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EC - Lecture 002 - Time Value of Money and Interest
EC - Lecture 002 - Time Value of Money and Interest
Engineering Economics
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Terminologies
• Interest (I), monetary unit – is the amount paid for the use of borrowed funds
(borrowers viewpoint) or the earnings generated by loaned capital (lenders viewpoint)
• Interest Rate (i), % - is the rate of capital growth, it is the ratio of the interest payable
or chargeable at the end of interest period and the amount of capital borrowed at the
beginning of that period.
• Interest Period (n) – is the time elapsed starting from the time capital is borrowed
to the time capital is paid. It is also the time for which the interest rate is applied.
• Principal or Present Worth (P), monetary unit – is the amount borrowed or invested
at the start of the interest period.
• Future Worth (F), monetary unit – is the amount accumulated at the end of the
interest period, it is the sum of the principal plus the interest earned for the interest
period.
𝑭 = 𝑷 + 𝑰
• Cash Flow – A term that refers to receipts (earnings, revenues) or disbursements
(payments, expenditures) of funds.
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Interest
• Interest is a factor that must be considered since earnings and expenditures occur at
different times. The time that funds are received or disbursed is of great consequence.
A present expenditures will not be the same as an expenditure of an identical amount in
the future, while, funds are loaned for the purpose of realizing a profit sometime in the
future.
• Simple Interest - it occurs when the interest earned is directly proportional to the
principal, the interest rate and the given interest period, it does not take into
account any interest accumulated from a preceding period.
𝐼 = 𝑃𝑖𝑛
𝐹 =𝑃+𝐼
𝐹 = 𝑃 + 𝑃𝑖𝑛
𝑭 = 𝑷 𝟏 + 𝒊𝒏
𝑷 = 𝑭 𝟏 + 𝒊𝒏 -1
• Ordinary Simple Interest – is computed on the basis of one bank year, where it is
common to consider a year to be composed of 12 months of 30 days each, or a total
of 360 days.
• Exact Simple Interest – is computed on the basis of the exact number of days for a
given year – 365 days for an ordinary year and 366 days for a leap year.
©2016 Slides created by Vernon Degala. 5
Interest
• Compound Interest – occurs when the interest owed from the previous
interest period becomes part of the total amount owed for the succeeding
interest period. Hence, the interest earned for a given interest period is
calculated based on the principal plus the accumulated interest at the start
of the period. The sum by which the principal has increased at the end of the
interest period is called the compound interest.
• Compound Amount – is the total amount due at the end of the interest period.
It is equal to the sum of the principal and the accumulated interest.
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Discrete Compounding
• It is the process of compounding interest at the end of every finite period, such
as weekly, monthly, or yearly.
Table: Comparative Table Showing the Equivalent Effective Interest Rates for Various Compounding
Periods at a Nominal Rate of 12%
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Continuous Compounding
• It is the counterpart of discrete compounding, the concept for such arises from the view that interest is earned every
day, hour, and minute. The interest earned is continuously added to the principal at the end of each infinitesimal
interest period, such that the number of compounding periods m per year is considered to be infinite.
From equation,
𝐹 =𝑃 1+𝑖 𝑛
From the derived equation it is clear that 𝑒 𝑖𝑛𝑛 corresponds to 1 + 𝑖 𝑛 , such that the effective rate for continuous compounding may
be computed as
𝒊𝒆 = 𝒆𝒊𝒏 − 𝟏
Equivalence
• The basic condition of equivalence is satisfied when the applied interest rate
sets the equivalent amount of receipts equal to the equivalent amount of
disbursements
– Payments may be added or subtracted directly if they occur at the same point
in time.
– Cash flows that are equivalent maybe referred to any point in time
– Two or more cash flows are equal if their equivalent values at any point in time are
equal.
– The applied interest rate for the specified time period must be reflected in
equivalence calculation.
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Inflation (i’)
• It is a condition describe by a decline in the purchasing power of money
brought about by a general increase in the prices of goods and services.
This translates to a steady decrease in the quantity of goods and services
that a fixed amount can purchase as time progresses.
• As a consequence, it is but appropriate to include in time value of money
computations the adjusted interest rate, 𝑖′, which reflects the actual or real
interest rate, 𝑖1, and the effects of the inflation rate, 𝑖2
1 + 𝑖 ′ = 1 + 𝑖1 1 + 𝑖2
𝑖 ′ = 1 + 𝑖1 1 + 𝑖2 − 1
Discount (D)
• A discount occurs when a transaction requires that interest be paid in advance, usually at the start of the
interest period. The discount is the difference between the amount indicated on the paper (face value)
and the price at which it is sold. The discount rate, d, is the ratio of the amount of discount to the future
worth of money, computed for one interest period, such that
𝑫 = 𝑭 − 𝑷 = 𝑭𝒅𝒏
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