ME 291

Engineering
Economy

ME-291 Engineering
Economy
Lecture 3

Simple and Compound Interest

Faculty of Mechanical Engineering

Ghulam Ishaq Khan Institute, Topi, Swabi
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 Economic Equivalence

• The time value of money and the interest

rate help develop the concept of economic

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equivalence.
• $100 today = $106 after one year, if the

Economy
interest rate is 6%
• $100 today = $94.34 before one year, if the
interest rate is 6%

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 Simple and Compound Interest

• The terms interest period, and interest rate

are useful in calculating equivalent sums of

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money for one interest period in the past and
one period in the future.

Economy
• But for more than one interest period, the
terms simple and compound interest become
important.

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 Simple Interest

• Simple interest is calculated using the principal only.

• Interest = (Principal) (number of periods) (interest rate)

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where the interest rate in this case is in decimals

Economy
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 Example 1.7

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Economy
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 Compound Interest

• The interest accrued for each interest period is calculated on

the principal plus the total amount of interest accumulated in
all previous periods.

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• Compound interest means interest on top of interest.
• Interest=(Principal + all accrued interest) (interest rate)

Economy
• Total due after a number of years =
Principal (1+interest rate) numberofyears

Interest rate in
this case is in
decimals

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 Example 1.8

• If an engineer borrows $1000 from the company credit

union at 5% per year compound interest, compute the total

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amount due after 3 years.

Economy
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 Terminology and Symbols

• P = Value or amount of money at a time designated

as the present or time 0. P is also referred to as

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present worth (PW).
• F = value or amount of money at some future time. F
is also referred to as future worth (FW).

Economy
• A = series of consecutive, equal, end-of-period
amount of money. A is also called the annual worth
(AW)
• n, N= number of interest periods; years, months,
days.
• i = interest rate or rate of return per time period;
percent per year, percent per month.
• t = time, stated in periods; years, months, days

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 Terminology

• The symbol P and F represent one-time occurrence.

• A occurs with the same value one each interest

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period for a specified number of periods.
• It should be clear that a present value P represents a
single sum of money at some time prior to a future

Economy
value F or prior to the first occurrence of an equivalent
series amount A.
• A always represents a uniform value, i.e. same
amount each period.
• Interest rate “i” is assumed to be compound rate,
unless specifically stated as simple interest.

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 Example 1.10

A new college graduate has a job with Boeing Aerospace. He plans to

borrow $10,000 now to help in buying a car. He has arranged to repay
the entire principal plus 8% per year interest after 5 year. Identify the

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engineering economy symbols involved and their values for the total
owed after 5 year.

Economy
Solution:
P = $10,000

i = 8% per year

n = 5 years

F=?

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 Example 1.11

Assume you borrow $2000 now at 7% per year

for 10 years and must repay the loan in

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equal yearly payments. Determine the
symbols involved and their values?

Economy
Solution:
P = $2000

i = 7% per year

n = 10 years

A = ? Per year for 5 years

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 Example 1.13

You plan to make a lump-sum deposit of $5000 now into an

investment account that pays 6% per year, and you plan to

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withdraw an equal end-of-year amount of $1000 for 5 years,
starting next year. At the end of the sixth year, you plan to
close your account by withdrawing the remaining money.
Define the engineering economy symbols involved?

Economy
Solution:
Time is expressed in years
P = $ 5000
A = $1000 per year for 5 years
F = ? At the end of year 6
i = 6% per year
n = 5 years for A series and 6 for the F
value

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 Example 1.14

Last year Smith’s father offered to put enough money into a

saving account to generate $1000 this year to help pay
Smith’s expenses at college. Identify the engineering

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economy symbols.

Economy
Solution:
Time is in years
P=?
i = 6% per year
n = 1 year
F = P + interest = ? + $1000

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 Introduction to solution by
computers

• To find present value P:

– PV(i%,n,A,F)
• To find future value F:

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– FV(i%,n,A,P)
• To find the equal, periodic value A:

Economy
– PMT(i%,n,P,F)
• To find the number of periods n:
– NPER(i%,A,P,F)
• To find the compound interest rate i:
– RATE(n,A,P,F)
• Note that the values of P,F,A should be entered by
taking in view the borrower and lender. Means if P,A
are +ive then F should be –ive in the case of Lender
and vice versa.

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 Minimum Attractive Rate of Return

• Engineering alternatives are evaluated upon the basis that

reasonable ROR can be expected.
• Therefore some reasonable rate must be established for the

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selection criteria phase of the engineering economy study.
• The reasonable rate is called Minimum Attractive Rate of
Return (MARR) and is higher than the rate expected from a

Economy
bank or some safe investment that involves minimal
investment risk.
• MARR is also referred to as the hurdle rate for projects; i.e.
to be considered financially viable the expected ROR must
meet or exceed the MARR or hurdle rate.
• MARR is not a value calculated like ROR. It is established
by (financial) management and used as a criterion against
which an alternative’s ROR is measured, when making the
accept/reject decision.
• ROR ≥ MARR > Cost of capital

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