LECTURE 3

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 LEARNING OUTCOMES

1. Role in decision
7. Economic equivalence
making
8. Simple and compound
2. Study approach
interest
3. Ethics and economics
9. Minimum attractive
4. Interest rate rate of return
5. Terms and symbols 10. Spreadsheet
6. Cash flows functions

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 ECONOMIC EQUIVALENCE
DEFINITION: COMBINATION OF INTEREST RATE (RATE OF
RETURN) AND TIME VALUE OF MONEY TO DETERMINE
DIFFERENT AMOUNTS OF MONEY AT DIFFERENT POINTS IN
TIME THAT ARE ECONOMICALLY EQUIVALENT

HOW IT WORKS: USE RATE I AND TIME T IN UPCOMING

RELATIONS TO MOVE MONEY (VALUES OF P, F AND A)
BETWEEN TIME POINTS T = 0, 1, …, N TO MAKE THEM
EQUIVALENT (NOT EQUAL) AT THE RATE I

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 ECONOMIC EQUIVALENCE
• Two sums of money at different points in time can be made
economically equivalent if:
• We consider an interest rate and,
• number of Time periods between the two sums

$20,000 is
received here

T=0 t = 1 Yr

$21,800 paid
back here
$20,000 now is economically equivalent to $21,800 one year from now IF the interest rate is set to1-4
equal to
?
 EQUIVALENCE ILLUSTRATED
• $20,000 now is not equal in magnitude to $21,800 1
year from now
• But, $20,000 now is economically equivalent to
$21,800 one year from now if the interest rate in 9%
per year.
• To have economic equivalence you must specify:
• timing of the cash flows
• interest rate (i% per interest period)
• Number of interest periods (N)

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 ECONOMIC EQUIVALENCE
• FOR EXAMPLE, IF THE INTEREST RATE IS 6% PER YEAR, $100
TODAY (PRESENT TIME) IS EQUIVALENT TO $106 ONE YEAR
FROM TODAY

• SO, IF SOMEONE OFFERED YOU A GIFT OF $100 TODAY OR

$106 ONE YEAR FROM TODAY, IT WOULD MAKE NO
DIFFERENCE FROM AN ECONOMIC PERSPECTIVE

• THE TWO SUMS OF MONEY ARE EQUIVALENT TO EACH

OTHER ONLY WHEN THE INTEREST RATE IS 6% PER YEAR

• THAT IS, AT A HIGHER OR LOWER INTEREST RATE, $100

TODAY IS NOT EQUIVALENT TO $106 ONE YEAR FROM TODAY

• THE SAME CONCEPT APPLIES A YEAR AGO, THAT IS A TOTAL

OF $100 TODAY IS ECONOMICALLY EQUIVALENT TO $100/1.06
= $94.34
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 SIMPLE AND COMPOUND
INTEREST
• Two “types” of interest calculations
• Simple Interest
• Compound Interest
• Compound Interest is more common worldwide
and applies to most analysis situations

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 SIMPLE AND COMPOUND
INTEREST
• Simple Interest is calculated on the principal amount
only
• Easy (simple) to calculate
• Simple Interest is:
• (principal)(interest rate)(time); $I = (P)(i)(n)
• Borrow $1000 for 3 years at 5% per year
• Let “P” = the principal sum
• i = the interest rate (5%/year)
• Let N = number of years (3)
• Total Interest over 3 Years...
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 FOR ONE YEAR
• $50.00 interest accrues but not paid
• “Accrued” means “owed but not yet paid”
• First Year:
P=$1,000

1 2 3

I1=$50.00

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 END OF 3 YEARS

• $150 of interest has accrued

P=$1,000

1 2 3

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1000

+ $150 of
interest
The unpaid interest did not earn
interest over the 3-year period 1-
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 SIMPLE INTEREST – EXAMPLE

• A COMPANY LOANED MONEY TO AN ENGINEERING STAFF

MEMBER FOR A RADIO-CONTROLLED MODEL AIRPLANE.
THE LOAN IS FOR $1,000 FOR 3 YEARS AT 5% PER YEAR
SIMPLE INTEREST

• HOW MUCH MONEY WILL THE ENGINEER REPAY AT THE

END OF 3 YEARS?

• THE INTEREST FOR EACH OF THE 3 YEARS IS:

INTEREST PER YEAR = $1,000 × 0.05 = $50
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TOTAL INTEREST FOR 3 YEARS IS $1,000 × 0.05 × 3 = $150
 SIMPLE INTEREST – EXAMPLE
• THE $50 INTEREST ACCRUED IN THE FIRST YEAR AND THE $50
ACCRUED IN THE SECOND YEAR DO NOT EARN INTEREST

• THE INTEREST DUE EACH YEAR IS CALCULATED ONLY ON

THE $1,000 PRINCIPAL

Amount Amount Interest Amount End of

Paid Owed Borrowed Year
0 0 0 $1,000 0
0 $1,050 $50 - 1
0 $1,100 $50 - 2
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$1,150 $1,150 $50 - 3 12
 COMPOUND INTEREST – EXAMPLE
• IF AN ENGINEER BORROWS $1,000 AT 5% PER YEAR COMPOUND
INTEREST, COMPUTE THE TOTAL AMOUNT DUE AFTER 3 YEARS

• THE INTEREST AND TOTAL AMOUNT DUE EACH YEAR ARE COMPUTED:

• YEAR 1 INTEREST: $1,000 × 0.05 = $50.00

TOTAL AMOUNT DUE AFTER YEAR 1 = $1,000 + $50 = $1,050

YEAR 2 INTEREST: $1,050 × 0.05 = $52.50

TOTAL AMOUNT DUE AFTER YEAR 2 = $1,050 + $52.5 = $1,102.50

YEAR 3 INTEREST: $1,102.5 × 0.05 = $55.13 1-

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TOTAL AMOUNT DUE AFTER YEAR 3 = $1,102.5 + $55.13 = $1,157.63
 COMPOUND INTEREST – EXAMPLE
 The $50 interest accrued in the first year and the $50
accrued in the second year do not earn interest

 The interest due each year is calculated only on the

$1,000 principal
Amount Amount Interest Amount End of
Paid Owed Borrowed Year
0 0 0 $1,000 0
0 $1,050 $50 - 1
0 $1,102.5 $52.5 - 2
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$1,157.63 $1,157.63 $55.13 - 3 14
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 EXAMPLE [1]
TIME VALUE OF MONEY
• YOU HAVE $1,000 AND YOU WANT TO BUY A $1,000
MACHINE

• SUPPOSE THAT YOU CAN INVEST MONEY AT 6%

INTEREST, BUT THE PRICE OF THE MACHINE
INCREASES ONLY AT AN ANNUAL RATE OF 4% DUE
TO INFLATION. AFTER A YEAR, YOU CAN STILL BUY
THE MACHINE AND YOU WILL HAVE $20 LEFT OVER
(EARNING POWER EXCEEDS INFLATION)

• IF THE PRICE OF THE MACHINE INCREASES AT AN

ANNUAL RATE OF 8% INSTEAD, YOU WILL NOT HAVE
ENOUGH MONEY TO BUY THE MACHINE A YEAR
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FROM TODAY. IN THIS CASE, IT IS BETTER TO BUY IT
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TODAY (INFLATION EXCEEDS EARNING POWER)
 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE
• DEMONSTRATE THE CONCEPT OF EQUIVALENCE USING THE
DIFFERENT LOAN REPAYMENT PLANS DESCRIBED BELOW.
EACH PLAN REPAYS A $5,000 LOAN IN 5 YEARS AT 8% INTEREST
PER YEAR

• PLAN 1: SIMPLE INTEREST, PAY ALL AT END. NO INTEREST OR

PRINCIPAL IS PAID UNTIL THE END OF YEAR 5. INTEREST
ACCUMULATES EACH YEAR ON THE PRINCIPAL ONLY
• PLAN 2: COMPOUND INTEREST, PAY ALL AT END. NO INTEREST OR
PRINCIPAL IS PAID UNTIL THE END OF YEAR 5. INTEREST
ACCUMULATES EACH YEAR ON THE TOTAL OF PRINCIPLE AND
ALL ACCRUED INTEREST
• PLAN 3: SIMPLE INTEREST PAID ANNUALLY, PRINCIPAL REPAID AT
END. THE ACCRUED INTEREST IS PAID EACH YEAR, AND THE
ENTIRE PRINCIPAL IS REPAID AT THE END OF YEAR 5
• PLAN 4: COMPOUND INTEREST AND PORTION OF PRINCIPAL 1-
REPAID ANNUALLY. THE ACCRUED INTEREST AND ONE-FIFTH16 OF
THE PRINCIPAL IS REPAID EACH YEAR
 PAYMENT PLAN
Amount Amount Interest Amount End of
Paid Owed Borrowed Year
0
1
2
3
4

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 1

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 2

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 3

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 4

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 TERMINOLOGY AND SYMBOLS

P = value or amount of money at a time designated as

the present or time 0.
F = value or amount of money at some future time.
A = series of consecutive, equal, end-of-period amounts
of money.
n = number of interest periods; years
i = interest rate or rate of return per time period;
percent per year, percent per month
t = time, stated in periods; years, months, days, etc

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 P AND F
• The symbols P and F represent one-time occurrences:
• It should be clear that a present value P represents a single sum
of money at some time prior to a future value F

$F

0 1 2 … … n-1 n

$P 1-
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 TYPES OF FINANCING

• EQUITY FINANCING
• –FUNDS EITHER FROM RETAINED EARNINGS,
NEW STOCK ISSUES, OR OWNER’S INFUSION
OF MONEY.
• DEBT FINANCING
• –BORROWED FUNDS FROM OUTSIDE
SOURCES – LOANS, BONDS, MORTGAGES,
VENTURE CAPITAL POOLS, ETC. INTEREST IS
PAID TO THE LENDER ON THESE FUNDS

FOR AN ECONOMICALLY JUSTIFIED PROJECT

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ROR ≥ MARR > WACC
 COST OF CAPITAL ( WACC )
SUPPOSE THE ALPHA COMPANY HAS A CAPITAL
STRUCTURE COMPOSED OF THE FOLLOWING, IN
MILLIONS:
 DEBT = 10
 COMMON EQUITY = 40
F THE COST OF DEBT IS 9%, THE COST OF EQUITY IS
15%,
WHAT IS ALPHA’S WEIGHTED AVERAGE COST OF
CAPITAL?
SOLUTION: 1-
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WACC = [(0.20)(0.09) + [(0.8)(0.15)]
 MINIMUM ATTRACTIVE RATE OF
RETURN
 MARR is a reasonable rate
of return (percent)
established for evaluating
and selecting alternatives
 An investment is justified
economically if it is
expected to return at least
the MARR
 Also termed hurdle rate,
benchmark rate and cutoff
rate
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 MARR CHARACTERISTICS

• MARR IS ESTABLISHED BY THE FINANCIAL

MANAGERS OF THE FIRM
• MARR IS FUNDAMENTALLY CONNECTED TO
THE COST OF CAPITAL
• BOTH TYPES OF CAPITAL FINANCING ARE
USED TO DETERMINE THE WEIGHTED
AVERAGE COST OF CAPITAL (WACC) AND
THE MARR
• MARR USUALLY CONSIDERS THE RISK
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INHERENT TO A PROJECT 27
 RULE OF 72’S FOR INTEREST
• A common question most often asked by
investors is:
• How long will it take for my investment to
double in value?
• Must have a known or assumed compound
interest rate in advance
• Assume a rate of 13%/year to illustrate….

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 RULE OF 72’S FOR INTEREST
• The Rule of 72 states:
• The approximate time for an investment to
double in value given the compound interest
rate is:
• Estimated time (n) = 72/i
• For i = 13%: 72/13 = 5.54 years

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 OPPORTUNITY COST
 DEFINITION: LARGEST RATE OF RETURN OF
ALL PROJECTS NOT ACCEPTED (FORGONE)
DUE TO A LACK OF CAPITAL FUNDS
 IF NO MARR IS SET, THE ROR OF THE FIRST PROJECT
NOT UNDERTAKEN ESTABLISHES THE OPPORTUNITY
COST

EXAMPLE: ASSUME MARR = 10%. PROJECT A, NOT FUNDED

DUE TO LACK OF FUNDS, IS PROJECTED TO HAVE RORA =
13%. PROJECT B HAS RORB = 15% AND IS FUNDED BECAUSE
IT COSTS LESS THAN A
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OPPORTUNITY COST IS 13%, I.E., THE OPPORTUNITY TO MAKE30
AN ADDITIONAL 13% IS FORGONE BY NOT FUNDING
 CHAPTER SUMMARY
• ENGINEERING ECONOMY FUNDAMENTALS
TIME VALUE OF MONEY
ECONOMIC EQUIVALENCE
INTRODUCTION TO CAPITAL FUNDING AND MARR
SPREADSHEET FUNCTIONS
• INTEREST RATE AND RATE OF RETURN
SIMPLE AND COMPOUND INTEREST
• CASH FLOW ESTIMATION
CASH FLOW DIAGRAMS
END-OF-PERIOD ASSUMPTION
NET CASH FLOW
PERSPECTIVES TAKEN FOR CASH FLOW ESTIMATION
• ETHICS
UNIVERSAL MORALS AND PERSONAL MORALS
PROFESSIONAL AND ENGINEERING ETHICS (CODE OF 1-
ETHICS) 31
 ASSIGNMENT NO. 1
• CHAPTER 1
• Q. NO.1, 4, 11, 13,, 16, 19, 22, 24, 40, 41
• Total Marks : 10
• Submission : PDF to be uploaded on LMS
of Handwritten pages.
(LATE SUBMISSION WILL NOT BE ACCEPTED)

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