Santa Cruz Institute (Marinduque) Inc.

Santa Cruz, Marinduque

Module in Investment and Portfolio Management
Week No. 6
Objectives of the Course:
1. To understand the time value of money.
2. To learn the common methods of determining the time value of money.
a. Simple Interest
b. Compound Interest
The Time Value of Money

Fixed-income securities are securities where the periodic returns, time when the returns
fall due and the maturity amount of the security are pre-specified at the time of issue. Such
securities generally form part of the debt capital of the issuing firm. Some of the common examples
are bonds, treasury bills and certificates of deposit.

What is Interest?
It is the amount of money earned by a given capital. From the borrower’s viewpoint,
interest is the amount of money paid for the use of a borrowed capital. From the lender’s viewpoint,
it is the income generated by the capital that was lent.
Simple and Compound Interest Rates

In simple terms, an interest payment refers to the payment made by the borrower to the
lender as the price for use of the borrowed money over a period of time. The interest cost covers
the opportunity cost of money, i.e., the return that could have been generated had the lender
invested in some other assets and a compensation for default risk (risk that the borrower will not
refund the money on maturity). The rate of interest may be fixed or floating, in that it may be
linked to some other benchmark interest rate or in some cases to the inflation in the economy.

Interest calculations are either simple or compound. While simple interest is calculated on
the principal amount alone, for a compound interest rate calculation we assume that all interest
payments are re-invested at the end of each period. In case of compound interest rate, the
subsequent period’s interest is calculated on the original principal and all accumulated interest
during past periods.

In case of both simple and compound interest rates, the interest rate stated is generally
annual. In case of compound interest rate, we also mention the frequency for which compounding
is done. For example, such compounding may be done semi-annually, quarterly, monthly, daily or
even instantaneously (continuously compounded).

SIMPLE INTEREST

In simple interest, the interest earned is by the principal is computed at the end of the
investment period, and thus, it varies directly with time.
 Santa Cruz Institute (Marinduque) Inc.
Santa Cruz, Marinduque

Ordinary and Exact Simple Interest

In ordinary simple interest, the interest is computed on the basis of one banker’s year.

1 banker’s year = 12 months

(30 days each month) = 360 days

In exact simple interest, the interest is based on the exact number of days of the year, where
there are 365 days for an ordinary year and 366 years for leap years.

Leap years occurs every four years for years that are exactly divisible by four, except
century marks (1800,1900, etc.) but not including those that are exactly divisible by 400
(2000,2400, etc.)

Elements of Simple Interest

P = principal or present worth

I = interest earned
F = future worth

𝐹 =𝑃+𝐼
r = simple interest rate (per year)
t = time in years or fraction of a year

Note: P may stand for the amount borrowed or invested, while F may stand for the amount to be
paid or amount accumulated.

𝐼 = 𝑃𝑟𝑡

or 𝐹 = 𝑃(1 + 𝑟𝑡)

Value of t
Example:
4 years; t = 4
3 months; t = 3/12 = ¼
90 days
Ordinary simple interest, t = 90/360
Exact simple interest, t = 90/365
2 years & 4 months; t = 2 + 4/12 = 2.3333
 Santa Cruz Institute (Marinduque) Inc.
Santa Cruz, Marinduque
Example:
What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pays
8% simple interest?

Answer: Here we have

P = 10000, R = 8% and T = 3 years
I = P * R * T = 10000 * 8%* 3 = 2400
Amount = Principal + Interest = 10000+2400 = 12400.

COMPOUND INTEREST
In compound interest, the interest is computed every end of each period (compounding
period), and the interest earned for that period is added to the principal (interest plus principal).
To demonstrate this, consider an investment of P1000 to earn 10% per year for three years.
The following diagram shows how the money grows.

0 1 2 3

P1000
P1100 P1210 P1331

Elements of Compound Interest

P = present worth or principal
F = future worth or compound amount
i = effective interest per compounding period (per interest period)
𝑖 = 𝑟/𝑚
n = total number of compounding
𝑛=𝑡𝑥𝑚
I = interest earned
𝐼 = 𝐹−𝑃
r = nominal interest rate
ER = effective interest
t = number of years of investment
m = number of compounding per year
 Santa Cruz Institute (Marinduque) Inc.
Santa Cruz, Marinduque
Future Worth of P
After n periods, the compound amount F is:

𝐹 = 𝑃(1 + 𝑖)𝑛

The term (1 + 𝑖)𝑛 , also denoted as (F/P, I, n) is called the single payment compound
amount factor.
Present Worth of F
The present worth of F is:

𝐹
𝑃=
(1 + 𝑖)𝑛
1
The term also denoted as (P/F, i, n) is called the single payment present-worth
(1+𝑖)𝑛
factor.
Values of i and n
The following examples show how to get the values of i and n.
Nominal interest rate, r = 12%
Number of years of investment, i = 5 years
Compounded Annually (m = 1)
i = 0.12/1 = 0.12
n = 5(1) = 5
Compounded Semi-Annually (m = 2)
i = 0.12/2 = 0.06
n = 5(2) = 10
Compounded Quarterly (m = 4)

i = 0.12/4 = 0.03
n = 5(4) = 20
Compounded Monthly (m = 12)

i = 0.12/2 = 0.06
n = 5(2) = 10
Compounded Bi-monthly (m = 6)

i = 0.12/6 = 0.02
n = 5(6) = 30
 Santa Cruz Institute (Marinduque) Inc.
Santa Cruz, Marinduque
Example:
What is the amount an investor will get on a 3-year fixed deposit of Rs. 10000 that pay 8%
interest compounded half yearly?

Answer:
Here P = 10000, R = 8% and T = 3, m = 2. The total interest income comes to:

𝐼 = 𝐹−𝑃
𝑟 𝑚𝑥𝑡
𝐼 = 𝑃(1 + ) −𝑃
𝑚
8% 12(3)
𝐼 = 10,000(1 + ) − 10,000
12

Amount = Principal + Interest = 10,000 + 2702.37 = 12,702.37.

Continuous Compounding
(m → ∞)

Interest may be compounded daily, hourly, per minute, etc. as a limit, interest may be
considered to be compounded an infinite number of times per year (m → ∞).

The future worth of P at an interest rate of r compounded continuously for t years is

𝑃𝑒 𝑟𝑡
Example:

Consider the same investment (Rs. 10000 for 3 years). What is the amount received on maturity if
the interest rate is 8% compounded continuously?

Answer:
Here P = 10000, e = 2.718, r = 8% and T = 3
The final value of the investment is P * ert
It comes to 10000 * e0.08*3 = 12712.50