TOPIC 2 PRINCIPLES OF

MONEY-TIME RELATIONSHIP

EQUITY CAPITAL AND DEBT CAPITAL

Equity

Capital: owned by the individuals who

have invested their money or property in a
business project or venture in the hope of
receiving a profit
Debt Capital: obtained from lenders (through
the sale of bonds) for investment; in return,
the lenders receive interest from the
borrowers

SIMPLE INTEREST AND COMPOUND INTEREST

interest
a. Simple

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 and the interest rate are said to be simple.
When the simple interest is applicable, the total interest,
earned or paid may be computed in the formula

also,

where:

principal amount lent or borrowed

accumulated amount or future worth
number of interest periods
interest rate per interest period
a.1 Ordinary simple interest is computed on the basis
of 12 months of 30 days each or 360 days a year.
1 interest period = 360 days
a.2 Exact simple interest is based on the exact number
of days in a year; 365 days for ordinary year and 366 days
for a leap year.
1 interest period = 365 or 366 days

b.
Interest
Compound

Whenever the interest charge for any interest period is based on the
remaining principal amount plus any accumulated interest charges up to
the beginning of that period, the interest is said to be compound.
If an amount exists at a point in time and is the interest rate per
period, the amount will grow to a future amount of by the end of one
period; by the end of two periods, the amount will grow to by the
end of three periods, the amount will grow to
and by the end of periods, the amount will grow to
similarly,
where
is called the single payment compound amount factor
is called the single payment present worth factor
is the future value
is the present value

NOMINAL RATE OF INTEREST AND EFFECTIVE

RATE OF INTEREST
Nominal

Rate of Interest
A nominal interest rate is an interest rate
that does not account for compounding.
By denition,
interest rate per interest period x number of
compounding periods per year
or

 Effective

Rate of Interest
An effective rate of interest is a rate
wherein the compounding of interest is taken
into account. Effective rates are commonly
expressed on an annual basis as an effective
annual rate; however, any time basis may be
used.

CONTINUOUS COMPOUNDING

The single payment compound mount factor, may be

written as

Increasing , the number of interest periods per year,

without limit, it becomes very large and approaches infinity
and approaches zero. This is the situation for continuous
compounding:
Set ; then and As approaches infinity, approaches zero,
hence

where

DISCOUNT
It is the difference between what it is
worth in the future and its present worth.

The rate of discount is the discount on

one unit of principal per unit of time.

EXAMPLE PROBLEMS
1. Determine the ordinary and exact simple interests on

PhP8,000 for the period from February 4 to September

28, 2012, if the rate of simple interest is 16%.
Solution:
a. Determine ; ordinary simple interest
where:
February
March
April
May
June

4 29 = 25 days
= 31 days
= 30 days
= 31 days
= 30 days

July

= 31 days
August
= 30 days
September 1 28 = 28 days
= 236 days
hence

b. Determine ; exact simple interest

the effective rate corresponding to each of the

2. Calculate

following rates: (a) 8% compounded semi-annually, (b) 10%

compounded quarterly, (c) 12% compounded bi-monthly, (d)
14% compounded monthly, (e) 16% compounded weekly, and
18% compounded daily.
Solution:
a. Determine ; effective rate of interest

b. Determine ; effective rate of interest

; effective rate of interest

c. Determine

d. Determine ; effective rate of interest

e. Determine ; effective rate of interest

f.
; effective rate of interest
Determine

3. At a certain interest rate compounded monthly, PhP5,000

will amount to PhP8,500 in 12 years. What is the amount at
the end of 5 years?
Solution:
Determine ; the future worth at the end of 5 years
Solving for

Solving for at the end of 5 years

4. How many years are required for PhP2,500 to increase to

PhP4,500 if invested at 12% compounded quarterly?
Solution:
Determine n; the required number of years

97 years

CASH FLOW DIAGRAM

Cash flow diagrams are used to depict
the timing and magnitudes of the cash flow
amounts in the present & future.

5. Before evaluating the economic merits of a proposed

investment, the XYZ Corporation insists that its engineers
develop a cash flow diagram of the proposal. An investment of
PhP100,000 that will produce uniform annual revenue of
PhP45,000 for 5 years and then have a positive salvage value
of PhP20,000 at the end of year 5. Annual expenses will be
PhP30,000 at the end of each year for operating and
maintaining the project. Draw a cash flow diagram

ANNUITIES AND CAPITALIZED COST

Annuity: consists of a series of equal payments made at
equal intervals of time.
TYPES OF ANNUITIES
a. Ordinary annuity: annuity where equal payments are
made at the end of each payment period starting from the first
period.
b. Deferred annuity: annuity where the payment of the first
amount is deferred a certain number of periods after the first.
c. Annuity due: annuity where the payments are made at
the end of each period, beginning from the first period.
d. Perpetuity: annuity where the payment periods extend
forever or in which the periodic payments continue indefinitely.

ORDINARY ANNUITY
Consider

the cash flow diagram:

The present worth, is the sum of the present

values of each of annuity payments.
Factor out

Multiply by
Subtracting by results to:

The term in brackets in is the conversion factor referred to as

the uniform series present worth factor (USPWF). It is the factor
used to calculate the equivalent value in year 0 for a uniform endof-period series of values beginning at the end of period 1 and
extending for periods.
Solving for
The term in brackets is called the capital recovery factor (CRF),
or factor. It calculates the equivalent uniform annual worth
overyears for a given in year 0, when the interest rate is .
The future worth, can be obtained using capital recovery factor

The expression in brackets in is the or sinking fund factor. It

determines the uniform annual series that is equivalent to a given
future amount .
Solving for
The term in brackets is called the uniform series compound
amount factor (USCAF), or factor.
1. How much money should you be willing to pay now for a
guaranteed $800 per year for 10 years starting next year, at a rate
of return of 14% per year?
Solution:
Determine ; the present worth

2. The president of Ford Motor Company wants to know the

equivalent future worth of a $100 million capital investment each
year for 8 years, starting 1 year from now. Ford capital earns at a
rate of 12% per year.
Solution:
Determine ; the future worth

DEFERRED ANNUITY

Consider the cash flow diagram

If each payment is then the present value of the deferred

annuity is
where:

The accumulated amount is the same as that for an ordinary

annuity.

ANNUITY DUE

Consider the cash flow diagram

If each payment is , then the present worth and future worth are
respectively

PERPETUITY

Consider the cash flow diagram

For a perpetuity where the periodic payments are each

equal to , the present value is

CAPITALIZED COST

The capitalized cost of any structure or property is the

sum of the first cost and the present worth of all costs for
replacement, operation, and maintenance for a long period of
time or forever, that is
where
hence
where
the amount needed to replace or maintain the property
every periods
the amount of principal invested at per period

If the property or structure costs to obtain and it will

have to be replaced every periods for the same amount,

then