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Engineering

Economy

Prepared by:

Engr. Glenn Ortiz

LECTURE 2: Interest and the Time Value of Money

Elements of Transactions Involving Interest

1. Many types of transactions involve interest-e.g.,

borrowing money, investing money, or purchasing

machinery on credit-but certain elements are common

to all of these types of transactions:

2. The initial amount of money invested or borrowed in

transactions is called the principal (P).

3.The interest rate (i) measures the cost or price of money

and is expressed as a percentage per period of time. It is the

amount paid for the use of borrowed capital or it is the

money earned by an investment.

4. A period of time called the interest period

(n)determines how frequently interest is calculated. (Note

that, even though the length of time of an interest period can

vary, interest rates are frequently quoted in terms of an

annual percentage rate.

5. A specified length of time marks the duration of the

transaction and thereby establishes a certain number of

interest periods (N).

6. A plan for receipts or disbursements (A) that yields a

particular cash flow pattern over a specified length of time. (For

example, we might have a series of equal monthly payments that

repay a loan.)

7. A future amount of money (F) results from the cumulative

effects of the interest rate over a number of interest periods.

8. Problems involving the time value of money can be conveniently

represented in graphic form with a cash flow diagram. Cash flow

diagrams represent time by a horizontal line marked off with the

number of interest periods specified. Arrows represent the cash

flows over time at relevant periods:

9. Upward arrows represent positive flows (receipts), and

downward arrows represent negative flows (disbursements).

Types of Interest

Simple interest- the type of interest that follows the

principle only the principal earned interest.

Simple Interest

I = Pin

Future worth or accumulated amount

F= P + I

F = P (1 + in)

where:

i= interest rate in decimal

n= number of years

Types of Simple Interest

Ordinary simple interest is computed based on 1

banker year = 360 days

Exact simple interest- is computed based on exact

number of days in one year as follows:

1 ordinary year (not divisible by 4) = 365 days

1 leap year (divisible by 4) = 366 days

1 century years = 100 years

If the century year is divisible by 400 it is a leap year,

otherwise it is an ordinary year

If the kind of simple interest is not mentioned in the

problem, assume it is an ordinary simple interest.

If exact simple interest, 30 days has September, April,

June and November. February has 28 or 29 days, the rest

31 days.

Compound Interest is type of interest that follows the

principle interest on top of an interest i.e. both

principal and interest earn interest.

Continuous Compounding assumes that compounding

continuously,

Nominal rate of interest (r) is the interest rate where

conversion is allowed.

Number of Compounding (m) is the number of

payments in one year.

Effective rate of interest (e) is the actual rate of interest

in one year. It is the interest rate for any compounding that

will give the same accumulation as computed compounded

annually.

Problem #1:

If P1000 accumulates to P1500

when invested at a simple interest

for three years, what is the rate of

interest?

Problem #2:

A loan of P5000 is made for a

period of 15 months, at a simple

interest rate of 15%, what future

amount is due at the end of the

loan period?

Problem #3:

If you borrowed money from your

friend with simple interest of 12%,

find the present worth of P50000,

which is due at the end of 7

months.

Problem #4:

Mr. J. Reyes borrowed money from

the bank. He received from the

bank P1842 and promised to repay

P2000 at the end of 10 months.

Determine the rate of simple

interest.

Problem #5:

A man borrowed money from a

loan shark. He receives from the

loan sharkand amount of P1342.00

and promised to repay P1500.00 at

the end of 3 quarters. What is the

simple interest rate?

Problem #6:

Determine the exact simple interest

on P5000 invested for the period

from January 15,1996 to October

12,1996, if the rate of interest is

18%.

Problem #7:

The exact simple interest of P5000

invested from June 21,1995 to

december 25,1995 is P100. What is

the rate of interest?

Problem #8:

Nicole has P20,400 in cash. She

invested it at 7% from March 1,2006

to November 1,2006 at 7% interest.

How much is the interest using the

Bankers rule(360 days)?

Problem #9:

The amount of P20000 was

deposited in a bank earning an

interest of 6.5% per annum.

Determine the total amount at the

end of 7 years if the principal and

interest were not withdrawn during

this period.

Problem #10:

A loan for P50,000 is to be paid in 3

years at the amount of P65,000.

What is the effective rate of

money?

Problem #11:

Find the present worth of a future

payment of P80,000 to be made in

six years with an interest of 12%

compounded annually.

Problem #12:

What is the effective rate

corresponding to 18% compounded

daily? Take 1 year is equal to 360

days.

Problem #13:

What nominal rate, compounded

semi annually, yields the same

amount as 16% compounded

quarterly?

Problem #14:

What rate of interest compounded

annully is the same as the rate of

interest of 8% compounded

quarterly?

Problem #15:

Find the compound amount if

P2500 is invested at 8%

compounded quarterly for 5years

and 6 months.

Problem #16:

About how many years will

P100,000 earn a compound interest

of P50,000 if the interest rate is 9%

compounded quarterly?

Problem #17:

Compute the equivalent rate of 6%

compounded semi-annually to a

rate compounded quarterly.

Problem #18:

P20,0000 was deposited on January

1,1988 at an interest rate of 24%

compounded semi annually. How

much would the sum be on January

1,1993?

Problem #19:

What is the present worth P100

payments at the end of the third

year and fourth year? The annual

interest rate is 8%.

Problem #20:

A firm borrows P2000 for 6 years at

8% . At the end of 6 years, it renews

the loan for the amount due plus

P2000 more for 2 years at 8%.What

is the total future worth? What is

the lump sum due?

Problem #21:

Find the present value of installment

payments of P1,000 now, P2,000 at the

end of the first year, P3,000 at the end

of the second year, P4,000 at the end of

the third year and P5,000 at the end of

the fourth year, if money is worth 10%

compounded annually.

Problem #22:

If money is worth 5%

compounded quarterly, find the

equated time for paying a loan

of P 150,000 due in 1 year and

P280,000 due in 2 years.

Problem #23:

BPI advertises 9.5% account that

yields 9.84% annually. Find how

often the interest is compounded.

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