MODULE 2

The Time Value of Money

Unit 1
Simple Interest and Compound Interest
UNIT LEARNING OUTCOMES

 TLO 2.1: To solve problems that involve time value of money calculations and to
illustrate economic equivalence involving single cash flows.

Diagnostic Test : Please answer the questions below and submit

your answers in our Google classroom under Classwork
Diagnostic Test M2.1

What is interest for you?

Where did you experience interest?

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 Interest
= is the amount of money paid for the use of borrowed capital or the
income produced by money which has been loaned.

1. Simple Interest

Simple interest is calculated using the principal only, ignoring any interest that had
been accrued in preceding periods. In practice, simple interest is paid on short – term loans
in which the time of the loan is measured in days.

I = Pni

F = P + I = P + Pni

F = P (1 + ni)

Where: I = interest paid or received ( pesos or dollars)

P = principal or present worth ( pesos or dollars)
n = number of interest periods ( years or semiannual, quarters, months days)
i = rate of interest per interest period (in %/period, in most cases %/yr)
F = accumulated amount or future worth ( pesos and dollars)

Example 1: What will be the future worth of money after 14 months, if a sum of ₱10,000 is
invested at a simple interest rate of 12% per year?
Given: P = ₱10,000
n = 14 months x ( 1 yr/12 months ) = 1.16667 years
i = 12%/year
Required: F =?
Solution:
𝟏𝟒
F = P(1+ni) = ₱10,000 [1 + ( x 0.12)] = ₱11,400
𝟏𝟐

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 (a) Ordinary simple interest is computed on the basis of 12 months of 30 days each
or 360 days a year.
1 year = 360 days and 1 month = 30days
Example 2: Determine the ordinary simple interest on ₱700 for 8 months and 15 days if the
rate of interest is 15%.
Given: P = ₱700
i = 15%/year
n = 8 months and 15 days
Required: I = interest = ?
Solution: Number of days = (8) (30) + 15 = 255 days
255
I = Pni = ₱700 x x 0.15 = ₱74.38 answer
360

(b) Exact simple interest is based on the exact number of days in a year, 365 days
for an ordinary year and 366 days for a leap year.
1 year = 365 days 1year= 366 days for leap year
Example 3: Determine the exact simple interest on ₱500 for the period from January 10 to
October 28, 1996 at 16% interest.
Given: P = ₱500
i = 16% /year
n = January 10 to October 28, 1996
Required: I = interest = ?
Solution: 1st step: solve for the value of n by identifying if year 1996 is a leap year or not
A year is considered a leap year if the year is divisible by 4, since 1996/4 = 499
therefore 1996 is a leap year.
Jan. 10 – 31 = 21 (excluding Jan.10)
February = 29 (leap year means February has 29 days instead of 28 days
March = 31
April = 30
May = 31
June = 30
July = 31
August = 31
September = 30
October = 28 (including Oct. 28)
292 days
292
Exact simple interest = ₱500 x x 0.16 = ₱63.83 answer
366

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 2. 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)

Note: The time scale is represented by a horizontal line. The scale made could be in years, semi-annual,
quarters, months, or days depending on the problem.

Example 4: A loan of ₱100 at simple interest of 10% will become ₱150 after 5 years.
Solution:
Cash flow diagram on the viewpoint of the lender
₱150

0 1 2 3 4 5

₱100
Cash flow diagram on the viewpoint of the borrower

₱100

0 1 2 3 4 5

₱150

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 3. Compound Interest

In calculation 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 4 n-1 n

F
Example: if P= P100,000 n=3 years i =10%
Pattern of interest compounding

Interest Principal at Interest Earned During Amount at End of year

Period Beginning of year year
Year I = ( P @ beg) x 10%
n
1 100,000 Pi = 10,000 P + Pi = 110,000
2 110,000 110,000 (10%) = 11,000 110,000+ 11,000=121,000
3 121,000 121,000(10%) = 12,100 121,000+12,100= 133,100

Therefore ,

Compound Interest (Borrower’s Viewpoint)

Interest Principal at Interest Earned During Amount at End of Period

Period Beginning of Period Period = I F
n
1 P Pi P + Pi = P(1+i)
2 P (1+i) P(1+i) i P(1+ni) + P(1+i) I = P (1+i)2
3 P (1+i)2 P (1+i)2 i P (1+i)2 + P (1+i)2 i = P (1+i)3
… … … …
n P (1+i)n - 1 P (1+i)n – 1 i P (1+i)n

F = P (1+i)n

The quantity (1+i)n is commonly called the “single

payment compound amount factor” and is
designated by the 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 i per

cent in n interest periods”.

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 P = F (1+i)-n

The quantity (1+i)-n is commonly 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 per

cent in n interest periods”.

4. Rates of Interest

(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

example: 12% compounded annually r=12% m=1 i = 12%/1 = 12%/year

12% compounded semi-annually r=!2% m=2 i = 12%/2 = 6%/SA

12% compounded quarterly r= 12% m= 4 i = 12%/4 = 3%/quarter

12% compounded monthly r= 12% m=12 i = 12%/12 = 1%/month

(b) Effective rate of interest or Effective Interest Rate (EIR)

Effective rate of interest is the actual or exact rate of interest of a nominal rate
on the principal during one year

Effective interest rate EIR = (1 + r/m)m - 1 = (1 + i)m -1

. If ₱1.00 is invested at a nominal rate of 15% compounded quarterly, after one year
this will become,
0.15 4
₱1 (1 + ) = ₱1.1586
4

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

Where: F1 = the amount ₱1.00 will be after one year

F1 = 1.1586

0 1 2 m

₱1.00
Example 5: Find the nominal rate which if converted quarterly could be used instead of 12%
compounded monthly. What is the corresponding effective rate?
Solution:
Let r = the unknown nominal rate
For the two or more nominal rates to be equivalent, their corresponding effective
rates must be equal.
Nominal rate Effective rate
𝑟
r% compounded quarterly (1 + )4 – 1
4

12% compounded monthly (1 +

0.12 12
) –1
12

𝑟
(1 + )4 – 1 = 1 ( 1+ 0.01)12 – 1
4
𝑟
1+ = ( 1.01)3 = 1.0303
4

r = 0.1212 or 12.12% compounded quarterly

Equation of Value

An equation of value is obtained by setting the sum of the sum of the values on a certain
comparison or focal date of one set of obligations equal to the sum of the values on the
same date of another set of obligation.

Steps: 1. Read problem.

2. make cashflow diagram

3. set focal date

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 4. make the equation (value of money should be computed
depending on the focal date that was set)

∑ values of one set of obligation = ∑ values of another set of obligations

Or

∑ values represented by arrows going up = ∑ values represented by arrows going down

Example 6: Find the amount at the end of two years and seven months if ₱1,000 is invested
at 8% compounded quarterly using simple interest for anytime less than a year interest
period.
Solution: Construct cash flow diagram (note that original cash flow is represented by color
black cash flow)
8%
For compound interest: i= = 2%, n = (2)(4) = 8 F2
4
F1
7
For simple interest: i = 8%, n =
12

0 1 2 2yrs & 7mns

compound simple
interest interest

Solve for F1 first ₱1,000

F1 = P (1+i)n = ₱1,000 (1+ 0.02)8 = ₱1,171.66

Then solve for F2
7
F2 = F1 (1+ni) = ₱1,171.66 [1+ (0.08)]= ₱1, 226.34
12

Or using equation of values

F2

0 1 2 2yrs & 7mns

compound simple
interest interest

₱1,000

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 Using “ 2 “ as focal point
( this means that end of year 2 is time present, therefore, cash flow P1,000 is 2 years
in the past while F2 is 7 months in the future. We solve for the future worth of P1000
and present worth of F2)
Equation:
1,000 (1.02) 8 = F2 { 1/ (1+(7/12)(.08)}

1171,66 = F2 {0.9954}
F2 = 1226.34
Example 7: A man bought a lot worth ₱1,000,000 if paid in cash. On the installment basis, he
paid a down payment of ₱200,000; ₱300,000 at the end of one year; ₱400,000 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% per year?
Solution:
Let Q= the final payment ₱800,000

0 1 2 3 4 5

₱300,000
₱300,000 (P/F, 20%,1) ₱400,000

₱400,000 (P/F, 20%,3) Q

Q (P/F, 20%,5)

Using “0” as focal date

₱800,000 = ₱300,000 (P/F, 20%,1) + ₱400,000 (P/F, 20%,3) + Q (P/F, 20%,5)

₱800,000 = ₱300,000 (1.20)-1 + ₱400,000 (1.20)-3 + Q (1.20)-5

₱800,000 = ₱300,000 (0.8333) + ₱400,000 (0.5787) + Q (0.4019)

Q = ₱792, 560

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 Using “3” as focal point

₱800,000

800,000 (F/P, 20%,3)

0 1 2 3 4 5

₱300,000
₱300,000 (F/P, 20%,2) ₱400,000

Q (P/F, 20%,2)

₱800,000(F/P,20%,3) = ₱300,000 (F/P, 20%,2) + ₱400,000 + Q (P/F, 20%,2)

₱800,000(1.20)3 = ₱300,000 (1.20)2 + ₱400,000 + Q (1.20)-2

₱800,000 ( 1.728) = ₱300,000 (1.44) + ₱400,000 + Q (0.6944)

Q = ₱792, 560

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 Solve following exercises (hand written in a short bond paper) . Submit your work in the
Google Classroom under classwork Assignment M2.1

Work on the following exercise. This is an opportunity for you to practice your knowledge and
skills you acquired in this unit. Final answers are provided at the end of each problem to serve
as your guide.
1. A loan of ₱2,000 is made for a period of 13 months, from January 1 to January 31 the
following year, at a simple interest rate of 20%. What future amount is due at the end
of the loan period? Ans: ₱2,433.33

3. Determine the exact simple interest on ₱5,000 for the period from Jan. 15 to Nov. 28,
1992, if the rate of interest is 22%. Ans: ₱955.74

4. A man wishes his son to receive ₱200,000 ten years from now. What amount should
he invest if it will earn interest of 10% compounded annually during the first 5 years
and 12% compounded quarterly during the next 5 years? Ans: ₱68,758.67

5. At a certain interest rate compounded semiannually, ₱5,000 will amount to ₱20,000

after 10 years. What is the amount at the end of 15 years? Ans: ₱40,029.72

6. Jones Corporation borrowed ₱9,000 from Brown Corporation on Jan. 1, 1978 and
₱12,000 on Jan. 1, 1980. Jones Corporation made a partial payment of ₱7,000 on Jan.
1, 1981. It was agreed that the balance of the loan would be amortized by two
payments, one of Jan. 1, 1982 and the other on Jan. 1, 1983, the second being 50%
larger than the first. If the interest rate is 12%, what is the amount of each payment?
Ans: ₱9,136.91; ₱13,705.36

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