Interest Considerations

Engineers define interest as the compensation paid for the use of

borrowed capital. The rate at which interest will be paid is
usually fixed at the time the capital is borrowed, and a guarantee
is made to return the capital at some set time in the future or
on an agreed-upon pay-off schedule.

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 SIMPLE INTEREST

If P represents the principal, n the number of time units or

interest periods, and i the interest rate based on the length of
one interest period, the amount of simple interest Z during n
interest periods is:-
Z=Pin
The principal must be repaid eventually; therefore, the
entire amount S of principal plus simple interest due after
n interest periods is:-
S = P + Z = P(1 + in)

2 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

 COMPOUND INTEREST

The total amount of principal plus compounded interest

due after n interest periods and designated as S is:-
S = P(l + i)n

The term (1 + i)n is commonly referred to as the discrete

single-payment compound-amount factor.

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NOMINAL AND EFFECTIVE INTEREST RATES

In common industrial practice, the length of the discrete

interest period is assumed to be 1 year and the fixed
interest rate i is based on 1 year. However, there are
cases where other time units are employed. Even
though the actual interest period is not 1 year, the
interest rate is often expressed on an annual basis.
Consider an example in which the interest rate is 3 percent
per period and the interest is compounded at half-year
periods. A rate of this type would be referred to as “6
percent compounded semiannually.” Interest rates
stated in this form are known as nominal interest rates.

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 NOMINAL AND EFFECTIVE INTEREST RATES

It is desirable to express the exact interest rate based on the

original principal and the convenient time unit of 1 year. A
rate of this type is known as the effective interest rate.

In common engineering practice, it is usually preferable

to deal with effective interest rates rather than with
nominal interest rates. The only time that nominal and
effective interest rates are equal is when the interest is
compounded annually.

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EFFECTIVE ANNUAL INTEREST RATE

Nominal annual interest rate= r

m= no of interest periods per year

6 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

DISCUSSION PROBLEM

7 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

DISCUSSION PROBLEM-SOLUTION

8 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

DISCUSSION PROBLEM-SOLUTION

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 COMPOUNDING CONTINUOUSLY

Although in practice the basic time interval for interest

accumulation is usually taken as one year, shorter time
periods can be used as, for example, one month, one day,
one hour, or one second. The extreme case, of course, is
when the time interval becomes infinitesimally small so
that the interest is compounded continuously.

10 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

 COMPOUNDING CONTINUOUSLY

Here S= Pern
Nominal annual interest rate= r
Principal= P Time period= n years

ieff = er -1 = effective annual interest rate

11 Dr. Pradipta Chattopadhyay | BITS Pilani, Pilani Campus

 Important References

• M.S. Peters & K.D. Timmerhaus, Plant Design and Economics for
Chemical Engineers, McGraw- Hill, 4th Edition, 1991.

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