Interest - the cost of holding money.

It is the amount charged by the lenders to the borrowers/

users of money, and is usually paid at regular intervals.

Simple Interest – the charging interest rate r based on a principal P over T number of years.
Interest = P x r x T
Principal = PHP500,000
Rate = 8%
Time = 5 years

Thus,
Interest = 500,000 x .08 x 5 = PHP200,000
Compound Interest - the interest in the first compounding period is added on the principal,
which will then be the basis for the interest to be computed for the next period. The formula
below shows the summary of the effects of adding on the interest, where m is the compounding
frequency.
Interest = ( P x (1 + r/m) (T x m) ) - P

Principal = PHP500,000
Rate = 8%
Time = 5 years
Compounding frequency = annually

Thus,
Interest = 500,000 x (1 + (0.08/1))(5x1) – 500,000 = PHP234,664.04
Effective Annual Rate (EAR)
The effective annual rate allows this comparison because it is the actual interest actually
paid or earned. It should be distinguished from the nominal rate, or the stated contractual rate
which is the interest charged by a lender or promised by a borrower.

The formula for computing the EAR is as follows:

EAR = ( 1 + ) m ) - 1

This is very similar to the formula for computing for interest earned using compounded
interest. The only difference is that EAR only takes into consideration the actual interest for one
year.

Mr. Lopez wishes to find the effective annual rate for his loan in BOD bank with a 5%
nominal annual rate when interest is compounded (1) annually, (2) semi-annually, and (3)
quarterly.
• For annual compounding: 5%
• For semiannual compounding: 5.06%
• For quarterly compounding: 5.09%
• For monthly compounding: 5.12%
• For daily compounding: 5.13%
Differentiate future value and present value.
 Future Value - the amount to which an investment will grow after earning interest. It is
the principal plus total interest earned over a stated period. So the future value of an
investment of PHP500,000.00 yielding an interest of 8% for a 5-year period compounded
annually is PHP734,664.04.
• Present Value - the amount you have to invest today if you want to have a certain
amount of cash flow in the future.
Differentiate the basic patterns of cash flow
 Single Amount (Lump Sum) - a single cash outflow is made and the total receipts will be
at a single future date.
• Annuity - periodic stream of equal cash flow at equal time intervals (annually, monthly,
etc.). For example, payment for a certain item shall be for 12 equal monthly instalments of
PHP1,000.
• Mixed Stream - unequal periodic cash flows that reflect no particular pattern. For
example, payments made by a customer are in 3 unequal instalments.

TIME AMOUNT
Year 1 1,500
Year 2 3,000
Year 3 2,500
Discuss the present value of a single amount.
Present Value - answers the question: How much must be invested today to produce a certain
amount in the future. Since future value is calculated by multiplying the present investment by
1 + interest rate compounded by the number of periods, we shall just reverse the process. This
method is called discounting
FV = PV x (1 + r) T

PV = FV/(1 + r) T

Illustration: You need P25,000.00 to buy a laptop when you enter into college 2 years from now.
How much must you invest now if the interest rate is at 6% per annum?
PV = 25,000/(1.062) = PHP22,249.91

You need to invest PHP22,249.91 to have PHP25,000.00 by the end of 2 years.

Illustrate how to calculate future value and present value of mixed streams of cash flows.
1. Future Value: Suppose that you choose to put your savings annually in MRI bank at 8% per
annum. For today, you put PHP1,200, on the second year PHP1,400, and PHP1,000 for the
third year. How much will you have available at the end of three years?

Factor multiplied by the Amount Deposited Future Value

(1.08)3 = 1.2597 PHP1,200 1,511.65
(1.08)2 = 1.1664 PHP1,400 1,632.96
(1.08)1 = 1.08 PHP1,000 1,080.00
Total FV P4,224.61

2. (Present Value) Suppose that you can buy a phone for PHP8,000 down payment with 4,000
for each of the next two years or pay PHP15,500 cash today. Given an interest rate of 8%,
which is a cheaper alternative?
Present Value
PHP8,000 8,000.00
PHP4,000/(1.081) 3,703.70
PHP4,000/(1.082) 3,429.36
Total PV PHP15,133.06
Discuss how to compute for present value and future value of annuity payments. Illustrate
how the present and future values are used.
An annuity is a stream of equal periodic cash flows over a specified period. First, you have
to distinguish between ordinary annuity and annuity due. Ordinary annuity payments are
made at the end of each period (usually annually), while for annuity due, the cash flow occurs
at the beginning of each period. We shall first illustrate ordinary annuities.
(Future Value of an Ordinary Annuity) The formula for computing the future value of an
ordinary annuity is as follows:

Cash flow x {[(1+r)t - 1)]/r}

Illustration: Mr. Mendoza wishes to determine how much the value of his savings in 5 years will
be if he will put PHP1,000 per year in a bank which provides 7% interest per annum.
FV = 1,000 x (FVA factor: 5.7507 period=5, rate=7%) = PHP5,750.70

(Present of an Ordinary Annuity) The formula for computing the present value of an
ordinary annuity is as follows:

Cash flow x {1 – [1/(1+r)t ]}/r

Illustration: Mr. Yusoph wants to buy a pair of shoes worth PHP10,500. He has the option
of paying it today for PHP10,500 or buying them in instalment where he has to pay a down
payment of PHP4,000 today, and the balance will be paid in two equal payments of PHP4,000
each for the next two years. Given an interest rate of 10%, which is the better option?

PV = 4,000 + 4000 x (PVA factor: 1.7355 period=2, rate=10%) = PHP10,932.00 for buying
on instalment vs. PV PHP10,500 for buying today.

The 4,000 down payment is not multiplied by the annuity factor because it is paid today.
Since buying on instalment would be more expensive, Mr. Yusoph should buy the pair of shoes
today.

1. You deposited PHP1,500 in a bank with an interest rate of 5% for 1 year. What is the future
value of your deposit?
Answer Key
FV = 1,500 x (1+0.05) = 1,575

2. You need to save up for P1,500 in 1 year. How much should you save now if the bank offers a
rate of 5%? (Find the present value)
Answer Key
PV = 1,500/(1+0.05) = 1,428.57

3. FNB pays 6% interest compounded semi-annually. SNB pays 6% compounded monthly.

Which bank offers the higher effective annual rate?
Answer Key
FNB = (1+(0.06/2))2 - 1 = 6.090%
SNB = (1+(0.06/12))12 = 6.168%
Therefore, SNB offers the higher effective annual rate. For equal rates, the
more compounding the better.

4. Compute the present value and future value of PHP100 cash flow for the following
combination of discount rates and times:
a. r = 8%, t = 5 years
b. r = 8%, t = 10years
c. r = 5%, t = 5years
d. r = 5%, t = 10 years
 Answer Key
r t PV FV
0.08 5 68.05832 146.9328
0.08 10 46.31935 215.8925
0.05 5 78.35262 127.6282
0.05 10 61.39133 162.8895

5. You deposit PHP1,000 in your bank account. If the bank pays 4% simple interest, how much
interest will you accumulate in your account after 10 years? What if the bank pays compound
interest?
Answer Key
Simple Interest = 1000 x .04 x 10 = 400
Compound Interest = 1000 x (1.0410) – 1000 = 480.24

6. Mario will be making a lump sum payment of PHP1.6 million on the condominium he is
buying two years from now. If he wants to set aside funds from now and invest it that will earn
interest of 3%, net of taxes every year and this amount is compounded annually, how much
does he need to invest today? What if the interest is compounded semi-annually, how much
does he need to invest today?
Answer Key
• PHP1,600,000/(1.03)2 = 1,508,153.45
• PHP1,600,000/(1.015)4 = 1,507,494.77

7. What is the present value of the following cash flow stream if the interest is 6%?
Year Cash Flow
1 300
2 400
3 500

Answer Key
PV = 300/1.06 + 400/(1.062) + 500/(1.063) = 1,059.827

8. What is the present value of a 3-year annuity of PHP100 if the discount rate is 6%?
Answer Key
PVA = 100 x PVA factor (2.673) = 267.3

9. What is the present value of a 5-year annuity payment of PHP1,000 with a discount rate of
5% if the first payment will be made today?
Answer Key
PVA = (1000 x PVA factor (4.329))/1.05 = 4,122.87