University of Prince Edward Island Lecture IV

Engineering 362- Engineering Finance Winter 2005

CHAPTER 4 – MORE INTEREST FORMULAS

After Completing This Chapter – the student should be able ….
• Solve problems modeled by Uniform Series (very common)
• Use arithmetic and geometric gradients
• Apply nominal and effective interest rates
• Use discrete and continuous compounding
• Use spreadsheets and financial functions to solve problems

Questions to Consider
• Without a calculator, what annual rate of return do you suppose it
would take to turn $5,000 into $20 Million in 51 years? 100%
200%?
• With a calculator, what was Anne Scheiber’s actual average annual
rate of return during the years she was investing?
• How does this rate compare to the overall performance of the stock
market during the period from 1944-1995.

Anne Schreiber’s Bonanza

• Anne Scheiber died in 1995 at age 101 with an estate >$20M

• Left entire estate to Yeshiva University in New York
• She Was a retired IRS auditor, not an heiress but invested wisely
• Started investing in 1944 with $5,000 he life savings to that point
• Portfolio was “garden variety”, with Coca Cola and Exxon
• Extremely frugal, reinvested her dividends, what motivated her?
• Jewish woman who didn’t receive promotions, wanted to give
scholarships and interest free loans to help woman advance

Chapter 3 presented the fundamental components or “building blocks” of engineering

economics, most problems are more complex and requires a deeper understanding of
different types of cash flows and interest calculations.

Uniform Series Compound Interest Formulas

Extremely common form of cash flow, automobile loans, house payments and many
other commercial loans vehicles are based on a uniform payment series.

Based on A = An end of year period cash receipt or disbursement in a uniform series

continuing for n periods, the entire series equivalent to P or F at interest rate i.

In Chapter 3 we saw that a sum P at one point in time would increase to F in n periods at
an interest rate i, represented by F = P(1+i)n. Otherwise single payment Formulas. We
will use this relationship to derive the uniform series equation.

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University of Prince Edward Island Lecture IV
Engineering 362- Engineering Finance Winter 2005

Arithmetic Gradient
It frequently happens that the cash flow series is not of a constant amount A. Instead,
there is a uniformly increasing series as shown:

Cash flows of this form may be resolved into two components:

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University of Prince Edward Island Lecture IV
Engineering 362- Engineering Finance Winter 2005

Derivation of Arithmetic Gradient Factors

The derivation of the formulas is well laid out on Page 99/100 of the text, essentially an
evolution and factoring of previous formulas.

Geometric Gradient
As opposed to arithmetic gradient where the period-by-period change is “uniform
amount”, there are other situations where the period change is a uniform rate, g.

Nominal & Effective Interest

Nominal Interest per year, “r”, is the annual interest rate without considering the effects
of compounding. 2.5% interest every 6 months, the nominal rate per year is 2.5 x 2 = 5%

Effective Interest Rate per year, “ia”, is the annual interest rate taking into account the
effect of compounding interest on interest during the year.

r – Nominal interest rate per interest period (typically one year).

i – Effective interest rate per interest period
ia – Effective interest rate per year
m – Number of compounding sub periods per time period

Effective Interest Rate per year = ia = (1+r/m)m - 1

w/ i=(r/m)
Effective Interest Rate per year = ia = (1+i)m - 1

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University of Prince Edward Island Lecture IV
Engineering 362- Engineering Finance Winter 2005

Important to remember that in chapter three “i” was referred to simply as the interest rate
per interest period. We were describing the effective interest rate without concerning
ourselves with the more precise definition and increased complexity.

Continuous Compounding

Effective Interest Rate per year = ia = er - 1

Not too concerned about this at this point in time.

Spreadsheets for Economic Analysis

Spreadsheets are used in most real world applications and include the following tasks:

1. Constructing cash flow tables

2. Using preprogrammed annuity functions to calculate P,F,A,n, or i.
3. Using block functions to calculate present worth or internal rate of return
4. Making graphs for analysis and convincing presentations
5. Calculating “what if’s” for different assumptions or variables.

Spreadsheet Annuity Functions

Spreadsheet Block Functions

Spreadsheets for Basic Graphing

Problems:

Text Examples: 4-1, 4-2, 4-3, 4-7, 4-12

Study Guide: 4-1, 4-7, 4-10, 4-11, 4-12, 4-17, 4-39

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University of Prince Edward Island Lecture IV
Engineering 362- Engineering Finance Winter 2005

=20,000 [ .01(1+.01)48]
(1+.01)48-1

=20,000[.01(1.6122)/1.6122-1]

=20,000(.0161/.6122)

=20000(.0263)
A = $526.70 where .0263 = (A/P,1%,48) √

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