Chapter 4: The Time Value of Money

Learning Objectives
 Understand the concept of “time value of money”
 Distinguish between simple and compound interest
 Understand the concept of “equivalence” of cash
flows
 Solve problems using Single Payment Compound
Interest Formulas
 Solve problems using Uniform Series Compound
Interest Formulas
 Apply arithmetic and geometric gradients in
modeling economic analysis
 Understand nominal and effective interest rates
 Apply continuous compounding
2
Money has a time value.
 Question: Would you rather
• Receive $1000 today or
• Receive $1000 1 year from today?
 Answer:----------
 Why?
• Earning power of money
• Purchasing power of money
• Money is a valuable asset
Because money is more valuable today than in the future,
we need to describe cash receipts and disbursements at
the time they occur.
3
 Cash in Cash out
Revenues Cost
Receipts Expenses
Expenditures
disbursements

When describing a cash:

- Value
- Sign ----------R is positive , E is negative
- Timing
 $10,000
5
0

$10,000 + I
F=15,000
P = 10,000 (Principal)
F = 15,000 = P + I ( Future equivalent of P)
I = $5,000 interest
n = 5 , no. of interest periods
Two types of interest
 1. simple:
I proportional to P, n, i.
 i is interest rate %/time period

 I = ixnxP
 I = 5000, P=10000, n=5
 i=I/(nP) = 5000/(10,000x5) = 0.1x100%=10%/year

 2. compound:
 Simple interest
Interest is computed only on the original sum
(the original principal P), and not on accrued
interest.

When the total interest earned or charged is

linearly proportional to:
– principal amount lent or borrowed (P)
▪ the initial amount of the loan (principal),
– number of interest periods (e.g., years) (n),
and
– interest rate per interest period (i ),
→ the interest and interest rate are said to be
simple.
7
Computation of simple interest

Total interest earned I = P  i  n

where P = Principal
i = Simple annual interest rate
n = Number of years

F = P + P in
where F = Amount due at the end of n periods (years)

8
 Example 4-1
If $5,000 were loaned for five years at a
simple interest rate of 8% per year, the
interest earned would be:
Total interest earned = P  i  n = $5,000  0.08  5
= $2,000
So, the total amount repaid at the end of
five years would be the original amount
($5,000) plus the interest ($2,000):

Amount due at end of loan =F = P + P  i  n = $7,000

9
For Simple interest , I is calculated at time zero, and it is
not affected with the way you pay within n periods

for the previous example if I decide to repay is 5 equal

annual payments

annual payment = 7000/5 = $1,400 / year

A = (P + I) / n

conclusion: you have to repay (P + I) in any pattern during

the 5 years.
 Compound Interest

 Interest is computed on the unpaid

balance, which includes the principal and
any unpaid interest from the preceding
period
 Charging interest on unpaid interest
(compounding)
 Common practice for interest calculation,
unless specifically stated otherwise

11
 Compound Interest: Example 4-2
Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%/year
 Pay principal and interest in one payment at end of 5 years

Balance at
the Interest
Beginning Balance at the Payme Principal Total
Yr of Year Interest end of Year nt Payment Payment
5400=P+iP
1 5000 P 400 iP P(1+i)
5832
5400*.08 P(1+i)+P(1+i)I
5400 =432 P(1+i)(1+i)
2 P(1+i) P(1+i)i P(1+i)^2
P(1+i)^2 +
iP(1+i)^2
P(1+i)^2(1+i)
3 P(1+i)^2 iP(1+i)^2 P(1+i)^3 12
 Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay principal and interest in one payment at end of 5
years
5000
I = $2,347 7347

Balance
at the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $0.00 $0.00 $0.00
2 $5,400.00 $432.00 $5,832.00 $0.00 $0.00 $0.00
3 $5,832.00 $466.56 $6,298.56 $0.00 $0.00 $0.00
4 $6,298.56 $503.88 $6,802.44 $0.00 $0.00 $0.00
5 $6,802.44 $544.20 $7,346.64 $2,346.64 $5,000.00 $7,346.64

total 29,332 2347 $2,346.64 $5,000.00 $7,346.64

13
 Repaying a Debt
repay 1/n th of the principal plus interest due

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay $1000 principal plus interest due

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5

14
 Repaying a Debt
repay 1/n th of the principal plus interest due

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay $1000 principal plus interest due
 I = $1,200
Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $1,000.00 $1,400.00
2 $4,000.00 $320.00 $4,320.00 $320.00 $1,000.00 $1,320.00
3 $3,000.00 $240.00 $3,240.00 $240.00 $1,000.00 $1,240.00
4 $2,000.00 $160.00 $2,160.00 $160.00 $1,000.00 $1,160.00
5 $1,000.00 $80.00 $1,080.00 $80.00 $1,000.00 $1,080.00

Total 15,000 1200 $1,200.00 $5,000.00 $6,200.00

15
 Repaying a Debt

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay interest due at end of each year and principal at end
of 5 years

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5
Subtotal
16
 Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay interest due at end of each year and principal at end of
5 years
Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
2 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
3 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
4 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
5 $5,000.00 $400.00 $5,400.00 $400.00 $5,000.00 $5,400.00

Subtotal 2000 $2,000.00 $5,000.00 $7,000.00

17
 Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay in 5 equal end-of-year payments of $1252.28
 A=5000(A/P,8%,5) =

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1 5000 400 5400 400 852.3 1252.3
2 4147.7 331.816 4479.516 331.8 920.5 1252.3
3 3227.2 258 3485.2 258 994.3 1252.3
4 1252.3
5 1252.3
Subtotal 6261.5

18
 Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay in 5 equal end-of-year payments of $1252.28

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $852.28 $1,252.28
2 $4,147.72 $331.82 $4,479.54 $331.82 $920.46 $1,252.28
3 $3,227.25 $258.18 $3,485.43 $258.18 $994.10 $1,252.28
4 $2,233.15 $178.65 $2,411.80 $178.65 $1,073.63 $1,252.28
5 $1,159.52 $92.76 $1,252.28 $92.76 $1,159.52 $1,252.28

Subtotal $1,261.41 $5,000.00 $6,261.41

19
Question ?

 If you were given the choice between the

4 alternative repayment plans, which one
would you choose?

20
 Equivalence
 If a firm believes 8% was reasonable, it would
have no preference about whether it received
$5000 now or was paid by any of the 4
repayment plans
 The 4 repayment plans are equivalent to one
another and to $5000 now at 8% interest (in
spite of the different repayment structure and
the total payment amount)
 They have equal comparable equivalent
values; in this case “the present” value
21
 Use of Equivalence in
Engineering Economic Studies
 Using the concept of equivalence, one can
convert different types of cash flows at different
points of time to an equivalent value at a
common reference point
 Equivalence need not be a single sum; it could be
a series of payments or receipts
 Equivalence is dependent on interest rate; two
series of payments may be equivalent at one
interest rate, but not equivalent at another

22
 Cash Flow Diagrams (CFD)
 CFD summarize costs & benefits occur over time
 CFD illustrates the size, sign, and timing of
individual cash flows

 Components of CFD
◦ A segmented time-based horizontal line, divided into
time units
◦ A vertical arrow representing a cash flow is added at the
time it occurs
◦ Cash flows are assumed to occur at the end of the
period
◦ Arrow pointing down for costs and up for benefits
23
Cash Flow Diagrams (CFD)
Timing of Cash Flow Size of Cash Flow
At time zero (now) Positive $100
1 time period from today Negative $100
2 time periods from today Positive $100
3 time periods from today Negative $150
4 time periods from today Negative $150
5 time periods from today Positive $50

$100 $100
$50
Period 1

0 1 2 3 4 5
End of period 4 is also beginning of
Today “time 0”
period 5
$100
$150 $150

24
Categories of Cash Flows
 First cost= initial investment = investment cost:
expenses to build or to buy and install.
 Operations and maintenance (O&M): annual
expense, such as electricity, labor, and minor
repairs
 Salvage value: receipt at project termination for
sale or transfer of the equipment
 Revenues: annual receipts due to sale of products
or services

25
 Drawing a Cash Flow Diagram
 CFD shows when all cash flows occur
 In a CFD, the end of period t is the same time as the
beginning of period t+1
 Rent, lease, and insurance payments are usually
treated as beginning-of-period cash flows
 O&M, salvage, revenues, and overhauls are assumed to
be end-of-period cash flows
 The choice of time 0 is arbitrary
 Perspective in assigning the sign of cash flow
 Show individual concurrent cash flows
26
Computing Cash Flows: Example 4-3
Cash flows of 2 payment options

To purchase a new $30,000 machine,

• Pay the full price now minus a 3% discount or
• Pay $5000 now; $8000 at the end of year 1;
and $6000 at the end of each of the next 4
years

27
 Example 4-3
Cash flows of 2 payment options
Pay in full Pay in 5 years
End of End of
Year Cash Flow Year Cash Flow
Table of cash

0 (now) -$29,100 0 (now) -$5,000

flows

1 0
2 0
3 0
4 0
5 0
cash flow
diagrams
1 -8,000
2 -6,000
3 -6,000
4 -6,000
5 -6,000

0 1 2 3 4 5 0 1 2 3 4 5
$5,000
$29,100 3% per year $8,000 $6,000
28
 Drawing Cash Flow Diagrams
with Spreadsheet
Stacked bar chart
0 1 2 3 4 5 6
$20,000
Capital $10,000
$-
Year Costs O&M Overhaul $(10,000)

Cash Flows
$(20,000)
0 $(80,000) $(30,000)
$(40,000)
1 $(12,000)
$(50,000)
2 $(12,000) $(60,000)
$(70,000)
3 $(12,000) $(25,000) $(80,000)
$(90,000)
4 $(12,000)
Year
5 $(12,000)
Capital Costs O&M Overhaul
6 $10,000 $(12,000)

29
 Interest Formulas
Notation used for compound interest calculations
• i = effective interest rate per interest period (stated as a
decimal)
• n = number of interest periods (usually periods when
cash flows occur)
• P = present sum of money; equivalent value of one or
more cash flows at the present reference point in time
• F = future sum of money; equivalent value of one or more
cash flows at a future reference point in time
• A = end-of-period cash flows in a uniform series
continuing for a certain number of periods, starting at the
end of the first period and continuing through the last

30
Single Payment
Compound Interest Formulas
 Single Payment Compound Amount Formula

0 1 2 n-1 n

i%

31
Single Payment
Compound Interest Formulas
Notation:
i = effective interest rate per interest period (stated as a decimal)
n = number of interest periods
P = a present sum of money
F = a future sum of money ( F is an amount, n periods from the
present, that is equivalent to P with interest rate i)

Single Payment Compound Amount Formula

F = P(1 + i) n

F = P(F/P, i%, n)
Single Payment Compound Amount Factor: Find
Functional F, given P, at i, over n
notation
32
 Single Payment
Compound Interest Formulas
Notation:
i = effective interest rate per interest period
n = number of interest periods
P = a present sum of money
F = a future sum of money
Single Payment Present Worth Formula
P = F(1 + i) -n

P = F(P/F, i%, n)
single payment present worth factor:
Find P, given F, at i, over n
33
Example 4-4 Single Payment Compound
Interest Formulas
$500 were deposited in a saving account (pays
1.5% per quarter) for 3 years

34
Example 4-4 Single Payment Compound
Interest Formulas
$500 were deposited in a saving account (pays
1.5% per quarter) for 3 years
F=?
iq = 1.5% / quarter
n = 3 x 4 = 12 quarters
F = P(1+i)n
0 1 2 11 12
iq=1.5% = 500(1+0.015)12
= $598.00
P=500
F=P+I
I = $98
35
Example 4-5 Single Payment Compound
Interest Formulas
Solve for P
Year Cash Flow
0 +P
1 0
2 0
3 -400
4 0
5 -600

P=?

0 1 2 3 4 5
i=12%
400 600
36
 Example 4-5 Single Payment Compound
Interest Formulas
Solve for P P = 400(P/F,12%,3) +
Year Cash Flow 600(P/F,12%,5)
0 +P
1 0 = 400(0.7118) +
2 0 600(0.5674)
3 -400
= 625.16
4 0
5 -600
Or P = F(1 + i) -n

P=? P = 400(1.12)^-3
0 1 2 3 4 5
+600(1.12)^-5

i=12% 400 600

I = 625 -600-400= -375 37
Problems involving unknown n or i
◦ We may know P, F, and i and want to find n
F = P(1 + i) n →
F F
= (1 + i) → log( ) = log(1 + i) n = n log(1 + i ) →
n
P P
log( F P )
n=
log(1 + i )
◦ We may know P, F, and n and want to find i
F
F = P(1 + i) → = (1 + i) n →
n
P
1n 1n
F  F  F
  = n   =1+ i → i =   −1
P P P
38
 Problems involving unknown n or i
◦ We may know P, F, and i and want to find n
To use these formulas:
1. We should have only two single cash P & F
2. Interest is compound not simple. F=P+inP

Refer to ch4 examples presentation

Ex 4-5 & 4-6

39
 Uniform Series
Compound Interest Formulas
Uniform (equal) series of receipts or payments; future
costs or benefits estimated to be the same or uniform for
each period of time
Examples:
• Automobile loans, mortgage payments, insurance
premium, rents, and other periodic payments
Notation:
A = an end-of-period cash flow in a uniform series,
(Annuity), continuing for n periods
A A A A

0 1 2 n-1 n
i% 40
 Uniform Series
Compound Interest Formulas
A A A A

0 1 2 n-1 n
F =A (1+i)^(n-1) + A i%
(1+i)^(n-2)+---A(1+i) +A
F
 (1 + i) n − 1 
F = A  = A( F A , i %, n)
 i 

41
 Uniform Series
Compound Interest Formulas
A A A A
Uniform Series Compound
Amount Formula
0 1 2 n-1 n
i%
 (1 + i) n − 1 
F = A  = A( F A , i %, n)
 i 
F
Uniform Series Sinking Fund formula
 i 
A = F  = F ( A F , i %, n)
 (1 + i) − 1 
n

42
Example 4-6 Uniform Series
Compound Interest Formulas

Jim wants to save money at the end of each

month to pay for some equipment of $1000
at the end of the year. If bank pays 0.5%
monthly interest, how much Jim has to
deposit every month?

43
 Example 4-6 Uniform Series
Compound Interest Formulas
Jim wants to save money at the end of each month to pay
for some equipment of $1000 at the end of the year. If
bank pays 0.5% monthly interest, how much Jim has to
deposit every month?
1000
0 1 2 3 4 5 9 10 11 12

A A A A A A A A A=?

i𝑚𝑜 = 0.5 %

A = F ( A F , i %, n) = 1000( A / F ,0.5%,12)
= 1000(0.0811) = $81.10
44
 Example 4-6 Uniform Series
Compound Interest Formulas
Jim wants to save money at the end of each month to pay
for some equipment of $1000 at the end of the year. If
bank pays 0.5% monthly interest, how much Jim has to
deposit every month?
1000
0 1 2 3 4 5 9 10 11 12

A A A A A A A A A=?
If he is saving at home (i=zero)

A=1000/12 = $83.3/month instead of 81.1

45
 Uniform Series
Compound Interest Formulas
P

0 1 2 n-1 n
 (1 + i) n − 1 
F = A  = A( F A , i %,An) A i% A A
 i 
F = P(1+i)^n

Uniform Series Present Worth Formula

 (1 + i) n − 1 
P = A n 
= A( P A , i %, n)
 i (1 + i ) 
46
 Uniform Series
Compound Interest Formulas
P
Uniform Series Capital
0 1 2 n-1 n
Recovery Formula
A A i% A A
 i (1 + i ) 
n
A = P  = P ( A P , i %, n)
 (1 + i) − 1 
n

Uniform Series Present Worth Formula

 (1 + i) n − 1 
P = A n 
= A( P A , i %, n)
 i (1 + i ) 
47
Example 4-7 Uniform Series
Compound Interest Formulas
Should you spend $6800 to buy a contract that pays $140 at
the end of each month for 5 years if you otherwise can make
1% per month on your money?

140 x 5 x 12 = 8400 yes

Here we ignored time value of money, which is wrong.

We should convert 140 to P using interest formulas, then

compare with 6800

48
 Example 4-7: Solution #1
Should you spend $6800 to buy a contract that pays $140 at
the end of each month for 5 years if the desired return is
1% per month? A=140

n=60 i=1%

P=?
P = A( P A , i %, n)
= 140( P A ,1%,60) = 140(44.955) = $6293.70

The contract is only worth $6293.70, so reject the offer.

49
 Example 4-7: Solution #2
A=?

n=60 i=1%

P=6800

A = P ( A P , i, n)
= 6800( A P ,1%, 60) = 6800(0.0222) = $150.96
The $6800 investment would generate $150.96
monthly at 1% per month, so reject the offer.

50
Example 4-8:

What amount, P, needs to be deposited in a saving

account that pays 15% interest, to support 3 later
withdraws?

Year Cash Flow 30

20 20
0 -P
1 0 0 1 2 3 4
2 +20
3 +30 i=15%
4 +20 P=?

51
Example 4-8:

30 30
20 20 20 20

0 1 2 3 4= 0 1 2 3 4+ 0 1 2 3 4 +0 1 2 3 4
P1 P2 P3

P
P = P1 + P2 + P3
= 20(P F,15%,2) + 30(P F,15%,3) + 20(P F,15%,4)
= 20(0.7561) + 30(0.6575) + 20(0.5718)
= $46.28

52
Relationships Between
Compound Interest Factors
Single Payment
1
(F/P, i%, n) =
(P/F, i%, n)
Uniform Series
1
(A/P, i%, n) =
(P/A, i%, n)
1
(F/A, i%, n) =
(A/F, i%, n)
53
Relationships Between
Compound Interest Factors

Uniform Series
n
(P/A, i%, n) =  (P/F, i%, t)
t =1

(F/A, i%, n) = (P/A, i%, n)(F/P, i%, n)

54
 100
A A A P (t=0) = 100 (P/A, i, 9)
F (t=9) = 100(F/A,i,9)
0 1 2 8 9
100
A A A
P (t=4) = 100 (P/A, i, 20)
F (t=24) = 100(F/A,i,20)
4 5 6 23 24

P4
P0= P4 x (P/F,i,4)
=100 (P/A, i, 20)x (P/F,i,4)
4 5 6 23 24
Or
P0 = 100 (F/A,i,20)(P/F,i, 24)
P0

0 1 2 23 24
 Interest Tables Interpolation

Factor values can be obtained in one of three ways:

1.Using the formulas
2.Interpolating between the tabulated values on both
sides of the unlisted desired value
3.Using a software which has the economy factors
programmed into it

 linear interpolation is
acceptable and is considered
sufficient as long as the
values of i or n are not too
distant from each other.
56
Problems involving unknown n or i
 It is more challenging to solve for n or i, for
instance:
◦ We may know P, A, and i and want to find n
◦ We may know P, A, and n and want to find i

 These problems present special challenges

that are best handled on a spreadsheet.

57
 Example 4-11: Finding i
Jill invested $1,000 each year for five years in a local
company and sold her investment after five years for
$8,000. What annual rate of return did Jill earn?

F = A(F/A, i%, n ) = $8,000 = $1,000(F/A, i %, 5)

So, (F/A, i%, 5) = $8,000 / $1,000 = 8 =

(1 + i) −1
5

i
Again, this can be solved using the interest tables and
interpolation: i = 23.65%
i% (F/A, i%, 5)
20% 7.442
i% 8.000
25% 8.207
58
There are specific spreadsheet functions to
find n and i.

One Excel function used to solve for n is

NPER (rate, pmt, pv, fv), which will compute the
number of payments of magnitude pmt required to pay
off a present amount (pv) [or future value (fv)] at a
fixed interest rate (rate).

One Excel function used to solve for i is

RATE (nper, pmt, pv, fv), which returns a fixed interest
rate for an annuity of pmt that lasts for nper periods to
either its present value (pv) or future value (fv).

59
Arithmetic (uniform) Gradient
The arithmetic gradient is a series of increasing cash flows,
where the period-by-period change in cash flows is a
constant amount, G

Notation:
G = a fixed amount increment per time period
End of Cash
Period Flows
(n-1)G
(n-2)G 1 0
20
2 G
10
0
3 2G
0 1 2 3 n-1 n : :
i% n (n-1)G
60
Arithmetic (uniform) Gradient
The arithmetic gradient is a series of increasing cash flows,
where the period-by-period change in cash flows is a
constant amount, G

Notation:
G = a fixed amount increment per time period
End of Cash
Period Flows
(n-1)G
(n-2)G 1 0
2G
2 G
G
0
3 2G
0 1 2 3 n-1 n : :
i% n (n-1)G
61
P0 = G/(1+i)^2 + 2G/(1+i)^3 + …..+ (n-1)G/(1+i)^n
The equations and tables only for increasing Gradient
(n-1)G

G
End of Cash
Period Flows
(n-1)G
(n-2)G 1 0
2G
2 G
G
0
3 2G
0 1 2 3 n-1 n : :
i% n (n-1)G
62
Arithmetic Gradient
Compound Interest Formulas
Arithmetic Gradient Present Worth Formula
= 𝐺(𝑃Τ𝐺 , 𝑖%, 𝑛)

Arithmetic Gradient Uniform Series Formula

1 𝑛
A=G − 𝑛 = 𝐺(𝐴Τ𝐺 , 𝑖%, 𝑛)
𝑖 (1 + 𝑖) − 1

63
Example 4-12 Application of Arithmetic
Gradient Interest Factors

Revenues from a new product will decline as

competitors enter the market. At an interest rate of 10%,
what is an equivalent uniform series?

Year Cash Flow A

24000
1 24000 18000
12000
2 18000 6000
3 12000
0 1 2 3 4 0 1 2 3 4
4 6000
i=10%
64
Example 4-12 Application of Arithmetic
Gradient Interest Factors
24000 A=24000
18000
12000
6000

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4

6000
12000
Year Cash Flow 18000

1 24000
2 18000
A = 24000 − 6000( A G,10%,4)
3 12000 = 24000 − 6000(1.381)
4 6000 = $15,714
65
Example 4-13 Application of Arithmetic
Gradient Interest Factors
 A car warranty is 3 years. Upon expiration, annual
maintenance starts at $150 and then climbs $25 per year
until the car is sold at the end of year 7. Use a 10%
interest rate and find the present worth of these expense.

Year Cash Flow 0 1 2 3 4 5 6 7

4 150
5 175 150 175
200 225
6 200
P
7 225
i=10%

66
 Example 4-13 Application of Arithmetic
Gradient Interest Factors

0 1 2 3 4 5 6 7 = 0 1 2 3 4 5 6 7 + 0 1 2 3 4 5 6 7

25 50
75
150 175
200 225 A=150

P P3

P3 = 150(P A,10%,4) + 25(P G,10%,4)

Year Cash Flow
= 150(3.170) + 25(4.378)
4 150
5 175 = $584.95
6 200 P0 = P3 (P F,10%,3) = 584.95(0.7513)
7 225
= $439.47
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 Geometric Gradient

The geometric gradient is a series of increasing or

decreasing cash flows, where the period-by-period
change in cash flows is a uniform rate or
percentage, g.
Notation:
g , f = a constant rate (+ or -) per period, that is,
the geometric gradient
A1 = cash flow at period 1 n-1
A1(1+g)
A1(1+g)n-2 g% of An-1
A1(1+g)2
A1 A1(1+g)
g% of A1

0 1 2 3 n-1 n
68
 Geometric Gradient

The geometric gradient is a series of increasing or

decreasing cash flows, where the period-by-period
change in cash flows is a uniform rate or
percentage, g.
Notation:
g , f = a constant rate (+ or -) per period, that is,
the geometric gradient
A1 = cash flow at period 1 n-1 A1(1+g)
A1(1+g)n-2 g% of An-1
121
100 110
g% of A1

0 1 2 3 n-1 n
69
 Geometric Gradient

P0 = A1/(1+i)+A1(1+g)/(1+i)^2+…..+A1(1+g)^(n-
1)/(1+i)^n

A1(1+g)n-1
A1(1+g)n-2 g% of An-1
A1(1+g)2
A1 A1(1+g)
g% of A1

0 1 2 3 n-1 n
70
Geometric Gradient
Compound Interest Formulas

Geometric Gradient Present Worth Formula

71
 Interest rate varies with time
A=200/month

n=20 i=2%/month n=60

i=1%/month

P0???

P=200(P/A,i?,60)???? wrong

P = P1 + P2
= 200 (P/A,1%20) + 200 (P/A,2%,40) (P/F,1%,20)
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Interest Rates that Vary with Time
 Interest rates often change with time (e.g., a variable
rate mortgage).
 We often must resort to moving cash flows one
period at a time, reflecting the interest rate for that
single period.
◦ The present equivalent of a cash flow occurring at the end
of period n can be computed with the equation below,
where ik is the interest rate for the kth period.
𝐹𝑛 𝑛
P= 𝑛 P ෑ(1 + 𝑖𝑘 ) = 𝐹𝑛
ς𝑘=1(1 + 𝑖𝑘 )
𝑘=1

If F3 = $2,500 and i1=8%, i2=10%, and i3=11%, then

73
 F , P , A, G, f or g.

 F and P to check i&n same time units

 If A or G or g are included , must check

the A&i&n G&i&n g&i&n

 1%/month not equal to 12%/year

 r=12% (nominal interest)

 It means 1%/month or 3%/Quarter or 6%/half year.

 We should specify compounding frequency

 1%/month-----------r=12%,compounded monthly
 3%/quarter-------r=12%,compounded quarterly
 6%/half year------r=12%, compounded semiannual

𝑟
i𝑚 =
𝑚
1%/month-----------r=12%,compounded monthly

im=1%/month P=100 n=1year

F=100 (1.01)^12

ieff (annual real i, will give same effect, means its equivalent to im)
F = 100(1+ieff)^1 = 100 (1.01)^12

ieff=(1.01)^12 - 1 = 0.126 x100% = 12.68%/year

 (1+im)^m – 1 = (1+r/m)^m -1
Nominal and Effective Interest Rates
Often, the time between successive compounding, or the
interest period, is less than one year (e.g., daily, monthly,
quarterly).
Notation:
r = Nominal annual interest ‫ اسميه غير حقيقيه‬rate per year
without considering the effect of any compounding
Annual Percentage Rate (APR)
im = Effective interest rate per compounding period
ieff = Effective annual interest rate taking into account the
effect of compounding , Annual Percentage Yield (APY)
m = Number of compounding periods per year

𝑟 𝑟 m
i𝑚 = i𝑒𝑓𝑓 = (1 + ) − 1 = (1 + 𝑖𝑚 )𝑚 − 1
𝑚 𝑚

77
 Nominal and Effective Interest
Nominal

Effective Annual Rate when compounded

Rate

Semi-
Yearly annually Quarterly Monthly Daily Continuously
1% 1% 1.0025% 1.0038% 1.0046% 1.0050% 1.0050%
2% 2% 2.0100% 2.0151% 2.0184% 2.0201% 2.0201%
3% 3% 3.0225% 3.0339% 3.0416% 3.0453% 3.0455%
4% 4% 4.0400% 4.0604% 4.0742% 4.0808% 4.0811%
5% 5% 5.0625% 5.0945% 5.1162% 5.1267% 5.1271%
6% 6% 6.0900% 6.1364% 6.1678% 6.1831% 6.1837%
8% 8% 8.1600% 8.2432% 8.3000% 8.3278% 8.3287%
10% 10% 10.2500% 10.3813% 10.4713% 10.5156% 10.5171%
15% 15% 15.5625% 15.8650% 16.0755% 16.1798% 16.1834%
25% 25% 26.5625% 27.4429% 28.0732% 28.3916% 28.4025%

78
Example 4-15: Finding effective interest
rates.
For an 18% nominal rate, compounded quarterly,
the effective annual interest is.

eff

For a 7% nominal rate, compounded monthly, the

effective annual interest is:

eff

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 Example 4-9: Analyzing a Loan

Maria has a 30-year monthly payment mortgage of

$100,000 at 7.5%, compounded monthly. She just
made her 12th payment. What is her remaining
balance after this 12th payment?

im=7.5/12=0.625%/month
n=30x12=360 months

80
 Example 4-9: Analyzing a Loan

0 1 2 3 12 360

P=100000
Balance Due?

Monthly Payment
A = 100000(A/P,0.625%,360) = $699.21
Balance at the end of 12 months (348 months
remaining)
Balance348 = 699.21(P/A, 0.625%, 348) = $99,077.53
81
Continuous Compounding

 Interest is typically compounded at the end of

discrete periods.
 In most companies cash is always flowing, and
should be immediately put to use.
 We can allow compounding to occur
continuously throughout the period.
 The effect of this compared to discrete
compounding is small in most cases.

82
 Continuous Compounding
Interest Formulas
For Continuous Compounding, the duration of the compounding
period decreases to an infinitely small duration, m 
r m
lim (1 + ) = lim(1 + x) r / x = e r Substituting in the
m → m x →0
compound interest
(1+i a ) = e r thus i a = e r − 1 formulae ….

Single Payment Compound Amount

F = PF/P, r, n = P(ern )
Single Payment Present Worth
P = FP/F, r, n = F(e −rn )
83
 r m
lim (1 + ) = lim(1 + x) r / x = e r
m → m x →0

(1+i a ) = e r thus i a = e r − 1

 F = P (1+i)^n = P (1+er-1)^n = Pe^rn

 Continuous Compounding
Interest Formulas

Continuous Compounding Sinking Fund

 er − 1 
A F , r, n =  r n 
 e − 1
Continuous Compounding Capital Recovery

 er n (er − 1) 
A P , r, n =  r n 
 e −1 

85
 Continuous Compounding
Interest Formulas

Continuous Compounding Uniform Series

Compound Amount

 er n − 1
F A , r, n =  r 
 e −1
Continuous Compounding Uniform Series Present
Worth
 er n − 1 
P A , r, n =  r n r 
 e (e − 1) 
86
Example 4-17: Application of Continuous
Compounding
How long will it take for money to double at 10%
nominal interest, compounding continuously?

F = 2P
N???
r=10%, compounded continuously

F=Pe(rn)

2=e^(rn)
Ln2 = 0.1n

88
Example 4-17: Application of Continuous
Compounding
How long will it take for money to double at 10%
nominal interest, compounding continuously?
𝐹
F = 𝑃(𝑒 𝑟⋅𝑛 ) → = 𝑒 (0.10)(𝑛)
𝑃
=2
(0.10)𝑛 = ln 2 = 0.693
𝑛 = 6.93 = 7 𝑦𝑒𝑎𝑟𝑠
Or
ieff = er − 1 = 10.5171%/year
𝐹
F = P(1 + i𝑒𝑓𝑓 )n →
n 𝑃
= (1.105171) = 2
n = 6.93

89
Example 4-18: Application of Continuous
Compounding
$500 were deposited in a credit union (pays 5%
compounded continuously) at the end of each year
for 5 years, how much do you have after the 5th
deposit?
 er n − 1
A=500/year F A , r, n =  r 
r=5%,compounded cont.  e −1
N=5
F???

90
Example 4-18: Application of Continuous
Compounding
$500 were deposited in a credit union (pays 5%
compounded continuously) at the end of each year
for 5 years, how much do you have after the 5th
deposit?
 er n − 1  e(0.05)5 − 1
F = AF A , r, n = A  r  = 500  (0.05)  = $2769.84
 e −1 e −1 
Or
ieff = er − 1 = 5.1271%
F = 500(F/A, 5.1271%, 5) = 500(5.5397) = 2769.84

91