Professional & Industrial Studies

(Lecture 4 P Matorwa)
Topics:-
Capital Investment Decisions
 CE 309-Professional and Industrial Studies
• Capital Investment Decisions
1. Introduction:-Mathematical methods of
calculating simple & compound interest &
equivalence as a basis for making Engineering
Economy studies
2. Irreducible factors:-It is not possible to convert
all factors under consideration to monetary
terms, some are irreducible, intangible or
judgments factors like reputation.

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 CE 309-Professional and Industrial Studies
• Interest calculations
– P = the principal, a sum of money invested in the initial year
or present sum of money
– i = the interest rate per unit of time expressed as a decimal.
– n = time, the number of units of time over which interest
accumulates
– I = simple interest, the total sum paid for the use of money at
simple interest
– F = a compound amount ;-a sum of money at the end of n
units of time at interest, i made up of principal plus interest
payable.
– A = uniform series end-of-period payment or receipt that
extends for n-periods
– S = salvage value or resale at the end of n-years/units
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 CE 309-Professional and Industrial Studies
• Capital Investment principles
4. Simple interest:-calculation of simple interest
5. interest = principal x interest rate x time
I = Pin
Example , a deposit of USD 10 000.00 in a bank
offering 15% per year will yield USD 1500 per year
6. Cash flow diagrams:-A horizontal line is used as the
timeline and vertical arrows to indicate direction of
cash flows with arrows pointing downwards being
negative cash flows and upwards being positive
F

0 1 2 3 4

i = 15%
P
 CE 309-Professional and Industrial Studies
• Capital Investment principles
9. Compound interest:- If the interest is now allowed to
remain invested with the capital at the same rate of
interest, it will itself earn interest. The process of
paying interest, as well on the initial investment, can
go on from year to year hence term compounding.
interest for second period =P(1 +i) i
Total Amount F, end of 2nd period =P(1 +i) +P(1 +i)i
= P(1 +i)(1 +i)
=P(1 + i)2

interest for third period =P(1 +i)2i

Total Amount F, end of 2nd period =P(1 +i) 2 +P(1 +i) 2i
= P(1 +i) 2 (1 +i)
=P(1 + i)3

F = P (1 + i)n

Example of a deposit of USD 150.00 in a bank for a period of 5years at a compound interest
rate of 6% per annum. F = USD 220.73
 CE 309-Professional and Industrial Studies
• Nominal and effective interest rates
10. When an annual rate is quoted , but compounding is
carried out for a period other than one year, the
annual rate is known as a nominal annual interest rate:
the actual annual interest rate which results from
compounding over periods of less than one is known as
an effective annual interest rate:-

The effective annual interest rate, I eff , is calculated from.

Ieff =(1 + r/m)m – 1

Where r is the nominal annual interest rate expressed as a decimal and m
denotes the number of compounding periods per year.
Example
A loan of USD 1000 is made at a nominal interest rate of 10 percent
compounded quarterly, what is the effective interest rate?
Effective interest rate, Ieff =(1 + 0.10/4)4 – 1 =0.1038
The annual interest would be 1000(0.1038) = USD103.80
 CE 309-Professional and Industrial Studies
• Present Worth(value)
11. An initial capital P, must be placed for n periods at an
interest rate of i, in order to generate an amount F at
the end of that period:-

In other words , P is the present worth(value) of F in n periods, for the given

rate of interest

F is being discounted to an equivalent value at a previous date below:

P = F[1 /(1 + 1)n ] = F(P/F, i%, n)

The factor 1/(1 + 1)n or (P/F, i%, n) is referred to as the single payment
discount present worth/value factor.
Example
An investor’s bank statement shows a credit of USD345 as a result of a small
investment 10years previously. Interest over this period has been 2.5
percent. What was the original investment?
I = 0.025 ; n = 10; F = usd345
From formula above P = F(P/F, 2.5%, 10) = 345(0.7812) = USD 269.51
 CE 309-Professional and Industrial Studies
• Equivalence
11. The concept of equivalence underlies the methods used
to compare different series of cash flows, one with
another
Example
USD 10000 at the end of 10years from now is equivalent to USD xX now if
the interest rate is 5%. What is X?

X is the present worth of USD10000 with i = 0.05,

Therefore X = 10 000(P/F, 5%,10) = 10 000(0.6139) =USD 6 139

Give other examples of equivalence??