ENGINEERING ECONOMICS 2021

TOPIC 2: THE CONCEPT OF EQUIVALENCE, CONTINUOUS COMPOUNDING, AND

DIECRETE PAYMENTS

ECONOMIC EQUIVALENCE

In economic analysis, “equivalence” means “the state of being equal in

value”. The concept is primarily applied in the comparison of different cash flows. As
we know from earlier lessons, money changes value with time; therefore, one of the
main factors when considering equivalence is to determine at which point(s) in time
the money transactions occur. A second factor is the specific amounts of money
involved in the transactions. Finally, the interest rate at which the equivalence is
evaluated must also be considered.

An equation of value is obtained by setting the sum of the values on a certain

comparison or focal date of one set of obligations equal to the sum of the values on
the same date of another set of obligations. The concept of equivalence shall be
used in the succeeding topics or concepts.

Illustrative Problems

1. If the interest rate is 8% per year, compounded annually, what is the equivalent
present value of Php 500, 000.00 (a) 1 year from today? (b) 5 years from today?
a. Present value 1 year from today

𝑃 = 𝐹(1 + 𝑖)
𝑃 = 500, 000(1 + 0.08)

𝑷 = 𝑷𝒉𝒑 𝟒𝟔𝟐, 𝟗𝟔𝟐. 𝟗𝟔𝟑

b. Present value 5 years from today

𝑃 = 𝐹(1 + 𝑖)
𝑃 = 500, 000(1 + 0.08)

𝑷 = 𝑷𝒉𝒑 𝟑𝟒𝟎, 𝟐𝟗𝟏. 𝟓𝟗𝟖𝟓

2. A man bought a lot worth Php 1, 000, 000.00 if paid in cash. On the installment
basis, he paid a down payment of Php 200, 000.00; Php 300, 000.00 at the end
of one year; Php 400, 000.00 at the end of three years and a final payment at
the end of 5 years. What was the final payment if interest was 20%?

Solution

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Let F5 = final payment

Let us first draw the cash flow diagram from the perspective of the buyer. If the number
of compounding is not stated in the problem, that means that it is compounded
annually.

Using the principle of equivalence, we need to designate a common focal point

where the computation is based. Here, we choose the present as our focal point.
Since a down payment of Php 200, 000.00 was made, the principal would be Php
800, 000.00. The succeeding payments then shall be computed in terms of their
present worth. Hence,

𝑃 = 𝐹(1 + 𝑖)

𝑃 = 𝐹 (1 + 𝑖) + 𝐹 (1 + 𝑖) + 𝐹 (1 + 𝑖)

800, 000 = 300, 000(1 + 0.2) + 400, 000 (1 + 0.2) + 𝐹 (1 + 0.2)

𝑭𝟓 = 𝑷𝒉𝒑 𝟕𝟗𝟐, 𝟓𝟕𝟔. 𝟎𝟎

We can also use the fifth year as our focal point. That means all computations or
terms in the equation are in terms of future worth in the 5 th year.

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𝐹 = 𝑃(1 + 𝑖)
𝐹 = 𝑃 (1 + 𝑖) − 𝑃 (1 + 𝑖) − 𝑃 (1 + 𝑖)
𝐹 = 800, 000(1 + 0.2) − 300, 000(1 + 0.2) − 400, 000(1 + 0.2)

𝑭𝟓 = 𝑷𝒉𝒑 𝟕𝟗𝟐, 𝟓𝟕𝟔. 𝟎𝟎

CONTINUOUS COMPOUNDING AND DISCRETE PAYMENTS

Continuous compounding can be thought of as a limiting case of the

multiple-compounding situation. Holding the nominal annual rate fixed and letting
the number of interest periods become infinite, while the length of each interest
period becomes infinitesimally small.

In continuous compounding, it is assumed that cash payments occur once

per year, but the compounding is continuous throughout the year.

In discrete compounding the interest is compounded at the end of each

finite – length period such as a month, a quarter or a year.

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Continuous Compounding (Lender’s Viewpoint)

𝑭 = 𝑷𝒆𝒓𝒏
𝑷 = 𝑭𝒆 𝒓𝒏
Where:
r = nominal rate of interest per year
r/m = rate of interest per period
m = number of interest periods per year
mn = number of interest periods in n years

ILLUSTRATIVE PROBLEMS

1. A savings bank offers long-term savings certificates at 7.5% per year,

compounded continuously. If a 10-year certificate costs Php 50, 000.00, what
will be its value at maturity? Compare with the value that would be obtained
if the interest were compounded annually rather than continuously.

Solution:

For continuous compounding,

𝐹 = 𝑃𝑒
𝐹 = (50, 000)𝑒 ( . )( )

𝑭 = 𝑷𝒉𝒑 𝟏𝟎𝟓, 𝟖𝟓𝟎. 𝟎𝟎𝟎𝟖

If compounded annually:

𝐹 = 𝑃(1 + 𝑖)

𝐹 = 50, 000(1 + 0.075)

𝑭 = 𝑷𝒉𝒑 𝟏𝟎𝟑, 𝟎𝟓𝟏. 𝟓𝟕𝟖𝟏

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2. Compare the accumulated amounts after 5 years of Php 1, 000.00 invested

at the rate of 10% per year compounded (a) annually, (b) semiannually, (c)
quarterly, (d) monthly, (e) daily, and (f) continuously.

Solution:

a. Compounded annually
𝐹 = 𝑃(1 + 𝑖)
𝐹 = 1, 000(1 + 0.1)

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟏𝟎. 𝟓𝟏

b. Compounded semiannually
𝐹 = 𝑃(1 + 𝑖)
𝐹 = 1, 000(1 + 0.05)

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟐𝟖. 𝟖𝟗

c. Compounded quarterly
𝐹 = 𝑃(1 + 𝑖)
𝐹 = 1, 000(1 + 0.025)

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟑𝟖. 𝟔𝟐

d. Compounded monthly
𝐹 = 𝑃(1 + 𝑖)
0.1
𝐹 = 1, 000(1 + )
12

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟒𝟓. 𝟑𝟏

e. Compounded daily
𝐹 = 𝑃(1 + 𝑖)
0.1
𝐹 = 1, 000(1 + )
365

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟒𝟖. 𝟔𝟏

f. Compounded continuously

𝐹 = (1, 000)𝑒 ( . )( )

𝑭 = 𝑷𝒉𝒑 𝟏, 𝟔𝟒𝟖. 𝟕𝟐

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EXERCISES 03
Direction: Solve the following problems. Show complete and neat solution. Show
illustrations (cash flow diagrams) if necessary.

1. A series of 10 annual payments of Php 200, 000.00 is equivalent to two equal

payments, one at the end of 15 years and the other at the end of 20 years.
The interest rate is 8%, compounded annually. What is the amount of the two
equal payments? (Ans. Php 2, 533, 110.292)

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2. How much money must be deposited in a savings account so that Php 275,
000.00 can be withdrawn 12 years hence, if the interest rate is 9% per year,
compounded continuously, and if all the interest is allowed to accumulate?
(Ans. Php 93, 388.77)

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