Lecture 4 - Introduction To Interest and Money-Time Relationships

EECO101 - ENGINEERING ECONOMY
Interest and Money-

Time Relationships
MODULE 1 Coverage
Lesson Concept of Interest and Time

Value of Money
Outline: Simple Interest
Compound Interest
Present and Future Worth
Nominal vs. Effective Interest
Module 1 Coverage
At the end of this lesson, the
Equivalence concepts
students will be able to learn..
Capital: Definition
It refers to wealth in the form of money or property that can
be used to produce more wealth.
Two Types:
Equity Capital – those owned by individuals who have invested
their money or property in a business project or venture in
the hope of receiving a profit.
Debt Capital / Borrowed Capital – obtained from lenders for
investment. Lenders in turn receive interest payment from the
borrowers.
Interest: Definition
Interest is the additional amount to be paid on a certain sum of
money borrowed or loaned.
This term is commonly used in banks, loans, installments and
investments.
3 common factors to be considered with regards to interest:
Principal - The amount of money being borrowed.
Rate of Interest - The percent to be used to calculate the
additional amount to be paid along with the principal.
Time - the period from the beginning when the money was
borrowed to the period that when the money should be returned
with the additional amount (interest).
Simple Interest
An interest is said to be simple when the total interest earned
or charged is linearly proportional to the initial amount of the
loan.
This type of interest applicable for a short-term duration
usually in days, weeks, months or even a few years with not so
large amounts of money.
This is not used frequently in modern commercial practice.
Simple Interest
Exact Simple Interest Ordinary Simple Interest
These two kinds of simple interest are only applicable if the unit of time used is in days.
Note: When simple interest (ordinary or exact) is not specified in any problem, it is
assumed as ordinary.
Calculating Total Amount to Pay
Future Amount - The total

amount to be paid by the
borrower to the lender.
The main amount to be paid
is the principal amount.
Interest is added to
compensate the duration
that the money was not used
by the lender.
Compound Interest
An interest is said to be compound when the interest charge for
any interest period is based on the remaining principal amount
plus any accumulated interest charges up to the beginning of the
period.
Compounding Periods
Annual (m=1)
There is only 1 interest period in a year
Semi-Annual (m=2)
There are 2 interest periods in a year
Quarterly (m=4)
There are 4 interest periods in a year (1 quarter = 3 months)
Monthly (m=12)
Compounding Periods
Bi-monthly (m=6)
There is only 6 interest period in a year
Weekly (m=52)
There are 52 interest periods in a year.
Daily (m=365)
Simple vs. Compound Interest
Simple Interest: Borrow Php 1,000 for 5 years at 12% per year.
Compound Interest: Borrow Php 1,000 for 5 years at 12% per year.
The more number of interest

periods the greater the
difference between simple
and compound.
The larger the interest
rate the greater also the
difference.
Simple interest is earned only once within the agreed period

of payment; Compound interest is earned periodically.
Simple interest grows in a consistent manner; Compound
interest increases exponentially period after period.
Rate of simple interest is annual; Compound interest rates
can be yearly, monthly, quarterly, weekly etc.
Simple interest is usually used for short term transactions
since it earns less; Compound interest is preferable for long
term transactions to increase wealth.
Examples:
On May 31, 2016 a businessman loans $15, 000 in the bank for
the expansion of his restaurant. It was agreed that he will pay
the amount with 6% interest on August 10, 2016. What is the
ordinary simple interest paid? (Note: Beginning date is not
included in the counting.) I = $174.59
A factory loaned $400,000 from a bank in order to improve the

automation system of its process. The factory needs to pay the
bank in 4 years with 10% interest rate. Find the future amount
to be paid. F = $560,000
Examples:
An organization loaned $14,000 from a bank at 9% interest. They
will pay a total of $20,300 within the agreed payment. How long
will the organization need to pay the amount? n = 5 years
Bill loaned $5,000 from the bank and agreed to pay the amount
of 6% compounded quarterly for 1 year. How much will he need to
pay within the year? F = $5,306.82
A father wants to give his daughter $10,000 at the time she

will turn 18. How much will he invest in the bank at 4%
interest compounded semi-annually if his daughter is 10 years
old now? F = $7,284.46
Additional Sample Problems:
Php 400 is loaned for 5 quarters at a simple interest rate of
3% per quarter. What is the total amount of interest to be
paid? What is the total amount owed after 5 quarters (that is
if principal and interest amount are to be paid only at the end
of 5 quarters) ?
Find the total interest earned by a principal loan of Php 1000

given a simple interest rate of 12% per month if the loan is
for 3 weeks, if the interest is 3.5% per quarter for 4 months,
and if the interest rate is 12.55% per annum for 27 months.
Effect of Different Interest Periods
Show the effect on the interest rate and the number of

periods for the given conditions below for an investment
worth $100,000.
6% compounded semi-annually for 5 years

6% compounded quarterly for 5 years
6% compounded monthly for 5 years
Other Useful Formulas
Finding Interest rate given Finding N when given P,

P, F, and n F, and i
The Nominal Interest Rate (r) is the annual interest rate in

most problems.
For compounded interest, the rate of interest usually quoted
is the nominal rate of interest which is the specific rate
of interest and the number of interest period per year.
This is because it has become customary to quote interest
rates on an annual basis, followed by the compounding period
if different from one year in length.
The Effective Interest Rate (i) on the
other hand is the actual interest rate
applied per interest period. The
effective interest rate is acquired by
using the expression as in compound
interest formula: i/m.
The actual or exact rate of interest
earned on the principal during one
year .
This is usually expressed on annual
basis unless specifically stated
otherwise.
Effective Interest Rates for Various Nominal Rates and Compounding
Frequencies
Example (Effective Interest Rate):

If a lender charges 12% interest, compounded quarterly, what
effective annual interest rate is the lender charging?
If a lender charges 12% interest, compounded monthly, what is

the effective interest rate per quarter?
If the 10% nominal rate is compounding quarterly, what is the
effective interest rate on one month?

Suppose that a lump
sum of $100 is
invested for 10 years
at a nominal interest
rate of 6% compounded
quarterly. How much
is it worth at the
end of the 10th year?
F = $181.40
Stan Moneymaker has a
bank loan for $10,000 to
pay for his new truck.
This loan is to be
repaid in equal end-of-
month installments for
five years with a
nominal interest rate of
12% compounded monthly.
What is the amount of
each payment? A =
$222.44
Ms. Paige has acquired a new printing press machine. Due to
insufficient funds, she agreed to pay the seller equal $150
every month for 13 months. The company charges an annual
interest rate of 8% compounded quarterly. How much does the
machine cost?
Equivalence in Compound Interest
What rate in percent compounded semi-annually is

equivalent to 20% compounded annually? i=0.19089023
What rate in percent that is compounding quarterly is

equivalent to 17% compounding monthly? i=0.172419706
Compare the future equivalent of Php 1,500 using the

converted interest rates.
Thank you!
End of this Lesson

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EECO101 - ENGINEERING ECONOMY

Interest and Money-

Lesson Concept of Interest and Time

Exact Simple Interest Ordinary Simple Interest

Future Amount - The total

The more number of interest

Simple interest is earned only once within the agreed period

A factory loaned $400,000 from a bank in order to improve the

A father wants to give his daughter $10,000 at the time she

Find the total interest earned by a principal loan of Php 1000

Show the effect on the interest rate and the number of

6% compounded semi-annually for 5 years

Finding Interest rate given Finding N when given P,

Nominal vs. Effective Interest

The Nominal Interest Rate (r) is the annual interest rate in

Example (Effective Interest Rate):

If a lender charges 12% interest, compounded monthly, what is

Example (Effective Interest Rate):

What rate in percent compounded semi-annually is

What rate in percent that is compounding quarterly is

Compare the future equivalent of Php 1,500 using the

End of this Lesson

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