ENGINEERING ECONOMY

Instructor: Lai Van Tai

 Chapter 2
TIME VALUE OF MONEY
Chapter 2: TIME VALUE OF MONEY
o Simple interest vs compound interest rates
o Interest rate: real/effective vs nominal
o Cash flow
o Time value of money: equivalences values between
Present - future - annual
Introduction
TÍNH TOÁN LÃI T C
S t ng ng
o Capital – and return to capital
Nh ng s ti n khác nhau nh ng th i i m
Interest
o khác
khá h and
nhau ó interest
có th b ngrate
nhau
h v giáiá tr
t ki
kinh
ht .
Lãi su t 10%/n m thì 1 tri u hôm nay 1,10
t i u n m sau
tri
è Value of money through time

i = 10%
$ 1.00
00 $1.10
0 1
 When the total interest earned or charged is linearly proportional to the i
of the loan (principal), the interest rate, and the number of interest peri
the principal is committed, the interest and interest rate are said to be s
interest is not used frequently in modern commercial practice.
SimpleWhen interest rate is applicable, the total interest, I , earned or
simple interest
computed using the formula

I = (P)(N)(i),

where P = principal amount lent or borrowed;

N = number of interest periods (e.g., years);
i = interest rate per interest period.

The total amount repaid at the end of N interest periods is P + I. Thus,

loaned for three years at a simple interest rate of 10% per year, the in
would be

I = $1,000 × 3 × 0.10 = $300.

The total amount owed at the end of three years would be $1,000 + $3
Notice that the cumulative amount of interest owed is a linear function
the principal (and interest) is repaid (usually not until the end of period
 TÍNH TOÁN LÃI T C
Compound Interest
Lãi t c ghép:
Whenever the interest charge for any interest period (a year, for example) is based
on the remaining principal amount plus any accumulated interest charges up to the
Lãi t c m i th i o n c tính theo s v n
beginning of that period, the interest is said to be compound. In short, compounding
Compound
g c và c interest t ng s rate
ng F when Given P ti n lãi tích lu c trong các
amounts to earning money on your reinvested earnings as well as your original savings.
The effect of compounding of interest can be seen in the following table for $1,000
th i o n tr c ó.
loaned for three periods at an interest rate of 10% compounded each period:

P dollars Ph isn ánh invested c hiatu a qupoint giá tr in theo timeth i gian
and i% is
c a ng ti n(1) cho c ph n ×ti10%n lãi(3)tr= (1) +c(2) ó.
(2) = (1)
per period, c the
s d amount
Amount
ng
Owed
trong
Period at Beginning of Period
will
Interest
th c t grow
Amount
for Period
to
Amount a future am
Owed
at End of Period

nd of one Ví d1 period;
2
: Tr l $1,000 by
i câu
$1,100
hthei c end VD of
a$100
$110
trên, two u periods,
n$1,100
$1,210
s d ng the
lãi su t ghép?
) = P(1 +3 i)2 ; by$1,210 the end of $121
three $1,331 periods, the am
V 3i lãi su t ghép i%, s th i o n là N, t ng
= P(1 As+youvi)cann;see,land
n lãi by
sau the
N thend i oof n Nlà: periods
P(1 + i) N the amou
a total of $1,331 would be due for repayment at the end of the third
period. If the length of a period is one year, the $1,331 at the end of three periods
(years) can be compared with the $1,300 given earlier for the same problem with simple
N
F = P(1 + i) .
interest. A graphical comparison of simple interest and compound interest is given in
Figure 4-1. The difference is due to the effect of compounding, which is essentially
the calculation of interest on previously earned interest. This difference would be
much greater for larger amounts of money, higher interest rates, or greater numbers of
interest periods. Thus, simple interest does consider the time value of money but does
not involve compounding of interest. Compound interest is much more common in
practice than simple interest and is used throughout the remainder of this book.
 Simple vs compound interest rates
CHAPTER 4 / THE TIME VAlue OF MONEY

Figure 4-1 1,331

Illustration of Simple 1,300 Compound Interest 1,300
versus Compound
Interest
1,210
Simple
1,200
Amount Owed ($)
Interest
1,200

1,100
1,100
1,100

1,000

0 1 2 3
End of Interest Period

by reducing them to an equivalent basis that is dependent on (1) the interest rate, (2) the
amounts of money involved, and (3) the timing of the monetary receipts or expenses.
Cash flow – convention
o Horizontal line à time scales (Months, quarter,
years….)
o Applying End-of-period cash flow convention
o The arrows signify cash flow place by the end of
period. Maybe downward (negative/ outflow) or
Upward (Positive/ inflow)
the preceding symbols and their placement on a cash-flow diagram. Notice that all
h flows have been placed at the end of the month to correspond with the convention
d in Table 4-1. In addition, a viewpoint has been specified.
The cash-flow diagram employs several conventions:

The horizontal line is a time scale, with progression of time moving from left to
right. The period (e.g., year, quarter, month) labels can be applied to intervals
Cash Flow Diagram
of time rather than to points on the time scale. Note, for example, that the end
of Period 2 is coincident with the beginning of Period 3. When the end-of-period

ure 4-2 Cash-Flow Beginning of End of F 5 $17,690.27

gram for Plan 3 of Month 1 Month 1
ble 4-1 (Credit Card
mpany’s Viewpoint)

0 1 2 3 45N
End of Month i 5 1% per Month

SECTION 4.5 / NOTATION AND CASH-FLOW DIAGRAMS AND TABLES 111

P 5 $17,000
A 5 $4,357.10
Figure 4-3 Cash-Flow
Diagram for Plan 2 of 0
Table 4-1 (Lender’s 1 2 3 45N
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Viewpoint) End of Month i 5 1% per Month

P 5 $17,000

cash-flow convention is used, period numbers are placed at the end of each time
interval, as illustrated in Figures 4-2 and 4-3.
 TER 4 / THE TIME VAlue OF MONEY

NotationCash
andflow
Cash-Flow Diagrams
factors and Tables
The following notation is utilized in formulas for compound interest calculations:

i = effective interest rate per interest period;

N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more cash flows
at a reference point in time called the present;
F = future sum of money; the equivalent value of one or more cash flows at
a reference point in time called the future;
A = end-of-period cash flows (or equivalent end-of-period values) in a
uniform series continuing for a specified number of periods, starting
at the end of the first period and continuing through the last period.

The use of cash-flow (time) diagrams or tables is strongly recommended for situations
in which the analyst needs to clarify or visualize what is involved when flows of money
occur at various times. In addition, viewpoint (remember Principle 3?) is an essential
feature of cash-flow diagrams.
The difference between total cash inflows (receipts) and cash outflows (expenditures)
for a specified period of time (e.g., one year) is the net cash flow for the period. As
discussed in Chapters 2 and 3, cash flows are important in engineering economy
because they form the basis for evaluating alternatives. Indeed, the usefulness of
a cash-flow diagram for economic analysis problems is analogous to that of the
 4.6.1 Finding F when Given P
In general, we see that F = P(1 + i)N , and the total amount to be repaid is $
If an amount of P dollars is invested at a point in time and i% is the inter
or growth) rate per period, the amount will grow to a future amount of P
by the
P(1 + i) The end of(1one
quantity N in Equation
+ i)period; by the end
(4-2)of
is two periods,
commonly the amount
called the singl
to P(1 + i)(1 +amount
compound i) = P(1 + i)2Numerical
factor. ; by the end of three
values periods,
for this factorthe
areamount
given inwit
Present and Future equivalent value
P(1 + i)2 (1 +from
column i) = the + i)3in; and
P(1 left the by
tables
the of
endAppendix C for
of N periods thea amount
wide range
will of
gr
i and N. In this book, we shall use the functional symbol (F/P, i%, N) fo
o FindingHence,
F when given
Equation (4-2)Pcan be expressed
F = P(1as+ i)N .

F = P(F/P, i%, N).

SECTION 4.6 / RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS 115
XAMPLE 4-3 Future Equivalent of a Present Sum
where the factor in parentheses is read “find F given P at i% interest per pe
F 5 Future Equivalent (Find)
Suppose
interest periods.” Note that the sequence of F andtoPrepay
that you borrow $8,000 now, promising in F/Pthe loan
is the princip
same as in
accumulated interest in four years at i = 10% per year. How much would you
at the end of four years?
i 5 Interest Rate per Period
Solution 0
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N–1 N — page 114 — #1
End of Period
To
Amount Owed Interest Owed Amount Owed End-o
Year P 5 Present
at Start of Year
Equivalent (Given) for Each Year at End of Year Paym

1 Figure = $ 8,000
P 4-5 General = $ 800
iPDiagram Relating
Cash-Flow + i) = $and8,800
P(1Equivalent
Present Future 0
2 Equivalent
P(1 + i)of Single Payments
= $ 8,800 iP(1 + i) = $ 880 P(1 + i)2 = $ 9,680 0
3 P(1 + i)2 = $ 9,680 iP(1 + i)2 = $ 968 P(1 + i)3 = $10,648 0
4 partP(1 + i)3 = $10,648
of Equation (4-3), whereiP(1 + i)3 = quantity,
the unknown $1,065 F,P(1 + i)4 on
is placed $11,713
= the =$
left-handFside
 4.6.1rate Finding
or growth) per period, theF amount
whenwillGivengrow to aPfuture amount of P + Pi =
Inthe
P(1 + i) by general, we see
end of one thatbyFthe
period; i)Nperiods,
P(1of+two
= end , and thethetotal amount
amount to be repaid is $
will grow
to P(1 2 ; by the is
endinvested
of three periods, the amount will grow
+ i)(1
If an2
+ i) = P(1
amount of +P3 i)dollars at a point in time and toi% is the inter
P(1 + i) (1 + i) = P(1 + i) ; and by the end of N periods the amount will grow to
or growth) rate per period, the amount will grow to a future amount of P
by the end of(1one N in Equation
P(1 + i) The quantity F+=i)period;
P(1 + i)N .by the end
(4-2)ofis two periods,
commonly the amount
called
(4-2) the singl
to P(1 + i)(1 +amount
compound i) = P(1 + i)2Numerical
factor. ; by the end of three
values periods,
for this factortheareamount
given inwit
Present
EXAMPLE 4-3 P(1 +and
i) 2 (1 Future
column +from
i) = the
P(1 equivalent
left
+ i) 3in
; the
and tables
by the value
of
endAppendix
of N periodsC for thea amount
wide range
will of
gr
Future Equivalent of a Present Sum
i and N. In this book, we shall use the functional
Suppose that you borrow $8,000 now, promising to repay the loan
symbol
principal plus
(F/P, i%, N) fo
o Finding
accumulatedFinterest
Hence, when
Equationgiven
in four years atP
(4-2) i can
= 10% beper
expressed
F =How
year. P(1as+ i)N
much . you repay
would
at the end of four years?
F = P(F/P, i%, N).
XAMPLE 4-3 Solution
Future Equivalent of a Present Sum
where the factor in parentheses is read “find F given P at i% interest per pe
Suppose thatperiods.”
interest you borrow
Note $8,000
that the now, promising
sequence of F toPrepay
and
Total the loan princip
in F/P is the same as in
Amount Owed Interest Owed Amount Owed End-of-Year
accumulated
Year
interest for
at Start of Year
in four years at at
Each Year
i= 10% per year.
End of Year
How much would you
Payment
at the end of four years?
1 P = $ 8,000 iP = $ 800 P(1 + i) = $ 8,800 0
2 P(1 + i) = $ 8,800 iP(1 + i) = $ 880 P(1 + i)2 = $ 9,680 0
3 Solution
P(1 + i)2 = $ 9,680 iP(1 + i)2 = $ 968 P(1 + i)3 = $10,648 0
4
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P(1 + i)3 = $10,648 iP(1 + i)3 = $1,065 P(1 + i)4 = $11,713 F = $11,713
114 — #1

In general, we see that F = P(1 + i)N , and the total amount to be repaid is $11,713. To
Amount Owed Interest Owed Amount Owed End-o
Year at Start of Year for Each Year at End of Year Paym
The quantity (1 + i)N in Equation (4-2) is commonly called the single payment
1 amount
compound $ 8,000 values
P factor.=Numerical $ 800
iP for this =factor P(1in+the
are given = $ 8,800
i) second 0
column2 from P(1
the +
lefti)in =
the$ tables
8,800of Appendix
iP(1 + i)C = for$ a 880
wide range
P(1 +of i)values
2 = $of9,680 0
i and N. In this book, 2we shall use the functional 2symbol (F/P, i%, N) for (1 3 + i)N .
Hence,3Equation + i)can=be$ expressed
P(1(4-2) 9,680 asiP(1 + i) = $ 968 P(1 + i) = $10,648 0
4 P(1 + i)3 = $10,648 iP(1 + i)3 = $1,065 P(1 + i)4 = $11,713 F =$
 In general, a good way to interpret a relationship such as Equation
the calculated amount, F, at the point in time at which it occurs, is equiv
can be traded for) the known value, P, at the point in time at which it oc
given interest or profit rate, i.

Present and
4.6.2Future equivalent
Finding value
P when Given F
MONEY
From Equation (4-2), F = P(1 + i)N . Solving this for P gives the relation
o Finding F when given P "N i%, N) for
! (P/F,
of values of i and N. We shall use the functional symbol
1
Hence, o Finding P when given F P=F
1+i
= F(1 + i)−N .

SECTION 4.6 / RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS
PThe
= F(P/F,
quantity i%, i)−N is called the single payment (4-5)
(1 +N). present worth factor
values for this factor are given in the thirdF column of the tables
5 Future Equivalent (Find) in Appe

quivalent of a Future Amount of Money

i 5 Interest Rate per Period
r (owner) has“m04_suli0069_17_se_c04”
an option to purchase0 a tract of land that
— 2017/12/15 —will be —
11:20 worth
page 115 — #12
six years. If the value of the land increases at 8% each year, how much
1 2 3 N–2 N–1 N
End of Period
investor be willing to pay now for this property?

P 5 Present Equivalent (Given)

ase price can be determined from

Figure Equation
4-5 General (4-5)
Cash-Flow and Relating
Diagram Table Present
C-11 Equivalent
in and Future
C as follows: Equivalent of Single Payments
 (1 +
receipts, each i)
of amount A, occurring at the end of each period for N periods w
where ainterest at i% per period. Such a uniform series is often called an annuity. It should
1 is the first term in the sequence, aN is the last term, and
h reduces to noted that the formulas−1 and tables to be presented
N−1 , are derived such that A0 occurs
ratio. If the
weend
letofbeach
= (1 + i) , a1
period, and thus,= (1 + i) and aN = (1 + i) , then
' N − 1(
(1 + i)
1. P (present equivalent value) occurs  first A (unifor
 one interest period before the
F = A amount), . N−1 − (4-8) 1
i  (1 + i) 
(1 the
+ i)
Present
N
and Future equivalent value
2. F (future equivalent value) occurs
after P, and
F = A  at the same time as
 1
lastA, and N perio
 ,
quantity {[(1 + i) − 1]/i} is called the uniform series compound amount factor. It
3. A (annual equivalent value) occurs at the1end−of periods 1 through N, inclusive.
e starting point for developing the remaining three uniform series interest factors. (1 + i)
Numerical o Finding
values F whenThe
for the uniform given
timing
series P foramount
relationship
compound P, A, andfactor
F can be observed
are given ininFigure
the 4-6. Four formu
which reduces
relating Ato to F and P will be developed.
h column o Finding P when givenaFwide range of values
of the tables in Appendix C for of i and N. We
use the functional symbol (F/A, 4.7.1 N) for this
i%, Finding factor.
F when Given A' (1Equation
Hence,
+ i)N − 1
(
(4-8)
be expressedo asFinding F when given A . period for N perio
If a cash flow in the amount of AFdollars
= Aoccurs at the end of each
i
and i% is the interest (profit or growth) rate per period, the future equivalent value,
F =atA(F/A,
the end ofi%, N).period is obtained by summing the future
the Nth (4-9)equivalents of each
The quantity
the cash{[(1 N
i) − 1]/i} is called the uniform series compound
flows.+Thus,
is theaccumulation”
mples of this type of “wealth starting point problem
for developing
based on thetheremaining three
(F/A, i%, N) uniform serie
r are provided here and in Table 4-2. values
Numerical A 5 for theAmounts
Uniform uniform
(Given)series compound amount facto

fourth column
A
of the
A
tables in A
Appendix
A
C forAa wide range of value
shall
0
ure Value of a College use the functional symbol (F/A, i%, N) for this factor. Hence
Degree 1 2 3 N–1 N 5 Number
can be expressed as End of Period of Interest
cent government study reported that a college degree is worth an extra $23,000 Periods
year in income (A) compared to what ai 5high-school graduate
Interest Rate per Period
F = makes.i%,
A(F/A, If N).
the
est rate (i) is 6%
P 5per year
Present and(Find)
Equivalent you work for 40 years (N), what F 5is theEquivalent
Future future(Find)
pound amount Figure
(F) of4-6this extraCash-Flow
General
Examples income? Diagram Relating Uniform Series (Ordinary Annuity) to Its Present
of this type of “wealth accumulation” problem based on t
Equivalent and Future Equivalent Values
factor are provided here and in Table 4-2.
ution
 receipts, each of amount A, occurring at the end of each period for N periods w
interest at i% per period. Such a uniform series is often called an annuity. It should
= $7,500(8.5595)
noted that the formulas and tables to be presented are derived such that A occurs
the end of each period, and thus,
= $64,196
1. P (present equivalent value) occurs one interest period before the first A (unifor
ng A when Given F amount),

Present and Future equivalent value

n (4-8) and solving for A, we find that
!
2. F (future equivalent value) occurs at the same time as the last A, and N perio
" after P, and
i
A=F 3. .A (annual equivalent value) occurs
(4-12)at the end of periods 1 through N, inclusive.
N
(1 + i) − 1
o Finding F when given
The timing P for P, A, and F can be observed in Figure 4-6. Four formu
relationship
tion (4-12) is the relation for findingrelating
the amount,
A to F A, of awill
uniform series
4.7.3 Finding
F be equivalent to F
A
and Pwhen Given
be developed.
curring at the
o endFinding P when
of N interest periodsgiven
that would
value as) its future value Taking
occurringEquation
at the end
4.7.1 of theand
(4-8)
Finding Flast
when period.
solving
GivenThe
forA A, we find that
otheFinding
kets is called sinking fundF factor.
when given A
Numerical values for this factor ! " period for N perio
If a cash flow in the amount of A dollars occurs at the end of each
sixth column of the tables in Appendix C for a wide range of values of i
o Finding A when
ll use the functional symbol (A/F, i%, at the
given
forofthis
N)end F
and i% is the interest (profit or growth)
factor.
the Nth Hence,
period
A = Frate per period, the future
is obtained by (1 + i)Nthe−future
summing
. equivalent value,
1 equivalents of each
the cash flows. Thus,
A = F(A/F, i%, N). (4-13)
Thus, Equation (4-12) is the relation for finding the amount, A, o
of cash flows occurring at the
A 5 Uniform end(Given)
Amounts of N interest periods that would
(have the same
A valueA as) its future
A value
A occurring
A at the end of the
quantity
0
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in brackets
page 124
is called
— #21
the sinking fund factor. Numerical valu
N–1 N 5 Number
are given in1 the sixth2 column 3of the tables in Appendix C for a wide r
of Interest
End of Period
i and N. We shall use the functional symbol (A/F, i%, N) for this fac
Periods
i 5 Interest Rate per Period
P 5 Present Equivalent (Find) A = F(A/F,
F 5 Future i%, N).(Find)
Equivalent

Figure 4-6 General Cash-Flow Diagram Relating Uniform Series (Ordinary Annuity) to Its Present
Equivalent and Future Equivalent Values
 P = A(P/A, i%, N). (4-11)
ividing both sides byFrom
(1 + i)Equation
N , we get (4-2), F = P(1+i)N . Substituting for F in Equatio
that ! "
EXAMPLE 4-9 Present Equivalent of N
an Annuity
(1 + i) − 1 (Uniform Series)
P=A .
! N
(4-10)
"
i(1 + i)Nthe installation (1 + i) − 1
N a newly designed
A micro-brewery is considering P(1 + i) = A
of .
boiler system
that burns the dried, spent malt and barley grains from the brewingi process. The
Present and Future equivalent value
Thus, Equation (4-10) is the
boiler will relation
produce forsteam
process finding
thatthe present
powers equivalent
the majority of the value (asenergy
brewery’s
f the beginning of theoperations,
first period)
Dividing saving
bothof$450,000
asides
uniform series
per year
by (1 + ofNthe
over
i) end-of-period
, we cash
boiler’s expected
get lifeflows
of 10 of
years. If
mount A for N periods.the interest rate is 12%
The quantity inper year, how
brackets ismuch
called money can the brewery
the uniform seriesafford to invest
present
Finding A when given F
orth factor.o Numerical
in the new boiler
values for system?
this factor are given in the fifth ! column N of " the
(1 + i) − 1
o Finding
ables in Appendix C for P when
a wide
Solution
rangegiven A of i and N.PWe=shall
of values
N
.
A use the functional
ymbol (P/A, i%, N) for this factor. Hence, i(1 + i)
In the cash flow diagram below, notice that the affordable amount (i.e., the
presentThus,
equivalent, P) occurs(4-10)
Equation one time
isperiod (year) before
the relation forthefinding
first end-of-year
the present
P = A(P/A,
cash flow of $450,000. i%, N). (4-11)
of the beginning of the first period) of a uniform series of end-of
A = $450,000
amount A for N periods. The quantity in brackets is called the u
resent Equivalentworth
of anfactor.
Annuity Numerical
(Uniformvalues
Series)for this factor are given in the
tables in Appendix C for a wide range of values of i and N. We sh
micro-brewery is considering the
0 installation
1 of
3 a newly 5 designed 7 boiler system
symbol (P/A, i%, 2N) for 4
this factor. 6
Hence, 8 9 10
hat burns the dried, spent malt and barley grains from the brewing process. The
End of Year

oiler will produce process steam that powers the majority of the brewery’s energy
P = A(P/A, i%, N).
perations, saving $450,000 per year over the boiler’s expected life of 10 years. If
he interest rate is 12% per year, how much money can the brewery afford to invest
n the new boiler system? P=?
XAMPLE 4-9 Present Equivalent of an Annuity (Uniform Series)
olution
 of the $17,000 Loan Principal
ng Equation (4-10) and solving forSECTION
A, we 4.7
find/ that
RELATING A UNIFORM SERIES (ANNUITY) TO ITS PRESENT AND FUTURE EQUIVALENT VAL

! "
i(1 + i)N example of this type of problem, together with a cash-flow diag
Another
A=P . (4-14)
MPLE 4-11 Computing (1Your
+ i)Nis−
solution, Monthly
given
1 Car
in Table 4-2.Payment

Youisborrow
Thus, Equation (4-14) $15,000
the relation fromthe
for finding your credit
amount, A,union to purchase a used car. The interest
of a uniform
Present and Future equivalent value
of cash flows occurring
rate onat your
the end
4.7.4loanof each of N interest
is 0.25%
Finding per month
A when ∗ and
periods that you
Given would
P will make a total of 36 monthly
uivalent to, or could be tradedWhat
payments. for, the
is present equivalentpayment?
your monthly P, occurring at the
Taking Equation
ning of the first period. The quantity in brackets(4-10) and
is called thesolving
capital for A, we find that
recovery
∗
Finding P when given A
. Numericalovalues for this factor are given in the seventh column of the tables
ppendix C for a wideSolution
range of values of i and N. We shall use the functional ! N "
i(1 + i)
ol (A/P, i%, o Finding A when given
N) for this factor. Hence,
The cash-flow diagram P below is drawn fromN the viewpoint of the bank
shown A=P .
(1 + i) − 1
Notice that the present amount of $15,000 occurs one month (interest period)
A = P(A/P, i%, N). (4-15)
before the first cash flow of the uniform repayment series.
Thus, Equation (4-14) is the relation for finding the amount, A, of a
An example that uses the equivalence between
series of cash aflows
present lump-sumatloan
occurring theamount
A 5 ?of each of N interest periods tha
end
a series of equal uniform monthly payments starting
be equivalent at the end
to, or could of month
be traded for,one
the present equivalent P, occurrin
ontinuing through month four was provided in Table 4-1 as Plan 2. Equation
beginning of the first period. The quantity in brackets is called the capital
) yields the equivalent value of A that∗ repays the $17,000 loan plus 1% interest
onth over four months: factor. Numerical values for this factor are given in the seventh column of th
in Appendix C for 0 a wide
1 2
range of3 values of i and
35 N.36We shall use the fu
symbol (A/P, i%, N) for this End
factor. of Month
Hence,
A = $17,000(A/P, 1%, 4) = $17,000(0.2563) = $4,357.10

entries in columns three and five of Plan 2 in Table 4-1 can now A= beP(A/P,
better i%, N).
rstood. Interest owed at the end of month one equals $17,000(0.01), and therefore
rincipal repaid out of the total end-of-month $15,000 of $4,357.10 is the
P 5payment
An example that
ence, $4,187.10. At the beginning of month two, the amountuses the of equivalence
principal owed between a present lump-sum loan
7,000 − $4,187.10 The amountandofaInterest
= $12,812.90. series
the ofpayment
equal
carowed uniform
at the isend of monthly
easily twopayments
calculated
month starting at(4-15).
is using Equation the end of mo
12.90(0.01) = $128.13, and and continuing
the principal through
repaid at thatmonth
time is four was provided
$4,357.10 − in Table 4-1 as Plan 2. E
A= $15,000(A/P, 1/4%,repays
36) the $17,000 loan plus 1%
13 = $4,228.97. The remaining entries
(4-15) in Plan
yields 2 are obtained
the equivalent valueby performing
of A that
TABLE 4-2 Discrete Cash-Flow Examples Illustrating Equivalence
Example Problems (All Using an Interest Rate of i = 10% per Year—See Table C-13 of Appendix C)

(a) In Borrowing– (b) In Equivalence Cash-Flow

To Find: Given: Lending Terminology: Terminology: Diagrama Solution
For single cash flows:
F P A firm borrows $1,000 for What is the future P = $1,000 F = P(F/P, 10%, 8)
eight years. How much equivalent at the end of N58 = $1,000(2.1436)
must it repay in a lump eight years of $1,000 at = $2,143.60
0
sum at the end of the the beginning of those
eighth year? eight years? F5?

P F A firm wishes to have What is the present F 5 $2,143.60 P = F(P/F, 10%, 8)

$2,143.60 eight years equivalent of $2,143.60 0 = $2,143.60(0.4665)
from now. What received eight years N58 = $1,000.00
amount should be from now?
deposited now to
provide for it? P5?
For uniform series:
F A If eight annual deposits of What amount at the end F5? F = A(F/A, 10%, 8)
$187.45 each are placed of the eighth year is = $187.45(11.4359)
in an account, how equivalent to eight = $2,143.60
much money EOY payments of 12345678
has accumulated $187.45 each?
immediately after A 5 $187.45
the last deposit?
 TABLE 4-2 (Continued)
P A How much should be
deposited in a fund
now to provide
for eight EOY
withdrawals of $187.45
each?
A F What uniform annual
amount should be
deposited each year in
order to accumulate
$2,143.60 at the time of
the eighth annual
deposit?
A P What is the size of eight
equal annual payments
to repay a loan of
$1,000? The first
payment is due one
year after receiving the
loan.
a The cash-flow diagram represents the example as stated in borrowing-lending terminology.
What is the present A 5 $187.45 P = A(P/A, 10%, 8)
equivalent of eight = $187.45(5.3349)
EOY payments of 1 2 3 4 5 6 7 8 = $1,000.00
$187.45 each?
P5?
What uniform payment at F 5 $2,143.60 A = F(A/F, 10%, 8)
the end of eight = $2,143.60(0.0874)
successive years is = $187.45
equivalent to $2,143.60 1 2 3 4 5 6 7 8
at the end of the eighth
year? A5?
What uniform payment at P 5 $1,000 A = P(A/P, 10%, 8)
the end of eight = $1,000(0.18745)
successive years is = $187.45
equivalent to $1,000 1 2 3 4 5 6 7 8
at the beginning of
the first year? A5?
 as of the beginning of the first year (time zero). The required movements of
money through time are shown graphically in Figure 4-10(a).
P0 = F1 (P/F, 20%, 1) = $100(0.8333) = $83.33
+F2 (P/F, 20%, 2) + $200(0.6944) + 138.88
+F3 (P/F, 20%, 3) + $500(0.5787) + 289.35
+A(P/A, 20%, 5) × (P/F, 20%, 3) + $400(2.9900) × (0.5787) + 692.26
Example $1,203.82.

End of Year
0 1 2 3 4 5 6 7 8
(a)

$100
3 (P/F, 20%, 1) $200

3 (P/F, 20%, 2)
$400 $400 $400 $400 $400
$500
P0 5 $1,203.82 3 (P/F, 20%, 3) 3 (P/A, 20%, 5)(P/F, 20%, 3)

End of Year
0 1 2 3 4 5 6 7 8
(b)
$100
$200

3 (F/P, 20%, 6) $400 $400 $400 $400 $400

$500
3 (F/A, 20%, 5)
3 (F/P, 20%, 7) 3 (F/P, 20%, 5)
the interest calculations—you can’t pay in fractions of a cent! For this example,
determine the amount of the 21st (and final) payment on the $100,000 loan when
20 payments of $10,000 have already been made. The interest rate remains at 8%
per year.

Example
Solution
The cash-flow diagram for this example is shown below. It is drawn from the lender’s
viewpoint.
F5 ?

$10,000

0 1 2 3 19 20 21
End of Year

$100,000

We need to determine the value of F that will make the present equivalent of all
loan payments equal to the amount borrowed. We can do this by discounting all
of the payments to time 0 (including the final payment, F) and setting their value
equal to $100,000.
 money. The APR is a nominal interest rate and does not account for compounding
were generally unable
that may occur, to compute
or be appropriate, their
during a year.APR
Beforeand compare
this legislation wasdifferent
passed fina
overbythree
plans.
interest Congress in 1969,
years thatcreditors
resultshad
fromno obligation
monthlytocompounding
explain how interestis charges
shownwere
in Figure
determined or what the true cost of money on a loan was. As a result, borrowers
4-19. were generally unable to compute their APR and compare different financing
The actual
plans. or exact rate of interest earned on the principal during one year is
28 Effective Annual Interest Rate
known Nominal
as the
A credit
and
effective rate.effective
It should be(real)
noted thatinterest
effectiverateinterest rates are always
expressed
AMPLE 4-28 on ancard
annual
Effective company
Annualbasis, charges
unless
Interest Rate an interest
specifically stated rate of 1.375%
otherwise. per text,
In this monththe
the interest
effective unpaid
A credit balance
rate of isallcustomarily
percompany
card year accounts.
charges The rate
annual
designated
an interest of by interest
i andper
1.375% rate,
themonth
nominal they claim
on interest
12(1.375%)
rate per yeartheby r.=In16.5%.
unpaid balance What
engineering is the effective
economy
of all accounts. studies
The rate
annual of interest
ininterest
which per claim,
compounding
rate, they year being char
isis annual,
12(1.375%) = 16.5%. What is the effective rate of interest per year being charged
i = r.by
Thetherelationship
company?
by the company?
between effective interest, i, and nominal interest, r, is

Solution
Solution i = (1 + r/M)M − 1, (4-32)
Equation
Equation (4-32)
(4-32) is usedto
is used to compute
compute thethe
effective rate ofrate
effective interest
of in this example:
interest in this example:
where M is the number of compounding ! periods
"12 per year. It is now clear from
!+ 0.165 "112
Equation (4-32) why i > r when M i =>11.
120.165
−
The effective rate of interesti is 1 + for describing
=useful − 1 the compounding effect of
= 0.1781, or 12
17.81%/year.
interest earned on interest during one year. Table 4-4 shows effective rates for various
Note that r = 12(1.375%)== 0.1781, or
16.5%, which 17.81%/year.
is the APR. In general, it is true that
nominal rates
r = and compounding
M(r/M), periods.
where r/M is the interest rate per period.
Interestingly,
Note that the
r=federal truth-in-lending
12(1.375%) = 16.5%, law which now requires
is the APR.a Instatement
general,regarding
it is true t
the annual percentage
r = M(r/M), where rate
r/M(APR)
is thebeing
interestcharged
rate perinperiod.
contracts involving borrowed
Numerous Web sites are available to assist you with personal finance decisions.
Take a look at www.dinkytown.net and www.bankrate.com.
Figure 4-19
ed ($)

$1,000 Compounded
Numerous Web sites are available to assist you with personal finance dec
5 Compounding More Often than Once per Year
 CHUY
Nominal and effective (real) N rateI
interest
G A CÁC LO
GI O I LÃIÃ SSU T
Lãi su t danh ngh a (LSDN) sang lãi su t th c
(LST) :
i = (1 + r/m1)m2 - 1
V i: i: LST trong th i an TÍNH TOÁN
r: LSDN trong th i an PHÁT BI U
m1: S th i o n GL trong th i an PB
m2: S th i o n GL trong th i an TT
THE TIME VAlue OF MONEY

4-HHH. Enrico Suarez has decided to purchase a house instead of renting an

apartment. He can afford a monthly payment of $800, and he has saved
Nominal and effective (real) interest rate
$6,000 to use as a down payment on a house. If the mortgage is 4% nominal
interest (compounded monthly) on a 30-year loan, how much can Enrico
afford to spend on a house? (4.7, 4.14)
4-III. Compute the effective annual interest rate in each of these situations: (4.14)
a. 10% nominal interest, compounded semiannually.
b. 10% nominal interest compounded quarterly.
c. 10% nominal interest compounded weekly.
4-JJJ. How many months does it take for a present sum of money to double if the
nominal interest rate is 12% per year and compounding is monthly? (4.14)
4-KKK. An APR of 3.75% produces an effective annual interest rate of 3.82%. What
is the compounding frequency (M) in this situation? (4.14)
4-LLL. A large bank has increased its annual percentage rate (APR) on credit cards
to 30%. This move was necessary because of the “additional risks” faced
by the bank in a weak economy. If monthly compounding is in effect, what
is the effective annual interest rate being charged by the bank? (4.15)
4-MMM. Compute the effective annual interest rate in each of the following
situations. (4.14)
a. 5.75% nominal interest, compounded quarterly.
b. 5.75% nominal interest, compounded daily.