CHPATER II

Principle of Money Time Relationship

Intended Learning Outcomes: At the end of this module the students will be able to:

1. Perform calculations for interest rates and rates of return;

2. Understand cash flows and how to graphically represent them;
3. Calculate simple and compound interest amounts for one or more time periods;

Time Value of Money Fundamentals

The concept of the time value of money asserts that the value of a peso today is worth more than the value of a
peso in the future. This is typically because a peso today can be used now to earn more money in the future. There is also,
typically, the possibility of future inflation, which decreases the value of a peso over time and could lead to a reduction in
economic buying power.
Today’s peso/dollar is also more valuable because there is less risk than if the peso/dollar was in a long-term
investment, which may or may not yield the expected results. On the other hand, delaying payment from an investment
may be beneficial if there is an opportunity to earn interest. The longer payment is delayed, the more available earning
potential there is. This can be enticing to businesses and may persuade them to take on the risk of deferment.
Interest and Money Time Relationships
Capital
The term capital refers to wealth in the form of money or property that can be used to produce more wealth.
Money has a time value.
The following reasons why Php100 today is “worth” more than Php100 one year from today:
1. Inflation
2. Risk
3. Cost of money (interest)
Cost of money is determined by an interest rate. It is established and measured by an interest rate, a percentage that is
periodically applied and added to an amount of money over a specified length of time.
Types of Capital
1. Equity Capital is that owned by individuals who have invested their money or property in a business project
or venture in the hope of receiving a profit.
2. Borrowed Capital is obtained from lenders for investment, with a promise to repay the principal and interest
on a specific date, whether or not the operations of the business have been profitable or not. In return, the
lenders receive interest from the borrowers.
Cash Flow Diagram
Cash flow is the stream of monetary values – costs and benefits – resulting from a project investment.
Cash flow diagram is a graphical representation of cash flows drawn in a time scale. It has three elements:
1. A horizontal line represents time with progression of time moving from left to right. The period labels can be
applied to intervals of time rather than to point on the time scale. A time interval is divided into an appropriate
number of equal periods.
2. Arrows represent cash flow and are place at the specified period. If distinctions are needed to be made,
downward arrows represent cash outflows (expenditures, disbursements) and upward arrows represents cash
inflows (income).
3. Depends on the person’s viewpoint. Unless otherwise indicated, all such cash flows are considered to occur at
the end of their respective periods. The following symbols nomenclatures will be used:
P = Present sum of money
F = Future sum of money
N = Number of interest periods
i= Interest rate per period

Simple Interest

When the total interest earned is linearly proportional to the amount of the loan (principal), the number of the
interest rate per interest periods for which the principal is committed, and the interest rate per interest period, the interest
is said to be simple.
 I =Pni
F = P + I = P + Pni
F = P (1+ni)

Where: I = interest

P = principal or present worth

n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future
Types of Simple Interest
1. Ordinary Simple Interest (OSI)
Based on one banker’s year which is equivalent to 300 days or 30 days in one month, is computed on the basis of
12 months of 30 days a year.
1 interest period = 360 days

OSI = Pni
Example:
Determine the ordinary simple interest on P8,000 for 8 months at 7% per year.

Example
Determine the ordinary simple interest on P700 for 8 months and 25 days if the rate of interest is 15%.

2. Exact Simple Interest (ESI)

Based in the exact number of days which is 365 days in ordinary year or 366 days for leap year.
is based on the exact number of days in year, 365 days for an ordinary year and 366 days for a leap year.
1 interest period= 365 or 366days
ESI = Pni
n
ESI = P (i) for ordinary year
365
n
ESI = P (i) for leap year
366
Example:
Determine the exact simple interest on P500 for the period from January 10 to October 28, 1996 at 16% interest.
Example
Determine the ordinary exact interest on P15,000 loan at 8% per year made from January 12 to September 24,
2007.

Example
What will be the future worth of money after 14months, if a sum of P10,000 is invested today at a simple interest
rate of 12% per year?

Cash-Flow Diagrams
A cash-flow diagram is simply a graphical representation of cash flows drawn on a time scale. Cash-flow
diagram for economic analysis problems is analogous to that of free body diagram for mechanics’ problems.

Receipt (positive cash flow or cash inflow)

Disbursement (negative cash flow or cash outflow)

A loan of 100 at simple interest of 10% will become P150 after 5 years.

Cash flow diagram on the viewpoint of the lender

P100

0 1 2 3 4 5

P150

Cash flow diagram on the viewpoint of the borrower

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 compounded.
In calculations of compound interest, the interest for an interest period is calculated on the principal plus total
amount of interest accumulated in previous periods. Thus, compound interest means “interest on top of interest.”
P

0 1 2 3 n-1 n

F
Compound Interest (Borrower’s Viewpoint)
Discrete Compounding
The formulas are for discrete compounding, which means that the interest is compounded at the end of each finite
length period, such as a month or a year.
Discrete Cash Flows
The Formulas also assume discrete (i,e., lump sum) cash flows spaced at the end of equal time intervals on a cash
flow diagram.
Derivation of Formula
Interest Principal at Interest Earned Amount at End
Period Beginning of During Period of Period
Period
1 P Pi P+Pi = P(1+ni)

2 P(1+i) P(1+i) i P(1+i) + P(1+i)i

= P(1+I) ²
3 P(1+i)² i P(1+i) ² i P(1+i) ² + P(1+i) ²i
=P(1)

... ... ... ...

n P(1+i) n-1 P(1+i) n-1i P(1+i) ⁿ

F = P (1+i) n
The quantity (1+i) is commonly called the “single payment compound amount factor” and is designed by the
n

functional symbol F/P, i%, n. Thus,

F = P (F/P, i%, n)
The symbol F/P, i% n is read as “F given P at per cent in n interest period.”
P = F(1+i)-n
The quantity (1-i)-nis called the “single payment present worth factor” and is designated by the functional symbol
P/F, i% ,n. Thus,
P = F (P/F i% n)
The symbol P/F, i%, n is read as “P given F at i percent in n interest periods.”
The Five Types of Cash Flows
Whenever patterns are identified in cash flow transactions, these patterns can be used to develop concise
expressions for computing either the present or future worth of the series. Cash flows can be classified into five
categories:
 1. Single Cash Flows: The simplest case involves the equivalence of a single cash present amount and its future
worth. Thus, the single-cash flow formula deal with only two amounts: the single present amount P, and its
future worth F.
2. Equal Uniform Series: Probably the most familiar category includes transactions arranged as a series of
equal cash flows at regular intervals, known as an equal-payment series (or uniform series)
3. Linear Gradient Series consists of cash flows that increase or decrease by uniform amount each periods.
4. Geometric Gradient Series consist of cash flows that increase or decrease by a fixed percentage.
5. Irregular Series consists of cash flows that change with no pattern.

Sample Problem:
How long will it take inventory to triple itself if invested of 12% per unit?

Interest

Interest from the viewpoint of the lender is the income produced by money which has been borrowed or invested.
For the borrower, it is the amount of money paid for the use of borrowed capital.

Rate of Interest is defined as the amount earned by one unit of principal during a unit of time
(a) Nominal rate of interest
The nominal rate of interest specifies the rate of interest and a number of interest periods in one year.
r
i=
m

where: i = rate of interest per interest period

r = nominal interest rate
m = number of compounding periods per year

n = Tm
where: n = no. of interest per periods
T = no. of years
m = number of compounding periods per year

If the nominal rate of interest is 10%compounded quarterly, then i= 10%/4= 2.5%, the rate of interest per interest
period.

The following list the different compounding periods and the occurrence in one year
annually once a year
semi- annually twice a year
Quarterly every 3 months
Bi – monthly every 2 months
Monthly every month
Semi- monthly twice a month
Weekly
Daily
Continuously

Example:
The sum of P10, 000 was deposited to a fund earning interest 10% per annum compounded quarterly, what was
the principal in the fund at the end of a year?
(b) Effective rate of interest

Effective rate of interest quotes the exact rate of interest for one year it should be noted that the effective interest
rates are always expressed on an annual basis.

Effective rate of interest is the actual or exact rate of interest on the principal during one year. If P1.00 is invested
at a nominal rate of 15% compounded quarterly, after one year this will become.

[
P1.00 1+ ( 0.154 )] = P1.1586
4

The actual interest actual interest earned is 0.1586, therefore, the rate of interest after one year is 15.86%. Hence,

Effective rate = F1 – 1= (1+i) m – 1

where: F1 = the amount P1.00 will be after one year

Sample Problems:
1. Consider, one unit of principal for one unit a time invested in a nominal interest of 12% compounded monthly.

2. A P2000 loan was originally made 8% simple interest for 4 years. At the end of this period the loan was extended
for 3 years, without the interest being paid, but the new interest rate was made 10% compounded semi-annually.
How much should the borrower pay at the end of the 7 years?

3. Find the normal rate which if converted quarterly could be used instead of 12% compounded monthly. What is the
corresponding effective rate?

4. Find the amount at the end of two years and seven months if P100 is invested at 8% compounded quarterly using
simple interest for anytime less than a year interest period.
Equation of Value
If cash flows occur on different periods, comparison of such should be made on a same focal date. Equation of
values is obtained by setting the sum of one set of obligation on a certain comparison or focal date equal to the sum of
another set of obligation on the same date.
Application of Compound Interest
Deposits ------- withdrawals
Loans ---------- repayments
Investment ---- income
Cash inflow --- cash outflow
Example
A man bought a lot worth P1000,000 if paid in cash. On the installment basis, he paid a down payment of
P20,000; P300, at the end of one year, P400, at the end of three years and a final payment at the end of five years. What
was the final payment if interest was 20%
Solution:

Continuous Compounding and Discrete Payments

In discrete compounding the interest is compound at the end of each finite- length period, such as a moth, a
quarter or a year.

r = nominal rate of interest per year

r
= rate of interest per period
m
m = number of interest periods per year
n = number of interest periods in n years

( mr )
F = P 1+ mn

m
Let = k, then m = rk, as m increases so must k
r

( ) ( ) [( ) ]
k
r 1 1
1+ mn
= 1+ rkn
= 1+ rn
m k k

The limit of 1+
r k
m ( )
as k approaches infinite is e

[( ) ]
k
1
1+ rn
= ern
k
 Thus, F= Pern
P = Fern
Example
Compare the accumulated amounts after 5 years of P1,000 invested at the rate of 10% per year compounded (a)
annually, (b) semiannually, (c) quarterly, (d) monthly, I daily, and (f) continuously.

Discount
Discount is defined as interest deducted in advance. In negotiable paper, it is the difference between the present
worth of the paper and its value sometime in the future.
Discount = Future Worth – Present Worth
The rate of discount is the discount on one unit of principal for one unit of time.
Rate of Discount
Rate of discount is defined as the discount of one unit of principal for one unit of time.
1.00

(1+i)-1
In the cash flow diagram,
P = (1+i)-1
And F = 1.00
Using the formula of discount,
d=F–P
d = 1 - (1+i)-1
d = 1 – __1__
1+i
Simplifying the equation will give us;
d
i=
1−d

and,
i
d=
1+ i
where d = rate of discount for the given period
i = rate of interest for the same period

Example
A man borrowed P5,000 from a bank and agreed to pay the loan at the end of 9 months. The bank discounted the
loan and gave him P4,000 in cash. (a) What was the rate of discount? (b) What was the rate of interest? (c) What was the
rate of interest for one year?
Solution
P4,000 P 0.80

P 5,000 P 1.00
Inflation
 Inflation is the increase in the prices for goods and services from one year to another, thus decreasing the
purchasing power of money.
FC = PC ( 1+ f)n
where:PC = present cost of a commodity
FC = future cost of the same commodity
f = annual inflation
n = number of years

Example
An item presently costs P1000. If Inflation is at the rate of 8% per year. What will be the cost of the item in two
years?

Example
An economy is experiencing inflation at the annual rate of 8%. If this continuous, what will P1000 be worth two
years from now, in terms of today’s peso?

Example
A man invested P10,000 at an interest rate of 10% compounded annually. What will be the final amount of his
investment, in terms of today’s pesos, after five years, if inflation remains the same at the rate of 8% per year?

ANNUITY
An annuity is a series of equal payments made at equal intervals of time. Financial activities like installment
payments, monthly rentals, life-insurance premium, monthly retirement benefits, are familiar examples of annuity.

Annuity certain can be classified into two, simple annuity and general annuity.
In simple annuity, the payment period is the same as the interest period, which means that if the payment is made
monthly the conversion of money also occurs monthly.
In general annuity, the payment period is not the same as the interest period. There are many situations where the
payment for example is made quarterly but the money compounds in another period, say monthly. To deal with general
annuity, we can convert it to simple annuity by making the payment period the same as the compounding periods by the
concept of effective rates

Types of Annuities
In engineering economy, annuities are classified into four categories. These are (1) ordinary annuity, (2) annuity
due, (3) deferred annuity, and (4) perpetuity. An annuity is a series of equal payments occurring at equal periods of time.

Symbol and Their Meaning

P = Value or sum of money at present
F = Value or sum of money at some future time
A = A series I periodic, equal amounts of money
n = Number of interest periods
I = Interest rate per interest period
Ordinary Annuity

An ordinary annuity is a series of uniform cash flows where the first amount of the series occurs at the end of the
first period and every succeeding cash flow occurs at te end of each period.
An ordinary annuity is one where the payments are made at the end of each period.
Characteristics of ordinary annuity:
 a.) P (present equivalent value)
- Occurs one interest period before the first A (uniform amount)
b.) F (future equivalent value)
- Occurs at the same time as the last A and n intervals after P
c.) A (annual equivalent vale)
- Occurs at the end of each period

Finding P when A is given

P = A (P/F, i%, 1) + A (P/F, i%, 2) + (P/F, i%, 3) +……. + A (P/F, i%, n-1) + A (P/F, 1%, n)
P = A (1+i)-1 + A (1+i)-2 + …… + A (1+i)-(n-1) + A (1+i)-n
Multiplying this equation by (1+i) result in
P + Pi = A + A (1+i)-1 + A (1+i)-2 + …… + A (1+i)-n+2 + A (1+i)-n+1
Subtracting the first equation from the second gives
P + Pi = A + A (1+i)-1 + A (1+i)-2 +…………… + A (1+i)-n+1
-P = - A (1+i)-1 - A (1+i)-2 +…………… + A (1+i)-n+1 – A (1+i)-n
Pi =A – A (1+i)-n
P

0 1 2 3 n-1 n

A AAAA
A(P/F,i%,1)
A(P/F,i%,2)

A(P/F,i%,3)

A(P/F,i%,n-1)

A(P/F,i%,n)
Cash flow diagram to find P given A

Solving for P gives

[ ]
−1
1−( 1+i )
P=A =A¿
i
The quantity in brackets is called the “ uniform series present worth factor” and is designated by the functional
symbol P/A, i%, n, read as “P given A at I percent in the interest periods. “ Hence Equation can be expressed as
P = A (P/A, i%, n)
Finding F when A is Given
F

0 1 2 3 n-1 n

A AAAA

A(F/P,i%,1)

A(F/P,i%,n-3)

A(F/P,i%,n-2)

A(F/P,i%,n-1)
 Cash flow diagram to find F given A

F = A + A (F/A, i%, 1) + ……. + A (F/P, i%, n-3) + A (F/P, 1%, n-2) + A(F/P, i%, n-1)
F = A + A (1+i) + ……… + A (1+i)-(n-3) + A (1+i)-n-2 + A (1+i)-n-1
Multiplying this equation by (1+i) results in
F + Fi = A + A (1+i) + A (1+i)2 + …… + A (1+i)n-2 + A (1+i)n-1 + A (1+i)n
Subtracting the First equation from the second gives
F + Fi = A (1+i) + ………. + A (1+i) n-2 + A (1+i)n-1 + A (1+i)n
- F = -A- A (1+i) + …… + A (1+i) n-2 + A (1+i)n-1
Fi = -A + A (1+i) n
Solving for F gives

F=A
[ ( 1+i )n−1
i ]
The quantity in brackets is called “Uniform series compound amount factor” and is designated by the functional
symbol F/A, i%, n, read as “F given at I percent in n interest period. “Equation can now be written as
F = A (F/A, i%, n)
Finding A when P is Given
Taking Equation and solving for A, we have

A=
[ i
1−( 1+i )
−n
]
The quantity in brackets is called the “capital recovery factor.” It will be denoted by the functional symbol A/P, i%, n
which is read as “ A given at I percent in an interest periods.” Hence
A = P (A/P, i%, n)
Finding A When F is Given

A=F
[ i
( 1+i )n−1 ]
The quantity in brackets is called the “sinking fund factor”. It will be denoted by the functional symbol A/F, i%, n
which is read as “ A given F at I per n interest periods.” Hence
A = F (A/F, i%, n)
Relation A/P, i%, n and A/F, i%, n

i i+(1+i)n−i ( 1+i )−n

+i= X
(1+i) n−1 i(1+ i)n−1 (1+i)
−n

i i
n +i= −n
(1+i) −1 1−(1+i)
A/F, i%, n+1 = A/P, i%, n
Thus,
Sinking fund factor + i = capital recovery factor

SAMPLE PROBLEMS……
 Annuity Due
An annuity due is one where the payments are made at the beginning of each period
An annuity due is series of uniform cash flows that occur at the beginning of each period.

Finding P When A is Given

P

0 1 2 3 n-1 n

Cash flow diagram given A to find P

P = A + A (P/A, i%, n-1)
P = A (1 + P/A, i%, n-1)

1−(1+i)−(n−1)
P=A⌊ ⌋+ A
i
−(n−1)
1−(1+i)
P=A⌊ +1⌋
i
Finding F When A is Given
F

0 1 2 3 n-1 n

A A A A A
Cash flow diagram given A to find F

F = A (F/A, i%, n+1) - A

F = A [(F/A, i%, n+1) -1
 −(n−1)
1−(1+i)
F=A⌊ ⌋ -A
i
(1+ i)(n +1)−1
F = A⌊ −1 ⌋
i

Example
A man bought an equipment costing P60, 000 payable in 12 quarterly payments, each installment payable at the
beginning of each period. The rate of interest is 24% compounded quarterly. What is the amount of each payment?

Amortization
Amortization is any method of repaying a debt, the principal and interest included, usually by a series of equal
payments at equal intervals of time.

Amortization Schedule
-is a table showing the payments throughout the total interest period.

Example
A debt of P5,000 with interest at 12% compounded semiannually is to be amortized by equal semiannual
payments over the next 3 years, the first due in 6 months. Find the semiannual payment and construct an amortization
schedule.
Summary of Interest Formulas and Relationships for Discrete Compounding

Table 3.1 provides a summary of the six most common discrete compound interest factors, utilizing notation of
the preceding sections. The formulas are for discrete compounding, which means that the interest is compounded at the
end of each finite length period, such as a month or a year.
Furthermore, the formulas also assume discrete (i.e., lump sum) cash flows spaced at the end of equal time
intervals on a cash-flow diagram.