Economic Study

Methods
Lecture 7

Dr. Lory Liza D. Bulay-og, PECE

Associate Professor
Economic Study Methods
A. The minimum attractive rate of return
B. Continuous Compounding
C. Discount Interest
D. Inflation
E. Time Value Equations and Cash Flow Diagrams
F. Present worth
G. Future worth
The Minimum Attractive
Rate of Return
The Minimum Attractive
Rate of Return (MARR)
is a reasonable rate of return
established for the evaluation
and selection of alternatives. A
project is not economically
viable unless it is expected to
return at least the MARR.
MARR is also referred to as the
hurdle rate, cutoff rate,
benchmark rate, and minimum
acceptable rate of return
The Minimum Attractive Rate of Return

In general,
Capital is developed in two ways: equity financing and debt financing
Equity financing - The corporation uses its own funds from cash on hand,
stock sales, or retained earnings. Individuals can use their own cash, savings,
or investments. In the example above, using money from the 5% savings
account is equity financing.

Debt financing - The corporation borrows from outside sources and repays
the principal and interest according to some schedule, much like the plans in
Table 1–1. Sources of debt capital may be bonds, loans, mortgages, venture
capital pools, and many others. Individuals, too, can utilize debt sources, such
as the credit card (15% rate) and bank options (9% rate) described above.
Continuous Compounding

Continuously compounded interest

- is interest that is computed on the initial principal, as well as all interest
other interest earned.
- The continuous payment of interest leads to exponential growth and is
many times used as an argument for wealth creation. Albert Einstein is credited
with the phrase “compound interest is the most powerful force in the universe.
- Single payment formulas for continuous compounding are determined by
taking the limit of compound interest formulas as m approaches infinity, where m is
the number of compounding periods per year. Here “e” is the exponential constant
(sometimes called Euler's number).
Continuous Compounding

Continuously compounded interest

Future Value Present Value

Where:
F = final amount (Future Value)
P = Principal (Initial Value)
r = nominal annual interest rate
n = time (years)
Example:

If you invest $1,000 at an annual interest rate of 5% compounded continuously,

calculate the final amount you will have in the account after five years.

Given:
P = 1000
Solution:
r = 5%
n=5
Example:

What should be the rate of interest for the amount of $5,300 to become double
in 8 years if the amount is compounding continuously?

Given
P = 5,300
Solution:
F = 2(5300) = 10,600
n=8
 Discount Interest
- is interest paid in advance
- A situation where all the interest on a loan is paid at once. That is, the interest
is deducted from the amount the borrower receives at the beginning of the loan.

Discount = Future worth – Present worth

The rate of discount is the discount on Rate of discount Rate of interest

one unit of principal for one unit of time

Where
d = rate of discount for the period involved
i = rate of interest for the same period
 Example:
A man borrowed P5,000 from a bank and agreed to pay the loan at the end of 9 months. The bank
discounted the loan and gave him P4,000 in cash.
(a) What was the rate of discount?
(b) What was the rate of interest?
(c) What was the rate of interest for one year?

Solution
(a) Rate of discount (d)
Discount = Future worth – Present worth
= 5,000 – 4,000
= 1,000
4,000
0

5,000
Solution
(b) Rate of interest (i)

(c) Rate of interest for one year

Note: discount = interest (I)
1 year = 12 months
 Inflation
- is the increase in the prices for goods and services from one year to
another, thus decreasing the purchasing power of money.
Inflation
Where
PC = present cost of a commodity
FC = future cost of the same commodity
f = annual inflation rate
n = number of years
In an inflationary economy, the
buying power of money decreases
as costs increase. Thus,
Where
F = is the future worth of the
present amount (P)
Inflation

If interest is being compounded at the

same time that inflation is occurring, the
future worth will be:
Example:

1. An item presently costs P1,000. If 2. An economy is experiencing

inflation is at the rate of 8% per inflation at an annual rate of 8%. If
year, what will be the cost of the this continuous, what will the worth
item in two years? two years from now, in terms of
today’s pesos.
3. A man invested P10,000 at an interest rate of 10% compounded annually. What
will be the final amount of his investment, in terms of today’s pesos, after five
years, if inflation remains the same at the rate of 8% per year?
Time Value Equations and
Cash Flow Diagrams
THANKS
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