INTEREST RATE AND

TIME VALUE OF MONEY

 INTEREST
• Defined as the cost of borrowing money
• Compensation for the service and risk of
lending money
• Can be classified as simple interest or
compound interest
INTEREST RATE

• Is the cost of borrowing money or the price paid for the

rental funds; the ratio of interest to the amount lent.
• Interest rates have an impact on the overall health of the
economy because they affect consumers’ willingness to
spend, save, or make business investment decisions.
HOW INTEREST RATES HOW MUCH TO PAY(OR
ARE DETERMINED? EARN)IN INTEREST?
• Supply and Demand Factors include:
• Inflation • The interest rate
• Government - Monetary • The amount of the loan
Policy
• How long it takes to
• Types of loans repay
• Time/Period
TYPES OF INTEREST

• Fixed Interest Rate

• Variable Interest Rate
• Annual Percentage Rate
• Prime Interest Rate
• Discounted Interest Rate
• Simple Interest Rate
• Compound Interest Rate
FIXED INTEREST RATE LOAN VS. VARIABLE RATE LOANS
A fixed Interest Rate loan is a loan where the interest rate doesn’t
fluctuate during the fixed rate period of the loan. This allows the
borrower to accurately predict their future payments. Variable rate
loans, by contrast,are anchored to the prevailing discount rate.

VARIABLE INTEREST RATE

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.
APR –ANNUAL PERCENTAGE RATE
•APR is the true effective interest rate for a loan . It is the actual yield to
the lender.
• The APR is calculated using the stated interest rate, any prepaid
interest(points) or other lender fees.
 DISCOUNT RATE
SCOPE OF DISCOUNT RATE
Can be used in two ways:
• Interest Rate that the central banks charge commercial banks and other financial institutions.
• The rate that one uses in the discounted cash flow (DCF) analysis
USES FOR BANKS
• Commercial banks borrow money for short-term operating requirements from the central bank
• Funds are generally given for 24 hrs or less.
• The interest rate that the central bank charges on such loans is the discount rate.
USES
• It helps in calculation of the NPV
• For calculating the time value of money
• To calculate the opportunity cost for firm.
The discount rate generally comes in three tiers:
1. The first is the primary credit program
2. Second tier is the secondary credit program
3. The third tier is the seasonal credit program
SIMPLE INTEREST
Simple interest is interest charge on
borrowed amount or Interest in
invested amount for entire period.

COMPOUND INTEREST
Compound interest is interest calculated
on the amount that includes the principal
plus accumulated interest of the previous
period.
 PRIME RATE OF INTEREST
• This is the lowest interest rate that banks charge their most reliable business borrowers. It
changes based on supply and demand for short-term funds.
• Banks adjust the interest rates they charge other borrowers by adding a premium to the
prime rate to account for risk. For example, if the prime rate is 15%, a short-term loan might
have an interest rate of 17% or higher.

THREE TYPES OF INTEREST RATE

• Fixed Interest Rate- The interest rate remains constant regardless of changes to the prime
rate.
• Floating Interest Rate- The interest rate adjusts based on changes to the prime rate.
• Effective Interest Rate- This is the actual interest rate a borrower pays, calculated by
dividing the total interest paid by the amount received by the borrower. It equals the
stated rate if interest is paid at maturity. If interest is deducted upfront (discounted loan),
the effective rate is higher than the stated rate.
 Annual interest rate implicit in the relationship between the, net proceeds of a borrowing
and the dollar cost of that borrowing.
NOMINAL VS. EFFECTIVE INTEREST RATE
The nominal rate is the stated rate of interest for an asset or investment scenario. It does
not normally change throughout the period, which is usually computed on an annual basis.
The effective rate, on the other hand, is the computed rate resulting from compounding of
interest for a specific period usually annualized or converted into one year.

Example
Andy invested his money amounting to P30,000 pesos in a bank giving 4% interest
compounded semi-annually. What is the nominal rate? What is the effective rate?
The nominal rate is 4% or the stated interest rate. The effective rate is 4.049%. It is computed
as 1+4% divided by 2 (semi-annual interest), multiplied by the same amount, then the
resulting figure deducted by 1.
TIME VALUE OF MONEY (TVM)
The concept that a sum of money is worth more now than the same sum will be at a future
date due to its earnings potential in the interim.

Effects of the Time Value of Money on daily routine life:

• Spending: With the same amount of money today, we can buy more goods
than in what we can in future.
• Saving: Saving money today has value in future in terms of fulfilling our
future necessities.
• Borrowing: To enjoy the benefits of a car today, you borrow money and
repay it slowly in future.
• Investing: Investing money will result maximizing the value of our surplus
money.
MEANING AND EFFECTS
Time value of money is defined as a concept which states that purchasing power of money
differs with the passage of time.

REASONS FOR CONCEPT

• Uncertain Future: One can control its spending, but he has no control over his income or
the inflows.
• Inflation: Money received today is more useful than money received in future.
• Attached Interest Factor: Where certain amount is received and paid at the later date, the
values are different.

WHY IS TIME SUCH AN IMPORTANT ELEMENT IN YOUR

DECISION?
IMPORTANCE OF TIME VALUE OF MONEY

TIME value of money is the potential of money to increase in value over time.
TVM & PV of interest itself too.
•Financial Management – One should compare PV of benefits with the
opportunity cost for decision making.
•Capital Budgeting – While deciding for which investment to opt, one should
consider the PV of cash flow.
•Personal Finance Decisions – TVM is an important concept to be considered
before buying an insurance, renting property or buying one in future.

•Investing – TVM helps in considering inflation, risk and investments

opportunity before investing.
SIMPLE INTEREST
SIMPLE INTEREST is the simplest form of calculation of interest payable or
receivable on the money advanced in exchange for its use.
 USAGE OF SIMPLE INTEREST
• Simple Interest has very limited usage now a days. It may be used in auto-
loan or personal loan, but with a rule.
• Rule: If a borrower pays an installment, he pays the interest portion first,
and the balance is then deducted from the principal portion.

Simple Interest is very

general way of charging
interest. In actual, the
calculations are more
complex. Now a days,
COMPOUND INTEREST is
being used for interest
calculation, where
interest is calculation on
Principle + Interest.
SIMPLE INTEREST FORMULA
Formula
SI = P₀(i)(n) or SI = P × r × t
SIMPLE INTEREST (PV)
SIMPLE INTEREST VS. COMPOUND INTEREST
COMPOUND INTEREST
Compound Interest is the method of calculating interest on any given
amount assuming that the interest earned each period is added to the
principal. Hence, you receive not only interest on your principal amount
but also the added interest each year. In the finance industry, compound
interest is often referred by the word magic interest as it is considered one
of the most fundamental wealth building ways.

Why Does Compound Interest Matter?

• Compound interest - interest earned on money that was previously
earned as interest.
• Compound interest causes interest and account balances to grow.
• Good for savings and investments, but can work against you in paying
interest on a loan.
• Frequency, time, interest rate, deposits, and the starting amount all
make compound interest powerful.
 KEY WORDS

• Compounding Periods – the number of times your total amount has interest
calculated on it
• Annually: once a year
• Semi-Annually: twice a year (2)
• Quarterly: four times a year(4)
• Monthly: once per month (12)
• Bi –Weekly: once every two weeks(26)
• Weekly: once a week (52)
• Daily: once a day(365)
THANKYOU!

Prepared by:
Arrago, Joy V.
Banate,Kristoff Sean