAPITAL

Equity Capital: owned by the individuals who

have invested their money or property in a
business project or venture in the hope of
receiving a profit
Debt Capital: obtained from lenders (through
the sale of bonds) for investment; in return,
the lenders receive interest from the
borrowers
 SIMPLE INTEREST AND COMPOUND INTEREST
a. Simple interest
When the total interest earned or charged is directly
proportional to the initial amount of the loan
(principal), the interest rate, and the number of interest
periods for which the principal is committed,
the interest and the interest rate are said to be simple.
When the simple interest is applicable, the total interest,
earned or paid may be computed in the formula

=
also,
= + = (1 + )
where:
principal amount lent or borrowed
accumulated amount or future worth
number of interest periods
interest rate per interest period
a.1 Ordinary simple interest is computed on the
basis of 12 months of 30 days each or 360 days a year.
1 interest period = 360 days
a.2 Exact simple interest is based on the exact
number of days in a year; 365 days for ordinary year
and 366 days for a leap year.
1 interest period = 365 or 366 days
b. Compound Interest
Whenever the interest charge for any interest period is based
on the remaining principal amount plus any accumulated interest
charges up to the beginning of that period, the interest is said to be
compound.
If an amount exists at a point in time and % is the interest
rate per period, the amount will grow to a future amount of +
= 1 + by the end of one period; by the end of two periods,
the amount will grow to 1 + 1 + = 1 + 2 ; by the
end of three periods, the amount will grow to 1 + 2 1 + =
1 + 3 ; and by the end of periods, the amount will grow to
= 1 + = /, %,
similarly,
= 1 + = /, %,
where
1 + is called the single payment compound amount factor
1 + is called the single payment present worth factor
is the future value
is the present value
 NOMINAL RATE OF INTEREST AND
EFFECTIVE RATE OF INTEREST
Nominal Rate of Interest
A nominal interest rate is an interest rate
that does not account for compounding.
By denition,
= interest rate per interest period x number
of compounding periods per year
or
= x
 Effective Rate of Interest
An effective rate of interest is a rate
wherein the compounding of interest is taken
into account. Effective rates are commonly
expressed on an annual basis as an effective
annual rate; however, any time basis may be
used.

Effective rate of interest = 1 + 1
 CONTINUOUS COMPOUNDING
The single payment compound mount factor, may be written
as

= 1+

Increasing , the number of interest periods per year, without

limit, it becomes very large and approaches infinity and

approaches zero. This is the situation for continuous compounding:

= lim 1 +

1 1
Set = ; then = and = . As approaches

infinity, approaches zero, hence
1
= lim 1 +
0
=
where
1
lim 1 + =
0
 DISCOUNT

It is the difference between what it is worth

in the future and its present worth.

=
The rate of discount is the discount on
one unit of principal per unit of time.

1
=1 = ; /, %, 1
1+ 1+
 EXAMPLE PROBLEMS
1. Determine the ordinary and exact simple interests on
PhP8,000 for the period from February 4 to September
28, 2012, if the rate of simple interest is 16%.
Solution:
a. Determine ; ordinary simple interest
=
where:
February 4 29 = 25 days
March = 31 days
April = 30 days
May = 31 days
June = 30 days
 July = 31 days
August = 30 days
September 1 28 = 28 days
= 236 days
hence
236
= PhP8,000 0.16
360
= PhP839.11
b. Determine ; exact simple interest
=
236
= PhP8,000 0.16
366
= PhP825.36
2. Calculate the effective rate corresponding to each of the
following rates: (a) 8% compounded semi-annually, (b) 10%
compounded quarterly, (c) 12% compounded bi-monthly, (d)
14% compounded monthly, (e) 16% compounded weekly, and
18% compounded daily.
Solution:
a. Determine ; effective rate of interest
= 1 + 1
2
0.08
= 1+ 1
2
= 8.16%
b. Determine ; effective rate of interest
= 1 + 1
4
0.10
= 1+ 1
4
= 10.38%
c. Determine ; effective rate of interest
= 1 + 1
6
0.12
= 1+ 1
6
= 12.62%
d. Determine ; effective rate of interest
= 1 + 1
12
0.14
= 1+ 1
12
= 14.93%
e. Determine ; effective rate of interest
= 1 + 1
52
0.16
= 1+ 1
52
= 17.32%
f. Determine ; effective rate of interest
= 1 + 1
365
0.18
= 1+ 1
365
= 19.72%
3. At a certain interest rate compounded monthly, PhP5,000
will amount to PhP8,500 in 12 years. What is the amount at
the end of 5 years?
Solution:
Determine ; the future worth at the end of 5 years
Solving for
= 1+
PhP8,500 = PhP5,000 1 + 12 12
1 + 144 = 1.7
 1
= 1.7
144 1
= 0.369%
Solving for at the end of 5 years
= PhP5,000 1 + 0.00369 12(5)
= PhP6,236.57
4. How many years are required for PhP2,500 to increase to
PhP4,500 if invested at 12% compounded quarterly?
Solution:
Determine n; the required number of years
= 1+
4n
0.12
4,500 = 2,500 1 +
4
1.03 4n = 1.8
4n ln 1.03 = ln 1.8
n = 4.97 years
 CASH FLOW DIAGRAM
Cash flow diagrams are used to depict the
timing and magnitudes of the cash flow
amounts in the present & future.
5. 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
PhP100,000 that will produce uniform annual revenue of
PhP45,000 for 5 years and then have a positive salvage value
of PhP20,000 at the end of year 5. Annual expenses will be
PhP30,000 at the end of each year for operating and
maintaining the project. Draw a cash flow diagram
 ANNUITIES AND CAPITALIZED COST
Annuity: consists of a series of equal payments made at
equal intervals of time.
TYPES OF ANNUITIES
a. Ordinary annuity: annuity where equal payments are
made at the end of each payment period starting from the
first period.
b. Deferred annuity: annuity where the payment of the
first amount is deferred a certain number of periods after the
first.
c. Annuity due: annuity where the payments are made
at the end of each period, beginning from the first period.
d. Perpetuity: annuity where the payment periods
extend forever or in which the periodic payments continue
indefinitely.
 ORDINARY ANNUITY
Consider the cash flow diagram:

The present worth, /, %, is the sum of the present

values of each of annuity payments.

= 1 + 1 + 1 + 2 + 1 + 3 + + 1 + 1
+ 1 + 2 + 1 +
Factor out

= 1 + 1 + 1 + 2 + 1 + 3 + + 1 + 1
 Multiply 1 by 1 + 1

1 + 1
2 3 4 1
= 1 + + 1+ + 1+ + + 1+ + 1+
 1 + 1 +
=
1+
1+ 1
= = /, %,
1+
The term in brackets in is the conversion factor referred to as the uniform
series present worth factor (USPWF). It is the / factor used to calculate the
equivalent value in year 0 for a uniform end-of-period series of values
beginning at the end of period 1 and extending for periods.
Solving for
1+
= = /, %,
1+ 1
The term in brackets is called the capital recovery factor (CRF), or /
factor. It calculates the equivalent uniform annual worth over years for a
given in year 0, when the interest rate is .
The future worth, /, %, can be obtained using capital recovery
factor
1 1+
=
1+ 1+ 1

= = /, %,
1+ 1
 The expression in brackets in is the / or sinking fund
factor. It determines the uniform annual series that is equivalent
to a given future amount .
Solving for
1+ 1
= = /, %,

The term in brackets is called the uniform series compound
amount factor (USCAF), or / factor.

1. How much money should you be willing to pay now for a

guaranteed $800 per year for 10 years starting next year, at a rate
of return of 14% per year?
Solution:
Determine ; the present worth
1+ 1
=
1+
 1 + 0.14 10 1
= $800
0.14 1 + 0.14 10
= $4,172.89
2. The president of Ford Motor Company wants to know the
equivalent future worth of a $100 million capital investment each
year for 8 years, starting 1 year from now. Ford capital earns at a
rate of 12% per year.
Solution:
Determine ; the future worth
1+ 1
=

1 + 0.12 8 1
= $100
0.12
= 1229.97
 DEFERRED ANNUITY
Consider the cash flow diagram

If each payment is , then the present value of the deferred

annuity is
= 1 +
where:
1+ 1
=
1+
1+ 1
= 1+ = /, %, /, %,
1+
The accumulated amount is the same as that for an ordinary
annuity.
 ANNUITY DUE
Consider the cash flow diagram

If each payment is , then the present worth and future worth are
respectively
1 + 1 1
= 1 + = 1 + /, %, 1
1 + 1
1 + +1
= 1 = /, %, + 1 1

 PERPETUITY

Consider the cash flow diagram

For a perpetuity where the periodic payments are each

equal to , the present value is

=

 CAPITALIZED COST
The capitalized cost of any structure or property is the sum of
the first cost and the present worth of all costs for replacement,
operation, and maintenance for a long period of time or forever,
that is
Capitalized Cost = FC +
where

= =
1+ 1 1+ 1
hence

Capitalized Cost = FC +
1+ 1
where
the amount needed to replace or maintain the property
every periods
the amount of principal invested at % per period
 If the property or structure costs to obtain and it will
have to be replaced every periods for the same amount,
then
Capitalized Cost = +

=+
1+ 1

= +
1+ 1
1+ +
=
1+ 1
1+
=
1+ 1
1
Capitalized Cost =
1 1 +