MODULE No.

5 INTEREST RATES AND FORMULAS

PROGRAM: BSCPE Year Level: 2ND YEAR Section: CPE 2A/2B/2C

COURSE CODE: BENG01 DESCRIPTION: ENGINEERING ECONOMY

LEARNING OUTCOMES
At the end of the period, the students should be able to:
1. Solve example problems of future worth, present worth and
annuity

2. Differentiate nominal interest rate from effective interest rate

3. Differentiate future worth method from annual worth Method

4. Explain internal and external rate of return method

Prepared: Reviewed and Checked:

RUJEVI S. BADAGUAS ENGR. MARIA THERESA B. PRENDA
Instructor Program Head

Recommending Approval: Approved:

WILMA WENG P. CASALME, PhD PROF. MICHAEL E. LIRIO, CPA, MMPA

Vice President for Academic Affairs President and College Administrator

INTERESTS FORMULA AND RATES

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY
 Program: BS COMPUTER ENGINEERING Topic: INTERESTS FORMULA AND RATES
Course: ENGINEERING ECONOMY Instructor: ENGR. RUJEVI S. BADAGUAS
Code BENG01 Module #: 5 Week #: 10-11 # of Pages: 13

I. Preliminaries
Introduction to the In this module includes the discussion of multiple interest formula, nominal and
Module Objective effective rates, bond value, future and annual worth method, and internal and external
rate of return method and we will solve and explain some worded problems.

Assessment/
Section Topics Learning Outcomes Evaluation Modality
Section 5.1 Interest Formula 1. Solve example problems of future Discussion/lecture Power Point
worth, present worth and annuity Presentation via
Section 5.2 Multiple Interest 05 Seatwork 1 Moodle
Formula 2. Differentiate nominal interest rate
from effective interest rate
Section 5.3 Nominal Interest
Rates and Effective Interest 3. Differentiate future worth method
Rates from annual worth Method

Section 5.4 Present Worth 4. Explain internal and external rate

Method of return method

Section 5.5 Bond Value

Section 5.6 Future and

Annual Worth Method

Section 5.7 Internal and

External Rate of Return
Method

II. Instructions
KEYWORDS AND CONCEPTS

Interest rate – relating present and future values of a single cash flows

Annuity – a series of uniform receipts, each of amount occurring at the end of each period for periods with
interest at per period
Ordinary Annuity – a series of equal payments made at the end of consecutive periods over a fixed length
of time

Deferred Annuity – an insurance contract designed for long-term savings which starts annual or monthly
payments

Multiple interest – considered where a series of cash outflows occur over a number of years

Nominal interest rate – interest is quoted as an annual rate

Effective interest rate – the actual or exact rate of interest earned on the principal during one year

Present worth method – a measure of how much money an individual or firm could afford to pay for the
investment in excess of its cost

Bond – an example of commercial value of the present worth of the future net cash flows that are expected
to be received through ownership of an interest-bearing certificate

Future worth method – it is based on the equivalent worth of all cash inflows and outflows at the end of the
study period at an interest rate

Annual worth method – equal annual series of amounts, for a stated study period, that is equivalent to the
cash inflows and outflows at an interest rate

Perpetuity – It is when annuity in which payments continue indefinitely

Linear gradients – involves receipts and expenses that are projected to increase or decrease by a uniform
amount each period

Internal rate of return method – most widely used rate of return method for performing engineering
economic analyses

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 External rate of return method – directly takes into account the interest rate external to a project at which
net cash flows generated by the project over its life can be reinvested

INTERESTS FORMULA AND RATES

SECTION 5.1 INTEREST FORMULA

 Relating present and future values of single cash flows

 Relating a uniform series (annuity) to present and future equivalent values
 for discrete compounding and discrete cash flows
 for deferred annuities (uniform series)
 Equivalence calculations involving multiple interest
 Relating a uniform gradient of cash flows to annual and present equivalents
 Relating a geometric sequence of cash flows to present and annual equivalents
 Relating nominal and effective interest rates
 Relating to compounding more frequently than once a year
 Relating to cash flows occurring less often than compounding periods
 For continuous compounding and discrete cash flows
 For continuous compounding and continuous cash flows

Future Worth

F = P ( 1 + i) N
Where:
F = Future worth of money
N = number of interest period
(1 + i) N = called the single payment compounding amount factor; symbolized
by (F/P, I %, N)

Hence
F = P (F/P, I %, N)

Example 1

Suppose you borrow ₱ 8000 now, promising to repay the loan principal plus accumulated interest in four
years at I = 10%/ year. How much would you repay at the end of four years?
Solution:

Present Worth

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 P = F (1 + i) – N
Where:
P = present worth of money
N = number of interest period
(1 + i) – N = called the single payment present worth factor; symbolized by
(P/F, i %, N)
Hence
P = F (P/F, i %, N)

Example 2

Leo is thinking of purchasing a tract of land that will be worth ₱ 500,000 in six years. If the value of the land
increases at 8% each year, how much should Leo be willing to pay now for this property?
Solution:

P = F (P/F, 8 %, 6)
P = F (1 + i) – N
P = ₱ 500,000 (1 + 0.08) – 6
P = ₱ 315,085

Annuity

Annuity is a series of uniform (equal) receipts, each of amount A, occurring at the end of each period for N
periods with interest at I % per period.

 Finding future equivalent income (inflow) value given a series of uniform equal payments

Uniform series compound amount factor, functionally expressed as F = A (F/A, i %, N)

 Finding present equivalent income (inflow) value given a series of uniform equal payments

Uniform series present worth factor, functionally expressed as P = A (P/A, i %, N)

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY
 Example 3

Suppose you make 15 equal annual deposits of ₱ 1000 each into a bank having 5% interest per year. The
first deposit will be made one year from this day. How much money can be withdrawn from this bank
account immediately after the 15th deposit?
Solution:

F = A (F/A, 5 %, 15)

=A
[
( 1+ i )N −1
i ]
= 1000
[
( 1+0.05 )15−1
0.05 ]
F = ₱ 21,578.60

SECTION 5.2 MULTIPLE INTEREST FORMULA

 Considered where a series of cash outflows occur over a number of years

 Considered when the value of the outflows is unique for each of a number (i.e. first three years)
 Considered when the value of outflows is the same for the last four years
 Used to find the following:
 Present equivalent expenditure
 Future equivalent expenditure
 Annual equivalent expenditure

Example 4

The expected maintenance expenditures for a certain equipment over eight years amounts as follows: ₱
100 for the first year, ₱ 200 for the 2nd year, ₱ 500 for the 3rd year, and ₱ 400 for each year onwards. Make
a cash flow diagram representing the expenditures. If I = 20% per year, find the following:
a. Present equivalent expenditure (P0)
b. Future equivalent expenditure (F8)
c. Annual equivalent expenditure (A)

Solution:
a. Find P0

b. Find F8

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 c. Find A using P0

SECTION 5.3 NOMINAL INTEREST RATES AND EFFECTIVE INTEREST RATES

Nominal Interest Rates

 If the compounding period isn’t a year:

 Interest is quoted as an annual rate (r) called the nominal interest rate
 To solve any problem, you must use a per period rate (r/m) = i

Where:
m is the number of compounding periods in a year
So:
F = P (1 + i) N
Becomes:
F = P (1 + r/m) N
Where:
n is the number of periods not the number of years

Effective Interest Rates

Effective interest rate (ieff) is the actual or exact rate of interest earned on the principal during one year. This
is actually expressed on annual basis. Converting nominal interest to effective interest rate yields:

Where:
i eff = effective interest rate
r = nominal rate of interest
N = number of compounding period/year

Effective interest rate is only equal to nominal rate of interest when compounding is on annual basis.

Example 5

A credit company charges at a rate of 1.375% per month on the unpaid balance of all accounts. The annual
interest rate is 16.6%. What is the effective rate of interest per year being charged by the company?

Solution:

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 SECTION 5.4 PRESENT WORTH METHOD

Present Worth (PW) is based on the concept of equivalent worth of all cash flows relative to the present. It
is a measure of how much money an individual or firm could afford to pay for the investment in excess of its
cost. To find PW, it is necessary to discount future amounts to the present by using the interest rate over
the appropriate study period.

Where:

i = effective interest rate per compounding period

k = index for each compounding period (0 ≤ k ≤ N)
F k = future cash flow at the end of period k
N = number of compounding periods in the planning horizon (i.e., study period)

Example 6

A special purpose machine is to be acquired by paying a ₱ 15,000 initial cash payment plus a debt
assumption of ₱ 135,000. The machine will generate additional net annual cash inflow of useful life of the
asset. At the end of its life, a salvage value of 10% of its initial cost will be realized. Assuming the effective
interest rate is 13.2% per annum, show whether the project is desirable by using the PW method.
Solution:

Since PW > 0, then acquiring the equipment is economically justified.

SECTION 5.5 BOND VALUE

Bond is an example of commercial value of the PW of the future net cash flows that are expected to be
received through ownership of an interest-bearing certificate. At any time, the value of the bond is the PW
of the future cash receipts.

Bondholders receive two types of payments:

 Series of periodic interest payments until the bond is retired

 Single payment equal to redemption or disposal price when the bond is retired or sold
TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY
 The PW of the bond is the sum of present worth of the two types of payments at the bond’s yield rate:

Where:

Z = face or par value

C = redemption or disposal price (usually equal to Z)
r = bond rate (nominal interest) per interest period
N = number of periods before redemption
i = bond yield rate per period
VN = value (price) of the bond N interest periods prior to redemption

Example 7

A bond with a face value of ₱ 50,000 pays at an interest of 8% per year. This bond will be redeemed at par
value at the end of its 20-year-life, and the first interest payment is due one year from now. How much
should be paid now for this bond in order to receive a yield of 10% per year on the investment?
Solution:
VN = C (P/F, i %, N) + r Z (P/A, i %, N)
VN = ₱ 50,000 (P/F, 10 %, 20) + ₱ 50,000 x 0.08 (P/A, 10 %, 20)
VN = ₱ 7,432.18 + ₱ 34,054.25
VN = ₱ 41, 486.43

SECTION 5.6 FUTURE AND ANNUAL WORTH METHOD

Future Worth Method

Future worth method is based on the equivalent worth of all cash inflows and outflows at the end of the
study period at an interest rate. A positive FW would result to acceptance of the problem solution.

Where:
i = effective interest rate, or MARR, per compounding period
k = index for each compounding period ( 0 ≤ k ≤ N)
Fk – future cash flow

Annual Worth Method

Annual worth (AW) is an equal annual series of amounts, for a stated study period, that is equivalent to the
cash inflows and outflows at an interest rate.
AW (i %) = R – E – CR (i %)
The AW of a project is equivalent to its PW and FW.
AW = PW (A/P, i %, N)
AW = FW (A/F, i %, N)
If AW is greater than or equal to zero, the project is economically attractive.

Annuity
Annuity is a series of equal payments occurring at equal periods of time.

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 Finding P given A:

Finding F give A:

Types of Annuity
1. Ordinary Annuity – is a series of equal payments made at the end of consecutive periods over a
fixed length of time. Payments can be made as frequently as every week, in practice they are
generally made monthly, quarterly, semi-annually, or annually.
2. Deferred Annuity – an insurance contract designed for long-term savings which starts annual or
monthly payments almost immediately, investors can delay payments from a deferred annuity
indefinitely. During that time, any earnings in the account are tax-deferred.

Example 8

What is the present worth of a 10-year annuity paying ₱ 10,000 at the end of each year, with interest of 15
% compounded annually?
Solution:
Finding P given A:

P= A
[ ( 1+i )N −1
i ( 1+i )
N
]
P = ₱ 50,187.69

Perpetuity

When annuity in which payments continue indefinitely, it is called perpetuity.

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 Gradients

Linear Gradient Series

A linear gradient series involves receipts and expenses that are projected to increase or decrease by a
uniform amount each period.

Example Gradient Diagram

The maintenance expense on a certain machine is ₱ 1,000 at the end of the first year and increasing at a
constant rate of ₱ 500 each for the next four years.

Cash flow diagram of a sequence of end-of-period cash flows increasing by a uniform gradient amount (G).

Formulas for Linear Gradient Series

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 Example 9

Suppose a certain end-of-year cash flows are expected to be ₱ 1,000 for the second year, ₱ 2,000 for the
third year, and ₱ 3,000 for the fourth year and that its interest is 15 % per year. Find the:
a. Present equivalent value at the beginning of the first year
b. Uniform annual equivalent value at the end of each of the four years
Solution:
a. Present equivalent value:
P0 = G (P/G, 15%, 4)

b. Uniform annual equivalent value:

A = G (A/G, 15%, 4)

SECTION 5.7 INTERNAL AND EXTERNAL RATE OF RETURN METHOD

Internal Rate of Return Method

Internal rate of return method is the most widely used rate of return method for performing engineering
economic analyses. It is also called as the investor’s method, the discounted cash flow method, and the
profitability index. Helps to solve for the interest rate that equates the equivalent worth of an alternative’s
cash inflows to be equivalent worth of cash outflows.

An IRR that is greater than the MARR would result to acceptance of the problem solution. By using a PW
formulation, the IRR is the i % at which:

Where:
Rk = net revenues or savings for the kth year
Ek = net expenditures including any investment cost for the kth year
N = project life (or study period)

There are some difficulties associated with IRR Method, these are:
 IRR method is difficult to compute given that it is associated with the trial and error method.
 It must be carefully applied and interpreted in the analysis of two or more alternatives when only
one of them is to be selected.

The main advantage of IRR is its widespread acceptance among industries.

Example 10

A capital investment of ₱ 10,000 can be made in a project that will produce a uniform annual revenue of ₱
5,310 for five years and then have a salvage (market) value of ₱ 2,000. The annual expenses will be ₱
3,000. The company is willing to accept any project that will earn at least 10 % per year on all invested
capital. Determine whether it is acceptable by using the IRR method
Solution:
PW = 0 = − 10,000 + (5,310 – 3,000) (P/A, i%, 5) + 2,000 (P/F, i%, 5)

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 To solve for i, use linear interpolation:

At i = 5%; PW = + ₱ 1,568
At i = 15%; PW = − ₱ 1,262

Applying linear interpolation, we will get:

Since IRR > MARR (10.5% > 10%), the project is acceptable.

External Rate of Return Method

External rate of return method directly takes into account the interest rate (ε) external to a project at which
net cash flows generated (or required) by the project over its life can be reinvested (or borrowed).

Three steps used in the calculating procedure:

I. All net cash outflows are discounted to time 0 (the present) at ε % per compounding period.
II. All net cash inflows are compounded to period N at ε %.
III. The external rate of return, which is the interest rate that establishes equivalence between the
two quantities, is determined.

Where:
Rk = excess of receipts over expenses in period k
Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
Ε = external reinvestment rate per period

Example 11

Determine whether the project, whose total cash flow diagram appears bellow, is acceptable when ε = 15%
and MARR = 20% per year.

Solution:

III. Viable and vibrant Activities

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 Description of the Learning Activities

Discussion – the students need to share ideas and knowledge about Interests Formula and Rates and
how it is related to the present situation

05 Seatwork 1 – the students will perform the seatwork to know how well they understand the lesson

IV. Opportunity to reflect and articulate students’ acquired knowledge.

Criteria for Evaluation

05 Seatwork 1 – PROBLEM SOLVING: Solve the problem and show the complete solution. (20
points)

Purpose of Activity

Discussion – The students are required to give their opinions and share their knowledge about the topics
being discussed. They also need to identify the different formulas to be used in each situation

05 Seatwork 1 – a seatwork will determine the students understanding of the whole lesson

Summary and Reflection

After the discussion, the student will write in their learning journal what they have learned in the lesson
being discussed and what they are expecting in the next topic.

I ALREADY I STILL WANT TO

TOPIC/S I LEARNED…… REFLECTION
KNEW…. KNOW…..
Interest Formula
Multiple Interest
Formula
Nominal Interest
Rates and Effective
Interest Rates
Present Worth
Method

Bond Value

Future and Annual

Worth Method
Internal and
External Rate of
Return Method
OVERALL
REFLECTION

V. Textbooks and other References

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY

 1. R. A. Chadderton, Purposeful Engineering Economics, 1st edition, Springer International Publishing
Switzerland, 2015
2. D. G. Newnan, J. Whittaker, T. G. Eschenbach and J. P. Lavelle, Engineering Economic Analysis,
3rd edition, Don Mills, Toronto, Ontario, 2014.
3. N. M. Fraser and E. M. Jewkes, Engineering Economics: Financial Decision Making for Engineers,
5th edition, Pearson, Toronto, Ontario, 2013
4. E. S. Prassas and R. P. Roess, Engineering Economics and Finance for Transportation
Infrastructure, 1st edition, Springer-Verlag Berlin Heidelberg, 2013

TANAUAN CITY COLLEGE BENG01 / MODULE NUMBER 5 ENGINEERING ECONOMY