LESSON 5

INTEREST RATE AND TIME VALUE OF MONEY

Interest DISCOUNT RATES

• Defined as the cost of borrowing money
• Compensation for the service and risk of lending money SCOPE OF DISCOUNT RATE
Can be used in two ways:
• Can be classified as simple interest or compound interest
• Interest rate that the central banks charge commercial
Interest Rate banks and other financial institutions.
• is the cost of borrowing money or the price paid for the • The rate that one uses in the discounted cash flow (DCF)
rental funds; the ratio of interest to the amount lent. analysis
• Interest rates have an impact on the overall health of the
USES FOR BANKS
economy because they affect consumers’ willingness to
spend, save, or make business investment decisions. • Commercial banks borrow money for short-term
operating requirements from the central bank
• Ex. Suppose that a $100 is lent and, at the end of the year,
and $110 must be paid back. The interest paid is $10 and • Funds are generally given for 24 hrs or less.
the interest rate is 10% (10÷100-0.10) • The interest rate that the central bank charges on such
loans is the discount rate.
How interest rates are determined?
• Supply and Demand USES
• Inflation • It helps in calculation of the NPV
• Government –Monetary Policy • For calculating the time value of money
• Types of loans • To calculate the opportunity cost for firm.
• Time/ Period • Determine the riskiness of an investment.
• Compare different investments
How Much to Pay (or Earn) in Interest? • Compare future worth of an investment
Factors include: • Calculation of the amount that one must invest now to
• The interest rate meet future investment goal.
• The amount of the loan
• How long it takes to repay The discount rate generally comes in three tiers:
1. The first is the primary credit program
Types of Interest 2. Second tier is the secondary credit program
• Fixed Interest Rate 3. The third tier is the seasonal credit program
• Variable Interest Rate
SIMPLE INTEREST
• Annual Percentage Rate
• Prime Interest Rate Simple interest is interest charged on borrowed amount or
• Discounted Interest Rate interest on invested amount for entire period (it does not include
• Simple Interest Rate interest on interest)
• Compound Interest Rate
Formula: Simple Interest = (P x I x T)/100
Fixed Interest Rate Loan VS. Variable Rate Loans Where; P = Principle Amount, I = Interest Rate; T = Time Period

A fixed interest rate loan is a loan where the interest rate Example: A person borrows $ 12,500 from a lender for three
doesn't fluctuate during the fixed rate period of the loan. This allows years at a rate of 10%.
the borrower to accurately predict their future payments. Variable
rate loans, by contrast, are anchored to the prevailing discount rate. The simple interest calculation will be as below:
Simple Interest = (12,500 x 10 x 3) / 100
Variable Interest Rate = $3,750

A variable interest rate is the opposite of a fixed interest

rate. The interest rate fluctuates with time. It is linked to the
movement of the base level of interest rate-prime rate. COMPOUND INTEREST

APR - Annual Percentage Rate Compounded interest is interest calculated on the amount
that includes the principal plus accumulated interest of the previous
• APR is the true or effective interest rate for a loan. It is the period.
actual yield to the lender.
• The APR is calculated using the stated interest rate, any Formula: Compound Interest = P [(1+i) t -1]
prepaid interest (points) or other lender fees. Where; P = Principle Amount, I = Interest Rate, T= Time Period

APR monthly or daily Example: A person borrows $50,000 loan from Nainital Bank at
a rate of 10% for 5 years compounded yearly.
APR = 10%
Monthly: 10% ÷ 12 = 0.83% Principal = $50,000; i = 0.10; t = 5 years.
Daily: 10% ÷ 365= 0.02%
So, compound interest will be:
CI= $50,000[(1+0.10)5-1] = $30,525.5
 Prime Rate of Interest Nominal vs. Effective Interest Rate

This refers to the lowest rate charged by banks to their The nominal rate is the stated rate of interest for an asset
most important and reliable business borrowers. It fluctuates based or investment scenario. It does not normally change throughout the
on the supply- and demand relationships for short term funds. period, which is usually computed on an annual basic. The effective
rate, on the other hand, is the computed rate resulting from
The interest rate charged by banks to their other borrowers compounding of interest for a specific period usually annualized or
is adjusted for the risks involved so that a certain percentage of converted into one year.
premium is added to the prime interest rate. Thus, if the prime
interest rate were 15%, the interest rate of short-term loans may be Example
17% or higher Andy invested his money amounting to ₱30,000 pesos in
a bank giving 4% interest compounded semi-annually. What is the
Fixed interest rate loan nominal rate? What is the effective rate?
This means that the regardless of changes in the prime The nominal rate is 4% or the stated interest rate. The
interest rate, the rate stated on a promissory note is to be observed. effective rate is 4.049%. It is computed as 1+4% divided by 2 (semi-
Thus, if a promissory note states that interest is at 16%, it should be annual interest), multiplied by the same amount, then the resulting
observed regardless of whether the prime interest rate goes up or figure deducted by 1.
down.

Floating Interest Rate

This means that the interest rate is subject to adjustment

depending on the changes in the prime interest rate. If the prime
interest rate is 15% and a 2% premium has been added, an upward
change in the former to 18% implies that the interest to be charged
on loans must be 20%.
Time Value of Money (TVM)
Effective Interest Rate
The concept that a sum of money is worth more now than
This is the rate of interest that a borrower is actually the same sum will be at a future date due to its earnings potential in
charged and is computed by dividing the amount of interest by the the interim.
amount received by the borrower. When interest is payable on
maturity date, effective interest rate is equal to the stated (or Effects of the Time Value of Money on daily routine life:
nominal) rate. When interest is deducted in advance (or the loan is • Spending: With the same amount of money today, we can
discounted), effective rate is higher than the stated interest rate. buy more goods than in what we can in future.
• Saving: Saving money today has value in future in terms
Annual interest rate implicit in the relationship between of fulfilling our future necessities.
the net proceeds of a borrowing and the dollar cost of that
• Borrowing: To enjoy the benefits of a car today, you
borrowing.
borrow money and repay it slowly in future.
Calculation: Net cost of borrowing (interest paid) / Net proceeds • Investing: Investing money will result maximizing the
value of our surplus money.
Net proceeds received may be less than amount borrowed due to:
• Discounting-interest deducted in advance MEANING AND EFFECTS
• Compensating balance requirement Time value of money is defined as a concept which states
that purchasing power of money differs with the passage of time.
Example: $2,000, 2 yr note discounted @ 6%
Discounted = Interest deducted in advance REASONS FOR CONCEPT
Simple Interest = $2,000 x .06 x 2 = $240 • Uncertain Future: One can control its spending, but he
Net proceeds = $2,000 – 240 = $1,760 has no control over his income or the inflows.
Effective interest = ($240/$1,760)/2yrs = 13.64/2 = 6.82% • Inflation: Money received today is more useful than
Effective Interest Rate = 6.82% money received in future.
• Attached Interest Factor: Where certain amount is
Stated Interest Rate received and paid at the later date, the values are different.
It referred to as nominal interest rate. The annual rate of Why is TIME such an important element in your decision?
interest specified stated in a contract.
TIME allows you the opportunity to postpone
Examples are: consumption and earn INTEREST.
• Rate per loan agreement
• Bond coupon rate IMPORTANCE OF TIME VALUE OF MONEY

It does not take into account compounding effects of TIME VALUE of MONEY basically defines that the
frequency of payments. value of a dollar is more now than what it will be in future.

Assume: • TVM & Compounding – TVM helps in calculating the

Semi-annual interest PV of interest earned on investment as well as on interest
• Stated rate = 6% itself too.
• Effective rate > 6% due to frequency of payments (one- • Financial Management – One should compare PV of
half of the interest is paid before end of year. benefits with the opportunity cost for decision making.
• Stated rate still 6%
 • Capital Budgeting – While deciding for which Simple Interest Formula
investment to opt, one should consider the PV of cash
flow. Formula
• Personal Finance Decisions – TVM is an important SI = P0 (i)(n) or SI= P x r x t
concept to be considered before buying an insurance,
renting property or buying one in future. SI: Simple Interest
• Investing – TVM helps in considering inflation, risk and
investments opportunity before investing. P0: Deposit today (t=0)

SIMPLE INTEREST i: Interest Rate per Period

SIMPLE INTEREST is the simplest form of calculation of n: Number of Time Periods

interest payable or receivable on the money advanced in exchange
Example
for its use.
Assume that you deposit $1,000 in an account earning 7%
CALCULATION
simple interest for 2 years. What is the accumulated interest at the
Principal x Rate x Time Period end of the 2nd year?

• Principle Amount is basis for calculation of Simple SI = P0(i)(n)

Interest. = $1,000(.07)(2)
= $140
• Rate of Interest should be in Rate/100 format
(percentage). Simple Interest (PV)
• Time period should be in the ‘Year' Format
Present Value is the current value of a future amount of
EXAMPLE money, or a series of payments, evaluated at a given interest rate.

Deposit amount USD 1000 for 5 years at 10% per annum What is the Present Value (PV) of the previous problem?
• The Present Value is simply the $1,000 you originally
deposited. That is the value today!
Simple Interest =1000 x 10/100 x 5 = USD 500
Simple Interest (FV)

If Time period would have been 3 months, then Int. Future Value is the value at some future time of a present
= 1000 x 10% x 3/12 = USD 25 amount of money, or a series of payments, evaluated at a given
interest rate.

USAGE OF SIMPLE INTEREST What is the Future Value (FV) of the deposit?
• Simple Interest has very limited usage now a days. It may FV = P0 + SI
be used in auto-loan or personal loan, but with a rule. = $1,000 + $140
• Rule: If a borrower pays an instalment, he pays the interest = $1,140
portion first, and the balance is then deducted from the
Determining Simple Interest
principal portion.
Example #1
Simple Interest is very general way of charging interest. In
Find the interest amount on $3,000 at 8% interest for one
actual, the calculations are more complex. Now a days,
year.
COMPOUND INTEREST is being used for interest calculation,
where interest is calculation on Principle + Interest. • Step 1: Interest = principal × rate × time
• Step 2: Interest = 3,000 x .08 × 1
How To Calculate Simple Interest
(Convert 8% to decimal form (.08) for formula.)
Simple interest = principal x rate x time • Step 3: Interest = $240 paid for the use of $3,000 for
one year.
Example: You invest $100 dollars at a 5% annual rate for one year:
100 X .05 X 1 = $5 simple interest for one year Example #2
Find the future value of $5,000 invested at 6% for three
• While interest is the fee paid on an amount of money, years using simple interest.
simple interest is a specific type of interest calculation
that does not account for compounding. • Step 1: Interest earned = principal • rate •
• When borrowing money, you repay the amount borrowed • Step 2: Interest earned = 5,000 • .06 • 3=$900
and make additional payments for interest (Convert 6% to form (.06) for formula.)
• When lending money, you set a rate and earn interest • Step 3: Future value = interest earned + principal
income on what you loan FV = $900+ $5,000
• When depositing money, interest-bearing accounts pay FV = $
interest income because money is being made available for
Example #3
the bank to then lend to others
A savings account is set up so that the simple interest
• The simple interest calculation provides a basic, general
earned on the investment is moved into a separate account at the end
way of understanding interest.
of each year. If an investment of P5,000 is invested at 4.5%, what
is the total simple interest accumulated in the checking account after
2 years.
 • Interest paid by bank is unknown • Now, since the money is being withdrawn, add the interest
• Rate changed to decimal to the principal.
• Time is 2 years
I = PRT
• Solve
I = (2400) (.045) (2/12)
I = $18
Simple interest= Principal x Rate x Time
$18 + $2400 = $2418
I = PRT
$2418 will be withdrawn
= (5,000) (.045) (2)
Simple Interest vs. Compound Interest
= P450
Calculated by using only the Based on the principal balance
principal balance of the loan plus any outstanding interest
each period. already accrued
Example #4 Fixed percentage of principal Interest compounds over time
When invested at an annual interest rate of 6% an account amount borrowed
earned P180.00 of simple interest in one year. How much money Principal is the same every Amount at the end of one year
was originally invested in account? year is the principal for the next
• Interest paid by bank is given year
• Principal is unknown Factor in business transactions, Apply to open-ended
• Rate changed to decimal investments, and financial situations, such as credit card
• Time is 1 year products extending multiple balance
periods or years
• Solve
Consider this example:
I = PRT You begin with $100 invested at 10% annual interest.

180 = P (.06) (1)

180 = .06 P
.06 .06

3,000 = P

Example #5
A savings account is set up so that the simple interest
earned on the investment is moved into a separate account at the end
of each year. If an investment of $7,000 accumulate $910 of interest
in the account after 2 years, what was the annual simple interest rate
on the savings account?
• Interest paid by bank
• Principle (invested)
• Rate is unknown COMPOUND INTEREST
• Time is 2 years
• Solve Compound interest is the method of calculating interest
• Change to % any given amount assuming that the interest earned each period is
added to the principal. Hence, you receive not only interest on your
I = PRT principal amount but also the added interest each year. In the finance
industry, compound interest is often referred by the word magic
910 = (7,000) (R) (2) interest as it is considered one of the most fundamental wealth
910 = (7,000) (2)R building ways.
910 = 14,000 R Why Does Compound Interest Matter?
14,000 14,000
• Compound interest = interest earned on money that was
0.065 = R previously earned as interest.
6.5% = R • Compound interest causes interest and account balances to
grow.
Example #6 • Good for savings and investments, but can work against
An investment earns 4.5% simple interest in one year. If you in paying interest on a loan.
the money is withdrawn before the year is up, the interest is prorated • Frequency, time, interest rate, deposits, and the starting
so that a proportional amount of the interest is paid out. If $2400 is amount all make compound interest powerful.
invested, what is the total amount that can be withdrawn when the
account is closed out after 2 months? Key Words
• Interest paid by bank - Unknown
• Rate is .045 • Compounding Periods - the number of times your total
• Time is 2 months (divide by 12) amount has interest calculated on it
• Solve • Annually: once a year
• Semi-Annually: twice a year (2)
 • Quarterly: four times a year (4) Example #2
• Monthly: once per month (12) P250 invested at 6.5% for 8 years compounded monthly.
• Bi-Weekly: once every two weeks (26)
Given:
• Weekly: once a week (52)
PV = 250
• Daily: once a day (365)
i = 0.00541666667
The Time Value of Money i = .0650/12 mos.
n = 96
“The greatest mathematical discovery of all time is n = 8*12
compound interest.” - Albert Einstein
Solution:
Present Value FV = PV (1+i)n
FV = 250 (1.0054)96
Today's value of a lump sum received at a future point in time: FV = 419.25

Seatwork #1
P500 invested at 12% for 10 years compounded annually.

Given:
PV = 500
i = 12%
Converting
n = 10 years
Change % to decimal
(Move 2 places to left & drop % sign) Formula: FV=PV( 1+i)n
Solution:
(1) 12% → .12 FV = 500(1.12)10
(2) 5% → .05 FV = 1,552.93
(3) 2½% → .025
(4) 8.5% → .085
Seatwork #2
Change from decimal to % P1,000 at 7.25% for 9 years compounded monthly.
(Move 2 places to right & add % sign) Compute for the FV?
(1) .098 → 9.8%
(2) .455 → 45.5% Solution:
FV = PV (1+i)n
COMPOUND INTEREST FORMULA FV =1000(1.006041666)108
FV = 1,916.57
Calculate compound interest using this formula:

Seatwork # 3:
Mr. B Deposit P1,000,000 to BDO with compound
interest of 5% per annum? Compute for the FV for five years?

Given:
PV = 1,000,000.
i=5%
n = 5 years
A = Total amount
FV= ?
p = principal
r = interest rate
Solution:
n = number of compounding periods
FV= PV( 1+i)n
t = time in years
FV= 1,000,000.00 (1.05)5
Determining Compound Interest FV= 1,276,281.56

Example #1 Seatwork #4:

P100 is invested at 10% interest compounded yearly for 6 Mr. B Deposit P 1,000,000 to BDO with 5% interest rate
years compounded semi-annually for five years?

Given: Given: Conversion of Time

PV = 100 PV = 1 Million m = n*m
I = 10% i=5% m = 5 *2
N = 6 years n = 5 years n = 10
Formula: FV = PV (1+i)n FV = ?
Solution: FV =100(1.10)6 Solution:
FV = 177.16 Conversion of interest FV= PV( 1+i)n
M = i/m FV= 1,000,000.00(1.025)10
M = .05/2 FV= 1,280,084.54
i = .025
Seatwork #5: n = 60
Mr. B Deposit P 800,000 to BDO with 12 % interest rate
compounded Quarterly for four years? Solution:
FV = PV( 1+i)n
Given: FV = 1,000,000.00(1.0042)60
PV = 800,000 FV= 1,285,917.25
i = 12 %
n = 4 years Example: (Present Value)
FV = ? If Mr. A would like to receive P 1,000,000.00 after 5 years
with 8 % compound interest per Annum. How much he need to
Conversion of interest Deposit today?
M = i/m
M = .12/4 Given:
i = .03 FV = 1Million
i = 8%
Conversion of Time n = 5 Years
m = n*m PV = ?
m = 4 *4
n = 16 Solution:
PV= FV/( 1+ i)5
Solution: PV= 1,000,000 /(1.08)5
FV= PV( 1+i)n PV= 680,583.20
FV= 800,000(1.03)16
FV= 1,283,765.15 To Check using FV Formula
FV = 680,583.20(1.08)5
Seatwork #6: FV= 1,000,000/999,999.99
Mr. B Deposit P1,000,000.00 to BDO with 5 % interest
rate compounded Quarterly for five years ? CONCLUSION
• By all the above discussion we get to know about the value
Given: of money with respect to time.
PV = 1 Million • We learn the importance of TVM how it will help in
i=5% making different decision which will provide profit to
n = 5 years firm.
FV = ? • We get to know how future value and present value of
money is calculated.
Conversion of interest • What are different techniques and methods for calculating
M = i/m TVM.
M =.05/4
i = .0125

Conversion of Time
m = n*m
m = 5 *4
n = 20

Solution:
FV = PV( 1+i)n
FV = 1,000,000.00(1.0125)20
FV= 1,282,037.23

Seatwork # 7:
Mr. B Deposit P1,000,000.00 to BDO with 5 % interest
rate compounded Monthly for five years? Compute for the Future
Value?

Given:
PV = 1 Million
i=5%
n = 5 years
FV = ?

Conversion of interest
M = i/m
M =.05/12
i = .0042

Conversion of Time
m = n*m
m = 5 * 12