Engineering Economy

Money-Time Equivalence
Relationship and Equivalence

Money is often said to be the driving force behind the world economy. However, its value is not
constant; it fluctuates over time. This chapter discusses the fundamental concept of the time value of
money. We will explore how the timing of cash flows influences their worth and how to compare
different monetary amounts across different time periods

A thorough understanding of these relationships is essential for making informed financial decisions.
Whether you are an individual planning for retirement, a business owner evaluating investment
prospects, or a financial analyst assessing project viability, the tools and concepts presented in this
chapter will be invaluable.

By the end of this chapter, you will have a solid grasp of interest rates, present value, future value, and
equivalence, empowering you to make sound financial judgments.

Learning Outcomes
By the end of this chapter, you should be able to:

Understand the Time Value of Money

1. Define interest and explain its role in the time value of money.
2. Differentiate between simple and compound interest.
3. Calculate future value and present value of lump sums.

Grasp the Concept of Equivalence

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1. Define equivalence and understand its importance in financial analysis.

2. Calculate equivalent values for different cash flow patterns.

Analyze Cash Flows

1. Construct cash flow diagrams to represent various cash flow patterns.

2. Calculate the equivalent value of different cash flow patterns.
3. Apply time value of money concepts to solve real-world financial problems.

Interest and Time Value of Money

Interest, to simply define, is the privilege of borrowing money. Suppose that an investor lends money
to a debtor. Then the latter must pay back the original sum loaned (the amount borrowed) plus an
interest (an additional sum earned at a particular rate). The capital originally invested in a
transaction is called the principal, and the sum of the principal plus the interest due at any time after
the investment of the principal is called the amount.

There are two main types of interest – simple and compound. These two will be discussed in the
succeeding sections.

Interest is the compensation paid for the use of borrowed money or the
return earned on invested funds. It represents the time value of money,
“Optimize which is the concept that a sum of money is worth more today than the
same sum in the future due to its potential earning capacity.
the use of
resources Role in Time Value of Money:
The time value of money principle states that a dollar today is worth more
over time.”
than a dollar in the future due to its earning potential. Interest quantifies
this value difference over time.

Interest as Compensation
Interest is the cornerstone of financial transactions. It represents the cost of borrowing money or the
return on invested funds. This section delves deeper into the concept of interest as compensation,
examining its role in both lending and borrowing activities.

Interest as the Price Paid for the Temporary Use of Funds

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Interest is essentially the cost of borrowing money. When an individual or an entity borrows funds,
they agree to pay back the principal amount (the original sum borrowed) plus an additional amount,
known as interest. This interest serves as compensation to the lender for providing the funds and for
taking on the risk associated with lending. In essence, interest is the price paid for the temporary use
of someone else's money.

The Time Value of Money Concept in Relation to Interest

The time value of money (TVM) is a financial principle that asserts that a sum of money is worth more
today than the same sum will be in the future due to its potential earning capacity. This concept is
fundamental to understanding interest, as it explains why interest is charged on borrowed funds.

The core idea behind TVM is that money can earn interest, so any amount of money is worth more the
sooner it is received. This is because the money can be invested or saved, earning a return over time.
For example, PhP 10,000 received today can be invested to grow to a larger amount in the future,
whereas PhP 10,000 received in the future has less time to earn interest.

In practical terms, TVM means that lenders need to be compensated for the opportunity cost of not
having access to their money while it is lent out. The interest charged on loans accounts for this
opportunity cost, ensuring that the lender is compensated for the potential returns they could have
earned if they had invested the money elsewhere.

The Role of Risk in Determining Interest Rates

Risk plays a crucial role in determining interest rates. When lenders provide funds to borrowers, they
face the risk that the borrower may not repay the loan. This risk can arise from various factors,
including the borrower's creditworthiness, economic conditions, and the nature of the investment or
project for which the funds are borrowed.

 Credit Risk: This is the risk that the borrower will default on the loan, meaning they will be
unable or unwilling to repay the principal and interest. Borrowers with lower credit scores or
higher risk profiles will generally be charged higher interest rates to compensate lenders for
the increased risk of default.
 Inflation Risk: Inflation erodes the purchasing power of money over time. If lenders expect
high inflation, they will demand higher interest rates to compensate for the decrease in the
value of the money when it is repaid in the future.

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 Liquidity Risk: This is the risk associated with how easily an asset can be converted into cash
without affecting its market price. Loans that are harder to sell or convert to cash carry higher
interest rates to compensate for this reduced liquidity.
 Market Risk: Economic and market conditions can impact the ability of borrowers to repay
loans. During periods of economic uncertainty or market volatility, interest rates may rise to
reflect the increased risk.
 Term Risk: The length of the loan term also affects interest rates. Generally, longer-term loans
carry higher interest rates because they expose lenders to risk for a more extended period.

From an engineering standpoint...

As a civil engineer, understanding the concepts of interest, the time value of money, and
the role of risk in determining interest rates is crucial for project planning and financing.
Civil engineering projects, such as the construction of bridges, highways, and buildings,
often require substantial capital investment. These projects typically involve long timelines and
significant upfront costs, making the understanding of financial principles essential for successful
project management.

 Project Financing: Large infrastructure projects often require financing through loans or
bonds. Understanding interest rates and how they are determined can help in negotiating
better terms for financing, ultimately reducing the cost of the project.
 Cost-Benefit Analysis: The time value of money is a critical component in performing cost-
benefit analyses for engineering projects. Future cash flows need to be discounted to their
present value to make accurate comparisons and decisions about the viability of projects.
 Risk Management: Identifying and mitigating risks associated with project financing is
essential. Civil engineers must consider factors such as credit risk and inflation risk when
planning projects to ensure financial stability throughout the project lifecycle.
 Budgeting and Forecasting: Accurate budgeting and forecasting require a solid understanding
of interest rates and the impact of time on project costs and revenues. This knowledge helps in
creating realistic financial plans and timelines.
 Investment Decisions: Engineers involved in project management may also need to make
investment decisions regarding equipment, technology, and materials. Understanding how
interest and the time value of money affect these decisions can lead to more cost-effective and
financially sound choices.

Interest as a Reward for Lending

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Interest can be viewed as a reward for lending money. When an individual or an entity lends money
to others, they forego the immediate use of those funds. In return, they receive interest as
compensation for the time the money is lent and the risk associated with lending. This reward
incentivizes individuals and institutions to lend money, facilitating the flow of capital within the
economy.

Interest as Income Generated from Lending Money

For lenders, interest represents income generated from their capital. This can be through various
channels:

 Personal Loans: Individuals who lend money to friends or family may charge interest,
generating income from the loan.
 Bank Deposits: Banks pay interest on savings accounts, certificates of deposit (CDs), and other
deposit accounts. This interest serves as income for account holders.
 Bonds: Investors who purchase bonds receive periodic interest payments, known as coupon
payments, which provide a steady stream of income.
 Mortgages and Other Loans: Financial institutions that provide mortgages, auto loans, and
other types of loans earn interest as income over the life of these loans.

The Role of Interest in Savings and Investments

Interest plays a significant role in encouraging savings and investments:

Savings: Interest rates on savings accounts and other deposit accounts incentivize individuals to save
money rather than spend it immediately. Higher interest rates make saving more attractive, as
individuals can earn more on their deposits.

 Investments: Interest rates affect various investment options:

 Bonds: Higher interest rates make bonds more attractive to investors seeking regular income.
 Real Estate: Mortgage interest rates influence the cost of borrowing for real estate investments.
Lower rates can spur investment in property, while higher rates might deter it.
 Stocks: Interest rates can impact stock market performance. Higher rates may lead investors
to shift from stocks to bonds, while lower rates can make borrowing cheaper for companies,
potentially boosting stock prices.
 Retirement Planning: Interest rates are crucial in retirement planning. Higher rates can
increase the returns on retirement savings, helping individuals build a larger nest egg for their
retirement years.

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Interest Rates as a Barometer of Economic Health

Interest rates serve as an important indicator of the overall economic health of a country:

Monetary Policy: Central banks, such as the Federal Reserve in the United States, use interest rates as
a tool to manage the economy. By raising or lowering rates, they can influence inflation, employment,
and economic growth. Higher interest rates typically slow down economic activity, while lower rates
can stimulate it.

 Inflation Control: Interest rates are closely linked to inflation. Central banks may increase
interest rates to curb high inflation by making borrowing more expensive and encouraging
saving. Conversely, they may lower rates to combat deflation and stimulate spending.
 Economic Growth: Interest rates impact consumer spending and business investment. Lower
rates reduce the cost of borrowing, encouraging both consumers and businesses to take loans
for spending and investment, thus driving economic growth. Higher rates can have the
opposite effect, slowing down economic activity.
 Investor Sentiment: Changes in interest rates can influence investor sentiment and market
behavior. For instance, higher rates may attract foreign investment seeking better returns,
leading to a stronger currency. Conversely, lower rates may encourage domestic investment
and spending.
 Credit Availability: Interest rates affect the availability of credit in the economy. Lower rates
make it easier for businesses and individuals to obtain loans, leading to increased spending
and investment. Higher rates can restrict credit availability, slowing down economic activities.

From an engineering standpoint...

As a civil engineer, understanding the dynamics of interest rates and their impact on
savings, investments, and economic health is essential for several reasons:

 Project Funding: Many large infrastructure projects require substantial financing.

Understanding interest rates helps in planning the cost of borrowing and securing favorable
loan terms, which can significantly impact the overall project budget and feasibility.
 Economic Indicators: Interest rates serve as a barometer of economic health. Being aware of
interest rate trends can help civil engineers anticipate changes in the construction market, such
as shifts in material costs, labor availability, and demand for infrastructure projects.
 Investment Decisions: Civil engineers involved in project management and company
operations need to make informed investment decisions. Knowledge of interest rates can guide
decisions on whether to invest in new equipment, technology, or expansion projects.

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 Cost Estimation: Accurate cost estimation is crucial for project planning. Understanding how
interest rates affect financing costs allows for more precise budgeting and financial planning,
ensuring projects remain within budget and are completed on time.
 Risk Management: Interest rates reflect the risk environment in the economy. Higher rates
may indicate higher perceived risks, affecting project financing and insurance costs. Being
aware of these factors helps in managing financial risks associated with engineering projects.

Interest as a Facilitator of Economic Activity

Interest rates play a crucial role in driving economic activity by influencing investment, growth, capital
formation, consumer spending, and business investment. By setting the cost of borrowing and the
reward for saving, interest rates impact decisions made by consumers, businesses, and governments.

Interest as a Catalyst for Investment and Growth

Interest rates are pivotal in determining the level of investment within an economy. Lower interest
rates reduce the cost of borrowing, encouraging businesses and individuals to take out loans for
investments. This can lead to:

 Business Expansion: Companies are more likely to invest in new projects, expand operations,
and purchase equipment when borrowing costs are low. This leads to increased production
capacity and potentially higher profits.
 Entrepreneurship: Lower interest rates make it easier for startups and small businesses to
obtain funding, fostering innovation and new business ventures.
 Infrastructure Development: Governments and private entities are more inclined to invest in
infrastructure projects, such as roads, bridges, and public facilities, when financing is
affordable. This not only creates jobs but also improves the overall efficiency of the economy.

Higher interest rates, on the other hand, can slow down investment by making borrowing more
expensive. This can lead to reduced business expansion and slower economic growth.

The Role of Interest in Capital Formation

Capital formation refers to the accumulation of capital assets, such as buildings, machinery, and
infrastructure, which are essential for economic productivity. Interest rates influence capital
formation in several ways:

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 Savings Incentives: Higher interest rates provide greater returns on savings, encouraging
individuals and institutions to save more. Increased savings can lead to more funds being
available for investment in capital projects.
 Investment Allocation: Interest rates help allocate resources efficiently by directing funds to
the most productive investments. Lower rates make it easier for companies to finance capital-
intensive projects, while higher rates may encourage more careful and efficient use of capital.
 Foreign Investment: Attractive interest rates can draw foreign investment into a country,
increasing the available capital for domestic projects. This influx of capital can further boost
economic development and infrastructure growth.

The Impact of Interest Rates on Consumer Spending and Business Investment

Interest rates directly affect both consumer spending and business investment, which are critical
components of economic activity:

Consumer Spending:

 Credit and Loans: Lower interest rates reduce the cost of borrowing for consumers, making it
more affordable to take out loans for big-ticket items such as homes, cars, and education. This
stimulates consumer spending, which drives economic growth.
 Disposable Income: Lower mortgage and loan payments free up disposable income, allowing
consumers to spend more on goods and services.
 Savings Rates: When interest rates are low, the incentive to save decreases, leading to higher
consumption levels. Conversely, higher interest rates encourage saving over spending.

Business Investment:

 Cost of Capital: Lower interest rates reduce the cost of capital for businesses, making it cheaper
to finance investments in new projects, technology, and expansion. This can lead to higher
productivity and growth.
 Profit Margins: Lower borrowing costs can improve profit margins, enabling businesses to
reinvest in their operations and expand their workforce.
 Risk Assessment: Higher interest rates increase the cost of borrowing, prompting businesses
to be more selective and risk-averse in their investment decisions. This can lead to slower
growth but potentially more sustainable investments.

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From an engineering standpoint...

As a civil engineer, understanding how interest rates facilitate economic activity is crucial
for effective project planning and management:

 Project Financing: The cost and availability of financing for large infrastructure projects are
heavily influenced by interest rates. Lower rates can make it easier to secure funding for
projects, while higher rates may require more careful financial planning and risk assessment.
 Economic Cycles: Interest rate trends can provide insights into economic cycles, helping civil
engineers anticipate changes in construction demand, material costs, and labor availability.
This knowledge can guide project scheduling and resource allocation.
 Investment Decisions: Engineers involved in strategic planning and investment decisions must
consider interest rates when evaluating the feasibility of new projects or expansions.
Understanding the cost of capital helps in making informed decisions that balance risk and
return.
 Public Policy and Infrastructure Development: Interest rates influence government spending
on infrastructure. Lower rates can lead to increased public investment in transportation,
utilities, and public works, creating opportunities for civil engineering projects. Conversely,
higher rates may constrain public budgets and slow down infrastructure development.
 Contracting and Procurement: Interest rates can affect the cost of materials and services
procured for engineering projects. Being aware of rate trends can help in negotiating better
contracts and managing project budgets effectively.

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 is termed "simple." Simple interest is computed based solely on the principal amount (i.e.,
the original sum), disregarding any interest accrued in prior periods.

Definition: Simple interest is the interest calculated only on the original principal amount of a loan
or investment. It does not consider any interest that accumulates on interest already earned or paid.

Interest is the "cost of capital" in engineering projects, reflecting the time value of money and the
risk associated with investments.

Formula: The formula for simple interest is:

𝐼 = 𝑃𝑟𝑡 where:

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 𝐼 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡
 𝑃 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 (𝑡ℎ𝑒 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦)
 𝑟 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (𝑒𝑥𝑝𝑟𝑒𝑠𝑠𝑒𝑑 𝑎𝑠 𝑎 𝑑𝑒𝑐𝑖𝑚𝑎𝑙)
 𝑡 = 𝑇𝑖𝑚𝑒 (𝑢𝑠𝑢𝑎𝑙𝑙𝑦 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

The final amount F, resulting from an investment of the principal 𝑃, can be computed as
follows:

𝐹 = 𝑃+𝐼

𝐹 = 𝑃 + 𝑃𝑟𝑡

𝐹 = 𝑃(1 + 𝑟𝑡)

Examples:

 Short-term loans: Many short-term loans, such as payday loans or certain personal loans,
often use simple interest calculations to determine the interest owed.
 Discount bonds: Certain types of bonds, such as Philippines Treasury bills, may use simple
interest to determine the discount rate and yield.

Limitations:
Does not account for the earning capacity of interest over time: Simple interest does
not take into consideration the compounding effect, where interest earns interest. This means
that over longer periods, the amount of interest earned or paid can be significantly less than
that calculated using compound interest.

Less suitable for long-term investments or loans: For investments or loans with longer
durations, compound interest provides a more accurate reflection of the true cost or return on
investment, as it accounts for the interest on accumulated interest.

Sample Calculation

Suppose you invest Php1,000 at an annual simple interest rate of 5% for 3 years.

𝐼 = 𝑃𝑟𝑡

𝐼 = 1000 × 0.05 × 3

𝐼 = 𝑃ℎ𝑝 150

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Applications in Engineering
As a civil engineer, understanding simple interest can be crucial in various contexts:

 Project Financing: Simple interest calculations can be used for determining the cost of
short-term project loans or for evaluating the financial viability of small-scale projects.
 Cost Estimation: In cost estimation and budgeting for infrastructure projects, simple
interest may be applied to short-term financial assessments.
 Loan Agreements: When negotiating terms for equipment financing or temporary funding,
simple interest offers a straightforward way to calculate interest costs over short periods.

Problem 1 Short-Term Loan Calculation

You take out a short-term loan of Php 5,000 at an annual simple interest rate of 8% for 6 months. How
much interest will you owe at the end of the loan period?

Solution: 𝐼 = 𝑃 𝑟 𝑡

where:

𝑷 = 5000 (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)

𝒓 = 0.08 (𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

𝒕 = 𝟔/𝟏𝟐 = 0.5𝑡 (𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

𝑰 = 𝟓𝟎𝟎𝟎 × 𝟎. 𝟎𝟖 × 𝟎. 5

𝑰 = 𝟐𝟎𝟎

So, you will owe Php 200 in interest at the end of 6 months.

Problem 2: Investment Earnings

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Question: You invest Php 2,000 in a savings account that offers a simple interest rate of 4% per year.
How much interest will you earn after 3 years?

Solution:

𝐼 = 𝑃𝑟𝑡

where:

𝑷 = 2000 (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)

𝒓 == 0.04 (𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

𝒕 = 3 (𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

𝐼 = 2000 × 0.04 × 3

𝐼 = 240

So, you will earn Php 240 in interest after 3 years.

Problem 3: Loan Repayment

Question: A borrower takes a loan of $10,000 at a simple interest rate of 7% per annum for 4 years.
What is the total amount to be repaid at the end of the loan period?

Solution: First, calculate the interest: 𝑰 = 𝑃𝑟𝑡 where:

𝑷 = 10000 (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)

𝑅 = 0.07 (𝑎𝑛𝑛𝑢𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)

𝒕 = 4 (𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

𝑰 = 𝟏𝟎𝟎𝟎𝟎 × 𝟎. 𝟎𝟕 × 𝟒 = 2800

The total amount to be repaid is the principal plus the interest:

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𝑻𝒐𝒕𝒂𝒍 𝑨𝒎𝒐𝒖𝒏𝒕 = 𝑷 + 𝑰

𝑻𝒐𝒕𝒂𝒍 𝑨𝒎𝒐𝒖𝒏𝒕 = 𝟏𝟎𝟎𝟎𝟎 + 𝟐𝟖𝟎𝟎

𝑻𝒐𝒕𝒂𝒍 𝑨𝒎𝒐𝒖𝒏𝒕 = 𝟏𝟐𝟖𝟎𝟎

So, the borrower will repay a total of $12,800 at the end of 4 years.

Problem 4 Loan Repayment

Question: If you earned $150 in interest from an investment of $1,500 over 2 years, what was the
annual simple interest rate?

Solution: Use the simple interest formula and solve for r: 𝑰 = 𝑃𝑟𝑡 where:

 𝑰 = 150 (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑎𝑟𝑛𝑒𝑑)

 𝑷 = 1500 (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)

 𝒕 = 2 (𝑡𝑖𝑚𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠)

𝟏𝟓𝟎 = 𝟏𝟓𝟎𝟎 × 𝒓 × 𝟐𝟏𝟓𝟎 = 1500 × 𝑟 × 2

Solving for

𝒓: 150=3000r, 𝑟 = = 0.05

So, the annual simple interest rate was 5%.

𝑨 = 𝑷 (𝟏 + 𝒏𝒓)𝒏×𝒕

CALCULATION OF THE TIME BETWEEN DATES

In the computation of interest, we include the last day but not the first day in computing
the time between two dates. Sometimes, the time between two dates is counted under the
assumption that each month has 30 days, we shall call the result the approximate time.

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Sample problem
Find the actual and approximate time between February 1, 2020 and June 28, 2021.

SOLUTION
Actual Time
Note that February 1 is the 32nd day of the year 2020. Therefore, a quick
computation of the number of days from February 1 to December 31, 2020 will
be 366* – 32 = 334 days.
To find the number of days from January 1 to June 28, 2021, we shall count
the number of days for each month. Hence, the number of days will be equal to
31 (Jan) + 28** (Feb) + 31 (Mar) + 30 (Apr) + 31 (May) + 28 (Jun) = 179 days.
Therefore, the total number of days from February 1, 2020 to June 28,
1993 is 334 + 179 = 513 days.

Note:

* Year 2020 is a leap year.

** February will only have 28 days since not 2021 is not a leap year.

Approximate Time
In finding the approximate time, we assume that each month has 30 days.
Therefore, to find the approximate number of days, we shall determine a
reference date in which we shall base our starting and ending dates. Let’s choose
January 1, 2020 as our reference. Thus,

June 28, 2021 2021 : 06 : 28

February 1, 2020 2020 : 02 : 01

0001 : 04 : 27

Therefore, the approximate time is (1 * 360) + (4 * 30) + 27 = 507 days

*
Year 2020 is a leap year.
**
February will only have 28 days since not 2021 is not a leap year.

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Simple Interest vs. Compound Interest

Simple interest is calculated solely on the principal

amount of an investment or loan. This means you earn
interest only on the initial amount, and there's no
compounding.

Formula:

Simple Interest (SI) = Principal (P) ×

Interest Rate (i) × Time (n)

Compound interest is calculated on both the principal and the accumulated interest. This "interest on
interest" effect leads to exponential growth over time.

Formula:

Compound Interest

DEFINITION

Compound interest is the interest on a loan or investment calculated based on both the
initial principal and the accrued interest from the previous periods. In compounding, the interest
due is added to the principal and thereafter earns interest. We shall illustrate this by an example.

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Example 1 Defining Compound Interest

K.A. Leocadio Engineering Solutions loans Php 100,000 at 5% per year compound
interest to cover the expenses of the company’s R&D project. The company shall pay the
principal and interest after 5 years. Compute the annual interest and total amount due after 5
years.
SOLUTION
Interest, year 1 : 100,000(0.10) = Php 10,000
Total due, year 1 : 100,000 + 10,000 = Php 110,000
Interest, year 2 : 110,000(0.10) = Php 11,000
Total due, year 2 : 110,000 + 11,000 = Php 121,000
Interest, year 3 : 121,000(0.10) = Php 12,100
Total due, year 3 : 121,000 + 12,100 = Php 133,100
Interest, year 4 : 133,100(0.10) = Php 13,310
Total due, year 4 : 133,100 + 13,310 = Php 146,410
Interest, year 5 : 146,410(0.10) = Php 14,641
Total due, year 5 : 146,410 + 14,461 = Php 161,051

As seen, the total amount due after 5 years is Php 161,051.

Analyzing Example 11 (the example given above), the total amount due at the end of each
year is

Year 1 : 100,000(1 + 0.10) = Php 110,000

Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10)(1 + 0.10)
Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10)2 = Php 121,000
Year 3 : 121,000(1 + 0.10) = 100,000(1 + 0.10)(1 + 0.10)(1 + 0.10)
3
Year 2 : 110,000(1 + 0.10) = 100,000(1 + 0.10) = Php 133,100
and so on…

From this, we can deduce that the total amount due at the end of 𝑘 years is
Year 𝑘 : 100,000(1 + 0.10)k

Hence, we can conclude the general formula

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𝑭 = 𝑷(𝟏 + 𝒊)𝒏
where, 𝐹 = total due at the end of n years (future amount)
𝑃 = principal amount
𝑛 = number of compounding periods (number of years)
𝑖 = interest rate

This general formula can be used to directly calculate the total amount due at the end of n years
without going through the intermediate steps.

Example 2 Compound Interest

Engr. Luzong invests Php 50,000 at a credit corporation at interest rate of 10%
compounded annually*. How much is the investment worth after 10 years?
SOLUTION
Using the derived general formula,
𝐹 = 50,000(1 + 0.10)

𝑭 = 𝐏𝐡𝐩 𝟏𝟐𝟗, 𝟔𝟖𝟕. 𝟏𝟐

Commonly, the compounding period may not always be annually. Sometimes, the
principal amount in compounded semi-annually, quarterly or monthly. We calculate this by
dividing the annual interest rate by a corresponding frequency factor (i.e., the number of times
the interest is compounded per year), and multiplying the number of years by the same factor
to produce the total number of times the interest is compounded. That is, putting into a
mathematical formula,
𝒓 𝒎𝒕
𝑭=𝑷 𝟏+
𝒎
where, 𝐹 = future amount
𝑃 = principal amount
𝑟 = annual interest rate
𝑚 = 2 for semiannually
𝑚 = 4 for quarterly
𝑚 = 12 for monthly

*
This means 10% per year compound interest.

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𝑚 = 52 for weekly
𝑚 = 365 for daily

Example 2 The Impact of Compounding Frequency

To illustrate how compounding frequency affects your earnings, let's consider investing $1,000 at a
5% annual interest rate for three years.

Annual Compounding

When interest is compounded annually, it's calculated once a year.

 𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = $1,000 × (1 + 0.05) = $1,157.63

Quarterly Compounding

With quarterly compounding, interest is calculated four times a year.

 𝑄𝑢𝑎𝑟𝑡𝑒𝑟𝑙𝑦 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 5% / 4 = 1.25%

 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 = 3 𝑦𝑒𝑎𝑟𝑠 × 4 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑠/𝑦𝑒𝑎𝑟 = 12 𝑞𝑢𝑎𝑟𝑡𝑒𝑟𝑠

𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = $1,000 × (1 + 0.0125) = $1,161.11

As you can see, quarterly compounding yields $3.48 more than annual compounding over the three-
year period.

The Time Value of Money and the Power of Compounding

The time value of money is a fundamental financial concept stating that money available today is
worth more than the same amount in the future. This is due to its potential earning capacity through
investment or interest.

Compounding is a direct application of this principle. It's the process of earning interest on both the
initial principal and the accumulated interest. This reinvestment of earnings leads to exponential
growth over time.

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The earlier you invest, the greater the impact of compounding. This is why starting to save
or invest early in life is crucial for long-term financial goals.

Deriving the Compound Interest Formula

To understand compounding mathematically, let's break down the formula:

𝑷: 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 (𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡)

𝒊: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑝𝑒𝑟𝑖𝑜𝑑

𝒏: 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

After one period:

 𝐴𝑚𝑜𝑢𝑛𝑡 = 𝑃 ∗ (1 + 𝑖)

After two periods:

 Amount = [𝑃 ∗ (1 + 𝑖)] ∗ (1 + 𝑖) = 𝑃 ∗ (1 + 𝑖)

After n periods:

 Amount = 𝑃 ∗ (1 + 𝑖)

Therefore, the future value (FV) of an investment after n periods is:

 𝑭𝑽 = 𝑷 ∗ (𝟏 + 𝒊)𝒏

This formula is the cornerstone of many financial calculations, from savings accounts to loan
repayments.

The Impact of Compounding Frequency

To illustrate the significant effect of compounding frequency on investment growth, let's calculate the
future value of a $1,000 investment earning 6% annual interest over three years under different
compounding scenarios.

Annual Compounding

With annual compounding, interest is calculated and added to the principal once a year.

 𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = $1,000 ∗ (1 + 0.06) = $1,191.02

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Semi-Annual Compounding

Interest is calculated and added every six months.

 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 6% / 2 = 3%

 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 = 3 𝑦𝑒𝑎𝑟𝑠 ∗ 2 𝑝𝑒𝑟𝑖𝑜𝑑𝑠/𝑦𝑒𝑎𝑟 = 6 𝑝𝑒𝑟𝑖𝑜𝑑𝑠

 𝐹𝑉 = $1,000 ∗ (1 + 0.03) = $1,194.05

Quarterly Compounding

Interest is calculated and added every three months.

 Periodic interest rate = 6% / 4 = 1.5%

 Number of periods = 3 years * 4 periods/year = 12 periods

 𝐹𝑉 = $1,000 ∗ (1 + 0.015) = $1,191.02

As you can see, the more frequently interest is compounded, the higher the final value
of the investment. In this example, quarterly compounding yields a slightly higher return than
annual compounding, but the difference becomes more pronounced over longer investment horizons
and higher interest rates.

Monthly Compounding and Calculation Tools

Monthly Compounding
When interest is compounded monthly, it's calculated and added to the principal twelve times a year.

 𝑃𝑒𝑟𝑖𝑜𝑑𝑖𝑐 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 6% / 12 = 0.5%

 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 = 3 𝑦𝑒𝑎𝑟𝑠 ∗ 12 𝑚𝑜𝑛𝑡ℎ𝑠/𝑦𝑒𝑎𝑟 = 36 𝑚𝑜𝑛𝑡ℎ𝑠

 𝐹𝑢𝑡𝑢𝑟𝑒 𝑉𝑎𝑙𝑢𝑒 (𝐹𝑉) = $1,000 ∗ (1 + 0.005) = $1,193.28

As you can see, monthly compounding yields an even higher return than quarterly compounding.

Using Financial Tools

While the formula for compound interest is straightforward, calculations can become complex,
especially when dealing with multiple compounding periods or irregular interest rates. This is where
financial tools come in handy.

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 Compound Interest Tables: These tables provide precalculated factors for different
interest rates and time periods, simplifying the calculation process.

 Financial Calculators: Dedicated financial calculators or functions within general-purpose

calculators can handle compound interest calculations efficiently.

 Spreadsheet Software: Programs like Microsoft Excel or Google Sheets offer built-in
financial functions, making it easy to perform complex calculations and analyze investment
scenarios.

By utilizing these tools, you can quickly determine the future value of investments under various
compounding frequencies and interest rates.

Problem 1 Impact of Interest Rate

 Scenario: You invest ₱275,000 in a savings account that offers an annual interest rate of 4%
compounded annually. How much will you have in the account after 7 years? Compare this to
what you would have with an annual interest rate of 8% for the same period.

 Solution:

o At 4% Interest Rate:

 𝐹𝑉 = ₱275,000 ∗ (1 + 0.04) = ₱371,500.25

o At 8% Interest Rate:

 𝐹𝑉 = ₱275,000 ∗ (1 + 0.08) = ₱473,251.30

Comparison: With an 8% interest rate, you will have ₱101,751.05 more than with a 4% interest rate
after 7 years.

Problem 2 Effect of Time

Scenario: You invest ₱110,000 at an annual interest rate of 5% compounded quarterly. How much
will the investment be worth after 10 years? Compare this to the value after 5 years.

 Solution:

o For 10 Years:

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 𝐹𝑉 = ₱110,000 ∗ (1 + 0.05/4)( ∗ )
= ₱183,206.42

o For 5 Years:

 𝐹𝑉 = ₱110,000 ∗ (1 + 0.05/4)( ∗ )
= ₱142,403.21

Comparison: The future value after 10 years is ₱40,803.21 more than after 5 years.

Problem 3 Doubling Time Using the Rule of 72

Scenario: You want to estimate how long it will take for your investment to double if the annual
interest rate is 9%. Use the Rule of 72 to calculate this.

 Solution:

o 𝐷𝑜𝑢𝑏𝑙𝑖𝑛𝑔 𝑇𝑖𝑚𝑒 = 72 / 9 = 8 𝑦𝑒𝑎𝑟𝑠

Conclusion: It will take approximately 8 years for the investment to double.

Problem 4 Exact Doubling Time Calculation

 Scenario: Calculate the exact number of years required to double an investment with an
annual interest rate of 7% compounded annually.

 Solution:

o 𝑛 = 𝑙𝑜𝑔(2) / 𝑙𝑜𝑔(1 + 0.07) ≈ 10.24 𝑦𝑒𝑎𝑟𝑠

Conclusion: It will take approximately 10.24 years to double the investment.

Problem 5 Comparing Different Compounding Periods

 Scenario: Compare the future value of ₱165,000 invested for 4 years at an annual interest
rate of 6% with annual, semi-annual, and monthly compounding.

 Solution:

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o Annual Compounding:

 𝐹𝑉 = ₱165,000 ∗ (1 + 0.06) = ₱208,614.59

o Semi-Annual Compounding:

 𝐹𝑉 = ₱165,000 ∗ (1 + 0.03) = ₱209,404.75

o Monthly Compounding:

 𝐹𝑉 = ₱165,000 ∗ (1 + 0.005) = ₱210,330.99

Comparison: Monthly compounding results in the highest future value, followed by semi-annual,
and then annual compounding.

Sample problems in civil engineering applications that involve calculating future values
with different interest rates, time periods, and compounding frequencies:

Problem 1 Inflation-Adjusted Savings Goal

Scenario: A civil engineering firm aims to accumulate ₱5,000,000 in 10 years for a major equipment
upgrade. Assuming an annual inflation rate of 3% and an investment earning 6% compounded
annually, how much should the firm invest initially?

Solution:

1. Calculate the future value in today's pesos:

o Future Value (FV) = ₱5,000,000

2. Calculate the inflation-adjusted discount rate:

o 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (1 + 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒) / (1 + 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒) − 1

o 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = (1 + 0.06) / (1 + 0.03) − 1

o 𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 ≈ 0.0291 𝑜𝑟 2.91%

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3. Calculate the present value (initial investment):

o 𝑃𝑉 = ₱5,000,000 / (1 + 0.0291)

o PV ≈ ₱3,713,251.62

The firm should invest approximately ₱3,713,251.62 initially to achieve a future value of
₱5,000,000 in 10 years, considering the effects of inflation.

Problem 2 Tax-Efficient Investment Strategies

Scenario: A civil engineer is considering investing ₱1,000,000 in either a taxable stock portfolio or
a tax-deferred retirement account. The expected annual return on the stock portfolio is 8%, and the
retirement account offers a guaranteed return of 5%. Assuming a marginal tax rate of 30%, which
option would provide a higher after-tax return?

Solution:

1. Taxable Stock Portfolio:

o 𝐵𝑒𝑓𝑜𝑟𝑒 − 𝑡𝑎𝑥 𝑟𝑒𝑡𝑢𝑟𝑛 = 8%

o 𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑟𝑒𝑡𝑢𝑟𝑛 = 8% ∗ (1 − 0.30) = 5.6%

2. Tax-Deferred Retirement Account:

o 𝐴𝑓𝑡𝑒𝑟 − 𝑡𝑎𝑥 𝑟𝑒𝑡𝑢𝑟𝑛 = 5% (𝑠𝑖𝑛𝑐𝑒 𝑖𝑡′𝑠 𝑡𝑎𝑥 − 𝑑𝑒𝑓𝑒𝑟𝑟𝑒𝑑)

Conclusion: The taxable stock portfolio with an after-tax return of 5.6% is more advantageous than
the tax-deferred retirement account with a 5% return.

Problem 3 Loan Repayment and Inflation

Scenario: A civil engineering firm borrows ₱10,000,000 to finance a new project at an interest rate
of 8% compounded annually. The loan term is 5 years. Assuming an annual inflation rate of 3%, what
is the real cost of the loan?

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Solution:

1. Calculate the total loan repayment:

o Using a loan amortization schedule or financial calculator, determine the total amount
paid back over the 5-year loan term.

2. Calculate the inflation-adjusted loan repayment:

o Adjust each loan payment for inflation using the formula:

 Inflation-adjusted payment = Actual payment / (1 + 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒)^𝑛

 Where n is the number of years since the payment was made.

3. Sum the inflation-adjusted payments to determine the real cost of the loan.

Note: Calculating the exact real cost of the loan requires detailed loan amortization data. However,
this general approach outlines the process of adjusting loan payments for inflation.

Problem 4 Investment Growth for Infrastructure Maintenance Fund

Question: A municipality invests ₱8,250,000 in a fund for future infrastructure maintenance, with
an annual interest rate of 5% compounded daily. How much will be in the fund after 20 years?

Solution:

 𝑷𝒓𝒊𝒏𝒄𝒊𝒑𝒂𝒍 (𝑷): ₱8,250,000

 𝑨𝒏𝒏𝒖𝒂𝒍 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝑹𝒂𝒕𝒆 (𝒊): 5% 𝑜𝑟 0.05

 𝑪𝒐𝒎𝒑𝒐𝒖𝒏𝒅𝒊𝒏𝒈 𝑷𝒆𝒓𝒊𝒐𝒅𝒔 𝒑𝒆𝒓 𝒀𝒆𝒂𝒓 (𝒎): 365

 𝑵𝒖𝒎𝒃𝒆𝒓 𝒐𝒇 𝒀𝒆𝒂𝒓𝒔 (𝒏): 20

Convert the annual rate to daily rate:

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Calculate the total number of compounding periods:

Using the compound interest formula:

The future value of the fund will be ₱22,444,998.75.

INTEREST COMPOUNDED CONTINUOUSLY

Consider the compound interest formula

𝑟
𝐹 =𝑃 1+
𝑚
If we are going to consider 𝑚 → ∞, then we have

𝑟
𝐹 = 𝑃 lim 1 +
→ 𝑚

𝑟 /
𝐹 = 𝑃 lim 1+
→ 𝑚

/
𝐹 = 𝑃 lim (1 + 𝑖)
→

Now, note that

/
𝑒 = lim (1 + 𝑛)
→

Therefore,
𝑭 = 𝑷𝒆𝒓𝒕

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where, 𝐹 = future amount

𝑃 = principal amount
𝑟 = nominal interest rate
𝑡 = number of years

We refer to this formula as formula for continuously compounding.

Example 3 Continuous Compounding

Find the future worth of a Php 1 million investment if it is invested for 10 years at an
interest rate of 8% compounded continuously.
SOLUTION
𝐹 = 1,000,000𝑒 ( . )( )
= 𝐏𝐡𝐩 𝟐, 𝟐𝟐𝟓, 𝟓𝟒𝟎. 𝟗𝟑

EQUIVALENT RATES

Two varieties of compound interest are equivalent if the effective rates for the two
varieties are equal.

Example 4 EQUIVALENT RATES

What nominal rate compounded quarterly is equivalent to 8% compounded monthly?

SOLUTION
𝐸𝑅 = 𝐸𝑅

𝑟 0.08
1+ −1= 1+ −1
4 12

𝒓 = 𝟖. 𝟎𝟓𝟑𝟓%

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