Engineering Economics

21S3101

INTEREST AND EQUIVALENCE (Part 2)

Engineering Management
Del Institute of Technology
 Equivalence

• Equivalence is a combination of interest rate and time

value of money to determine the different amounts of money
at different point in time that are equal in economic
value.

• Even though the amounts and timing of the cash flows may
differ, the appropriate interest rate makes them equal.

• Equivalence is dependent on the interest rate!

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 Equivalence

• If we deposit P dollars today for n periods at interest rate i,

we will have F dollars at the end of period n.

• We can also say that, F dollars at the end of period n is

equal to P dollars now, if our earning power is measured in
terms of interest rate i.
F

Fn = P (1 + i)n
0
n
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P Engineering Economics

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 Equivalence (Example)
At 10% interest, what is the equivalent worth of of $ 5.000 now 5 years from
now?
Analysis of the problem is that P = $ 5.000, n = 5, i = 10%, F = ?
F5 = $ 5.000 (1 + 0,1)5
F5 = $ 8.053
So, $ 5.000 now is said to be equivalent to $ 8.053 five years from now at the
interest rate of 10% per year.
But if the interest rate applicable is 12%, then $ 8.053 in 5 years no longer be
equivalent to $ 5.000 today.
Analysis of the problem is that F = $ 8.053, n = 5, i = 12%, P = ?
P = $ 8.053 (1 + 0,12)-5
P = $ 4.570
So, $ 8.053 in 5 years from now at 12% interest
rate is said to be equivalent $ 4.570 today. 21S3101
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 Compound Interest

• An interest rate is quoted on an annual basis and is referred to as

nominal interest.

• However, interest may be payable on a semiannual, quarterly,

monthly or day basis.

• In order to determine the amount compounded, the following

equation applies :
𝑖 (𝑚 )(𝑛)
𝐹 = 𝑃 ൤1 + ൬ ൰൨
𝑚
Where :
m = The number of interest periods per year
n = The number of years
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i = The nominal interest Engineering Economics

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 Compound Interest (Example)

If $ 5.000 were invested for 10 years at 10% nominal interest compounded

semiannually, what would be the future amount?
Analysis of the problem is that P = $ 5.000, i = 10%, m = 2, n = 10 , F = ?

𝑖 (𝑚 )(𝑛)
𝐹 = 𝑃 ൤1 + ൬ ൰ ൨
𝑚
0.1 (2)(10)
𝐹 = $ 5.000 ൤1 + ൬ ൰ ൨
2
𝐹 = ($ 5.000)(1.05)20

𝐹 = $ 13.266

If interest compounded quarterly, what would be the future amount?

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 Compound Interest (Example)

Analysis of the problem is that P = $ 5.000, i = 10%, m = 4, n = 10, F = ?

0.1 (4)(10)
𝐹 = $ 5.000 ൤1 + ൬ ൰ ൨
4
𝐹 = ($ 5.000)(1.025)40

𝐹 = $ 13.425

If interest compounded monthly, what would be the future amount?

Analysis of the problem is that P = $ 5.000, i = 10%, m = 12, n = 10, F = ?

0.1 (12)(10)
𝐹 = $ 5.000 ൤1 + ൬ ൰ ൨
12

𝐹 = ($ 5.000)(1.0083)120
21S3101
𝐹 = $ 13.535 Engineering Economics

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 Compound Interest (Example)
If interest compounded daily, what would be the future amount?

Analysis of the problem is that P = $ 5.000, i = 10%, m = 365, n = 10, F = ?

0.1 (365)(10)
𝐹 = $ 5.000 ൤1 + ൬ ൰ ൨
365

𝐹 = ($ 5.000)(1.000274)3650

𝐹 = $ 13.589

Note : It is necessary to carry the number of digits to six to reflect the

difference in the future amounts.

If companies immediately invest receipts from sales and/or services, the

interest on this cash is compounded and the process is called continuous
compounding. 21S3101
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 Uniform Series Compound Amount Factor
• Since most engineering economy problems define “a period” as one year,
the uniform cash flow is an annual cash flow denoted by A for all period
lengths.

An end-of-period cash receipt or disbursement in a uniform series,

A continuing for n periods, the entire series equivalent to P or F at
interest rate i.
• In case general case for n years :

• After some operations we have : The term inside inside the

brackets is called the uniform
ሺ1 + 𝑖 ሻ𝑛 − 1
𝐹 = 𝐴ቈ ቉ series compound amount
𝑖 factor and has the notation
(F/ A, i, n).
𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑛) 21S3101
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 Uniform Series Compound Amount Factor
Example :
You deposit $500 in a credit union at the end of each year for 5 years. The
credit union pays 5% interest, compounded annually. Immediately after the
fifth deposit, how much can you withdraw from your account ?
F

0 1 2 3 4 5

A A A A A

Solution :
ሺ1 + 0.05ሻ5 − 1 There will be $2763 in
𝐹 = $500 ቈ ቉
0.05 the account following
the fifth deposit.
= ($500)(5.5256)
21S3101
= $ 2,763 Engineering Economics

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 Uniform Series Compound Amount Factor
Alternate Solution :

𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑛) There will be $2763 in the account

= $ 500(5.526) following the fifth deposit.
21S3101
= $ 2,763 Engineering Economics

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 Uniform Series Sinking Fund Factor
• A sinking fund is a separate fund into which one makes a uniform series
of money deposits ( A) to accumulate a desired future sum (F) by the
end of period n.

• If the previous equation is solved for A, we have :

where :

is called the uniform series sinking fund factor and

is written as (A/F, i, n).

The equation :
21S3101
𝐴 = 𝐹(𝐴/𝐹, 𝑖, 𝑛) Engineering Economics

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 Uniform Series Sinking Fund Factor

Example :
Assuming there is a need for $ 15,000 in 5 years, it was decided to deposit a
certain amount of money at the end of every year for 5 years at 5% interest.
What would the annual amount to be deposited be?

An analysis of the problem is that F = $ 15,000, n = 5, i = 0.05, A = ...?

0.05
= $ 15,000 ൤ ൨
ሺ1.05ሻ5 − 1

= $ 2,715

The annual amount to deposit is $ 2,715 21S3101

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 Uniform Series Sinking Fund Factor
Alternate Solution :

𝐴 = 𝐹(𝐴/𝐹, 𝑖, 𝑛) The annual amount

= $ 15,000(0.1810) to deposit is $ 2,715
21S3101
= $ 2,715 Engineering Economics

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 Uniform Series Capital Recovery Factor

• If we use the sinking fund formula and substitute for F the single payment
compound amount formula, we obtain :

𝑛
𝑖
ሺ ሻ
𝐴=𝑃 1+𝑖 ൤ ൨
ሺ1 + 𝑖 ሻ𝑛 − 1

𝑖 ሺ1 + 𝑖ሻ𝑛
𝐴 = 𝑃ቈ ቉
ሺ1 + 𝑖 ሻ𝑛 − 1

𝑖 ሺ1 + 𝑖 ሻ𝑛 is called the uniform series capital recovery factor

ቈ ቉
ሺ1 + 𝑖 ሻ𝑛 − 1 and has the notation (A/P, i, n)

21S3101
𝐴 = 𝑃(𝐴/𝑃, 𝑖, 𝑛) Engineering Economics

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 Uniform Series Capital Recovery Factor

Example :
A person desires to borrow $ 20,000 now to be paid back in 5 years at 5%
compound annually. How much is this person required to pay annually ?

An analysis of the problem is that P = $ 20,000, n = 5, i = 0.05, A = ...?

𝑖 ሺ1 + 𝑖ሻ𝑛
𝐴 = 𝑃ቈ ቉
ሺ1 + 𝑖 ሻ𝑛 − 1

0.05ሺ1 + 0.05ሻ5
= $ 20,000 ቈ ቉
ሺ1 + 0.05ሻ5 − 1

= $ 4,620

The annual amount to pay is $ 4,620 21S3101

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 Uniform Series Capital Recovery Factor
Alternate Solution :

𝐴 = 𝑃(𝐴/𝑃, 𝑖, 𝑛) The annual amount to pay is $ 4,620

= $ 20,000(0.2310)
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= $ 4,620 Engineering Economics

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 Uniform Series Present Worth Factor

• If the capital recovery formula is solved for the present sum P, we obtain
the uniform series present worth formula :
𝑖 ሺ1 + 𝑖ሻ𝑛
𝐴 = 𝑃ቈ ቉
ሺ1 + 𝑖 ሻ𝑛 − 1

ሺ1 + 𝑖 ሻ𝑛 − 1
𝑃 = 𝐴ቈ ቉
𝑖 ሺ1 + 𝑖 ሻ𝑛

ሺ1 + 𝑖ሻ𝑛 − 1 is called the uniform series present worth factor

ቈ ቉ and has the notation (P/A, i, n)
𝑖 ሺ1 + 𝑖 ሻ𝑛

𝑃 = 𝐴(𝑃/𝐴, 𝑖, 𝑛)

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 Uniform Series Present Worth Factor

Example :
A person wants to borrow as much money as possible today with an annual
payment of $ 5.000 at the end of each year for 5 years. If he is charged 5%
interest compounded, how much could he borrow?

An analysis of the problem is that A = $ 5,000, n = 5, i = 0.05, P = ...?

ሺ1 + 𝑖 ሻ𝑛 − 1
𝑃 = 𝐴ቈ ቉
𝑖 ሺ1 + 𝑖 ሻ𝑛

ሺ1 + 0.05ሻ5 − 1
= $5,000 ቈ ቉
0.05ሺ1 + 0.05ሻ5

= $ 21,645

The total amount he could borrow is $ 21,645 21S3101

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 Uniform Series Present Worth Factor
Alternate Solution :

𝑃 = 𝐴(𝑃/𝐴, 𝑖, 𝑛) The total amount he could

= $ 5,000(4.329) borrow is $ 21,645
21S3101
= $ 21,645 Engineering Economics

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 Summary of Compound Interest Factor

Discrete Payments
Factor Find Given
Discrete Compounding
Single Payment
Compound Amount F P 𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑛)
1
Present Worth P F 𝑃=𝐹 𝑃 = 𝐹(𝑃/𝐹, 𝑖, 𝑛)
(1 + 𝑖)𝑛
Uniform Series
ሺ1 + 𝑖 ሻ𝑛 − 1
𝐹 = 𝐴ቈ ቉ 𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑛)
Compound Amount F A 𝑖
𝑖
𝐴 = 𝐹൤ ൨ 𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑛)
Sinking Fund A F ሺ1 + 𝑖 ሻ𝑛 − 1
ሺ1 + 𝑖 ሻ𝑛 − 1
Present Worth P A 𝑃 = 𝐴ቈ ቉ 𝑃 = 𝐴(𝑃/𝐴, 𝑖, 𝑛)
𝑖 ሺ1 + 𝑖ሻ𝑛
𝑖 ሺ1 + 𝑖 ሻ𝑛
Capital Recovery A P 𝐴 = 𝑃ቈ ቉ 𝐴 = 𝑃(𝐴/𝑃, 𝑖, 𝑛)
ሺ1 + 𝑖 ሻ𝑛 − 1

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 Practice

1. If you invest $40,000 in a stock whose value grows at 2% per year,

your investment is nearest what value after 5 years?
2. An account pays interest at 1.5% per month. If you deposit $5000 at
the beginning of this year, how much could you withdraw at the end of
next year?
3. A machine will need to be replaced 15 years from today for $10,000.
How much must be deposited now into an account that earns 5% per
year to cover the replacement cost?
4. Your friend withdrew $630,315 from an account into which she had
invested $350,000. If the account paid interest at 4% per year, she kept
her money in the account for how many years?
5. If $ 500 were deposited at the end of every year for 10 years in an
account earning 5% interest compounded annually, how much will be in
the account at the end of 10 years?
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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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