Economic Environment accumulated in previous periods.

Thus, compound interest means “interest on the top

of interest”.
Engineering Economy – analysis and evaluation of the factors that will affect the
economic success of engineering projects to the end that a recommendation can be Elements of Compound Interest
made which will ensure the best use of capital. P = present worth
Consumer goods and services – those products or services that are directly used by F = future worth
people to satisfy their wants i = effective interest per compounding period (per interest
Producer goods or services – used to produce consumer goods and services or other period); i = r/m
produce goods n = total number of compounding; n = t x m
Necessities – products or services that are required to support human life and I = interest earned; I = F – P
activities, that will be purchased in somewhat the same quantity even though the r = nominal interest rate
price varies considerably. ER = effective interest rate
Luxuries – products or services that are designed by humans and will be purchased t = number of years of investment
if money is available after the required necessities have been obtained. m = number of compounding per year
Demand – quantity of a certain commodity that is bought at a certain price at a given
place and time. Future worth of P
 Elastic Demand – occurs when a decrease in a selling price result in a greater After n periods, the compound amount F is:
than proportionate increase in sales F = P (1+i)n, where (1+i)n
 Inelastic Demand – occurs when a decrease in the selling price produces a Values of i and n
less than proportionate increase in sales Nominal interest rate, r = 12%
 Unitary Elasticity of Demand – occurs when the mathematical product of Number of years of investment, t = 5 years
volume and price is constant.  Compounded annually (m=1)
Perfect Competition – occurs in a situation where a commodity or service is i = 0.12/1 =0.12
supplied by a number of vendors and there is nothing to prevent additional vendors n = 5(1) =5
entering the market.  Compounded semi-annually (m=2)
Monopoly – opposite of perfect competition i = 0.12/2 = 0.06
Perfect Monopoly – exist when unique product or service is available from single n = 5(2) =10
vendor and that vendor can prevent the entry of all others into the market  Compounded quarterly (m=4)
Oligopoly – exists when there are so few suppliers of a product or service that action i = 0.12/4 = 0.03
by one will almost inevitably result in similar action by the others. n = 5(4) = 20
Law of Supply and Demand – “Under condition of perfect competition the price at  Compounded monthly (m=12)
which a given product will be supplied and purchased is the price that will result in i = 0.12/12 = 0.01
the supply and demand being equal.” n = 5(12) = 60
Law of Diminishing Returns – “When the use of one of the factors of production is  Compounded bi-monthly (m = 6)
limited, either in increasing cost or by absolute quantity, a point will be reached i = 0.12/6 = 0.02
beyond which an increase in the variable factors will result in a less than n = 5(6) =30
proportionate increase in output.” Continuous Compounding (m=∞)
F = P ert
Interest and Money – Relationships Effective interest rate – actual interest earned in one year period
ER = (1+r/m)m – 1
Interest – amount of money paid for the use of borrowed capital or the income Effective rate of r (%) compounded continuously
produced by money which has been loaned. ER = er – 1
Equivalent Nominal Rates
Cash-Flow Diagram/s – is simply a graphical representation of cash flows drawn on ERM = ERQ
the time scale. Cash-flow diagram for economic analysis problems is analogous to
that of free body diagram for mechanics problems. Sample Problems:

Simple Interest – is calculated using the principal only, ignoring any interest that
had been accrued in preceding periods. In practice sample interest is paid on short-
term loans in which the time of the loan is measured in days.
Ordinary Simple Interest – the interest is computed on the basis of one banker’s
year.
1 banker’s year = 12 months
(30 days each month) = 360 days
Exact Simple Interest – the interest is based on the exact number of days of the
year, where there are 365 days for an ordinary year and 366 days for leap years.
Leap year occurs every four years for years that is exactly divisible by 4, except
century marks (1800. 1900, etc.) but not including those that are exactly divisible by
400 (2000, 2400, etc.)
1. Find the interest on P 6800 for 3 years at 11% simple interest.
2. A man borrowed P 10,000 from his friend and agrees to pay at the
end of the 90 days under 8% simple interest rate. What is the
required amount?
3. Annie buys a television set from a merchant who offers P 25,000 at
the end of 60 days. Annie wishes to pay immediately and the
merchant offers to compute the required amount on the assumption
that money is worth 14% simple interest. What is the required
amount?
4. A tag price of a certain commodity is for 100 days. If paid in 31 days,
there is a 3% discount. What is the simple interest paid?

Elements of Simple Interest: 5. Accumulate P 5,000 for 10 years at 8% compounded quarterly.

P = principal or present amount
I = interest earned 6. How long will it take 1,000 to amount to 1,346 if invested at 6%
F = future worth compounded quarterly?
r = simple interest rate (yearly)
t = time in years or fraction of the year 7. How long will it take for an investment to double its amount if
F=P+I invested at an interest rate of 6% compounded bi-monthly?
I = Prt
F = P (1+rt) 8. What is the effective rate for an interest rate of 12% compounded
continuously?
Value of n
Example: 9. If nominal interest rate is 3%, how much is 5,000 worth in 10 years in
 4 years; t = 4 a continuously compounded account?
 3 months; t =3/12 =1/4
 Ordinary simple interest, t= 90/360 10. Convert 12% compounded semi-annually to x% compounded
 Exact simple interest, t=90/365 or 90/366 monthly.

Compound Interest – In calculations of compound interest the interest for an

interest period is calculated on the principal plus total amount of interest

ES 412 Engineering Economy