Simple and Compound

Interest
4/29/2012 1
Two types of interest calculations
Simple Interest
Compound Interest
Compound Interest is more common worldwide
and applies to most analysis situations
Simple and Compound Interest
4/29/2012 2
Simple Interest
Calculated on the principal amount only
Easy (simple) to calculate
Simple Interest is:
(principal)(interest rate)(time)
$I = (P)(i)(n)
Simple and Compound Interest
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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)
Simple and Compound Interest
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Simple Interest
DEFINITION
I = P(i)(N)
I = $1000(0.05)(3) = $150.00
Total Interest over 3 Years
Simple and Compound Interest
4/29/2012 5
Year by Year Analysis Simple Interest
Year 1
I
1
= $1,000(0.05) = $50.00
Year 2
I
2
= $1,000(0.05) = $50.00
Year 3
I
3
= $1,000(0.05) = $50.00
Accrued Interest Year 1
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Accrued means owed but not yet paid
First Year:
1 2 3
I
1
=$50.00
P=$1,000
$50.00 interest accrues but not paid
1 2 3
I
1
=$50.00
P=$1,000
Accrued Interest Year 2
4/29/2012 Authored by Don Smith, TX A&M University 7
Year 2
1 2 3
I
1
=$50.00
P=$1,000
$50.00 interest accrues but not paid
I
2
=$50.00
End of 3 Years
4/29/2012 8
$150 of interest has accrued
I
2
=$50.00
1 2 3
I
1
=$50.00
P=$1,000
I
3
=$50.00
Pay back $1000 +
$150 of interest
The unpaid interest did not earn interest over
the 3-year period
Simple Interest: Summary
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In a multiperiod situation with simple interest:
The accrued interest does not earn interest during the succeeding time
period
Normally, the total sum borrowed (lent) is paid back at the end of the
agreed time period PLUS the accrued (owed but not paid) interest.
Compound Interest
4/29/2012 10
Compound Interest is much different
Compound means to stop and compute
In this application, compounding means to
compute the interest owed at the end of the
period and then add it to the unpaid balance of
the loan
Interest then earns interest
Compound Interest
4/29/2012 11

To COMPOUND stop and compute the associated interest and add it to
the unpaid balance.
When interest is compounded, the interest that is accrued at the end of a
given time period is added in to form a NEW principal balance.
That new balance then earns or is charged interest in the succeeding time
period

Compound Interest
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To COMPOUND stop and compute the associated interest and add it to
the unpaid balance.
When interest is compounded, the interest that is accrued at the end of a
given time period is added in to form a NEW principal balance.
That new balance then earns or is charged interest in the succeeding time
period

Compound Interest
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Assume:
P = $1,000
i = 5% per year compounded annually (C.A.)
N = 3 years
Compound Interest Cash Flow
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For compound interest, 3 years, we have:
I
2
=$52.50
I
1
=$50.00
1 2 3
P=$1,000
I
3
=$55.13
Owe at t = 3 years:
$1,000 + 50.00 + 52.50 +
55.13 = $1157.63
Compound Interest: Calculated
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For the example:
P
0
= +$1,000
I
1
= $1,000(0.05) = $50.00
Owe P
1
= $1,000 + 50 = $1,050 (but, we dont pay yet!)
New Principal sum at end of t = 1: = $1,050.00
Compound Interest: t = 2
4/29/2012 16

Principal and end of year 1: $1,050.00
I
1
= $1,050(0.05) = $52.50 (owed but not paid)
Add to the current unpaid balance yields:
$1050 + 52.50 = $1102.50
New unpaid balance or New Principal Amount
Now, go to year 3.
Compound Interest: t = 3
4/29/2012 17

New Principal sum: $1,102.50
I
3
= $1102.50(0.05) = $55.125 = $55.13
Add to the beginning of year principal yields:
$1102.50 + 55.13 = $1157.63
This is the loan payoff at the end of 3 years
Note how the interest amounts were added to form a new principal sum with
interest calculated on that new amount
4/29/2012 18

Five plans are shown that will pay off a loan of $5,000 over 5 years with
interest at 8% per year.
Plan1. Simple Interest, pay all at the end
Plan 2. Compound Interest, pay all at the end
Plan 3. Simple interest, pay interest at end of each year. Pay the principal at
the end of N = 5
Plan 4. Compound Interest and part of the principal each year (pay 20% of
the Prin. Amt.)
4/29/2012 19

Plan 5. Equal Payments of the compound interest and principal reduction
over 5 years with end of year payments.
Note: The following tables will show the five approaches. For now, do not try
to understand how all of the numbers are determined (that will come later!)
Focus on the methods and these table illustrate economic equivalence
8% Simple Interest
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Simple Interest: Pay all at end on $5,000 Loan
Plan 2: Compound Interest 8%/yr
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Pay all at the End of 5 Years
Simple Interest Pd. Annually
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Principal Paid at the End (balloon Note)
Compound Interest
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20% of Principal Paid back annually
Equal Repayment Plan
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Equal Annual Payments (Part Principal and Part Interest
Comparisons 5 Plans
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Plan 1 Simple interest = (original principal)(0.08)
Plan 2 Compound interest = (total owed previous year)(0.08)
Plan 3 Simple interest = (original principal)(0.08)
Plan 4 Compound interest = (total owed previous year)(0.08)
Plan 5 Compound interest = (total owed previous year)(0.08)
Analysis
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Note that the amounts of the annual payments are different for each
repayment schedule and that the total amounts repaid for most plans are
different, even though each repayment plan requires exactly 5 years.
The difference in the total amounts repaid can be explained (1) by the time
value of money, (2) by simple or compound interest, and (3) by the partial
repayment of principal prior to year 5.

Terminology and Symbols
4/29/2012 27

Specific symbols and their respective definitions has been developed for
use in engineering economy
Symbols tend to be standard in most engineering economy texts world-
wide
Mastery of the symbols and their respective meanings is most important
in understanding of the subsequent material!

Terminology and Symbols
4/29/2012 28
P = value or amount of money (principal)
at a time designated as the present or time
0.
Also P is referred to as present worth
(PW), present value (PV), net present value
(NPV), discounted cash flow (DCF), and
capitalized cost (CC); dollars


Terminology and Symbols
4/29/2012 29

F = value or amount of money at some future
time.
Also F is called future worth (FW) and future
value (FV); dollars

Terminology and Symbols
4/29/2012 30

A = series of consecutive, equal,
end-of-period amounts of money.
Also A is called the annual worth (AW) and
equivalent uniform annual worth (EUAW);
dollars per year, dollars per month
n = number of interest periods; years,
months, days

Terminology and Symbols
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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
P and F
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The symbols P and F represent one-time occurrences:
Specifically:
$P
$F
t = n
0 1 2 n-1 n
P and F
4/29/2012 33

It should be clear that a present value P
represents a single sum of money at some time
prior to a future value F
This is an important basic point to remember
Annual Amounts
4/29/2012 34

It is important to note that the symbol A
always represents a uniform mount (i.e., the
same amount each period) that extends through
consecutive interest periods.
Annual Amounts
4/29/2012 35
Cash Flow diagram for annual amounts might
look like the following:
0 1 2 3 .. N-1 n

$A $A $A $A $A
A = equal, end of period cash flow amounts
Interest Rate i% per period
4/29/2012 36

The interest rate i is assumed to be a
compound rate, unless specifically stated
As simple interest

The rate i is expressed in percent per interest
period, for example, 12% per year.

Terminology and Symbols
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For many engineering economy problems:
Involve the dimension of time
At least 4 of the symbols { P, F, A, i% and n }
At least 3 of 4 are either estimated or
assumed to be know with certainty.

Solution by Computer
4/29/2012 38

Use of a spreadsheet similar to Microsofts
Excel is fundamental to the analysis of
engineering economy problems.
Appendix A of the text presents a primer on
spreadsheet use
All engineers are expected by training to know
how to manipulate data, macros, and the
various built-in functions common to
spreadsheets
Spreadsheets
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Excel supports (among many others) six built-
in functions to assist in time value of money
analysis
Master each on your own and set up a variety
of the homework problems (on your own)
Excels Financial Functions
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To find the present value P: PV(i%,n,A,F)

To find the future value F: FV(i%,n,A,P)

To find the equal, periodic value A:
PMT(i%,n,P,F)


Financial Functions - continued
4/29/2012 41

To find the number of periods n:
NPER(i%,A,P,F)
To find the compound interest rate i:
RATE(n,A,P,F)
To find the compound interest rate i:
IRR(first_ cell:last_ cell)

Financial Functions - continued
4/29/2012 42
To find the present value P of any series:
NPV(i%,second_cell_last cell) + first cell
These built-in Excel functions support a wide
variety of spreadsheet models that are useful in
engineering economy analysis.
Study Examples 1.10 and 1.11





Minimum Attractive Rate of
Return (MARR)
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Firms will set a minimum interest rate that the financial managers of the
firm require that all accepted projects must meet or exceed.
The rate, once established by the firm is termed the Minimum Attractive
Rate of Return (MARR)
The MARR is expressed as a per cent per year
Numerous models exist to aid the financial managers is estimating what
this rate should be in a given time period.
MARR (cont.)
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An investment is a commitment of funds and resources in a project with
the expectation of earning a return over and above the worth of the
resources that were committed.
Economic Efficiency means that the returns should exceed the inputs.
In the for profit enterprise, economic efficiencies greater than 100% are
required!
MARR Hurdle Rate
4/29/2012 45

In some circles, the MARR is termed the Hurdle Rate
Capital (investment funds) is not free
It costs the firm money to raise capital or to use the owners of the firms
capital.
This cost is often expressed as a % per year

Cost of Capital: Personal Example
4/29/2012 46

Assume you want to purchase a new computer
Assume you have a charge card that carries a 18% per year interest rate.
If you charge the purchase, YOUR cost of capital is the 18% interest rate.
Very high!

Cost to a Firm
4/29/2012 47

Firms raise capital from the following sources
Equity using the owners funds (retained earnings, cash on hand
(belongs to the owners)
Owners expect a return on their money and hence, there is a cost to
the firm
DEBT the firm borrows from outside the firm and pays an interest rate
on the borrowed funds
Costing Capital
4/29/2012 48

Financial models exist that will approximate the firms weighted average
cost of capital for a given time period.
Once this cost is approximated, then, new projects up for funding MUST
return at least the cost of the funds used in the project PLUS some
additional per cent return.
The cost is expressed as a % per year just like an interest rate.
Setting the MARR: Safe Investment
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First, start with a safe investment possibility
A firm could always invest in a short term CD paying around 4-5%
But investors will expect more that that!
The firm should compute its current weighted average cost of capital
(See Chapter 10)
This cost will almost always exceed a safe external investment rate!

Setting the MARR (cont.)
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Assume the weighted average cost of capital (WACC) is say, 10.25% (for
the sake of presentation)
Certainly, the MARR must be greater than the firms cost of capital in
order to earn a profit or return that satisfies the owners!
Thus, some additional buffer must be provided to account for risk
and uncertainty!

Setting a MARR (cont.)
4/29/2012 51

Start with the WACC
Add a buffer percent (?? Varies from firm to firm)
This yields an approximation to a reasonable MARR
This becomes the Hurdle Rate that all prospective projects should earn in
order to be considered for funding.
MARR
4/29/2012 52
0%
RoR - %
MARR - %
Safe Investment WACC - %
Acceptable range for new
projects
4/29/2012 53

Assume a firms MARR = 12%
Two projects, A and B
A costs $400,000 and presents an estimated 13% per year.
B cost $100,000 with an estimated return of 14.5%

4/29/2012 54
What if the firm has a budget of say $150,000
A cannot be funded not sufficient funds!
B is funded and earns 14.5% return or more
A is not funded, hence, the firm looses the
OPPORTUNITY to earn 13%
This often happens!

Cash Flow Diagramming
4/29/2012 55

Engineering Economy has developed a graphical technique for
presenting a problem dealing with cash flows and their timing.
Called a CASH FLOW DIAGRAM
Similar to a free-body diagram in statics
First, some important TERMS . . . .

Important TERMS
4/29/2012 56
CASH INFLOWS
Money flowing INTO the firm from outside
Revenues, Savings, Salvage Values, etc
CASH OUTFLOWS
Disbursements
First costs of assets, labor, salaries, taxes paid, utilities, rents,
interest, etc

Cash Flows
4/29/2012 57

For many practical engineering economy problems the cash flows must
be:
Assumed know with certainty
Estimated
A range of possible realistic values provided
Generated from an assumed distribution and simulated

Net Cash Flows
4/29/2012 58
A NET CASH FLOW is
Cash Inflows Cash Outflows
(for a given time period)
We normally assume that all cash flows occur:
At the END of a given time period
End-of-Period Assumption
4/29/2012 59
END OF PERIOD convention
ALL CASH FLOWS ARE ASSUMED TO OCCUR AT THE END OF AN
INTEREST PERIOD EVEN IF THE MONEY FLOWS AT TIMES WITHIN
THE INTEREST PERIOD.
THIS IS FOR SIMPLIFICATION PURPOSES
The Cash Flow Diagram: CFD
4/29/2012 60
Extremely valuable analysis tool
First step in the solution process
Graphical Representation on a time scale
Does not have to be drawn to exact scale
But, should be neat and properly labeled
Required on most in class exams and part of the grade for the
problem at hand
Cash Flow diagrams
4/29/2012 61
Assume a 5-year problem
The basic time line is shown below
Now is denoted as t = 0
Displaying Cash Flows
4/29/2012 62
A sign convention is applied
Positive cash flows are normally drawn upward from the time line
Negative cash flows are normally drawn downward from the time line

CF Diagram
4/29/2012 63
Positive CF at t = 1
Negative CFs at t = 2 & 3
4/29/2012 64
Before solving, one must decide upon the perspective of the problem
Most problems will present two perspectives
Assume a borrowing situation for example
Perspective 1: From the lenders view
Perspective 2: From the borrowers view
Impact upon the sing convention
4/29/2012 65
Assume $5,000 is borrowed and payments are $1100 per year.
Draw the cash flow diagram for this
First, whose perspective will be used?
Lenders or the Borrowers ? ? ?
Problem will infer or you must decide.
Lending - Borrowing
4/29/2012 66
From the Lenders Perspective
0 1 2 3 4 5
-$5,000
A = +$1100/yr
Lending - Borrowing
4/29/2012 67
From the Lenders Perspective
0 1 2 3 4 5
P = +$5,000
A = -$1100/yr
Example
4/29/2012 68
A father wants to deposit an unknown lump-sum amount into an
investment opportunity 2 years from now that is large enough to withdraw
$4000 per year for state university tuition for 5 years starting 3 years from
now.
If the rate of return is estimated to be 15.5% per year, construct the cash
flow diagram.
CF Diagram
4/29/2012 69
Rule of 72: Estimating doubling
Time and Interest Rate
Rule of 72: Estimating Doubling Time and
Interest Rate
4/29/2012 71
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.
Rule of 72s for Interest
4/29/2012 72
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
Rule of 72s for Interest
4/29/2012 73
Likewise one can estimate the required interest rate for an investment to
double in value over time as:
i
approximate
= 72/n
Assume we want an investment to double in say 3 years.
Estimate i rate would be: 72/3 = 24%
Spreadsheet Applications
4/29/2012 74
Section 1.12 introduces the concepts associated with using a
spreadsheet program like Microsoft Excel.
To build and improve your knowledge of modeling by using Excel you
must build your own models and experiment with the various functions
You instructor will determine the extent and depth of use of Excel for this
course
Simple Interest
I=Pni => Final Amount (F) = P + I = P + Pni
Say you have a simple interest loan.
Say you borrow $5,000 (P) at a rate of 10% (i) for a
period of 5 years (n). What is the interest and the
amount due at payback?
F = $5,000 + {5,000 (0.10)}(5) = $5,000 + $500(5) =
$5,000 (P) + $2,500 (I)
Interest owed (I) is $2,500
Principal owed (P) is $5,000
Final amount owed (F) is $7,500
Compound Interest
F = P (1+i)
n

Say you have a compound interest loan.
Say you borrow $5,000 (P) at a rate of 10% (i) for a
period of 5 years (n). What is the interest and the
amount due at payback?
F = $5,000 (1+0.10)
5
= $5,000 (1.10)
5
= $5,000
(1.6105) = $8,052.55
Interest owed (I) is $3,052.55
Principal owed (P) is $5,000
Final amount owed (F) is $ 8,052.55
Single Payment Compound Amount
(F/P i, n) = (1+i)
n

Say you have a compound interest loan.
Say you borrow $5,000 (P) at a rate of 10% (i) for a
period of 5 years (n). What is the interest and the
amount due at payback?
Using Appendix A, Discrete Interest Factors, Table A.14
for 10%, left-hand column, n = 5 years
F = $5,000 (F/P 10, 5) = $5,000 (1.10)
5
= $5,000 (1.611)
= $8,055
Interest owed (I) is $3,055
Principal owed (P) is $5,000
Final amount owed (F) is $ 8,055

P = $5,000
F = $8,055
1 2 3 4 5
Single Payment Present Worth
(P/F i, n) = 1(1+i)
n
=> P = F(P/F, I, n) sometimes called the Discount
Factor
Say you want to have $20,000 at the end of your 5 year college
career for a down payment on a BMW.
How much money must be deposited, on the first day of college, into
an account yielding 5% interest annually?
Using Appendix A, Discrete Interest Factors, Table A.9 for 5%, n = 5
years
F = $20,000 (P/F 5, 5) = $20,000 (0.7835) = $15,670

P = $15,670
5 4 3 2 1
F = $20,000
( )
n
i + 1
1
Uniform Series Compound Amount
Equal amounts deposited over successive periods
F = A(F/A 1, n) = Future Worth
Say you grandparents deposit $2,000 a year for 5 years in a guaranteed
interest instrument bearing 5% per year compounded annually.
If the first deposit is made one year from now, how much money will
accumulate after your 5 year college degree?
Using Appendix A, Discrete Interest Factors, Table A.9 for 5%, n = 5 years
F = $2,000 (F/A 5, 5) = $2,000 (5.526) = $11,052
|
|
.
|

\
| +
=
i
i
A F
n
1 ) 1 (
A = $2000 A = $2000 A = $2000 A = $2000 A = $2000
F = $11,052
Uniform Series Sinking Fund Factor
Reciprocal of the Uniform Series Compound Amount A = F(A/F 1, n)
Uniform number of deposits that must be made to equal some specific value
in the future.
Say you need to have $10,000 by the time you graduate.
Say you find a fund that will pay 5% interest
What is the value of the equal annual deposits for 5 years, assuming the first
deposit is made one year from now?
Using Appendix A, Discrete Interest Factors, Table A.9 for 5%, n = 5 years
A = $10,000 (A/F, 5, 5) = $10,000 (0.1810) = $1,810
If the first deposit is paid now, A = A (P/F, i, n)
=> A = $1,810 (P/F, 5, 5) = $1,810 (0.7835) = $1,418.15
A = $1,810 A = $ 1,810 A = $ 1,810 A = $ 1,810 A = $ 1,810
F = $10,000
|
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|

\
|
+
=
1 ) 1 (
n
i
i
F A
Uniform Series Present Worth Factor
P = A(F/A, i, n)(P/F, i, n) => (P/A, I, n) = (F/A, I, n)(P/F, I, n) =>
P=A(P/A, i, n)
Say you promise to pay your parents $2,000 / year for 5 years after
graduation to partially repay them for supporting you through college
Say you get a $10,000 signing bonus from your new job.
How much must be deposited into an account yielding 5%
compounded annually in order to meet your annual repayment
promise?
P = $2,000 (P/A, 5, 5) = $2,000 (4.3295), using Table A.9 = $8,659
|
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|

\
|
+
+
=
n
n
i i
i
A P
) 1 (
1 ) 1 (
A = $2000 A = $2000 A = $2000 A = $2000 A = $2000
P = $8,659
Uniform Series Capital Recovery Factor
A = P(A/P, i, n)
Say you get a $10,000 signing bonus from your new job and you
deposit it into an account that yield a 5% interest rate compounded
annually.
How much can be withdrawn equally each year for 10 years?
A = $10,000 (A/P, 5, 10) = $10,000 (0.1295), using Table A.9, =
$1,295

|
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|

\
|
+
+
=
1 ) 1 (
) 1 (
n
n
i
i i
P A
P = $10,000
Gradient Conversion Factor
Used when withdrawals and/or payments increase / decrease over
time (e.g. rent, staggered rate increases for energy, etc.).
A
1
= Original Amount, A
2
= Additional Amount
Say you sign a lease and know the lease rate will increase by $100
per month each year for 5 years; you now pay $500 per month. You
also know that utilities will increase 10% a year for the same period
(utilities are included in the rent).
What is the present value of those increases?
P= {$6,000 (A
1
) + $1,200(A
2
) (A/G, 10, 5)}(P/A, 10, 5) =
{$6,000 + $1,200 (1.8101)}(3.7908) = P = $30,978.8725
$500
$600
$700
$800
$900
i
nG
i
i
i
G
F
n

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=
1 ) 1 (
( ) ) , , / ( ) , , / (
) , , / (
) , , / (
1
) , , / (
2 1
1
n i A P n i G A A A P
n i G A G A A
n i F A
i
n
i
n i G A
+ = =>
= =>
=
P = $30,978.8725
Find the Interest Rate
Lets say your parents deposited $1,000 per year into a
savings account and there now is $13,743 in the account after
ten (10) years. What rate of interest did the account yield?
F=A(F/A, i, n)
$13,743 = 1,000 (F/A. i, 10)
(F/A, i, 10) = $13,743 $1,000 = 13.7430
Go to Appendix A and look for 13.743 in the F/A column with n
= 10
(F/A, 6, 10) = 13.295 & (F/A, 6, 10) = 13.981 => interpolate
( )
% 6531 . 6 6531 . 0 6
) 1 (
686 . 0
448 . 0
6 6 7
295 . 13 981 . 13
295 . 13 743 . 13
6
= + =
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+ =
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+
Nominal and Effective Interest Rates
Interest rates are usually quoted on an annual basis
The % rate seen on TV is a nominal interest rate of
Annual Percentage Rate (APR) and the
compounding period is monthly.
For example, Honda advertises a 1.9% APR for 60
months => 1.9/12 = 0.1583% per month
However, the effective interest rate or Annual
Effective Yield or Annual Percentage Yield (APY) is
different.
APY
APY
% 94 . 1 0194 . 0 1 0194 . 1
1 ) 0016 . 0 1 ( 1
12
019 . 0
1
12
12
= = =
+ =
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+ =
Continuous Compounding
Interest rate is specified at a certain percent.
The most common application would be a loan to
purchase a house, property, building in which to
house a business, etc..
Continuous interest requires different interest factors
and, consequently, different calculations than the
previous.
Appendix C (Stevens) will be used.
Single Payment Compound Amount
Discrete rates, as previous
F = P(F/P, r, n)
Continuous Interest Rate Tables Appendix C (Stevens)
Say you inherit an account from your grandparents worth $10,000
You convert it to an account yielding 5% interest, compounded
continuously and you plan to keep the $ in the account for 10 years.
How much will you have at the end of 10 years?
F = $10,000 (F/P, 5, 10) = $10,000 (1.649) from Table C.5 (Stevens)
= $16,490.00
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P F P F , , /
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|
= cn
c
r
P F P F , , /
0 1 2 3 4 5 6 7 8 9 10
P = $10,000
F = $16,490
Single Payment Present Worth
P = F(P/F, r, n)
Say you want to have $10,000 in 5 years.
How much would you have to deposit in an account
today, that yields 5% interest compounded continuously?
P = $10,000 (P/F, 5, 5), = $10,000 (0.7788) from Table
C.5 (Stevens) = $7,788.00
F = $10,000
0 1 2 3 4 5
P = $7,788
Uniform Series Compound Amount
(Future Worth)
Equal amounts deposited over successive periods
F = A(F/A r, n) = Future Worth
Say you have an account that pays you 5% interest compounded
continuously.
How much will you accrue if you deposit $5,000 every year for 5 years?
F=$5,000(F/A, 5, 5) = $5,000 (5.540) = $26,700

1
1
) , , / (

= =
r
rn
e
e
n r A F A F
F = $27,700
0 1 2 3 4 5
A = $5,000 A = $5,000 A = $5,000 A = $5,000 A = $5,000
Uniform Series Compound Amount (Future Worth)
What if you deposit $5,000 semi-annually? (i.e. every 6 months)



You could interpolate between 2% and 3%. If you want to, go ahead!
However, you could do the following, which you should know how to
do.
F = $56,126.48
0 1 2 3 4 5
) 10 , 5 . 2 , / ( ) 5 ( 2 ,
2
5
, / 5000 $ A P A P P =
(

=
48 . 126 , 56 $ ) 2253 . 11 ( 000 , 5 $
0253 . 0
2840 . 0
000 , 5 $
1 0253 . 1
1 2840 . 1
000 , 5 $
1
1
000 , 5 $
1
1
000 , 5 $ ) 10 , 5 . 2 , / ( 000 , 5 $
025 . 0
25 . 0
) 10 )( 025 . 0 (
) 10 )( 025 . 0 (
= = |
.
|

\
|
= |
.
|

\
|

=
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|
.
|

\
|

=
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|
.
|

\
|

= =
e
e
e
e
A F F
2490 . 229 , 26 $ ) 2253 . 11 ( 000 , 5 $
0253 . 0
2840 . 0
000 , 5 $
1 025315121 . 1
1 284025417 . 1
000 , 5 $
1
1
000 , 5 $ ) 10 , 5 . 2 , / ( 000 , 5 $
) 025 . 0 (
) 10 )( 025 . 0 (
= =
|
.
|

\
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=
|
.
|

\
|

=
|
|
.
|

\
|

= =
e
e
A P P
Uniform Series Sinking
Fund Factor
Reciprocal of the Uniform Series Compound Amount A = F(A/F 1, n)
Uniform number of deposits that must be made to equal some specific value in
the future.
Say you inherit and asset that has $10,000 in it.
Also say that the account, paying 5% interest compounded continuously, has
only been open for 5 years.
How much was deposited annually, in equal amounts, into the account?
A = $10,000 (A/F, 5, 5) = $10,000 (0.1805) = $1,805 Also,
|
|
.
|

\
|

= =
1
1
) , , / (
rn
r
e
e
n r F A F A
F = $10,000
0 1 2 3 4 5
A = $1,805 A = $1,805 A = $1,805 A = $1,805 A = $1,805
806 , 1 $ ) 1806 . 0 ( 000 , 10 $
2840 . 0
0513 . 0
000 , 10 $
1 2840 . 1
1 0513 . 1
000 , 10 $
1
1
000 , 10 $
) 5 )( 05 . 0 (
05 . 0
= =
|
.
|

\
|
=
|
.
|

\
|

=
|
|
.
|

\
|

=
e
e
A
Uniform Series Present
Worth Factor
Combination of Uniform Series Compound Amount (Future Worth)
and Uniform Series Sinking Fund Factor
P = A(P/A, r, n) = (F/A, r, n)(P/F, r, n)
Say you set up an annuity from which you want to receive $3,000 per
year to spend on a vacation each year.
How much do you need to put into an account initially, that pays 5%
interest compounded continuously, if you are planning for 5 years?
P = $3,000(P/A, r, n) = $3,000 (4.3143) = $12,942.90
|
|
.
|

\
|
=
|
.
|

\
|
|
|
.
|

\
|

= =

1
1 1
1
1
) . , / (
rn
rn
rn r
rn
e
e
e e
e
n r A P A P
A = $3,000
0 1 2 3 4 5
P = $12,942.90
A = $3,000 A = $3,000 A = $3,000 A = $3,000
6725 . 935 , 12 $ ) 3119 . 4 ( 000 , 3 $
0513 . 0
2212 . 0
3000 $
1 0513 . 1
7788 . 0 1
000 , 3 $
1
1
000 , 3 $
05 . 0
) 5 )( 05 . 0 (
= =
|
.
|

\
|
=
|
.
|

\
|

=
|
|
.
|

\
|

=

e
e
P
Uniform Series Present
Worth Factor
Now, since you have worked at your position for 5 years, you want to
take 2 vacations per year.
This means you will withdraw $3,000 semi-annually (twice per year).
How much do you need to put in an account yielding 5% interest
compounded continuously?
Interpolate? Or
) 10 , 5 . 2 , / ( ) 5 ( 2 ,
2
5
, / 3000 $ A P A P P =
(

=
2490 . 229 , 26 $ ) 7431 . 8 ( 000 , 3 $
0253 . 0
2212 . 0
000 , 3 $
1 0253 . 1
788 . 0 1
000 , 3 $
1
1
000 , 3 $ ) 10 , 5 . 2 , / ( 000 , 3 $
) 025 . 0 (
) 10 )( 025 . 0 (
= =
|
.
|

\
|
=
|
.
|

\
|

=
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|
.
|

\
|

= =

e
e
A P P
0 1 2 3 4 5
P = $26,229.25
Uniform Series Capital
Recovery Factor
Reciprocal of the Uniform Series Present Worth Factor.
Say that at graduation, your parents, family, and friends all donate to an account,
paying an interest rate of 6% compounded continuously, that is worth $10,000
What are the maximum and equal monthly withdrawals that can be made for 2
years?
Wait! Dont forget that these interest rates are APR compounded monthly. So, r
= 0.06/12 = 0.005 and n = 12(2) because you are going to make monthly
withdrawals.
|
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.
|

\
|

= =
rn
r
e
e
P n r P A P A
1
1
) , , / (
0866 . 442 $ ) 0442 . 0 ( 000 , 10 $
1131 . 0
0050 . 0
000 , 10 $
8869 . 0 1
1 0050 . 1
000 , 10 $
1
1
000 , 10 $ ) 24 , 005 . 0 , / ( 000 , 10 $ ) 2 ( 12 ,
12
06 . 0
, / 000 , 10 $
) 24 )( 005 . 0 (
005 . 0
= = |
.
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\
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= |
.
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\
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=
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.
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\
|

= =
(

=

e
e
P A P A A
P=$10,000
Conversion of Continuous Interest Rates to an
Effective Interest Rate
Effective Annual Rate = e
r
1
An Annual Rate of 5% continuously compounded
e
0.05
1 = 1.051271096 1 = 0.0513 or 5.13% per
year compounded annually
Equivalence
Compare receipts & disbursements that occur at
different times
Put on an equivalent basis by considering
magnitude, timing, and interest rate of receipts
Application of interest factors
Equivalent present worth
Equivalent future worth
Equivalent annual amount
Does not imply an actual cash transactions
It is an amount that has the same monetary effect
Equivalence (cont.)
Say you are a landlord with monetary receipts (rent)
Also say you are renting a storage room for $1000.00 / year
for 5 years.
Say you take that income and put it into a money market
account that yields 5% interest compounded annually.

$1000.00 (P/A, 5, 5) = $1000.00 (4.3295), [Table A.9, Stevens]
= $4,329.50 Equivalent Present Amount (what it is worth
today)

Equivalent Future Amount (carry forward 10 years) $4,329.5
(F/P,5,10) = $4,329.50 (1.629) = $7,052.76

Equivalent Annual Amount
$4,329.50 (A/P,5,10) = $4,329.5 (0.1295) = $560.67
$7,052.76 (A/F,5,10) = $7,052.76 (0.0795) = $560.69

Auto Loans
Interest rate quoted on auto loans are Simple
Interest rates
Monthly car payments = Future amount (based on
simple interest # months

months of
erest simple on based Amount Future
Payment Car Monthly
#
) int (
=
months of
erest simple on based Amount Future
Payment Car Monthly
#
) int (
=
Auto Loans (cont.)
Say you buy a used mustang at a used car lot.
You put $10,000 down and you will owe $15,000
Say you get 8% interest on the $15,000
Calculate your monthly payment = P + (n)(i) # of
months
00 . 600 $
30
000 , 18 $
3
3000 000 , 15 $
30
) 08 . 0 )( 5 . 2 ( 000 , 15 $ 000 , 15 $
= =
+
=
+
=
MP
MP
00 . 600 $
30
000 , 18 $
3
3000 000 , 15 $
30
) 08 . 0 )( 5 . 2 ( 000 , 15 $ 000 , 15 $
= =
+
=
+
=
MP
MP
Auto Loans (cont.)
Say that you want to know the effective rate that you are
actually paying for your used car loan.
P = A (P/A, i, n) => $15,000 = $600 (P/A, I, 30) +>
(P/A,i,30) = $15,000/600 = 25 +> interpolation!
Look for (P/A, i, 30) close to 25, TabelA.3 @ 1% =
25.8077 & Table A.4 @ 1.1/4% = 24.8886




This is the rate compounded monthly, since a monthly
payment amount was used

% 6593 . 15 1 ) 02197 . 0 1 (
12
= + = rate annual Effective
% 2197 . 1 1 2197 . 0 ) 25 . 0 )( 8787 . 0 (
1 ) 25 . 0 (
9191 . 0
8077 . 0
1 ) 00 . 1 25 . 1 (
8886 . 24 8077 . 25
25 8077 . 25
= => + = => =
+
(

|
.
|

\
|
= => +
(

|
.
|

\
|

=
i i i
i i
Auto Loans (cont.)
Now you want to know the effective annual rate
(EAR)
% 6593 . 15 1 ) 02197 . 0 1 (
12
= + = rate annual Effective
Home Loan
Say you take advantage of the foreclosure market
and buy a starter home for $100,000.00.
Say you put $15,000 down and you borrow
$85,000.00 for a 30 year loan at 5% interest.
Remember, home loans are compounded
continuously!
What would your monthly payment be?
|
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.
|

\
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+
+
=
1 ) 1 (
) 1 (
n
n
i
i i
P A
Home Loan (cont.)
Home Loan (cont.)
So, how much principal is paid off at the end of the
10
th
mortgage payment?
B
10
=$85,000 (F/P, 0.0042, 10) - $458.3830 (F/A,
0.0042, 10)
( )
( )
( )
5589 . 035 , 1 $ , 4411 . 964 , 83 $
0549 . 4682 $ 50 . 646 , 88 $ ) 2143 . 10 ( 3830 . 458 $ 50 . 646 , 88 $
0042 . 0
0429 . 0
3830 . 458 $ 0429 . 1 000 , 85 $
1
1
3830 . 458 $ 000 , 85 $
1
1
3830 . 458 $ 000 , 85 $
) 10 , 0042 . 0 , / ( 3830 . 458 $ ) 10 , 0042 . 0 , / ( 000 , 85 $
10
10
10
0042 . 0
) 10 ( 00420 . 0 (
) 10 ( 00420 . 0 (
10
10
10
= =
= =
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=
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\
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=
=>
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\
|

=
=> =
I B
B
B
e
e
e B
e
e
e B
A F P F B
r
rn
rn
Home Loan (cont.)
So, what if you pay your normal payment plus an extra
payment of the same amount that you designate to pay off the
principal? That is you make two (2) payments of the same
amount each month; one regular and one toward the principal
(only).
Using data from previous example and subtracting the
principal payments
( )
( )
3692 . 621 , 79 $ 0549 . 4682 $ 0237 . 866 , 83 $$
) 2143 . 10 ( 3830 . 458 $ 0429 . 1 17 . 416 , 80 $$
) 2143 . 10 ( 3830 . 458 $ 0429 . 1 ) 83 . 583 , 4 $ 000 , 85 ($
) 10 , 0042 . 0 , / ( 3830 . 458 $ ) 10 , 0042 . 0 , / ))( 10 ( 3830 . 458 000 , 85 ($
10
10
10
10
= =
=
=> =
=> =
B
B
B
A F P F B
Bonds
Financial instrument used to obtain funds (most often by
municipalities).
Can be government, for-profit, non-profit organizations.
A bond is a debt issued on the basis of a face value
which is to be paid at the bonds maturity date (x number
of years).
Certain amounts of $ are paid between the time that
bond is issued and its maturity date.
This $ is paid annually, semi-annually, or quarterly and is
a function of a contracted bond rate (k) and the bonds
face value (V)
Bonds (cont.)
P = Bond Purchase Price
V = Bond Face Value
k = Contracted (interest) Rate
C = Number of periods per year
n = Number of years to maturity
kV/C = Amount of interest received (or paid) per
period
Bonds (cont.)
Equivalent present amount of the cash receipts is set
equal to the purchase price. The result is:



Where:
r = earned nominal rate
C = compounding periods
However, it should be noted that r has to be found by
trial and error
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+
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.
|

\
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|

\
|
=
c
r
F P V cn
c
r
A P
C
kV
P , / , , /
Bonds (cont.)
Say you purchase a 10 year bond for $1,000 and the
face value of the bond is $1,000 with a 12%
guaranteed yield compounded semi-annually. The
contracted rate (k) and the actual earned rate will be
equal. Find the effective rate.

( ) % 36 . 12 1236 . 0 1
2
12 . 0
1
994 . 999 $ 8 . 311 194 . 688 $ ) 3118 . 0 ( 1000 $ ) 4699 . 11 ( 60 000 , 1 $
) 10 ( 2 ,
2
12
, / 1000 $ ) 10 ( 2 ,
2
12
, / 60 000 , 1 $
) 10 ( 2 , , / 1000 $ ) 10 ( 2 , , /
2
) 1000 )( 12 . 0 (
000 , 1 $
2
= = + =
= + = + =
=>
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\
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+
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=
=>
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\
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+
|
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|

\
|
=
nnualrate Ef f ectivea
F P A P
c
r
F P
c
r
A P
Bonds (cont.)
What if you only paid $900 for the bond with a face value
of $1000?




You could try 13% or 14%. Which one would you try? Ill
take the high road and use 14%


$900 = $60(P/A,7,20) + $1000(P/F,7,20) = $60(10.5940)
+ $1000(0.2584) = 4635.64 + $258.40 = $894.04

) 12 (?
? 1000 $
900 $ 1000 $
12
20 ,
2
14
, / 1000 $ 20 ,
2
14
, / 00 . 60 $ 900 $
20 ,
6
, / 1000 $ 20 ,
6
, /
2
) 1000 )($ 12 . 0 (
900 $

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+ =
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+
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=
=>
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+
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=
r
and F P A P
r
F P
r
A P
|
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+
|
.
|

\
|
= 20 ,
2
14
, / 1000 $ 20 ,
2
14
, / 00 . 60 $ 900 $ F P A P
Bonds (cont.)
So,
% 37 . 14 1437 . 0 1 143696566 . 1
1 ) 0694375 . 1 ( 1
2
138875 . 0
1
% 8875 / 13 8875 . 1 12
) 2 (
96 . 105
100
12 ) 12 14 (
04 . 894 1000
900 1000
12
2
2
= = =
=
|
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\
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+ =
= + =
=>
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\
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+ =
|
.
|

\
|

+ =
Rate Annual Ef f ctive
R
r
Inflation
Inflation is based on:
Actual dollars
Real dollars
Actual Dollars: Actual currency transactions
estimated to occur at some point in time (inflation +
interest rates)
Real Dollars: Constant worth dollars that have the
same purchasing value as the dollar at some
reference point in time (time stands still). (interest
rate with adjustment for inflation)
Inflation
A
t
= R
t
(1+e)
t

A
t
= Actual value of $ at the end of t periods
R
t
= Real $ at the end of t periods
(1+e)
t
= inflation adjustment where e = inflation rate
Assumes that is inflation rate is constant over the t
periods
Equivalent present amount for a series of cash
transaction is based on actual dollars.


If real dollars are used, the equivalent present amount is
calculated as:
ei i e f
f A P
n
t
t
t
+ + =
=

=

0
) 1 (

+ =
n
t
t
t
i R P
0
) 1 (
Inflation Example
Less say you have a series of cash transactions
Inflation rate = 5%, Interest rate = 10%
Year
0 $5,000
1 $5,000
2 $5,000
3 $5,000
4 $5,000
Total $25,000
= 0.05 + 0.10 + [(o.o5)(0.10)] = 0.155
ei i e f + + =
Inflation Example
P = $5000 + $5000 (1 + 0.155)
-1
+ $5000 (1 + 0.155)
-2

+ $5000 (1 + 0.155)
-3
+ $5000 (1 + 0.155)
-4
=>
P = $5000 + $5000(0.8658) + $5000(0.7496) +
$5000(0.6490) + $5000(0.5619) =>
P = $5000 + $4329 + $3748 + $3245 + $2809.5 =
$19131.50 vs. $25,000 =>
$25,000 - $19131.50 = $5,868.50 loss in value.

=
n
t
t
t
f A P
0
) 1 (
Inflation (cont.)
Different components in an economic analysis may have
different inflations rates associated with each one.
Gasoline
Groceries
Clothing
Labor
Etc.
Some things are unresponsive to inflation
Depreciation
Lease fees
Loan interest charges (except adjustable rate mortgages)
4/29/2012 117
Engineering Economy:
Application of economic factors and criteria
to evaluate alternatives considering the
time value of money (interest and time)
Involves modeling the cash flows
Computing specific measures of economic
worth
Using an interest rate(s)
Over a specified period of time
Summary
4/29/2012 118
The concept of equivalence helps in
understanding how different sums of money at
different times are equal in economic terms
4/29/2012 119
Simple and Compound Interest
The differences between simple interest (based on
principal only) and compound interest (based on
principal and interest upon interest) have been
described in formulas, tables, and graphs
Compounding of Interest
The power of compounding is very noticeable,
especially over long periods of time.
Notion of computing interest on interest
4/29/2012 120
The MARR
The MARR is a reasonable rate of return
established as a hurdle rate to determine if
an alternative is economically viable.
The MARR is always higher than a return
from a safe investment.
4/29/2012 121
Attributes of Cash Flows
Difficulties with their estimation.
Difference between estimated and actual value.
End-of-year convention for cash flow location.
Net cash flow computation.
Different perspectives in determining the cash flow
sign convention.
Construction of a cash flow diagram.

Homework
2-1, 2-2, 2-3, 2-4, 2-6, 2-8, 2-12, 2-13, 2-15,
2-17, 2-19, 2-21, 2-23, 2-26, 2-28, 2-29,
2-33, 2-34, 2-36, 2-37, 2-38, 2-39, 2-40