Engineering Economics

21S3101

INTEREST AND EQUIVALENCE

Engineering Management
Del Institute of Technology
 Computing Cash Flow

• Cash flows have:

– Costs (disbursements) > a negative number
– Benefits (receipts) > a positive number
Example :
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.
$ 1.000
End of Year Cash Flow
0 $ 1,000 0 1 2
1 $ (580)
2 $ (540) $ 580 $ 540
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 Computing Cash Flow (Example)

Consider a truck that is going to be purchases for $55,000. It will cost

$9,500 each year to operate including fuel and maintenance. It will need
to have its engine rebuild in 6 years for a cost of $22,000 and it will be
sold at year 9 for $13,000. Here is the cash flow diagram :
Salvage Value -
Operating Cost
EOY $ 3,500
0 1 2 3 4 5 6 7 8 9

$ 9,500 $ 9,500 $ 9,500 $ 9,500

$ 9,500 $ 9,500 $ 9,500
Operating Cost $ 31,500
Operating Cost +
$ 55.000 Rebuild Cost
Initial Cost 21S3101
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 Computing Cash Flow (Practice)

Let's say for start a bakery shop Andi requires $ 50.000

initial investment. For the first three years total revenue
per year by $15.000, but after three years the market
competition will impact to make decrease of revenue
10% every year. In year sixth, he must restore each
equipment with total cost of $5.000. By the end of year
10th he still can sell old equipment for $ 3000. Compute
the bakery shop Andi cash flow!

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 Time Value of Money

• Money has value

– Money can be leased or rented
– The payment is called interest
– If you put $100 in a bank at 9% interest for one time
period you will receive back your original $100 plus $9

Original amount to be returned = $100

Interest to be returned = $100 x 9% = $9

Change in the amount of money (because of interest) over

time is called time value of money
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 Type of Interest

• There are two kinds of interest : simple interest and

compound interest.
– Simple interest : the practice of charging an
interest rate only to an initial sum (original
amount).
– Compound interest : the practice of charging an
interest to an initial sum and to any previously
accumulated interest that has not been
withdrawn.
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 Simple Interest

• Interest that is computed only on the original sum or principal

Total interest earned = P x i x n

Where :
P = Present sum of money
i = Interest rate
n = Number of periods (years)

• Amount of money due at the end of a loan

F = P + Pin or F = P(1+in)
Where :
F = Amount of the loan P plus the total interest earned or
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 Simple Interest

Example :
Andi put the money $1.000 in a bank with interest 9% per year. Calculate
total interest earned Andi will receive in 5 years!

Total interest earned 5 years = $ 1.000 x 9% x 5

= $ 450 or $ 90/year
F (5 years) = $ 1.000 + $ 450
= $ 1.450

You have agreed to loan a friend $5.000 for 5 years at simple interest rate of
8%. How much interest will you receive from the loan? How much will your
friend pay you at the end of 5 years?

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 Compound Interest
• Interest that is computed on the original unpaid debt and
the unpaid interest
• Total interest earned :
In = P(1+i)n - P
Where :
P = Present sum of money
i = Interest rate
n = Number of periods (years)
Example :
If you put $100 in a bank at 9% interest for two time period. Calculate total
interest you will receive back!

I2 = $100 x (1+.09)2 - $100 = $18.81 21S3101

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 Compound Interest
• Compound interest is calculated using the principal plus the
total amount of interest accumulated in previous.

• Hence, compound interest means “interest on top of

interest”

• Amount of money due at the end of a loan :

Fn = P(1+i)1(1+i)2…..(1+i)n or Fn = P (1 + i)n

Where :
F = The total amount of money or future value
P = Present sum of money
i = Interest rate 21S3101
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 Compound Interest
Example :
You have agreed to loan a friend $5000 for 5 years at a of 8% per year
compound interest. How will this change affect the amount that your
friend pays you at the end of 5 years?

Solution :

Year Total Principal (P) Interest (i) Future Value (F)

1 5000 $5000 × 0.08 = 400 $5000 + 400 = 5400
2 5400 5400 × 0.08 = 432 5400 + 432 = 5832
3 5832 5832 × 0.08 = 467 5832 + 467 = 6299
4 6299 6299 × 0.08 = 504 6299 + 504 = 6803
5 6803 6803 × 0.08 = 544 6803 + 544 = 7347

F5 = $ 5.000 (1 + 0.08)5 The total amount due at the end

F5 = $ 7.347 of the fifth year is $7347. 21S3101
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 Repaying a Debt
Four Ways to Repay a Debt :
Repay Repay Interest Earned
Plan Principal Interest
1 Equal annual Interest on unpaid Declines
installments balance

2 End of loan Interest on unpaid Constant

balance

3 Equal annual installments Declines at

increasing rate
4 End of loan Compound and Compounds at
pay at end of loan increasing rate until
end of loan
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 Repaying a Debt (Example)

You have agreed to loan a friend $5000 for 5 years at a interest rate of 8%
per year. You make four ways to repay debt :
Total Owed + Principal Total EOY
Year Amount Owed Interest 8%
Interest Payment Payment
Plan 1: Constant principal payment plus interest due (Constant Principal)
1 $5000 $400 $5400 $1,000 $1400
2 4000 320 4320 1000 1320
3 3000 240 3240 1000 1240
4 2000 160 2160 1000 1160
5 1000 80 1080 1000 1080
   $15,000 $1,200   $5,000 $6,200
Plan 2: Annual interest payment and principal payment at end of 5 years (Interest Only)
1 $5000 $400 $5400 $0 $400
2 5000 400 5400 0 400
3 5000 400 5400 0 400
4 5000 400 5400 0 400
5 5000 400 5400 5000 5400
   $25,000 $2,000   $5,000 $7,000
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 Repaying a Debt

Total Owed + Principal Total EOY

Year Amount Owed Interest 8%
Interest Payment Payment
Plan 3: Constant annual payments (Constant Payment)
1 $5000 $400 $5,400 $852 $1252
2 4148 331 4479 921 1252
3 3227 258 3485 994 1252
4 2233 178 2411 1074 1252
5 1159 93 1252 1159 1252
   $15,767 $1,260   $5,000 $6,260
Plan 4: All payment at end of 5 years (All at Maturity)
1 $5000 $400 $5,400 $0 $0
2 5400 432 5832 0 0
3 5832 467 6299 0 0
4 6299 504 6803 0 0
5 6803 544 7347 5000 7347
   $29,334 $2,347   $5,000 $7,347

Total Payment EOY (End of Year ) Fifth Year

Plan 4 > Plan 2 > Plan 3 > Plan 1

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 Equivalence

• Equivalence is an essential factor in engineering

economic analysis.

• When an organization is indifferent as to whether

it has a present sum of money now or the
assurance of some other sum of money (or series
of sums of money) in the future, we say that the
present sum of money is equivalent to the future
sum or series of sums.
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 Equivalence

Given the choice of these two plans which would you choose?

Year Plan 1 Plan 2

1 $1400 $400
2 1320 400
3 1240 400
4 1160 400
5 1080 5400
Total $6200 $7000

To make a choice the cash flows must be altered so a comparison

may be made. 21S3101
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 Technique of Equivalence

• Determine a single equivalent value at a

point in time for plan 1.
• Determine a single equivalent value at a
point in time for plan 2.
Both at the same interest rate

• Judge the relative attractiveness of the two

alternatives from the comparable
equivalent values.
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 Single Payment Compound Interest Formulas

Interest Formulas :
• To understand equivalence, the underlying
interest formulas must be analyzed.
• Notation:
I = Interest rate per interest period
n = Number of interest periods
P = Present sum of money (Present worth)
F = Future sum of money (Future worth)
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 Single Payment Compound Interest

Beginning Interest for Ending

Year
balance period balance
1 P iP P(1+i)

2 P(1+i) iP(1+i) P(1+i)2

3 P(1+i)2 iP(1+i)2 P(1+i)3

n P(1+i)n-1 iP(1+i)n-1 P(1+i)n

P at time 0 increases to P(1+i)n at the end of time n.

Or a Future sum = present sum (1+i)n 21S3101
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 Single Payment Compound Interest

Notation for Calculating a Future Value

• Formula:
F=P(1+i)n
is the single payment compound amount factor
• Functional notation:
F=P(F/P,i,n)

Notation for Calculating a Present Value

• Formula:
P=F(1/1+i)n=F(1+i)-n
is the single payment present worth factor
• Functional notation:
P=F(P/F,i,n) 21S3101
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 Single Payment Compound Interest (Example)

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 :
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.

Alternate Solution :
The equation F = P(1 + i)n need not be solved. Instead, the single payment
compound amount factor, (F/ P, i, n), is readily found in the tables given in Appendix
C Engineering Economic Analysis by Donald G Newnan.
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 Single Payment Compound Interest

F = P(F/P,i,n) = 500(F/ P, 6%, 3)

= 500 (1.191) = $595.50 21S3101
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 Handbook

• Donald G. Newnan et al., Engineering Economic Analysis

Eleventh Edition, Oxford University Press: New York, 2012.

• Chan S. Park, Fundamentals of Engineering Economics,

Pearson Education Limited: Edinburgh Gate, 2013.

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