0401301- Engineering Economics

Lecture 4 Topics:
1) Equivalence
2) Single payment compound
interest formula

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 Equivalence in General:
• Example:
• You travel at 68 miles per hour
• Or 110 kilometers per hour

• Thus:
• 68 mph is equivalent to 110 kph
based on the different measuring scales.

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 Equivalence in General:
• Is “68” equal to “110”?
‒Not in terms of absolute numbers.
‒But they are “equivalent” in terms of the
two measuring scales.
‒ Miles
‒ Kilometers

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Economic Equivalence
• Two different sums of money at two different
points in time can be made economically
equivalent if:
‒ We consider an interest rate and,
‒ No. of time periods between the two sums

Equality in terms of Economic Value

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 Example:
A company obtained a loan for one year.
The following is the CFD for the transaction
(the company’s perspective):
$20,000 is
received here

t = 1 Yr
t=0

$21,800 paid
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 Example: continue
• $20,000 now is not equal in magnitude to
$21,800 after 1 year from now.
• But, $20,000 now is economically
equivalent to $21,800 one year from now
if the interest rate in 9% per year.
- Another way to put it is as follows:

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 • If you were told that the interest rate is 9%
and you can choose one of the following
options. What would you choose?
‒ $20,000 now or
‒ $21,800 one year from now?

• The two sums are economically equivalent

at 9% interest rate.
‒ If the interest rate is 11%, what would you
choose and why?

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 Repaying Debt
• $5000 is owed and is to be repaid in 5 years
at interest rate 8%.
– Many ways the debt can be repaid. The total
amount of interest incurred is different for the
different repayment plans.
• The following tables present different plans
to pay back $5000 in 5 years.

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• Plan 1 is equivalent to $5000 present
worth (now) and plan 2 is equivalent to
$5000 present worth (now) at 8% interest
rate.
– Conclusion: Plan 1 and 2 are equivalent.
Further, the four plans are equivalent.

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Equivalence is dependent on Interest rate:
• Plans 1 to 4 in the previous table are
equivalent using 8% interest rate.
– The four plans are equivalent to $5000 at time
0.
• If we increase the interest rate to 9%, the
interest payments for the four plans will
increase.
– Each plan would repay less than the principal
of $5000 and as a result they are not
equivalent at 9% interest rate.
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Application of Equivalence Calculations:
• In comparing alternatives:
– if alternatives are equivalent then we are
indifferent and we can choose either one of
them.
– If alternatives are not equivalent then one of
them must have preference from the
economic prospective.

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• To facilitate comparing alternatives, a
series of interest formulas must be derived.
• Notation to be used:
i = Interest rate per interest period (9% is 0.09).
n = Number of interest periods.
P = Present sum of money (Present worth).
F = Future sum of money (Future worth).

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Single payment compound interest formula
Suppose a sum of money is invested at interest
rate i. How much the future worth after n years?
Interest
Beginning Ending
Year for
balance balance
period
1 P iP P(1+i)1
2 P(1+i) iP(1+i) P(1+i)2
3 P(1+i)2 iP(1+i)2 P(1+i)3
n P(1+i)n–1 iP(1+i)n–1 P(1+i)n
Future sum after n periods = present sum
now multiplied be (1+i)n
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• The future sum (F) of a given present sum (P) at an
interest rate i and after n periods is given by the
following formula:
F = P(1+i)n
– Single payment compound amount formula.
• In functional notation: F=P(F/P, i ,n)
– Ex.: F=5000(F/P,6%,10) is read as the future worth of
$5000 present worth, at an interest rate 6% per period,
and after 10 periods.
– The factors (F/P, i, n) for different i and n values are provided in
Tables 1 through 29 of the text book.
F = P(1+i)n = P(F/P, i, n)
• The functional notation is dimensionally correct ( F = P F
P ).

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 Example:
If $500 were deposited in a bank saving account, how
much would be in the account in three years if the bank
paid 6% interest compounded annually (yearly)?
F=?
Solution:
Receipts(+)
0 1 2 3

Disbursement(-)
P=$500 N=3 and i=0.06

F=P(1+i)n = 500(1+0.06)3 = $596

Thus $500 now will yield $596 in three years at interest rate
of 6% compounded yearly.

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Or the single payment compound amount factor, (1+i)n is
obtained from Table 11.
(1+i)n = (F/P, i , n) = (F/P,6%,3) = 1.191
F = 500 (F/P,6%,3) = 500(1.191) = $ 596
Table 11 Discrete Cash Flow: Compound Interest Factors

Note: For exams, you have to be able to use the formulas

or the tables.
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Single payment present worth formula

• The present sum P of given a future sum F at an

interest i and n periods is:
P = F(1+i)-n
– Single payment present worth formula.
• In functional notation: P = F (P/F, i, n)
– The factors (P/F, i, n) for different i and n values are
provided in Tables 1 through 29 of the text book.
P = F(1+i)-n = F(P/F, i, n)

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 Example:
If you wish to have $800 in a saving account at the end of 4
years, and 5% interest was paid annually, how much
should you put into the saving account now?
F = $800
Receipts(+)
0 1 2 3 4

Disbursement(-)

P=?

F = $800, i=0.05, n=4, P= unknown.

P = F(1+i)-n = 800(1+0.05)-4 = 800(0.8227) = $658

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Or:
P = F (P/F, i, n) = $800(P/F, 5%, 4)
From the interest tables, (P/F, 5%, 4) = 0.8227
P = $800(0.8227) = $658
Table 10 Discrete Cash Flow: Compound Interest Factors

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Example:
How much money would be in your account at the end of
three years assuming $500 is deposited now? Given that
the bank pays 6% interest, compounded quarterly.
Solution:
– 6% interest: interest is assumed to be for one-year
period, unless other period is described.
– Compounded quarterly: this means there are four
interest periods per year; each interest period is 3
months long.
i =(6%)/4= 1.5% per quarter compounded quarterly.
For total 3 years duration, there are 12 interest periods.
F = P(1+i)n = P ( F/P, i, n)
= 500(1+0.015)12 = 500(F/P, 1.5%, 12) = $598

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Example:
$10,000 is borrowed for one year at 12% interest,
compounded monthly. If the same amount of money could
be borrowed for one year at 12% interest, compounded
semi-annually, how much could be saved in interest
charge?
• 12% compounded monthly is 12%/12 = 1% per month.
One year is 12 periods: F = 10000(1.01)12 = $11,268
• 12% compounded semi-annually is 12%/2 = 6% per 6-
months.
One year is 2 periods of 6-months: F = 10000(1.06)2 =
$11,236
• $32 can be saved.
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Example:
If a $100 will worth $110 next year and its worth was $90 a
year ago, compute the interest rate for the past
year and the interest rate for the next year?
F = P(1+i)1
• Interest rate for the past year:
100=90(1+i) then i = 0.111 or 11.1%
• Interest rate for the next year:
110=100(1+i) then i = 0.10 or 10%

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Example:
Assume that $90 is invested a year ago will return $150
after 5 years from now. What is the annual interest rate in
this situation?
F = P (1+i)n
150 = 90 (1+i)6
1.6666 = (1+i)6
Log(1.6666) = 6 Log(1+i) taking log of both sides
0.037 = Log (1+i) taking the anti-log for both sides
1.089 = 1+i
i= 0.089 = 8.9%

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