University of Palestine

College of Engineering & Urban Planning

Engineering Economy

Chapter 3
Interest and Equivalence

Lecture 6 (A)

1st Semester 2020/2021

Instructor: Eng. Abdallah Adwan

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. . .After Completing This Chapter

:The student should be able to
• Defines the time value of money.
• Distinguishes between simple and compound interest in engineering
economic analysis.
• Explains equivalence of cash flows.
• Defines nominal, effective, and periodic interest rates.
• Applies single payment compound interest formulas.

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COMPUTING CASH FLOWS

EXAMPLE 3–1
The manager has decided to purchase a new $30,000 mixing machine. The machine
may be paid for in one of two ways:
1. Pay the full price now minus a 3% discount.
2. Pay $5000 now; at the end of one year, pay $8000; at the end of each of the next
four years, pay $6000.
List the alternatives in the form of a table of cash flows.

SOLUTION
The first plan represents a lump sum of $29,100 now, the second one calls for
payments continuing until the end of the fifth year.as shown below.

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COMPUTING CASH FLOWS

SOLUTIO
N

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COMPUTING CASH FLOWS

EXAMPLE 3–2
A man borrowed $1000 from a bank at 8% interest. He agreed to repay the loan in
two end-of-year payments. At the end of each year, he will repay half of the $1000
principal amount plus the interest that is due. Compute the borrower’s cash flow.

SOLUTION

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TIME VALUE OF
MONEY
Question: Would you prefer $100 today or $100 after 1 year?
A dollar today is worth more than a dollar next year
Money makes money -Investments are expected to earn a return
The change in the amount of money (through investment) over a given period of
time is called “time value of money.”
 Money has a time value because it can earn more money over time (earning
power)
 Money has a time value because its purchasing power changes over time
(inflation)
The “time value of money” is the most important concept in engineering economy
 The amount and timing of a project’s cash flows (operating expenses;
revenues) are crucial to the value of a project’s worth.

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Interest
Some people would pay to have money available for use. The charge for its use is called
interest rate.
Interest is a compensation for using money and for uncertainties related to future value of
money
It also called Rate of Return (RoR) on investment.

Two types of interest:

Simple interest: the practice of charging an interest rate only to an initial sum (principal
amount).
 Interest on principal only

Compound interest: the practice of charging an interest rate to an initial sum and to any
previously accumulated interest that has not been withdrawn.
 Interest earns interest on interest; compounds over time

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Simple Interest
Simple interest is interest that is computed only on the original sum, not on
accrued interest.
Thus if you were to loan a present sum of money P to someone at a simple
annual interest rate i (stated as a decimal) for a period of n years, the amount of
interest you would receive from the loan would be

Total interest earned = P × i × n =

Pin
At the end of n years the amount of money due you, F, would equal the amount of the
loan P plus the total interest earned. That is, the amount of money due at the end of
the loan would be
F = P + Pin
or
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F = P ( 1 + in).
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Simple Interest
EXAMPLE 3–3
A bank gave your friend a $1000 for three years at a simple interest rate of 8%
per year. How much money the bank should be receiving from your friend at
the end of these three years?

P = Principal amount
= $1,000
i = Interest rate
= 8%
n = Number of interest periods
= 3 years

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Simple Interest

EXAMPLE 3–4
You have agreed to loan a friend $5000 for 5 years at a simple interest rate of 8%
per year. How much interest will you receive from the loan? How much will your
friend pay you at the end of 5 years?
SOLUTION
Total interest earned = Pin = ($5000)(0.08)(5)= $2000
Amount due at end of loan = P + Pin = 5000 + 2000 = $7000

In Example 3-4 the interest earned at the end of the first year is (5000)(0.08)(1)=
$400, but this money is not paid to the lender until the end of the fifth year. As a
result, the borrower has the use of the $400 for 4 years without paying any interest
on it. This is how simple interest works.
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Compound Interest
Compounded interest is interest that is charged on the original sum and any
accumulated, un-paid interest.
 Interest = (principal + all accrued interest) (interest rate)

EXAMPLE 3–5 A bank gave

your friend a $1000 for three
years at a compound interest rate
of 8% per year. How much
money the bank should be
receiving from your friend at the
end of these three years?

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Compound Interest
EXAMPLE 3–5
To highlight the difference between simple and compound interest, rework Example 3-3 using an
interest rate of 8% per year compound interest. How will this change affect the amount that your
friend pays you at the end of 5 years?

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Repaying a Debt
You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years. There are many ways the debt can be repaid:

Plan 1 (Constant Principal), At end of each year pay $1,000 principal plus interest due.

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Repaying a Debt
Plan 2 (Interest Only) Annual interest payment and principal payment at end of 5 years.

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Repaying a Debt
Plan 3 (Constant Payment) Pay in five end-of-year payments.

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Repaying a Debt
Plan 4 (All at Maturity) All payment at end of 5 years.

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Repaying a Debt
Summary of Payment Plans

Question: What common property do all four plans have?

Interest rate = (total interest paid)/(total amount owed)

or Total interest paid = (interest rate) * (total amount owed)

Since the total amount owed vary for the four plans, but the interest rate does not, the
total interest paid also varies.
We can simply say that these four plans are EQUIVALENT
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Equivalence
Different sums of money at different times may be equivalent (equal in
economic value) to each other.
Each of the plans on the previous slide is equivalent because each repays
$5000 at the same 8% interest rate.

$100 now is said to be equivalent to $106 one year from now, if the $100 is
invested at the interest rate of 6% per year.

If two or more situations are to be compared, their characteristics must be

placed on an equivalent basis.
Equivalence is dependent on interest rate.
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SINGLE PAYMENT COMPOUND INTEREST

FORMULAS
 To facilitate equivalence computations, a series of interest formulas will be derived. We use
the following notation:
o i = interest rate per interest period; in the equations the interest rate is stated as a decimal
(that is, 9% interest is 0.09).
o n = number of interest periods.
o P = a present sum of money.
o F = a future sum of money at the end of the nth interest period, which is equivalent to P with
interest rate i.
 Suppose a present sum of money P is invested for one year at interest rate i. At the end of the
year, we should receive back our initial investment P, together with interest equal to iP, or a
total amount P + iP. Factoring P, the sum at the end of one year is P(1 + i).
 Let us assume that, instead of removing our investment at the end of one year, we agree to let
it remain for another year. How much would our investment be worth at the end of Year 2?
The end-of-first-year sum P(1 + i) will draw interest in the second year of i P(1 + i). This
means that at the end of Year 2 the total investment will be
P(1 + i) + i[P(1 + i)]
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SINGLE PAYMENT COMPOUND INTEREST

FORMULAS
This may be rearranged by factoring out P(1 + i), which gives
P(1 + i)(1 + i) or P(1 + i)2
If the process is continued for Year 3, the end-of-the-third-year total amount will be P(1 + i) 3; at
the end of n years, we will have P(1 + i)n . The progression looks like:

In other words, a present sum P increases in n periods to P(1 + i)n . We therefore have a
relationship between a present sum P and its equivalent future sum, F.
Future sum = (Present sum) (1 + i)n
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F = P(1 + i)n
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Single payment compound interest formulas

This is the single payment compound amount formula and is written in functional
notation as
F = P(F/P, i, n)
The notation in parentheses (F/P, i, n) can be read as follows:
To find a future sum F, given a present sum, P, at an interest rate i per interest period,
and n interest periods hence.
Or Find F, given P, at i , over n.

If we take F = P(1 + i)n and solve for P, then

P = F(1 + i)−n
This is the single payment present worth formula. The equation P = F(1 + i)−n
in our notation becomes
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P = F(P/F, i, n)
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College of Engineering & Urban Planning

Single payment compound interest formulas

EXAMPLE 3–6
If $500 were deposited in a bank savings account, how much would be in the
account 3 years from now if the bank paid 6% interest compounded annually?
SOLUTION
From the viewpoint of the person depositing the $500, the cash flows are:
P = $500, i = 0.06, n = 3,
and F is unknown

F = P(1 + i)n = 500(1 + 0.06)3 = $595.50

Thus if we deposit $500 now at 6% interest, there
will be $595.50 in the account in three years.

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Single payment compound interest formulas

ALTERNATE SOLUTION
Knowing n = 3, locate the proper row in the 6% table of Appendix C. To find F given P, look in
the first column, which is headed “Single Payment, Compound Amount Factor”: or F/P for n =
3, we find 1.191.
Thus, F = 500(F/P, 6%, 3) = 500(1.191) = $595.50

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