Chapter 3 - Interest and Equivalence

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7, 8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other techniques

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Economic Decision Components

Where economic decisions are immediate we need to consider:
amount of expenditure taxes

Where economic decisions occur over a considerable period of time we need to also consider the consequences of:
interest inflation
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Computing Cash Flows

Cash flows have:
Costs (disbursements) a negative number Benefits (receipts) a positive number
Example 3-1

End of Year 0 1 2

Cash flow $ (1,000.00) $ 580.00 $ 580.00

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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 .09 = $9

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Simple Interest
Interest that is computed only on the original sum or principal Total interest earned = I = P i n , where:
P = present sum of money, or principal (example: $1000) i = interest rate (10% interest is a .10 interest rate) n = number of periods (years) (example: n = 2 years)
I = $1000 x .10/period x 2 periods = $200
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Future Value of a Loan With Simple Interest

Amount of money due at the end of a loan
F = P + P i n or F = P (1 + i n ) Where,
F = future value
F = $1000 (1 + .10 x 2) = $1200

Simple interest is not used today

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Compound Interest
Compound Interest is used and is computed on the original unpaid debt and the unpaid interest. Year 1 interest = $1000 (.10) = $100
Year 2 principal is, therefore: $1000 + $100 = $1100

Year 2 interest = $1100 (.10) = $110 Total interest earned is: $100 + $110 = $210 This is $10 more than with simple interest
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Compound Interest (Contd)

Future Value (F) = P + Pi + (P + Pi)i = P (1 + i + i + i 2) = P (1+i)2 = 1000 (1 + .10) 2 = 1210 In general, for any value of n:
Future Value (F) = P (1+i)n Total interest earned = In = P (1+i)n - P Where,
P present sum of money i interest rate per period n number of periods
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Compound Interest Over Time

If you loaned a friend money for short period of time the difference between simple and compound interest is negligible. If you loaned a friend money for a long period of time the difference between simple and compound interest may amount to a considerable difference.

P 1000 1000 1000 1000 1000 1000 1000

n 1 2 3 10 20 30 40

i% 10% 10% 10% 10% 10% 10% 10%

F $1,100.00 $1,210.00 $1,331.00 $2,593.74 $6,727.50 $17,449.40 $45,259.26

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Nominal and Effective Interest

Interest rates are normally given on an annual basis with agreement on how often compounding will occur (e.g., monthly, quarterly, annually, continuous). Nominal interest rate /year ( r ) the annual interest rate w/o considering the effect of any compounding (e.g., r = 12%). Interest rate /period ( i ) the nominal interest rate /year divided by the number of interest compounding periods (e.g., monthly compounding: i = 12% / 12 months/year = 1%). Effective interest rate /year ( ieff or APR ) the annual interest rate taking into account the effect of the multiple compounding periods in the year. (e.g., as shown later, r = 12% compounded monthly is equivalent to 12.68% year compounded yearly.
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Interest Rates (contd)

We use i for the periodic interest rate Nominal interest rate = r (an annual rate) Number of compounding periods/year = m r = i * m, and i = r / m Let r = .12 (or 12%) Interest Period m = interest periods / year Annual 1 Quarter Month 4 12
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i = interest rate / period .12 .03 .01

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Effective Interest
If there are more than one compounding periods during the year, then the compounding makes the true interest rate slightly higher. This higher rate is called the effective interest rate or Annual Percentage Rate (APR) ieff = (1 + i)m 1 or ieff = (1 + r/m)m 1 Example: r = 12, m = 12 ieff = (1 + .12/12)12 1 = (1.01)12 1 = .1268 or 12.68%
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Consider Four Ways to Repay a Debt

Plan Repay Principal Equal installments End of loan Repay Interest Interest Earned

1
2 3 4

Interest on unpaid balance Interest on unpaid balance Equal installments

Compound and pay at end of loan

Declines
Constant Declines at increasing rate Compounds at increasing rate until end of loan
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End of loan

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Plan 1 Equal annual principal payments

Year
1 2 3 4 5

Balance
5000 4000 3000 2000 1000

P
1000 1000 1000 1000 1000

i
500 400 300 200 100

Payment
1500 1400 1300 1200 1100 6500

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Plan 2 Annual interest + balloon payment of principal

Year
1 2 3 4 5

Balance
5000 5000 5000 5000 5000

i
500 500 500 500

Payment
500 500 500 500 500 7500

5000

500

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Plan 3 Equal annual payments (installments)

Year
1 2 3 4 5

Balance
5000.00 4181.00 3280.10 2289.11 1199.02

P
819.00 900.90 990.99 1090.09 1199.10

i
500.00 418.10 328.01 228.91 119.90

Payment
1319 1319 1319 1319 1319 6595

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Plan 4 Principal & interest at end of the loan

Year
1 2 3 4 5

Balance
5000 5500 6050 6655 7320.50

P
0 0 0 0 0

i
500 550 605 665.50 732.05

Payment
0 0 0 0 8052.55 8052.55

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Which plan would you choose?

Total Principal + Interest Paid
Plan 1 = $6500 Plan 2 = $7500 Plan 3 = $6595 Plan 4 = $8052.55

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Equivalence
When an organization is indifferent as to whether it has a present sum of money now or, with interest the assurance of some other sum of money in the future, or a series of future sums of money, we say that the present sum of money is equivalent to the future sum or series of future sums.
Each of the four repayment plans are equivalent because each repays $5000 at the same 10% interest rate.

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To further illustrate this concept, given the choice of these two plans which would you choose?
Year 1 2 3 4 5 Total Plan 1 $1400 1320 1240 1160 1080 $6200 Plan 2 $400 400 400 400 5400 $7000

To make a choice the cash flows must be altered so a comparison may be made.
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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. You will learn a number of methods for finding comparable equivalent values.
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Analysis Methods that Compare Equivalent Values

Present Worth Analysis (Ch. 5) - Find the equivalent value of cash flows at time 0. Annual Worth Analysis (Ch. 6) - Find the equivalent annual worth of all cash flows. Rate of Return Analysis (Ch. 7, 8) - Compare the interest rate (ROR) of each alternatives cash flows to a minimum value you will accept. Future Worth Analysis (Ch. 9) - Find the equivalent value of cash flows at time in the future. Benefit/Cost Ratio (Ch. 9) - Use equivalent values of cash flows to form ratios that can be easily analyzed.
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Interest Formulas
To understand equivalence the underlying interest formulas must be analyzed. We will start with Single Payment interest formulas. Notation:
i = Interest rate per interest period. n = Number of interest periods. P = Present sum of money (Present worth, PV). F = Future sum of money (Future worth, FV).

If you know any three of the above variables you can find the fourth one.
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For example, given F, P, and n, find the interest rate (i) or ROR
Principal outstanding over time (P) Amount repaid (F) at n future periods from now We know F, P, and n and want to find the interest rate that makes them equivalent: If F = P (1 + i)n Then i = (F/P)1/n - 1 This value of i is the Rate Of Return or ROR for investing the amount P to earn the future sum F
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Functional Notation
Give P, n, and i, we can solve for F several ways:
Use the formula and a calculator Use the factors and functional notation in the tables in the back of the text Use the financial functions (fx) in EXCEL Use the financial functions available in many calculators

In this course we will use the factors or EXCEL spreadsheet functions unless otherwise instructed
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Cash Flow Diagrams

We use cash flow diagrams to help organize the data for each alternative.
Down arrow disbursement cash flow Up arrow - Income cash flow n = number of compounding periods in the problem i = interest rate/period
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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) F = 5000(F/P, 6%, 10) F =P(F/P) which is dimensionally correct. Find the factor values in the tables in the back of the text.403 - Cal Poly Pomona - SA5 EGR 28

Using the Functional Notation and Tables to Find the Factor Values
F = 5000(F/P, 6%, 10) To use the tables:
Step 1: Find the page with the 6% table Step 2: Find the F/P column Step 3: Go down the F/P column to n = 10

The Factor shown is 1.791, therefore: F = 5000 (1.791) = $8955

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Using EXCEL Spreadsheet Functions

On the menu bar select the fx icon Select the Financial Function menu Select the FV function to find the Future Value of a present sum (or series of payments): FV(rate, nper, pmt, PV, type) where:
rate = i nper = n pmt = 0 PV = P type = 0
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Notation for Calculating a Present Value

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) P=5000(P/F, 6%, 10)

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Example: P=F(P/F, i, n)
F = $1000, i = 0.10, n = 5, P = ?
Using notation: P = F(P/F, 10%, 5) = $1000(.6209) = $620.90

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