Professional Documents
Culture Documents
Chapter 4 Economy
Chapter 4 Economy
(BPK 30905)
CHAPTER 4:
•Introduction
•Simple interest
•Compound interest
•The concept Equivalence
•Cash flow-diagram table
•Applications of Future and Present values
INTRODUCTION
• Capital refers to wealth in the form of money or property
that can be used to produce more wealth.
Example: ending amount owed is RM110,000 & Beginning amount owed is RM100,000,
therefore; Interest = RM10,000 (RM110,000 – RM100,000)
When money is borrowed the interest paid is the When money is lent or invested, the interest
charge to the borrower for the use of the earned is the lender’s gain from providing
lender’s property a good to another use
Example 4.2:
You borrow RM10,000 for 60 days at 5% simple interest per year (assume a 365 day year). What
is the total amount borrowed by end of 60 days?
▪ Interest = (P )(N)(i)
= (10,000)(0 .05)(60/365)
= RM82.19
▪ Total borrowed = RM10,000 + RM82.19
= RM10,082.19
COMPOUND INTEREST
Therefore,
Compound interest reflects both the remaining principal and any
accumulated interest. For RM1,000 at 10%…
Example:
OR
100 (1 + 0.08)8
= RM 185.09
NOMINAL AND EFFECTIVE INTEREST
RATES
The concepts of nominal and effective are used when interest is
compounded more than once each year.
Nominal rates:
1. Often states as the annual interest rate for credit cards, loans, and house
mortgages.
2. Also known as Annual Percentage Rate (APR).
3. E.g. an APR of 15% is the same as nominal 15% per year or a nominal
1.25% per month.
NOMINAL AND EFFECTIVE INTEREST
RATES (CONT.)
Effective rates:
1. Commonly stated as annual rate of return for investments, certificates of deposit,
and savings account.
2. Also known as Annual Percentage Yield (APY).
3. It is used to compare the annual interest between loans with different compounding
terms (daily, monthly, annually, or other).
The nominal rates will never exceeds the effective rate, and similarly APR < APY
NOMINAL AND EFFECTIVE INTEREST
RATES (CONT.)
Example 4.4:
A. A visa credit card carries an interest rate of 1% per month on the unpaid
balance. Calculate the effective rate per semiannual and annual periods.
NOMINAL AND EFFECTIVE INTEREST
RATES (CONT.)
Solution:
1. r = 6% per semiannual; M = 6
i = (1 + 0.06/6)6 – 1
= 0.0615 (6.15%)
Example 4.4:
B. If the card’s interest rate is stated at 3.5% per quarter, find the
effective semiannual and annual rates.
NOMINAL AND EFFECTIVE INTEREST
RATES (CONT.)
Solution:
1. M = 2; r = 7%
i = (1 + 0.07/2)2 – 1
= 0.0712 (7.12%)
2. M = 4; r = 14%
i = (1 + 0.14/4)4 – 1
= 0.1475 (14.75%)
P T
E
C N C E
O N E
C A L
H E I V
T U
EQ
THE CONCEPT OF EQUIVALENCE
• Using these elements we can “move” cash flows so that we can compare them at
particular points in time.
THE CONCEPT OF EQUIVALENCE
THE CONCEPT OF EQUIVALENCE
(CONT.)
Different sums of money at different times may be equal in economic
value
RM110 one
year from now
RM90 last year
RM100 now
Interpretation: RM90 last year, RM100 now, and RM110 one year
from now are equivalent only at an interest rate of 10% per year
THE CONCEPT OF EQUIVALENCE (CONT.)
Example 4.5:
Company X makes auto batteries available to General Motors dealers. In general the batteries
are stored throughout the year, and a 5% cost increase is added each year to cover the
inventory carrying charge for the distributorship owner. Make calculations to show which
of the following statements are true and which are false about battery costs.
1. The amount RM98 now is equivalent to a cost of RM105.60 one year from now.
2. A truck battery cost of RM200 one year ago is equivalent to RM205 now.
3. A RM38 cost now is equivalent to RM39.90 one year from now.
4. A RM3,000 cost now is equivalent to RM2,887.14 one year ago.
5. The carrying charge accumulated one year on an investment of RM2,000 worth of batteries
is RM100.
THE CONCEPT OF EQUIVALENCE (CONT.)
Solution:
1. The amount RM98 now is equivalent to a cost of RM105.60 one year
from now.
RM98 (1.05) = RM102.9 ≠ RM105.60 FALSE
OR
RM105.60/1.05 = RM100.57 ≠ RM98
• The diagram includes what is known, what is estimated and what is needed.
• Once the cash flow diagram is complete, another person should be able to
work the problem by looking at the diagram.
• The time line is a horizontal line divided into equal periods such as days,
months, or years.
CONSTRUCTING A CASH FLOW
DIAGRAM (CONT.)
• Each cash flow, such as a payment or receipt, is plotted along this line at the
beginning or end of the period in which it occurs.
• Funds that you pay out such as savings deposits or lease payments are negative
cash flows that are represented by arrows which extend downward from the
time line with their bases at the appropriate positions along the line.
• Funds that you receive such as proceeds from a mortgage or withdrawals from a
saving account are positive cash flows represented by arrows extending upward
from the line.
CONSTRUCTING A CASH FLOW
DIAGRAM (CONT.)
+ Cash flow
- Cash flow
CONSTRUCTING A CASH FLOW
DIAGRAM : LENDER VIEWPOINT
CONSTRUCTING A CASH FLOW
DIAGRAM (CONT.)
Example 4.6:
Construct a cash flow diagram for the following cash flows: RM10,000 outflow
at time zero, RM3,000 per year inflow in years 1 through 5 at an interest rate
of 10% per year, and an unknown future amount in year 5.
CONSTRUCTING A CASH FLOW
DIAGRAM (CONT.)
CONSTRUCTING A CASH FLOW DIAGRAM
Example 4.7
The XYZ Corporation insists that its engineers develop a cash-flow diagram of the
proposal.
An investment of $10,000 can be made that will produce uniform annual revenue of
$5,310 for five years and then have a market (recovery) value of $2,000 at the end of
year (EOY) five.
Annual expenses will be $3,000 at the end of each year for operating and maintaining
the project.
Draw a cash-flow diagram for the five-year life of the project. Use the corporation’s
viewpoint.
CONSTRUCTING A CASH FLOW DIAGRAM Example 4.7 (Solution)
CONSTRUCTING A CASH FLOW TABLE
Example 4.8
Two feasible alternatives for upgrading the heating, ventilation, and air conditioning (HVAC)
system have been identified. Either Alternative A or Alternative B must be implemented.
At the end of eight years, the estimated market value for Alternative A is $2,000 and for
Alternative B it is $8,000.
Assume that both alternatives will provide comparable service (comfort) over an eight-year
period, and assume that the major component replaced in Alternative B will have no market
value at EOY eight.
(1) Use a cash-flow table and end-of-year convention to tabulate the net cash flows for both
alternatives.
(2) Determine the annual net cash-flow difference between the alternatives (B − A).
CONSTRUCTING A CASH FLOW TABLE Example 4.8
P = present sum of money; equivalent value of one or more cash flows at a reference
point in time; the present; $ (a.k.a. present worth)
F = future sum of money; equivalent value of one or more cash flows at a reference
point in time; the future; $ (a.k.a. future worth)
Functional
symbol
1. The quantity (1 + i)-N is called the single payment present worth factor.
2. The term on is read “P given F at i% interest per period for N interest
periods.”
SINGLE-PAYMENT FACTORS (CONT.)
Description: Formula:
▪ P = RM100, i = 8%, N = 8, F = ?
F = P (1 + i)N
= 100 (1 + 0.08)8
= 100 (1.08)8
= 100 (1.8509)
= RM185.09
▪ F = P (F/P, i%, N)
= 100 (F/P, 8%, 8)
= 100 (1.8509)
= RM185.09
SINGLE-PAYMENT FACTORS (CONT.)
Example 4.10:
What is the present worth of RM30,000 in year 8 at an interest rate of 10% per
year?
▪ F = RM30,000, N = 8, i = 10%, P = ?
P = F (1 + i)-N
= 30,000 (1 + 0.10)-8
= 30,000 (1.10)-8
= 30,000 (0.4665)
= RM13,995
▪ P = F (P/F, i%, N)
= 30,000 (P/F, 8%, 10)
= 30, 000 (0.4665)
= RM13,995
SINGLE-PAYMENT FACTORS (CONT.)
Example 4.11:
If an engineer invested RM15,000 on 1.1.1991 into a retirement account that earned 6% per year
interest, how much money will be in the account on 1.1.2016?
▪ F = P (F/P, i%, N)
= 15,000 (F/P, 6%, 25)
= 15,000 (4.2919)
= RM64,378.50
Example 4.12:
i = √ F/P
N
- 1
= √ (2.31/1.07)
12 -1
= 0.0662 or 6.62% per year
Example 4.12 (cont.):
The average price of gasoline in 2005 was RM2.31 per gallon. We computed the
average annual rate of increase in the price of gasoline to be 6.62%. If we assume that
the price of gasoline will continue to inflate at this rate, how long will it be before we
are paying RM5.00 per gallon?
= log (5.00/2.31)
log (1 + 0.0662)