Lecture IR 5 2021

Arab Academy for Science, Technology COLLEGE OF ENGINEERING AND
and Maritime Transport INDUSTRIAL RELATIONS TECHNOLOGY
LECTURE (5)
INTRODUCTION TO INDUSTRIAL
ECONOMICS
1` Dr. Kamal El-Nahhas 10 November 2020

LECTURE OUTLINES
 Introduction
 Time value of money
 Simple and Compound Interest
 Compounding Period
 Cash-Flow Diagram
 Present Worth and Future Worth
 Annual Worth and Gradients
 Annual Future Worth (Sinking Fund)
 Annual Present Worth (Installment Loan)
 Capitalized Cost (Infinite Life Analysis)
INTRODUCTION
Engineers often serve as managers or executive
officers of businesses and therefore are required to
make financial as well as technical decisions.
Even in companies where the managers are not
engineers, engineers serve as advisers and provide
reports and analyses that influence decisions.
Dr. Kamal El-Nahhas 10 November 2020

Time value of money

The time value of money is important when one is
interested either in investing or borrowing the
money.
The original investment or the borrowed amount (i.e.
loan) is known as the principal.

Time value of money

In case of an investment made in the past, the total
amount of interest accumulated till now is given by;
Amount of interest = Total amount to be received –
original investment (i.e. principal amount)
Similarly in case of a loan taken in past, the total
amount of interest is given by;
Amount of interest = Present amount owed –
original loan (i.e. principal amount)

Rate of Interest
When the interest amount is expressed as the
percentage of the original amount per unit time, the
resulting parameter is known as the rate of interest
and is generally designated as “i”.
The time period over which the interest rate is
expressed is known as the interest period.
The interest rate is generally expressed per unit year.
However in some cases the interest rate may also be
expressed per unit month.

Simple and Compound Interest

Simple interest:
The interest is said to simple, when the interest is
charged only on the principal amount for the interest
period.
The total amount of interest accumulated for a given
interest period is simply a product of the principal
amount, the rate of interest and the number of
interest periods. I = total amount of interest
I  Pni P = Principal amount
n = number of interest periods
F  P  I  P  Pni  P(1  ni) i = rate of interest
F = the total amount
if $1 000 were to be loaned at 7% annual simple interest for

five years, calculate the interest and the total amount F to be
repaid at the end of five years.
the interest would be:

l = Pni =1000 X 5 X 0.07 = $350
and the total amount F to be repaid at the end of five years
is
F = P+l = 1000+350 = $1350

Simple and Compound Interest

Compound interest:
The interest is said to be compound, when the
interest for any interest period is charged on
principal amount plus the interest amount accrued
in all the previous interest periods. Compound
interest takes into account the effect of time value
of money on both principal as well as on the accrued
interest also.
P = Principal amount
F  P(1  i) n n = number of interest periods
i = rate of interest
F = the total amount
if $1 000 were to be loaned at 7% annual compound interest

for five years, calculate the interest and the total amount F
to be repaid at the end of five years.
the total amount F to be repaid at the end of five years is

F  P(1  i ) n
F  1000(1  0.07)5  $1402.55
and the interest would be:
l = F - P = 1402.55 – 1000 = $402.55
Compounding Period
Annual interest rate could be compounded:
(a) annually, (b) semiannually, (c) monthly, and
(d) daily.
The change in the compounding period changes
the sum.
Thus, to compare different alternatives, we must
know the stated or nominal annual interest rate
and the compounding period.

Example
F  P(1  i) n
Annually: i = 0.12, n = 4 x 1 = 4 periods

Semi-annually: i = 0.12/2, n = 4 x 2 = 8 periods
Monthly: i = 0.12/12, n = 4 x 12 = 48 periods
Daily: i = 0.12/365, n = 4 x 365 = 1460 periods
12 Dr. Kamal El-Nahhas

Example
F  P(1  i) n
Annually: i = 0.12, n = 4 x 1 = 4 periods
F  P(1  i) n  8000(1  0.12) 4  8000(1.12) 4  $12588.15
Semi-annually: i = 0.12/2, n = 4 x 2 = 8 periods
0.12 42
F  P (1  i )  8000(1 
n
)  8000(1.06)8  $12750.78
2
13 Dr. Kamal El-Nahhas

Effective Annual Rate

We can also define an effective annual rate, often
called annual percentage rate (APR), for
comparison purposes.
The annual percentage rate (APR) is then the
interest rate that would have produced the final
amount under annual compounding (rather than
semiannual, monthly, or other compounding).

Effective Annual Rate

In previous example, for semi-annual compounding:
i = 0.12/2, n = 4 x 2 = 8 periods
0.12 42
F  P (1  i )  8000(1 
n
)  8000(1.06)8  $12750.78
2
APR can be found as follows:
F  $12750.78  8000(1  APR) 4
APR= 0.1236 = 12.36%

Cash-Flow Diagram
The graphical representation of the cash flows i.e. both
cash outflows and cash inflows with respect to a time
scale is generally referred as cash flow diagram.

Present Worth and Future Worth

The value of any transaction (loan, investment, and
so on) changes with time because of interest.
Thus, to express the value of a transaction, you must
also give the point in time at which that value is
computed.
We will examine several methods of stating the
value of a transaction.


Present worth (P) is the worth of a monetary
transaction at the current time. P  F (1  i)  n
It is the amount of money that must be invested now
in order to produce a prescribed sum at another date.
Future worth (F) is the worth of a monetary transaction
at some point in the future. F  P(1  i) n
lt is an analysis of what the future amount of money
will be if we take some particular course of action
now.


If the guaranteed sum (four years later) is equal to
$12588.15, the present worth at 12% annual
interest (compounded annually) is $8000.
P  F (1  i)  n
Banker's cash-flow diagram.

Annual Worth and Gradients
With present and future worth analysis, we

resolved cash flows into single equivalent cash
sums.
We can also state the value of a transaction on an
equivalent annual basis.
Annual worth (A) is the worth of monetary
transactions that have been converted to an
equivalent uniform annual cost or benefit.


An annuity involves a series of equal payments at
regular intervals. The value of such a series will be
developed from the idea of compound interest.
Consideration of the point in time at which
compounding begins will be of prime importance.
Several forms of annuities are:
• Annual Future Worth (Sinking Fund)
• Annual Present Worth (Installment Loan)
• Capitalized Cost (Infinite Life)


In many cases, annual payments do not occur in
equal-amount payment series.
If these costs increase (or decrease) in equal dollar
amounts each year, they are referred to as
arithmetic gradients (G).
Geometric gradients occur in cases where a uniform
payment increases (or decreases) by a constant
percentage.

Annual Future Worth (Sinking Fund)

A sinking fund is an annuity that is designed to
produce an amount of money at some future time. It
might be used to save for an expenditure that you
know is going to occur
Saver's cash-flow diagram.

 1  i n  1
F  A 
 i 
Annual Present Worth (Installment Loan)

A second and very popular way that annuities are
used to retire a debt is by making periodic payments
instead of a single large payment at the end of a
given time period.
This time-payment plan, offered by most retail
businesses and lending institutions, is called an
installment loan.

Company's cash-flow diagram.
Buyer's cash-flow diagram.


Therefore, since

F  P1  i   A
n 1  i   1
n

 i 
the present worth becomes
 1  i n  1 1  1  i  n 
P  A n 
 A 
 i1  i    i 
The term within the brackets is known as the present worth
of a sinking fund, or the uniform annual payment present-
worth factor.
Capitalized Cost (Infinite Life Analysis)

Capitalized cost (CC) refers to the present worth (P)
of a project or investment that is assumed to last
forever.
Public works projects like dams, railroads, and
irrigation systems are typical capitalized-cost
calculations.


Suppose that you want the monthly amount (A) to
continue after your death to be disbursed to your
heirs.
1  1  i  n 
P  A 
 i 
and consider that, as n approaches infinity (∞), the

numerator becomes 1, yielding
A
P
i

We can restate the problem by asking what amount
of money P must be available at retirement so that
an amount A can be withdrawn each month and
never affect the principal amount P.

Lecture IR 5 2021

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Arab Academy for Science, Technology COLLEGE OF ENGINEERING AND

and Maritime Transport INDUSTRIAL RELATIONS TECHNOLOGY

1` Dr. Kamal El-Nahhas 10 November 2020

Dr. Kamal El-Nahhas 10 November 2020

Time value of money

Dr. Kamal El-Nahhas 10 November 2020

Time value of money

Dr. Kamal El-Nahhas 10 November 2020

Dr. Kamal El-Nahhas 10 November 2020

Simple and Compound Interest

if $1 000 were to be loaned at 7% annual simple interest for

the interest would be:

8` Dr. Kamal El-Nahhas 10 November 2020

Simple and Compound Interest

if $1 000 were to be loaned at 7% annual compound interest

the total amount F to be repaid at the end of five years is

Dr. Kamal El-Nahhas 10 November 2020

Annually: i = 0.12, n = 4 x 1 = 4 periods

12 Dr. Kamal El-Nahhas

Annually: i = 0.12, n = 4 x 1 = 4 periods

F  P(1  i) n  8000(1  0.12) 4  8000(1.12) 4  $12588.15

Semi-annually: i = 0.12/2, n = 4 x 2 = 8 periods

13 Dr. Kamal El-Nahhas

Effective Annual Rate

Dr. Kamal El-Nahhas 10 November 2020

Effective Annual Rate

Dr. Kamal El-Nahhas 10 November 2020

Dr. Kamal El-Nahhas 10 November 2020

Present Worth and Future Worth

Dr. Kamal El-Nahhas 10 November 2020

Present Worth and Future Worth

Dr. Kamal El-Nahhas 10 November 2020

Present Worth and Future Worth

Banker's cash-flow diagram.

Dr. Kamal El-Nahhas 10 November 2020

Annual Worth and Gradients

With present and future worth analysis, we

Dr. Kamal El-Nahhas 10 November 2020

Annual Worth and Gradients

Dr. Kamal El-Nahhas 10 November 2020

Annual Worth and Gradients

Dr. Kamal El-Nahhas 10 November 2020

Annual Future Worth (Sinking Fund)

Saver's cash-flow diagram.

Annual Present Worth (Installment Loan)

Dr. Kamal El-Nahhas 10 November 2020

Annual Present Worth (Installment Loan)

Company's cash-flow diagram.

Buyer's cash-flow diagram.

Dr. Kamal El-Nahhas 10 November 2020

Annual Present Worth (Installment Loan)

Capitalized Cost (Infinite Life Analysis)

Dr. Kamal El-Nahhas 10 November 2020

Capitalized Cost (Infinite Life Analysis)

and consider that, as n approaches infinity (∞), the

Capitalized Cost (Infinite Life Analysis)

Dr. Kamal El-Nahhas 10 November 2020

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