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1. Introduction to Eng’g Economics

UNIVERSITY OF GONDAR
INSTITUTE OF TECHNOLOGY
DEPARTMENT OF CONSTRUCTION TECHNOLOGY AND MANAGEMENT
Engineering Economics Lecture Notes
Target Group: 5 th year Civil Engineering
Getahun Fetene (B.Sc. in Civil Engineering; M.Sc. in Construction Technology and Management)
O Engineering economics has two major components .
(Economics , Engineering)
O What is the concept behind economics?
 Economics is the social science that studies the
production, distribution, and consumption of goods and
services.
O Engineering?
 Engineering is the use of physical laws (scientific
principles ) to design and build machines, vehicles,
structures (bridges, tunnels, roads,, and buildings) etc.
O Engineering economics is a subset of economics
concerned with the use and application of economic
principles in the analysis of engineering decisions.
2

Cont… Cont…
For example: O To be able to decide whether a project is viable or not,
O In cases of investment, investors want to know if the
or to compare different projects, we have to find a
project is economically viable or not. (Real estate, mining, common measure/criteria.
factory etc.) O Financial analysis gives us the tools/methods to
O Creditors need to know if the project is secure enough perform this evaluation.
so that they can get their money back. O Therefore, a project manager has to be able to provide
O Sometimes we are also confronted with two or more a convincing financial analysis of the project.
alternatives.
 In this situation, we want to know which alternative
produces the greatest net benefit.

3 4

Costs & Benefits Tools/ Methods of Financial Analysis

O Any project, whether it is relatively simple or complex O Several financial analysis methods could be used to
involves costs and benefits. evaluate
 The economic viability of a project
O At the beginning of a project an investment is usually
 To compare the financial merits of several projects
required.
 To calculate the lifetime worth of a system and perform the
 Equipment has to be purchased, replacement analysis
 Buildings have to be constructed, and O Some of these analysis tools are:
 A host of other activities have to be conducted  Equivalent Present worth method
O All of these activities require expenditure of resources.  Equivalent future worth method

O If the system is producing an end item, then the  Annual equivalent method
revenue received by selling the produced items is the  Rate of return method
benefit obtained.  Benefit cost ratio
 Life time worth
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Time Value of Money
O Money can have different values at different times.
This is because money can be used to earn more
money between the different instances of time.
O Obviously, $10,000 now is worth more than $10,000 a
year from now. This is the earning power of money over
time and is called time value of money.
O We have to be careful not to confuse the earning power
of money, which is related to interest rate, with the
buying power of money, which is related to inflation
7 O Interest Period (N) = time period/frequency at which interest is calculated 8
Cont…
Example on Interest and Interest Rate:
1. A student deposits $1000 in a savings account that pays
interest at the rate of 6% per year.
a) How much money will the student have after one year?
b) An investor makes a loan of $5000, to be repaid in
one lump sum at the end of one year. What annual interest
rate corresponds to a lump-sum payment of $5425?
Solution:
a) The student will have his original $1000, plus an interest
payment of 0.06 x $1000 = $60. Thus, the student
will have accumulated a total of $1060 after one year.
b) The total amount of interest paid is $5425- $5000 = $425.
Hence the annual interest rate is
9 10
Cash Flow & Cash Flow Diagrams
O A cash flow is the difference between total cash receipts
(inflows) and total cash disbursements (outflows) for a given
period of time.
O The graphic presentation of the costs and benefits over the
time is called the cash flow diagram (CFD).
O The following conventions are used in the construction of
the cash flow diagram:
 The horizontal axis represents time
 The vertical axis represents costs and benefits
 Costs are shown by downward arrows
 Benefits are shown by upward arrows
 Each cash flow is assumed to occur at the end of the
respective time period.
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Basic Terminologies
These are some of the basic terms which are used throughout the course.
O Principal (P) = initial amount of money invested
O Future Value (F)= amount or sum at the end of interest period
O Interest (I) = An extra amount of money paid to the lender for the use of
money during the period of a loan, just as you pay a rent on a house or a car.
 This extra amount of money is known as interest.
O Interest Rate(i) = is the percentage of the money you pay for its use over a
time period. In investment terminology, it is called the minimum acceptable
rate of return (MARR).
 Example: If you borrow “A“ dollars at yearly interest rate (i), at the end of
the year the interest is (Ai), and the total amount you have to pay back to
the lender is A+Ai.
Factors affecting interest rate
O The interest rate will depend on the interest period it is
required.
 If money is borrowed for a long period, then the
uncertainty of the economy will introduce a risk factor
and influence the interest rate.
 For short periods, it can be assumed that the economy is
stable and the risk is predictable.
O Availability of money in the financial market also has
an effect on the interest rate.
 If the banks have more money than people need to
borrow, then the interest rate is low and vice versa.
Cont…
The Costs/expenses and the benefits/receipts due to engineering projects
usually fall into one of the following categories :
O First/Initial cost: expense to build or to buy and install
O Operational and Maintenance cost (O&M): annual expense, such
as electricity, labor, and minor repairs
O Revenues: annual receipts/benefits due to sale of products or services
O Salvage value: receipt at project termination for sale or transfer of
the equipment.
O Overhaul: major capital expenditure that occurs during the asset’s
life.
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Methods of Calculating Interest Cont…

1.Simple Interest O Then, both the principal and the accumulated
O Simple interest is a fixed percentage of the principal interest are repaid. The total amount due can
(the amount of money borrowed),multiplied by the life be expressed as:
of the loan. Interest calculated on the principal only.

I = 𝑃 𝑁𝑖 𝐹 = 𝑃 + 𝑃𝑁𝑖 = 𝑃 1 + 𝑁𝑖
Where: I = total amount of simple interest
P = Principal amount
Where: F = Future Value
N = Life of Loan
P = Principal amount
i = Interest Rate
N = Life of Loan
O Normally, when a simple interest loan is made, i = Interest Rate
nothing is repaid until the end of the loan period
13 14

Cont…
2. Compound Interest:
O In case of compound interest, the interest obtained in the
preceding period is added to the principal to calculate the
interest for the succeeding period.
Cont…
O For the second interest period, the interest is determined as:
𝐼 2 = 𝐹1 ∗ 𝑖 = 𝑃 1 + 𝑖 ∗ 𝑖
The total amount accumulated is :
𝐹2 = 𝐹1 + 𝐹1𝑖 = 𝑃 1 + 𝑖 + 𝑃 1 + 𝑖 𝑖 = 𝑃 1 + 𝑖 ∗ 1 + 𝑖

O During a given interest period, the current interest is 𝐹2 = 𝑃(1 + 𝑖)2

determined as a percentage of the principal plus the
previously accumulated interest. O For the third interest period, the interest is determined as:
O Thus, for the 1st interest period, the interest is determined 𝐼3 = 𝐹2𝑖 = 𝑃(1 + 𝑖)2 ∗ 𝑖
as : The total amount accumulated is :
𝐼1 = 𝑃𝑖 𝐹3 = 𝐹2 + 𝐹2𝑖 = 𝑃(1 + 𝑖)2 + 𝑃(1 + 𝑖)2 ∗ 𝑖 = 𝑃(1 + 𝑖)2 ∗ (1 + 𝑖)
The total amount accumulated is :
𝐹1 = 𝑃 + 𝑃𝑖 = 𝑃(1 + 𝑖) 𝐹3 = 𝑃(1 + 𝑖)3
15 16

Cont… Cont…
O In general, if there are “N” interest periods, we have: Principal
Interest Future Value
𝐼𝑁 = 𝐹 (𝑁 − 1) ∗ 𝑖 and Period Amount
(P)
(I) (F) = (P) + (I)

1 P Pi P+Pi = P(1+i)

𝐹𝑁 = 𝐹 𝑁−1
+ [𝐹(𝑁 − 1) ∗ 𝑖 ] 2 P(1+i) P(1+i)*i P(1+i) + P(1+i)*i =P(1+i)(1+i) = P(1+i)2

3 P(1+i)2 P(1+i)2*i P(1+i)2 + P(1+i)2*i = P(1+i)2(1+*i) = P(1+i)3

𝐹𝑁 = 𝐹 𝑁−1
[1 + 𝑖 ] 4 P(1+i)3 P(1+i)3*i P(1+i)3 + P(1+i)3*i = P(1+i)3(1+i) = P(1+i)4

. . . .
𝑁−1
𝐹𝑁 = 𝑃 1 + 𝑖 ∗ [1 ∗ 𝑖 ] . . . .

N-1 P(1+i)(N-2) P(1+i)(N-2)*i P(1+i)(N-2) + P(1+i)(N-2)*i = P(1+i)(N-2)(1+i) = P(1+i)(N-1)

𝑭𝑵 = 𝑷 𝟏 + 𝒊 𝑵 N P(1+i)(N-1) P(1+i)(N-1)*i P(1+i)(N-1) + P(1+i)(N-1)*i = P(1+i)(N-1)(1+i) = P(1+i)N

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Cont… Cont…
Example:
1. A student borrows $3000 from his uncle in order to
finish school. His uncle agrees to charge him simple
interest at the rate of 5.5% per year. Suppose the
student waits two years and then repays the entire
loan. How much will he have to repay?
Solution:
The interest type is simple interest
F= P+I
F= P+PNi
Note: Unless other wise the interest type is given, all problems will be solved F = P(1+Ni) = 3000*(1+2*0.055)= 3330
using compound interest concepts after wards. 19 20

Cont… Equivalence Calculations

Example: O Equivalence calculations are usually made to compare
2. A student deposits $1000 in a savings account that alternatives.
pays interest at the rate of 6% per year, compounded O Two or more projects are economically equivalent if they
annually. have the same result when measured by any of the financial
a) If all of the money is allowed to accumulate, how much analysis tools.
will the student have after 12 years? O There are certain rules that one should follow to make these
calculations.
Solution:
 They need to have a common time basis
F = P+I  They need to have a common interest rate
F = P(1+i)N= 1000*1.0612 = 2012.2  Equivalence is maintained regardless of anything
O Projects that are equivalent at one interest rate are not
necessarily equivalent when another interest rate is used.
21 22

Cont… Cont…
Example : If N=15 years, F= P(1+i)15 =10,000(1.1)15 = 41,772.48
Assume you are offered to choose 10,000 birr now or As 41,772.48 > 25,937.425 choose 41,772.48
25937.425 birr after N years with i=10% . Which offer do you
accept, if
 N=10 years You have seen that 25,937.425 is equivalent of 10,000 now
 N=8 years after 10 years if i=10% , Are these cash flows also equivalent
 N=15 years at the end of year 5?
Solution: Solution:
If N=10 years , F= P(1+i)N =10,000(1.1)10 = 25,937.425 (F5)1 = P1(1+i)N = 10,000(1.1)5 = 16,105.1
They are both equivalent. you can choose either of one. 25937.425
𝐹10
𝐹5 2 = 𝑁 = 1.1 5 =16,105.1
1+𝑖
If N=8 years, F= P(1+i)8 =10,000(1.1)8 = 21,435.89
This shows that the two cash flows still remain equivalent.
As 25,937.425 > 21,435.89 choose 25,937.425 23 24

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Cont…
O If i=12% are these cash flows still equivalent?

Solution:
F = P(1+i)N =10,000(1.12)10 = 31,058.48 > 25, 937.425 Engineering Economics
This shows that the change in the interest rate (i ) has
made the two cash flows no more equivalent.
Lecture Notes
Day-2

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Compound Interest Formulas Single cash flow

F
O Compound interest factors permit cash flow analysis to 0 1 2 3 4 ……………..…N year
be done conveniently using interest formulas, tables and
spread sheets. P

O Four discrete cash flow patterns are examined: 𝐹 = 𝑃(1 + 𝑖)𝑁 = 𝑃(𝐹/𝑃, 𝑖, 𝑁)
 Single Cash Flow = Single disbursement or receipt 𝑁
1+𝑖 𝑖𝑠 𝑘𝑛𝑜𝑤𝑛 𝑎𝑠 𝑠𝑖𝑛𝑔𝑙𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑓𝑎𝑐𝑡𝑜𝑟
 Annuity/Equal/uniform series = set of equal
disbursements or receipts over a sequence of time F
P
 Linear/Arithmetic gradient series = set of
disbursements or receipts that change by a constant 0 1 2 3 4 ………..………N year
amount from one period to the next. 𝐹
 Irregular/Geometric Gradient Series = set of 𝑃= 𝑁 = 𝐹(𝑃/𝐹, 𝑖, 𝑁)
1+𝑖
disbursements or receipts that change by a constant 1 …..Known as single payment present worth factor (SPPWF)
proportion from one period to the next. 1+𝑖 𝑁
27 28

Annuity/uniform Series Cont…

Example:
1+𝑖 𝑁−1 A student plans to deposit $600 each year in a savings account,
𝐹 =𝐴∗ over a period of 10 years. If the bank pays 6% per year, compounded
𝑖 annually, how much money will have accumulated at the end of the
𝐹 = 𝐴(𝐹/𝐴, 𝑖, 𝑁) 10-year period?

1+𝑖 𝑁 −1
• = uniform series
𝑖
compound amount factor
𝑖
𝐴 = 𝐹∗ 1+𝑖 𝑁−1
1+𝑖 𝑁−1 𝐹 = 𝐴∗
𝐴 = 𝐹(𝐴/𝐹, 𝑖, 𝑁) 𝑖
𝑖
• 𝑁 = uniform series 𝐹 = 600 ∗
1.0610 − 1
= 𝟕𝟗𝟎𝟖. 𝟒𝟖
1+𝑖 −1
sinking fund factor
0.06
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Time shifts in a uniform series Cont…

O If the initial deposit takes place at time zero and the 1+𝑖 𝑁 −1 1.15−1
O 𝐹 =𝐴∗ = 1000 ∗ = 6105.1
last payment is zero, each payment will be 𝑖 0.1
compounded for one more year
If the initial deposit is made at t=0
1+𝑖 𝑁−1 𝐴 ∗ ( 1 + 𝑖 𝑁 − 1)
𝐹 = 𝐴∗ ∗ 1+𝑖 𝐹 = ∗ 1+𝑖
𝑖 𝑖
5
1000 ∗ (1.1 − 1)
O Example: Suppose you want to deposit 1000 birr at the 𝐹 = ∗ 1.1 = 𝟔𝟕𝟏𝟓. 𝟔𝟏
0.1
end of each year for 5 yrs. If i=10% what will be your
final amount after 5 yrs. F  10001  i 5  1000(1  i ) 4  1000(1  i )3  1000(1  i ) 2  1000(1  i )1
5
 1610.51  1464.1  1331  1210  1100
 6715.61birr
31 32

Uniform Series Present Value Factor Cont…

𝐴 1+𝑖 𝑁−1
𝑃 =
𝑖 1+𝑖 𝑁

𝑃 𝑖 1+𝑖 𝑁
𝐴=
1+𝑖 𝑁−1
Example: 𝐴 1+𝑖 𝑁−1
𝑃 =
An engineer who is planning his retirement has decided that he 𝑖 1+𝑖 𝑁
will have to withdraw $10 000 from his savings account at the
end of each year. How much money must the engineer have in
the bank at the start of his retirement, if his money earns 6% 10000∗ 1.06 12
−1
per year, compounded annually, and he is planning a 12-year 𝑃 =
0.06∗1.0612
= 83838.4
retirement (i.e., 12 annual withdrawals)?
33 34

Arithmetic Gradient Series Cont…

O A series of disbursements or receipts that starts at zero
at end of first period and then increases at a constant
amount from period to period.

𝐺∗ 1 + 𝑖 𝑛 − 𝑖𝑛 − 1
𝑃 =
𝑖2 ∗ 1 + 𝑖 𝑛

1 + 𝑖 𝑁 − 1 𝑁𝐺
𝐹 =𝐺∗ − 1+𝑖 𝑁 −1 1+𝑖 𝑁 −𝑖𝑁−1
𝑖2 𝑖 𝑃 = [𝐴0 ∗ 𝑁 ]+ [G* ]
𝑖∗ 1+𝑖 𝑖2∗( 1+𝑖 𝑁

1+𝑖 𝑁 −1] + 1+𝑖 𝑁−1 𝐺∗𝑁

𝐴=
𝐺 ∗ 1 + 𝑖 𝑛 − 𝑖𝑛 − 1 F = [A0* [𝐺 ∗ − ]
𝑖 ∗ ( 1 + 𝑖 𝑛 − 1) 𝑖 𝑖2 𝑖
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Cont… Cont…
Example:
1. An employee with an annual pay of $30,000 is told

that he is going to get an annual pay increase of

$1,200 each year. The increase starts in the second
𝐺 ∗ 1 + 𝑖 𝑛 − 𝑖𝑛 − 1
𝐴=
𝑖 ∗ ( 1 + 𝑖 𝑛 − 1) year of his employment. What is the total pay of his

1+𝑖 −1
𝑁 1+𝑖 𝑁−1 1+𝑖 𝑁 −1 increase compounded annually at the end 5-years
𝑃 = 𝐴0 ∗ + [𝐴 ∗ 𝑁 ] = 𝐴𝑜 + 𝐴 ∗ 𝑁
𝑖∗ 1+𝑖 𝑁 𝑖∗ 1+𝑖 𝑖∗ 1+𝑖
period with an assumed interest rate of 7%?
𝑁
1+𝑖 −1] + 1+𝑖 𝑁−1 1+𝑖 𝑁 −1
F = [A0* [𝐴 ∗ ] = 𝐴𝑜 + 𝐴 ∗
𝑖 𝑖 𝑖
37 38

Cont… Cont…
Solution: 2. An engineer is planning for a 15-year retirement. In
order to supplement his pension and offset the
anticipated effects of inflation, he intends to withdraw
$5000 at the end of the first year, and to increase the
withdrawal by $1000 at the end of each successive year.
How much money must the engineer have in his savings
account at the start of his retirement, if money earns 6%
1+𝑖 𝑁 −𝑖𝑁−1 per year, compounded annually?
F=G*
𝑖2∗( 1+𝑖 𝑁

1.075− 0.07∗5 −1
𝐹 = 1200 ∗ = 9,176
0.072∗1.075
39 40

Cont…
Solution:

41 42

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Cont… Geometric Gradient Series

A0 =5000 O A series of disbursement or receipt that increases or
decreases by a constant proportion (percentage)
G = 1000
through time.
1+𝑖 𝑁 −1 1+𝑖 𝑁 −𝑖𝑁−1
𝑃 = [𝐴0 ∗ 𝑁 ] + [G* ]
𝑖∗ 1+𝑖 𝑖2∗( 1+𝑖 𝑁

1.0615 − 1 1.0615 − 0.06 ∗ 15 − 1

𝑃 = 5000 ∗ + 1000 ∗
0.06 ∗ 1.0615 0.062 ∗ 1.0615

𝑃 = 106,115.8

43 44

Cont… Nominal and Effective Interest Rates

−1
𝐴 1+𝐺 𝐴∗ 1+𝐺 𝑁
𝑃 = +𝐴∗ +⋯..+ O The nominal interest rate is the annual interest rate
1+𝑖 1+𝑖 2 1+𝑖 𝑁 divided by the number of compounding periods in the
year.
1+𝑖 1 1+𝐺
Let 𝑖0 = −1 =
1+𝐺 1+𝑖0 1+𝑖
O If the yearly rate of interest is compounded quarterly,
𝑁−1 the quarterly nominal interest rate is the yearly interest
1 + 𝑖0 1
(𝑃/𝐴, 𝐺, 𝑖, 𝑁) = 𝑖 ∗ 1 + 𝑖 𝑁 ∗ rate divided by four.
0 0 1+𝐺 𝑖𝑎𝑛𝑛𝑢𝑎𝑙
𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 =
𝑃𝑒𝑟𝑖𝑜𝑑

45 46

Cont… Cont…
O Effective interest rate (ieff) is the rate at which the For example:
interest over “N” periods is obtained. The annual interest rate is 6%, and the interest is
O The total Interest (I) gained over “N” periods is: compounded quarterly.
𝐼 = 𝐹𝑁 − 𝑃 = 𝑃 1 + 𝑖𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑁 − 𝑃 = 𝑃𝑖𝑒𝑓𝑓  What is the quarterly nominal interest rate?
𝑁  What is the effective annual interest rate if compounded
𝐼 = 𝑃 1 + 𝑖𝑁𝑜𝑚𝑖𝑛𝑎𝑙 − 1 = 𝑃𝑖𝑒𝑓𝑓
quarterly?
Solution:
O From the above equation, the interest rate over “N” 6%
periods is: 𝑖𝑁𝑜𝑚𝑖𝑛𝑎𝑙 = = 1.5%
4
𝑁
ieff = 𝑃 1+𝑖𝑁𝑜𝑚𝑖𝑛𝑎𝑙 −𝑃 = (1 + 𝑖𝑁𝑜𝑚𝑖𝑛𝑎𝑙)𝑁 − 1
𝑃 i𝑒𝑓𝑓 = 1 + 0.015 4 − 1 = 6.13%
47 48

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Quize-1 Continuous Compounding

O Continuous compounding can be thought of as a
Given that annual interest rate is 10%. If the interest is limiting case of the multiple-compounding situation.
Holding the annual interest rate fixed at i and letting
compounded monthly:
the number of interest periods become infinite, while
a) What will be the nominal interest rate? the length of each interest period becomes
infinitesimally small, we obtain:
b) What will be the effective interest rate? 𝑖𝑒𝑓𝑓 = lim [ 1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑁 − 1]
𝑁→∞

𝑖𝑎𝑛𝑛𝑢𝑎𝑙
𝑖𝑒𝑓𝑓 = lim 1+ 𝑁 −1
𝑁→∞ 𝑁

49 𝑖𝑒𝑓𝑓 = 𝑒𝑖 𝑎𝑛𝑛𝑢𝑎𝑙 − 1 50

Interest Periods Coincide

Example With Payment Periods
A savings bank is selling long-term savings certificates O When the interest periods and the payment periods
that pay interest at the rate of 7.5% per year, coincide, it is possible to use the compound interest
compounded continuously. formulas, provided the interest rate, i, is taken to be
 What is the effective interest rate? the effective interest rate for that interest period.
O Moreover, the number of years, N, must be replaced by
𝑖𝑒𝑓𝑓 = 𝑒𝑖 𝑎𝑛𝑛𝑢𝑎𝑙 − 1
the total number of interest periods, MN.
.
𝑖𝑒𝑓𝑓 = 𝑒0 075 − 1 = 0.0779 = 7.79%
1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑁𝑀 − 1
𝑃=𝐴∗
𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 ∗ 1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑁𝑀

1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑁𝑀 −1
𝐹 =𝐴∗
51 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙 52

Example
An engineer wishes to purchase an $80 000 home by Solution:
making a down payment of $20 000 and borrowing the 𝑖𝑎𝑛𝑛𝑢𝑎𝑙 𝑖
remaining $60 000, which he will repay on a monthly ∗ 1 + 𝑎𝑛𝑛𝑢𝑎𝑙 𝑀𝑁
𝐴=𝑃∗ 𝑀 𝑖 𝑀
basis over the next 30 years. If the bank charges interest 1+ 𝑎𝑛𝑛𝑢𝑎𝑙
𝑀𝑁 − 1
𝑀
at the rate of 9.5% per year, compounded monthly, how
much money must the engineer repay each month?
Solution: 0.095 0.095 12 ∗ 30
∗ 1+
12 12
𝐴 = 60,000 ∗ 0.095 ∗
1+ 12 30 − 1
12

𝑨 = 𝟓𝟎𝟒. 𝟓𝟏
53 54

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Interest Periods Are Smaller Example

than Payment Periods
An engineer deposits $1000 in a savings account at the
O If the interest periods are smaller than the end of each year. If the bank pays interest at the rate of
payment periods, then the interest may be 6% per year, compounded quarterly, how much money
will have accumulated in the account after 5 years?
compounded several times between payments.
Solution:
The nominal interest rate is i = 6%/4 = 1.5% per quarter;
O One way to handle problems of this type is to the first deposit accumulates for 16 quarters; etc
determine the effective interest rate for the
given interest period, and then treat each
payment separately.

55 56

Interest Periods Are Larger

Cont…
𝐹 = 𝑃 ∗ (1 + 𝑖)𝑁
𝐹 = 1000 ∗ 1.015 16 + 1000 ∗ 1.015
∗ 1.015 4 + 1000 ∗ 1.015 0
Than Payment Periods
O If the interest periods are larger than the payment periods, some of
the payments may not have been deposited for an entire interest
12 + 1000 ∗ 1.015 8 + 1000 period. Such payments do not earn any interest during that interest
period.

𝑭 = 𝟓𝟔𝟓𝟐. 𝟓 O Situations of this type can be treated in the following manner:

 Consider all deposits that were made during the interest period
Or using effective annual interest rate: to have been made at the end of the interest period (and
𝑖𝑒𝑓𝑓 = (1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙)𝑀 − 1 therefore to have earned no interest during that interest period).
𝑖𝑒𝑓𝑓 = 1 + 0.015 4 − 1
𝑖𝑒𝑓𝑓 = 0.06136 = 6.136%
 Consider all withdrawals that were made during the interest
period to have been made at the beginning of the interest period
1+𝑖 𝑁−1 (again earning no interest).
𝐹 = 𝐴∗
𝑖
1.0614 5 − 1
𝐹 = 1000 ∗ = 𝟓𝟔𝟓𝟐. 𝟓
0.0614 57 58

Example Solution
A person has $4000 in a savings account at the To find the balance in the account at the end of the
beginning of a calendar year; the bank pays interest at calendar year, we calculate the nominal interest rate,
6% per year, compounded quarterly. The following table 6%/4 = 1.5% per quarter. Then, lumping the amounts at
shows the transactions carried out during the calendar the effective dates and applying, we obtain:
year; the second column gives the effective dates
according to rules 1 and 2 above.
Quarter Effective Date Deposite Withdrawal
Jan 1-Jan 175
Feb 31-Mar 1200
Mar 1-Apr 1500
Apr 1-Apr 50
May 1-Apr 250
Jun 30-Jun 65
Jul 30-Jun 115
Aug 1-Jul 800
Sep 30-Sep 1600
Oct 1-Oct 350
Nov 1-Oct 750
Dec 31-Dec 2300 59 60

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Cont…

𝐹 = 𝑃(1 + 𝑖𝑛𝑜𝑚𝑖𝑛𝑎𝑙)𝑁
𝐹= 4000 − 175 ∗ 1.015 4 + 1200 − 1800 ∗ 1.015 3 + 180 − 800 ∗ 1.015 2

+ 1600 − 1100 ∗ 1.015 + 2300

61
𝑭 = 𝟓𝟔𝟎𝟏. 𝟐𝟏

11