Ecnomic Notes 2

Interest and Money-Time Relationships
Capital
● refers to wealth in the form of money or property that can be used to produce more wealth.
● Equity Capital - owned by individuals who invested their money or property in a business project
● Debt Capital / Borrowed Capital – obtained from lenders for investment.
Interest
● cost of money often expressed as a percentage that is periodically applied
● the return obtainable from the productive investment and efficient use of money resources during
a specific time period
● the compensation ( return ) for the administrative expenses of making the loan, for the risk that
the loan will not be repaid, and for the earnings forgone had the money been placed in other
investments
● it is the profit from lending money, or the earning power of money
● the amount paid for the use of borrowed money, the cost of borrowing money
Simple Interest
I=(P)(N)(i)
Where :
● P = principal amount lent or borrowed
● N = number of interest period ( e.g. years )
● i = interest rate per interest period
Sample Problem 1
Php 400 is loaned for 5 quarters at a simple interest rate of 3% per quarter
a) What is the total amount of interest to be paid?

b) 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 ) ?
I = Principal * Period * Rate = (400) * (5) * (0.03) = 60

Total Amount Owed = Principal + Interest = 400 + 60 = 460
Sample Problem 2
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
Interest = Principal * Period * Rate

Interest = 1000 * 0.12 * 3/4 = 90
Interest = 1000 * 0.035 * 4/3 = 46.67
Interest = 1000 * 0.1255 * 27/12 =282.38
Compound Interest
F = P (1 + i)N
Where:
● F = future amount
● P = principal
● i = effective interest rate
● N = number of period
Sample Problem 1
If Php 400 is loaned for 5 quarters at a compound interest of 3% per quarter compounded quarterly, find
the total amount owed at the end of the last quarter
F = 400 (1 + 0.03)5 = 463.71
Notations and Cash Flow Diagrams
i = effective interest rate per period

N = number of compounding periods
P = present sum of money; the equivalent value of one or more cash flows at a reference point in time
called the present
F = future sum of money; the equivalent value of one or more cash flows at a reference point in time
called the future
A = end-of- period cash flows ( or any other equivalent end- of-period values ) in A uniform series
continuing for a specified number of periods, starting at the end of the first period and continuing
through the last period
Sample Problem 1
Mrs. Green has just purchased a new car for $12,000. She makes a down payment of 30% of the
negotiated price and then makes payments for $303.68 per month thereafter for 36 months.
Furthermore, she believes the car can be sold for $3,500 at the end of three years. Draw a cash flow
diagram of this situation from Mrs. Green’s viewpoint.
Nominal Interest Versus Effective Interest Rate
Nominal Rate of Interest (r)

● 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 periods 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.
Example: a nominal rate of 8% compounded quarterly: i = 8% / 4 = 2%
Effective Rate of Interest

● 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
Converting Nominal Interest to Effective Interest Rate
ieff = ( 1+ r/N )N – 1
Where :
● ieff is the effective interest rate
● r is the nominal rate of interest
● N is the number of compounding period per year
○ 2 = semi-annual
○ 4 = quarterly
○ 12 = monthly
○ 365 = daily
Effective interest rate is only equal to nominal rate of interest when compounding is on an annual basis.
When N>1, i>r.
Sample Problem 1
Find the nominal rate which if compounded quarterly could be used instead of 12% compounded
monthly. What is the corresponding effective rate?
ieff = ( 1+ r/N )N – 1 = ( 1 + 0.12/12 )12 - 1 = 12.68%
Interest Formulas relating Present and Future Equivalent Values of Single Cash Flows
Sample Problem 1
A chemical engineer wished to accumulate a total of Php 10,000 in a savings account at the end of 10
years. If the bank pays only 4% compounded quarterly, what should be the initial deposit?
Sample Problem 2
What amount can be withdrawn two years from now from a bank offering a nominal rate of 40%
compounded quarterly if Php 1,000 is deposited now?
Sample Problem 3
Solve problem 2 by using the effective rate of interest.
Sample Problem 4
By the conditions of a will, the sum of Php 25,000 is left to a girl to be held in trust by her guardian until it
amounts to Php 45,000. When will the girl receive the money if the fund is invested at 8% compounded
quarterly?
Sample Problem 5
If Php 1,000 becomes Php 5,743 after 15 years, when invested at an unknown rate of interest
compounded semi-annually, determine the unknown nominal rate and the corresponding
effective rate.

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Interest and Money-Time Relationships

a) What is the total amount of interest to be paid?

I = Principal * Period * Rate = (400) * (5) * (0.03) = 60

Interest = Principal * Period * Rate

F = 400 (1 + 0.03)5 = 463.71

Notations and Cash Flow Diagrams

i = effective interest rate per period

Nominal Rate of Interest (r)

Example: a nominal rate of 8% compounded quarterly: i = 8% / 4 = 2%

Effective Rate of Interest

Converting Nominal Interest to Effective Interest Rate

ieff = ( 1+ r/N )N – 1 = ( 1 + 0.12/12 )12 - 1 = 12.68%

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