ECE 201 Unit 2 Money Time Relationship and Equivalence - Part1

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UNIT

MONEY-TIME RELATIONSHIPS AND


2 EQUIVALENCE

LESSONS COVERED

2.1. Cash flows


2.2. The concept of equivalence
2.3. Interest and the Time Value of Money
2.3.1. Simple Interest
2.3.2. Compound Interest
2.3.3. Annuity
2.3.4. Arithmetic and Geometric Gradients

DURATION

12 hours

INTRODUCTION

In this unit, types of cash flow will be presented and diagramming using
different perspective will be taught step by step.

The economic equivalence which is a combination of interest rate and time


value of money to determine the different amounts of money at different points in
time will be shown that they are equal in economic value. This will be illustrated
using simple and compound interest, as well as annuity and gradients which are
under the compound interest.

OBJECTIVES / COMPETENCIES

At the end of the lesson, the students should be able to:

1. Describe and calculate economic equivalence.

2. Draw the cash flow diagram of a certain problem.

3. Understand and work problems that account for the time value of money,
cash flows occurring at different times with different amounts, and
equivalence at different interest rates.

Unit 2: Money-Time Relationships and Equivalence 20


PRETEST

Assume that you wanted to buy a mobile phone which unit is iPhone11 Pro with
128GB memory. Between the three shops below, which instalment plan will you
choose? What is or are your basis and considerations in choosing the instalment
plan?

iPhone11 pro 128 GB memory


Instalment for Instalment for 24
SHOP SRP Data Plan
12 months months
SHOP A 51,990 N/A 2275 N/A
SHOP B 51,990 4420 2253 N/A
2350 599 (2GB data)
2300 799 (3GB data)
2100 999 (5GB data)
2050 1299 (8GB data)
1499 (10GB
2000
data)
SHOP C 1799 (15GB
N/A N/A 1650
(postpaid) data)
1999 (16GB
1600
data)
2499 (21GB
1300
data)
2999 (31GB
1250
data)

Discuss your answer here.


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Unit 2: Money-Time Relationships and Equivalence 21


LESSON 2.1. CASH FLOWS

 Typical Cash Outflows and Inflows

Cash Inflow Estimates


 Income: P150,000 per year from sales of solar-powered watches
 Savings: P24,500 tax savings from capital loss on equipment salvage
 Savings: P150,000 per year saved by installing more efficient air
conditioning
 Receipt: P750,000 received on large business loan plus accrued interest
 Revenue: P50,000 to P75,000 per month in sales for extended
battery life iPhones

Cash Outflow Estimates


 Operating costs: P230,000 per year annual operating costs for
software services
 First cost: P800,000 next year to purchase replacement
earth moving equipment
 Expense: P20,000 per year for loan interest payment to bank
 Initial cost: P1 to P1.2 million in capital expenditures for a water
recycling unit

Unit 2: Money-Time Relationships and Equivalence 22


 Cash Flow Types

 Cash Flow Diagramming

Illustration #1

Draw a cash-flow diagram for the five-year life of the project using the
corporation’s viewpoint.

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 P10,000 can be made that will produce uniform annual
revenue of P5,310 for five years and then have a market (recovery) value of
P2,000 at the end of year (EOY) five. Annual expenses will be P3,000 at the end
of each year for operating and maintaining the project.

Cash Flow Diagram:

 Cash Inflows:
Annual revenue = P5,310 for five years
Market (recovery) value = P2,000 at the end of year (EOY) five

 Cash Outflows:
Investment = P10,000
Annual expenses = P3,000

Unit 2: Money-Time Relationships and Equivalence 23


LESSON 2.2. THE CONCEPT OF EQUIVALENCE

 Economic equivalence is a combination of interest rate and time value of money


to determine the different amounts of money at different points in time that are
equal in economic value.
 Alternatives should be compared when they produce similar results, serve the
same purpose, or accomplish the same function.
 How can alternatives for providing the same service or accomplishing the same
function be compared when interest is involved over extended periods of time?

Consider the comparison of alternative options, or proposals, by reducing them to


an equivalent basis that is dependent on
1. the interest rate,
2. the amounts of money involved,
3. the timing of the monetary receipts or expenses.

Illustration #2:

Suppose you have a P 17,000 balance on your credit card. You decide to
repay the P 17,000 debt in four months. An unpaid credit card balance at the
beginning of a month will be charged interest at the rate of 1% by your credit card
company.

For this situation, we have selected three plans to repay the P17,000 principal
plus interest owed.

Analysis:

Whichever plan you chose to pay your credit card balance, it is still equivalent
to the principal value that you owed, in this case, P 17,000.

Unit 2: Money-Time Relationships and Equivalence 24


LESSON 2.3. INTEREST AND THE TIME VALUE OF MONEY

 Interest
 Money is invested or borrowed in thousands of transactions every day.
 When an investment is cashed in or when borrowed money is repaid, there is
a fee that is collected or charged. This fee is called interest.

In any financial transaction, there are two parties involved:


 an investor, who is lending money to someone
 and a debtor, who is borrowing money from the investor

 For the debtor, interest is the payment for the use of the borrowed capital
while for the investor; it is the income from invested capital.

 Time Value of Money


 It is recognized that a dollar today is worth more than a dollar one or more
years from now because of the interest (or profit) it can earn.
 Money has a time value, and if money remains uninvested (like in a large
bottle), value is lost.
 Money changes in value not only because of interest rates; inflation (or
deflation) and currency exchange rates also cause money to change in value.

LESSON 2.3.1. SIMPLE INTEREST

Simple Interest (I) is defined as the interest on a loan or principal that is based
only on the original amount of the loan or principal.

When the time is given in days, there are two different varieties of simple
interest in use:

Unit 2: Money-Time Relationships and Equivalence 25


 The general practice in Canada is to use exact interest
 The general practice in the United States and in international business
transactions is to use ordinary interest (also referred to as the Banker’s
Rule).

Note:
When simple interest (ordinary or exact) is not specified in the problem, it is
assumed to be ordinary.

Example Problem #1

If the rate of interest is 14 %, determine the ordinary simple interest on


P50,000 for 7 months and 10 days.

Solution:

Example Problem #2

Solve for the ordinary and exact simple interest on P 25,000 for the period
from April 14 to November 7, 2017. The rate of interest is 11%.

Solution:

Analysis:

Notice that ordinary interest is always greater than the exact interest and thus it
brings increased revenue to the lender.

Unit 2: Money-Time Relationships and Equivalence 26


Example Problem #3

A loan shark made a loan of P100 to be repaid with P120 at the end of one
month. What was the annual interest rate?

Solution:

Example Problem #4

How long will it take P3000 to earn P60 interest at 6%?

Solution:

Example Problem #5

A businessman borrowed P 175,000 from a lending firm at 10% simple


interest. He received the borrowed money less the interest, but at the end of 1 year,
he obliged to pay back P 175,000. What is the actual rate of the interest?

Solution:

Example Problem #6

What is the future worth of P 31,000 invested at 13% simple interest for 30
months?

Solution:

Unit 2: Money-Time Relationships and Equivalence 27


Example Problem #7

If the amount of interest is P17,000 after 3.5 years and the rate of simple
interest is 9%, what is the principal amount?

Solution:

Example Problem #8

A deposit of P1500 is made into a fund on March 18. The fund earns simple
interest at 5%. On August 5, the interest rate changes to 4.5%. How much is in the
fund on October 23?

Solution:

Try This!

ACTIVITY 1

Try to solve these simple interest problems.

1. A loan of P15 000 is taken out. If the interest rate on the loan is 7%, how much
interest is due and what is the amount repaid if
a) The loan is due in seven months;
b) The loan was taken out on April 7 and is due in seven months?

2. Determine the exact and ordinary simple interest on a 90-day loan of P8000 at
8.5%.

Your Solutions:

Unit 2: Money-Time Relationships and Equivalence 28


 Demand Loan

 On a demand loan, the lender may demand full or partial payment of the loan
at any time and the borrower may repay all of the loan or any part at any time
without notice and without interest penalty.
 Interest on demand loans is based on the unpaid balance and is usually
payable monthly.
 The interest rate on demand loans is not usually fixed but fluctuates with
market conditions.

Example Problem #9

Interest on the loan, calculated on the unpaid balance, is charged to her


account on the 1st of each month.
The rate of interest on the loan per annum
August 16 12%
September 25 11.5%
November 20 12.5%.

Calculate the interest payments required and the total interest paid.

Unit 2: Money-Time Relationships and Equivalence 29


Try This!

ACTIVITY 2

Solution:

RATE OF # OF
BALANCE INTEREST
INTEREST DAYS
AUG 17 - SEPT 1

SEPT 2 - SEPT 17

SEPT 18 - SEPT 25

SEPT 26 - OCT 1

OCT 2 - OCT 7

OCT 8 - NOV 1

NOV 2 - NOV 12

NOV 13 - NOV 20

NOV 21 - DEC 1

DEC 2 - DEC 15

Unit 2: Money-Time Relationships and Equivalence 30


POST-TEST 1

Simple Interest

1. Your friend made an investment of P 45,000 for 2 months at 15% simple interest.
If withholding tax is 20%, what is the net interest that he will receive at the end of
2 months? ANS. P900

2. Determine the exact simple interest on P5, 000 for the period from Jan.15 to
Nov.28, 2020, if the rate of interest is 22%. ANS. 955.74

3. A company that manufactures general-purpose transducers invested P2 million 4


years ago in high-yield junk bonds. If the bonds are now worth P2.8 million, what
rate of return per year did the company make on the basis of simple interest.
ANS. 10% per year

4. Mr. Mañalac invested P 100,000 to a certain business which earns P 10,000


every 2 months for 10 years and at the end of 10 years, he will receive his P
100,000 investment plus the earned interest. Compute for the simple rate on the
investment per year. ANS. 60%

5. TMI Systems, a company that customizes software for construction cost


estimates, repaid a loan obtained 3 years ago at 7% per year simple interest. If
the amount that TMI repaid was P120,000, calculate the principal of the loan.
ANS. 99,173.55

6. An investment was made two years and three months ago at 7% simple interest.
The investor has just received the principal amount of the investment along with
the P 30,000 interest. What is the principal amount of the investment?
ANS. P190.476.19

Unit 2: Money-Time Relationships and Equivalence 31


LESSON 2.3.2. COMPOUND INTEREST

Compound Interest is defined as interest of loan or principal which is based


not only on the original amount of the loan or principal but the amount of loan or
principal plus the previous accumulated interest.

 Continuous Compounding

 What Is the Difference Between Nominal And Effective Rate of Interest?

Nominal rate of interest


 is defined as basic annual rate of interest
 rate of interest and a number of interest periods in one year,

Unit 2: Money-Time Relationships and Equivalence 32


If nominal rate of interest is 10 % compounded quarterly, then

Example:
A principal amount of 100 gains an interest at a nominal rate of 10%
compounding quarterly for 1 year. What is the future amount?

Effective rate of Interest


 is defined as the actual or the exact rate of interest earned on the principal
during a one-year period.

Note:
NR = ER (if the interest is compounded annually)
ER > NR (if the number of interest periods per year exceeds one)

 Equate Nominal and Effective Rate Of Interest

Example Problem #1

Which is better, the interest earned by 46,800 for 10 years at 11% simple
interest or that earned by the same amount for 10 years at 11% compounded
annually?

Solution:

Unit 2: Money-Time Relationships and Equivalence 33


Example Problem #2

Determine the future worth of an investment of 25,000 after 3 years if invested


at 11% compounded bi-monthly?

Solution:

Example Problem #3

If 10,000 will amount 70,000 in 8 years, what is the amount after 16 years if
money is compounded annually?

Solution:

Example Problem #4

You are planning to sell a 1 hectare (10,000 m2) lot which costs 200 per
square meter at present. If you wish to sell it after 5 years, what will be the price of
your lot if it is expected to appreciate at the rate of 20% per annum?

Solution:

Unit 2: Money-Time Relationships and Equivalence 34


Example Problem #5

A debt of 13,000 will amount to 27,000 after 3.5 years. What nominal rate is
applied if the interest is compounded bi-monthly? Quarterly?

Solution:

Example Problem #6

A man deposited P100,000 in Coconut Bank. After 2 years, he withdrew


P9,000. After another 2 years, he again withdrew P15,000. If he wishes to withdraw
all his savings after 7 years from the time of his deposit, what amount will he receive
if annual interest rate is 7%?

Solutions:

Unit 2: Money-Time Relationships and Equivalence 35


POST-TEST 2

Compound Interest

1. In order to make CDs look more attractive as an investment than they really are,
some banks advertise that their rates are higher than their competitors’ rates;
however, the fine print says that the rate is based on simple interest. If you were
to deposit P10,000 at 10% per year simple interest in a CD, what compound
interest rate would yield the same amount of money in 3 years?
ANS. 9.14%

2. A newlywed couple is planning to build a house of their own. They are


considering two options:
a. The construction of a house now, to cost 500,000.
b. The construction of a smaller house now, to cost 250,000 and at the end of 3
years, an extension to be added to cost 350,000.
Which of the two options is more economical if the interest rate is 20%
compounded annually and depreciation not to be considered?
ANS. OPTION B IS MUCH ECONOMICAL BY 47,453.70

3. A man wishes his son to receive P200, 000 ten years from now. What amount
should he invest if it will earn interest of 10% compounded annually during the
first 5 years and 12% compounded quarterly during the next 5 years?
ANS. P68, 757.82

4. Jones Corporation borrowed P9, 000 from Brown Corporation on Jan. 1, 2014
and P12, 000 on Jan. 1, 2016. Jones Corporation made a partial payment of P7,
000 on Jan. 1, 2017. It was agreed that the balance of the loan would be
amortizes by two payments one of Jan. 1, 2018 and the other on Jan. 1, 2019,
the second being 50%larger than the first. If the interest rate is 12%. What is the
amount of each payment?

ANS. P9, 137.18; P13, 705.77

5. A man won 300,000 in a lottery decided to place 50% of his winning in a trust
fund for the college education of his son. If the money will earn 14% per year
compounded quarterly, how much will be the money at the end of ten years when
his son will be starting his college education?
ANS. P593,888.96

6. What principal amount is equivalent to a withdrawal of 10,600 on the 2 nd year,


4,000 on the 4th year, and a deposit of 5,400 on the 5th year and a final
withdrawal of 9,800 on the 8th year? Interest rate is 5% compounded semi-
annually.
ANS. P15,269.12

Unit 2: Money-Time Relationships and Equivalence 36


SUGGESTED READINGS AND WEBSITES

http://engineeringandeconomicanalysis.blogspot.com/2013/12/economic-
equivalence.html
https://www.extension.iastate.edu/agdm/wholefarm/html/c3-14.html
https://mathalino.com/reviewer/engineering-economy/interest
https://www.mathsisfun.com/money/interest.html
https://www.mathsisfun.com/money/compound-interest.html
https://www.mathsisfun.com/money/annuities.html

ANSWER KEY

ACTIVITY 1

ACTIVITY 2

REFERENCES

Blank, L., & Tarquin, A., (2018). Engineering Economy (8th edition). New York, NY:
McGraw-Hill Education

Khan, Z., Siddiquee, A., Kumar, B., & Abidi, M., (2018). Principles of Engineering
Economics with Applications (2nd edition). New York, NY: Cambridge
University Press

Park, C. S. (2016). Contemporary Engineering Economics (6th edition). London, UK:


Pearson Education Limited

Sullivan, W., Wicks, E. & Koelling, C. (2015). Engineering Economy (16th edition).
Upper Saddle River, NJ: Pearson Higher Education, Inc.

Unit 2: Money-Time Relationships and Equivalence 37

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