ENGR 3360U Winter 2014

Unit 4.1-3
Interest, Equivalence and Repeated Cash Flows
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 4 Interest and Equivalence

Change Record
2014-I-01 Initial Creation
Text references: Chapters 3 and 4

4-2

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
1-3

Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
2014-I-01

10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Unit 4 Contents
4-1 Time Value of Money
4-2 Equivalence
4-3 Single Payment Compound Interest
4-4 Annual Payments
4-5 Arithmetic Gradient
4-6 Geometric Gradient
4.7 Finding Interest Rates or n Periods
4-8 Continuous Compounding
4-4

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Learning Objectives

4-5

Time Value of Money

Simple and Compound Interest
Equivalence
Single Payment Compound Interest
Formulas

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4-1 Time Value of Money

What would you rather have?

$1000.00 now
$1000.00 5 years from now

Why?
The amount of goods and services one can purchase

with the same amount of money normally decreases

over time (inflation).
Therefore, in the above example the actual value of
money changes at some rate over time.
This rate is typically expressed as some percentage per
period of time.

4-6

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Interest: Simple Interest

Simple interest is interest applied ONLY to the
original sum.
Interest is never calculated on previous interest
calculations.
Interest earned = P x i x n

Where: P = present sum, i = interest rate/period, n = # of time periods

Total money after n periods (F):

F=P+Pxixn
OR F=P(1+i x n)

4-7

Where: F = future sum

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Notation
P = present sum today (time 0)
F = future sum of money after the last of n
time periods
n = number of time periods (normally
years)
i = interest rate (normally percentage/year)
A = annual payment per year

4-8

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

ANSI Standard Notation for Interest Factors

Standard notation has been adopted to
represent the various interest factors
Consists of two cash flow symbols, the
interest rate, and the number of time periods
General form:(X/Y,i%,n)
X represents what is unknown
Y represents what is known
i and n represent input parameters; can be known
or unknown depending upon the problem

4-9

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Notation - continued
Example: (F/P,6%,20) is read as:
To find F, given P when the interest rate is 6%
and the number of time periods equals 20.

In problem formulation, the standard

notation is often used in place of the closedform equivalent relations (factor)
Tables at the back of the text provide
tabulations of common values for i% and n
(see Table FOOFOO)
4-10

2014-I-01 Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Compound Interest
Normally, the compound interest method is
used.
Simple interest is not used unless
specifically stated otherwise.
Interest is calculated on the accumulated
amount and not simply on the original
amount.
Interest on top of interest
4-11

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Compound Interest
Consider a $25,000 investment at 10%/year,
compounded:
Year

4-12

Total at
start of
Year n

$25000

$2500

$27500

$27500

$2750

$30250

$30250

$3025

$33275

$33275

$3327.50

$36602.50

2014-I-01

Interest
Amount
accumulated accumulated
at end of
at end of
year n
year n

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4.2 Equivalence
Equivalence with respect to the time value
of money implies that:

A sum of money in one time period may have

the same value to a different sum in another
time period with respect to an interest rate.

Example:

$1000 now is equivalent to:

4-13

$1100 one year from now at 10% per year

$1050 one year from now at 5% per year
$1210 two years from now at 10% per year
$1102 two years from now at 5% per year

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Equivalence
Equivalence is dependent on Interest Rate!
Equivalence is useful when:

There are cash flows (+ve and/or ve) over n

time periods that need to be compared
There are alternative comparisons of multiple
cash flows

4-14

alternative projects with cash flows over n time

periods

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4.3 Single Payment Compound Interest Formulas

S we have seen:
F = P(1+i)n
The above formula is the:
Single payment compound amount formula which is
written in functional notation as:
F = P(F/P, i, n)

The notation in brackets meaning:

4-15

Future sum F, given present sum P at interest rate I

per interest period for n' periods

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Example
$3000.00 deposited in a bank account at 7%
per year interest would be how much after
four years?
F = P(F/P, 7%, 4)
F = 3000(1+0.07)4
F = $3932.39

4-16

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Single Payment Compound Interest Formulas

Suppose you want to find an equivalent

value now for a desired future value?

4-17

F = P(1+i)n
Rearranging:
P = F/(1+i)n = F(1+i)-n
The notation becomes:
P = F(P/F, i, n)

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Example
If you want to have $3000.00 in the bank
after four years at 7% per year interest,
what would you have to deposit now?
P = F(P/F, 7%, 4)
P = 3000(1+0.07)-4
P = $2288.69

4-18

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Summary
The time value of money is an important concept in
engineering economics.
To calculate equivalency across multiple periods one
must include the calculation of a percentage rate per
period (e.g., interest rate).

F = P(1+i)n = P(F/P, i, n)
P = F/(1+i)n = F(1+i)-n = F(P/F, i, n)
The notation factors can be calculated from the formula
or looked up in standard tables. See the back of the
textbook.
4-19

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

4-20

2014-I-01

FOOFOO

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

Example
The recent enhancements made by Ipsco, Inc. to its large-diameter
pipe mill in Regina are estimated to save $50,000 in reduced
maintenance this year.
a) If the steel maker considers these types of savings worth 20%
per year, find the equivalent value of this result in 5 years.
b) If the $50,000 maintenance savings occurs now, find its
equivalent value 3 years earlier with an interest of 20%

4-21 2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

(a)
P = $50,000

F=?

i = 20%/year n = 5 years

F = P(F / P, i, n) = $50,000(F / P, 20%, 5)

= 50,000(2.4883)
= $124,415.00
We could also use Excel FV(20,5,,50000)

4-22

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 4 Interest and Equivalence

(b)
In this case, t = 0 and for P, t = -3
P = F(P / F, i,n) = 50,000(P / F, 20%, 3)
= 50,000(0.5787)
= $28,935.00
Or PV(20,3,,50000) in Excel.

4-23 2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco