Time Value of Money – Part I

A. Interest
What is interest?
• The word interest is from the Latin word intereo, which means “to be lost.” Interest developed from the
concept that lending goods or money results in a loss to the lender because he or she did not have the
use of the goods or money that is loaned.
• From the borrower’s (debtor’s) point of view, interest is the price that a he/she must pay for credit.
• From the lender’s (creditor’s) point of view, interest is the compensation that an he/she receives for
lending his money.
• In Islamic banking, interest is referred to as riba.
• Interest can be simple interest or compound interest. Under simple interest, only the amount borrowed
(i.e. the principal) earns interest. On the other hand, under compound interest, both the principal and
the interest earn interest.

Why is it important?
• Many financial decisions involve a trade-off between present and future consumption. People who save
money (i.e. defer current consumption) expects to earn something in order to afford their future
consumption. Interest is important because people use it in deciding whether to spend their money now
or save and enjoy a greater purchasing power later.

B. Time Value of Money

• The Time value of Money (TVM) states that “a peso received today is worth more than a peso to be
received tomorrow”.
• This core principle in Finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.
• Future value of peso = Present value of peso + interest
• Some of the basic supports for TVM are:
o Money received today has no risk of being not received at all.
o Money received today has higher purchasing power.
o The lender must be compensated for opportunity cost of lending his/her funds.

C. Simple Interest
• Simple interest is an interest computed on the amount the borrower received at the time the loan is
obtained and is added to that amount when the loan becomes due. Simply stated, only the principal
amount of the loan earns interest.
• Interest = Principal × Rate × Time
o Under exact simple interest method, if the time component is stated in days, the denominator
is 365 days.
o Under ordinary simple interest method, 360 days is used. This is also called the Banker’s Rule.

D. Bank Discount
• Under a bank discount arrangement, the interest is computed on the maturity value of the loan and is
deducted from that amount to determine the amount to be received by the borrower. The interest is
being deducted (discounted) in advance, making the amount payable at maturity of the loan equal to
the amount of the principal.
• Bank discount = Principal × Discount rate × Time
• Proceeds = Principal - bank discount
• Since the amount of cash received by the borrower (the proceeds) is less than the principal amount of
the loan, the effective interest rate for this type of loan is higher than the stated (or nominal) interest
rate.

E. Promissory Notes
 • “A promissory note is an unconditional promise in
writing made by one person to another, signed by the
maker, engaging to pay on demand, or at a fixed or
determinable future time, a sum certain in money to
order or to bearer.” (Negotiable Instruments Law)
• Date of the note – the date when the note was issued
• Maturity date – date when the maturity value is
become due
• Maturity value = principal + interest
• Date of discount – the date when the note has been discounted
• A note is said to have been discounted if it was converted into cash by the holder prior to its date of
maturity.
• Discount period – is counted from the date the note was discounted up to its maturity date

Problems:
1. Erwin invested ₱300,000 in a company that returns 8.50% simple interest every year. He invested the amount
for 5 years. How much did he earn? What is the value of the said investment after 5 years?

2. Rocky borrowed ₱480,000.00 from a bank that charges 5.6% simple interest every year. how much will rocky
pay after 8 months? 3 years? 4.5 years?

3. On May 5, 2018, Ray borrowed ₱575,000.00 at a simple interest rate of 6.15%. If Ray must pay on February
21, 2019, how much should he pay using the exact interest method? Under the ordinary simple interest
method?

4. Mirasol availed of a ₱245,000.00 loan at 14.00% discount rate for 9 months. Find the bank discount and
proceeds of the loan. Compute for the effective interest rate.

5. Megawide Company received a ₱150,000.00 simple interest note for 5 months at 12% simple interest from
one of its customers. After 3 months, Megawide needed cash so it discounted the note at a certain bank at a
discount rate of 14.00%. How much proceeds will Megawide received from the discounted note?

6. Megawide Company received a ₱350,000.00 bank discount note for 6 months from one of its customers.
After 3 months, Megawide needed cash so it discounted the note at a certain bank at a discount rate of
14.00%. How much proceeds will Megawide received from the discounted note?

7. On July 30, AJ borrowed ₱300,000 from Jonathan and another ₱300,000 from Jake. AJ paid on September
21. Jonathan is charging 4.50% exact simple interest while Jake is charging 4.30% ordinary simple interest.
Compute for the difference between the payments made for Jonathan and Jake.

8. Monty has a ₱500,000.00 cash deposited in his bank account. How long will it take for his money to earn
simple interest of ₱121,062.50 at 7.45%?

9. Bellamy is planning to buy, in cash, one 3-bedroom rest house and a Toyota Land Cruiser in 5 years. Luckily,
he was able to find an investment that pays 20% simple interest. If the Land Cruiser at that time will cost
₱5,000,000.00 and the rest house will cost to ₱3,500,000.00, how much should Bellamy invest today to be
able to buy the rest house and the car?

10. Abby obtained from the Bank of Commerce a ₱10,000,000.00 loan to finance her planned business
expansion. The bank gave her a 4% bank discount loan that is to mature in 5 years.
a. How much is the principal amount of the loan?
b. How much proceeds did Abby received?
c. What is the effective annual rate of the loan?

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 11. Raven received a 6-month, 12% promissory note dated March 29, 2018 amounting to ₱150,000.00 from one
of her customers. Due to some economic setbacks affecting her business, cash flow problems occurred, and
she was forced to discount the note to a local bank two months short of its maturity date. The bank discounted
the note at 16%. How much proceeds did Raven receive? Compute for Raven’s gain (loss) on discounting
the note.

Additional Problems with Answers:

1. Alison goes to the bank and borrows ₱150,000 at 9.50% for 250 days. If the bank uses the ordinary simple
interest method, how much interest will Alison have to pay? ₱9,895.83

2. Almira goes to a credit union and borrows ₱230,000 at 8% for 119 days on March 31, 2018.
a. If the credit union computes interest by the exact interest method, what is the amount of interest on the
loan? ₱5,998.90
b. If the interest is computed using the ordinary interest method, how much will Almira have to pay on
maturity? ₱236,082.22
c. When is the maturity date of the obligation? July 28, 2018

3. Alyssa obtained a loan on April 4 and had a due date of July 18. What is the number of days of the loan? 105
days

4. John Industries borrowed money at 9% interest for 125 days. If the interest charge was ₱5,600, use the
ordinary interest method to compute the amount of principal of the loan. ₱179,200.00

5. What is the rate of interest on a loan of ₱250,000 for 245 days, if the amount of interest is ₱19,600, using the
ordinary interest method? 11.52%

6. How many years will it take ₱50,000 invested at 8% simple interest to double in value? How long will it take
to double if the interest rate is increased by 12%? 12.5 years; 5 years

7. Angela signed a ₱200,000 bank discount note with the Planter’s Bank. The discount rate is 13% and the term
of the note is 11 months. What is the amount of the bank discount, and how much proceeds did Angela’s?
receive? ₱23,833.33; ₱176,166.67

8. Anne wants ₱5,000 in cash. She applied for a 90-day loan from a bank that charges 16% discount. What is
the amount of the loan that Anne must apply for? ₱5,208.33

9. What is the effective interest rate of a bank discount note for ₱400,000 at a bank discount rate of 11% for a
period of 9 months? 11.99%

10. Jim signed a ₱10,000 bank discount note at a bank discount rate of 13%. If the term of the note was 125
days, what was the effective annual rate of the note? 13.61%

11. The Lumber Company received a ₱350,000 promissory note at 10% simple interest for 6 months from a one
of its customers. After 4 months, the note was discounted at Westminster Bank at a discount rate of 14%.
How much did Lumber Company receive as proceeds from the discounted note? ₱358,925.00

12. Click Manufacturing received a ₱400,000 promissory note at 12% simple interest for 95 days. After 70 days,
Click discounted the note at the Far West Bank at a discount rate of 15%. The note was dated September
12.
a. When is the maturity date of the note? December 16
b. What is the maturity value of the note? ₱412,666.67
c. When was the noted discounted? November 21
d. How much proceeds did Click received after discounting the note? ₱408,368.06
e. How much is the gain (loss) on discounting? ₱965.27 loss

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