Minggu 2 - Chapter 03 Interest and Equivalence

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ENGINEERING
Newnan, Lavelle, and Eschenbach
ECONOMIC
ANALYSIS, 12/e Copyright © 2014 by Oxford University Press
Chapter 3
Interest and Equivalence
Copyright Oxford University Press 2014

Chapter Outline
• Time Value of Money

• Interest Calculations
• Cash Flow Equivalence
• Single Payment Compound Interest
Formulas
• Nominal and Effective Interest Rates

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
Computing Cash Flows
• Question: Would you rather

• Receive $1000 today; or
• Receive $1000 10 years from today?
• Answer: Of course today!
• Why?
• I could invest $1000 today to make more money
• I could buy a lot of stuff today with $1000
• Who knows what will happen in 10 years

Computing Cash Flows
• Because money is more valuable today than in

the future, we need to describe cash receipts
and disbursements at time they occur.

Example 3-1
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

Example 3-1
Cash flows of 2 payment options
Pay in full Pay in 5 years
End of End of
Year Cash Flow Year Cash Flow
0 (now) -$29,100 0 (now) -$5,000
1 0 1 -8,000
2 0 2 -6,000
3 0 3 -6,000
4 0 4 -6,000
5 0 5 -6,000
0 1 2 3 4 5 0 1 2 3 4 5
$5,000
$29,100 $8,000

Example 3-2
Cash flow for repayment of a loan
To repay a loan of $1,000 at 8% interest in 2 years
• Repay half of $1000 plus interest at the end of each year
$1000
Cash
Yr Interest Balance Repayment Flow
0 1000 1000
1 80 500 500 -580 0 1 2
2 40 0 500 -540
$540
$580

Time Value of Money
• Money has purchasing power

• Money has earning power
• Money is a valuable asset
• People are will to pay some charges (interests)
to have money available for their use

Simple Interest
Interest is computed only on the original sum, and

not on accrued interest
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒 = 𝑃𝑃 × 𝑖𝑖 × 𝑛𝑛 (3-1)
Where P = Principal
i = Simple annual interest rate
n = Number of years
Amount of money at the end of 𝑛𝑛 years,

𝐹𝐹 = 𝑃𝑃 + 𝑃𝑃 × 𝑖𝑖 × 𝑛𝑛 ( 3-2)
Where F = Amount due at the end of n years

Example 3-3
Simple Interest Calculation
Loan of $5000 for 5 yrs at simple interest rate of 8%
Total interest earned = $5000(8%)(5) = $2000

Amount due at end of loan = $5000 + 2000 = $7000

Compound Interest
• Interest is computed on the unpaid balance,

which includes the principal and any unpaid
interest from the preceding period
• Common practice for interest calculation, unless
specifically stated otherwise

Example 3-4
Compound Interest Calculation
• Loan of $5000 for 5 yrs at interest rate of 8%
Balance at the Balance at the end

Year Beginning of the year Interest of the year
1 $5,000.00 $400.00 $5,400.00
2 $5,400.00 $432.00 $5,832.00
3 $5,832.00 $466.56 $6,298.56
4 $6,298.56 $503.88 $6,802.44
5 $6,802.44 $544.20 $7,346.64

Repaying a Debt
Plan #1: Constant Principal
• Repay of a loan of $5000 in 5 yrs at interest rate of 8%
• Plan #1: Constant principal payment plus interest due
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
Subtotal $1,200.00 $5,000.00 $6,200.00

Repaying a Debt
Plan #2: Interest Only
• Plan #2: Annual interest payment and principal payment at end of 5 yrs
Balance at
the Balance at
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 $2,000.00 $5,000.00 $7,000.00

Repaying a Debt
Plan #3: Constant Payment
• Plan #3: Constant annual payments
Balance at
the Balance at
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

Repaying a Debt
Plan #4: All at Maturity
• Plan #4: All payment at end of 5 years
Balance at
the Balance at
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
Subtotal $2,346.64 $5,000.00 $7,346.64

A Closer Look at the 4 Repayment
• Differences:
• Repayment structure (repayment amounts at various
points in time)
• Total payment amount
• Similarities:
• All interest charges were calculated at 8%
• They all achieved the same purpose of repaying the
loan within 5 years

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

Equivalence
• ratio = total interest paid /total amount owed

at the beginning of year.
Total amount
Total Interest
Plan owed at the ratio
paid
beginning of year
1 $ 1200 $ 15000 0,08

2 2000 25000 0,08
3 1260 15767 0,08
4 2347 29334 0,08
From our calculations, we more easily see why the repayment
plans require the payment of different total sums of money,
yet are actually equivalent to each other.
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 is dependent on interest rate

Given the choice of these two plans which
would you choose?
Year Plan 1 Plan 2
1 $1400 $400
2 1320 400
3 1240 400
4 1160 400
5 1080 5400
Total $6200 $7000
To make a choice the cash flows must be altered so a
comparison may be made.
23
Technique of Equivalence
• Determine a single equivalent value at a

point in time for plan 1.
• Determine a single equivalent value at a
point in time for plan 2.
Both at the same interest rate.
•Judge the relative attractiveness of the

two alternatives from the comparable
equivalent values.
24
Single Payment
Notation:
𝑖𝑖 = interest rate per compounding period
𝑛𝑛 = number of compounding periods
𝑃𝑃 = a present sum of money
𝐹𝐹 = a future sum of money
Single Payment Compound Amount Formula
𝐹𝐹 = 𝑃𝑃(1 + 𝑖𝑖)𝑛𝑛 (3-3)
𝐹𝐹 = 𝑃𝑃(𝐹𝐹 ⁄𝑃𝑃 , 𝑖𝑖, 𝑛𝑛) (3-4)
Find F, given P, at 𝑖𝑖, over 𝑛𝑛

Single Payment Compound Interest
Beginning Interest for Ending

Year
balance period balance
1 P iP P(1+i)
2 P(1+i) iP(1+i) P(1+i)2
3 P(1+i)2 iP(1+i)2 P(1+i)3
n P(1+i)n-1 iP(1+i)n-1 P(1+i)n
P at time 0 increases to P(1+i)n at the end of time n.

Or a Future sum = present sum (1+i)n
26
Example 3-5 Single Payment
$500 were deposited in a saving account (pays 6%
compounded annually) for 3 years
F=?
F = P(1+i)n = 500(1+0.06)3
= $595.50
0 1 2 3 Or
i=6%
F = P(F/P, i, n) = 500(F/P, 6%, 3)
P=500
= 500(1.191) = $595.50

Single Payment
Notation:
𝑖𝑖 = interest rate per compounding period
𝑛𝑛 = number of compounding periods
𝑃𝑃 = a present sum of money
𝐹𝐹 = a future sum of money
Single Payment Present Worth Formula
𝑃𝑃 = 𝐹𝐹(1 + 𝑖𝑖)−𝑛𝑛 (3-5)
𝑃𝑃 = 𝐹𝐹(𝑃𝑃⁄𝐹𝐹, 𝑖𝑖, 𝑛𝑛) (3-6)
Find P, given F, at 𝑖𝑖, over 𝑛𝑛

Wish to have $800 at the end of 4 years, how much
should be deposited in an account that pays 5% annually?
F=800
P = F(1+i)-n = 800(1+0.05)-4
= $658.16
0 1 2 3 4 Or
i=5%
P = F(P/F, i, n) = 800(P/F, 5%, 4)
P=?
= 800(0.8227) = $658.16

Tabulate the future value factor for interest rates of
5%, 10%, and 15% for n’s from 0 to 20 (in 5’s).
18.000
16.000
15%
n 5% 10% 15% 14.000
0 1.000 1.000 1.000 12.000
5 1.276 1.611 2.011 10.000
10 1.629 2.594 4.046 8.000

10%
15 2.079 4.177 8.137 6.000
20 2.653 6.727 16.367 4.000
2.000 5%
0.000
0 5 10 15 20 25

$100 were deposited in a saving account (pays 6%
compounded quarterly) for 1 years
F=?
iqtr =1.5%, n = 4 quarters
F = P(1+i)n = 100(1+0.015)4
0 1 2 3 4 = $106.14
i=1.5%
F = P(F/P, i, n) = 100(F/P, 1.5%, 4)
P=100
= 100(1.061) = $106.10

Nominal and Effective
Interest Rates
Notation:
𝑟𝑟 = Nominal interest rate per year without considering the
effect of any compounding
𝑖𝑖 = Effective interest rate per compounding period
𝑖𝑖𝑎𝑎 = Effective annual interest rate taking into account the
effect of compounding
𝑚𝑚 = Number of compounding periods per year
𝑟𝑟 𝑟𝑟 𝑚𝑚 𝑚𝑚 (3-7)
𝑖𝑖 = , 𝑖𝑖𝑎𝑎 = (1 + ) − 1 = 1 + 𝑖𝑖 −1
𝑚𝑚 𝑚𝑚 (3-8)
For Continuous Compounding 𝑖𝑖 = 𝑒𝑒 𝑟𝑟 − 1 (3-9)

Example 3-9 Nominal and
Effective Interest Rates
If a credit card charges 1.5% interest every month, what
are the nominal and effective interest rates per year?
𝑟𝑟 = 12 × 1.5% = 18%
𝑟𝑟 𝑚𝑚 0.18 12
𝑖𝑖𝑎𝑎 = (1 + ) − 1 = (1 + ) − 1 = 0.1956
𝑚𝑚 12
18% Compounded Monthly
18% interest: Assume a yearly rate if not stated
Compounded monthly: Indicates 12 periods/year
[18%/year] / [12months/year] = 1.5% / month

Example 3-10 Application of
Nominal and Effective Interest Rates
“If I give you $100 today, you will write me a check
for $120, which you will redeem or I will cash on your
next payday.”
a) Bi-weekly interest rate = ($120-100)/100 = 20%
Nominal annual rate = 20% * 26 = 520%
b) Effective annual rate
26
𝑟𝑟 𝑚𝑚 520%
𝑖𝑖𝑎𝑎 = (1 + ) − 1 = 1 + − 1 = 113.48
𝑚𝑚 26
c) End-of-the-year balance
𝐹𝐹 = 𝑃𝑃(1 + 𝑖𝑖)𝑛𝑛 = 100(1 + 0.20)26 = $11,448

Nominal and Effective Interest
(Table 3-3)
Nominal Effective Annual Rate when compounded
Rate Yearly Semiannually 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%

Continuous Compounding
Interest Formulas
Effective annual interest rate
(3-9)
𝑟𝑟
𝑖𝑖𝑎𝑎 = 𝑒𝑒 − 1
Single Payment Compound Amount
𝐹𝐹 = 𝑃𝑃 𝐹𝐹 ⁄𝑃𝑃 , 𝑟𝑟, 𝑛𝑛 = 𝑃𝑃(𝑒𝑒 𝑟𝑟𝑟𝑟 ) (3-15)
Single Payment Present Worth

𝑃𝑃 = 𝐹𝐹[𝑃𝑃⁄𝐹𝐹, 𝑟𝑟, 𝑛𝑛] = 𝐹𝐹(𝑒𝑒 −𝑟𝑟𝑟𝑟 ) (3-16)

How much would be in the account for $2000
deposit in a bank that pays 5% nominal interest,
compounding continuously?
𝐹𝐹 = 𝑃𝑃 𝑒𝑒 𝑟𝑟𝑟𝑟 = 2000𝑒𝑒 (0.05)(2) = $2210.34
or
𝑖𝑖𝑎𝑎 = 𝑒𝑒 𝑟𝑟 − 1 = 𝑒𝑒 0.05 − 1 = 5.1271%
𝐹𝐹 = 𝑃𝑃(1 + 𝑖𝑖)2 = 2000(1 + 5.1271%)2 = $2210.34

How long will it take for money to double at 10%
nominal interest, compounding continuously?
𝐹𝐹 = 𝑃𝑃 𝑒𝑒 𝑟𝑟𝑟𝑟 = 𝑒𝑒 (0.10)(𝑛𝑛) = 2
0.10 𝑛𝑛 = 𝑙𝑙𝑙𝑙𝑙 = 0.693
𝑛𝑛 = 6.93 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

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Note: These PowerPoints were developed to

support the US edition of the text. In some

Interest and Equivalence

Copyright Oxford University Press 2014

• Time Value of Money

Copyright Oxford University Press 2014

• Understand the concept of “time value of

• Question: Would you rather

Copyright Oxford University Press 2014

• Because money is more valuable today than in

Copyright Oxford University Press 2014

To purchase a new $30,000 machine,

Copyright Oxford University Press 2014

Copyright Oxford University Press 2014

Copyright Oxford University Press 2014

• Money has purchasing power

Copyright Oxford University Press 2014

Interest is computed only on the original sum, and

Amount of money at the end of 𝑛𝑛 years,

Where F = Amount due at the end of n years

Copyright Oxford University Press 2014

Total interest earned = $5000(8%)(5) = $2000

Copyright Oxford University Press 2014

• Interest is computed on the unpaid balance,

Copyright Oxford University Press 2014

Balance at the Balance at the end

Copyright Oxford University Press 2014

Subtotal $1,200.00 $5,000.00 $6,200.00

Copyright Oxford University Press 2014

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

Copyright Oxford University Press 2014

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

Copyright Oxford University Press 2014

Subtotal $2,346.64 $5,000.00 $7,346.64

Copyright Oxford University Press 2014

Copyright Oxford University Press 2014

• If a firm believes 8% was reasonable, it would

Copyright Oxford University Press 2014

• ratio = total interest paid /total amount owed

1 $ 1200 $ 15000 0,08

Copyright Oxford University Press 2014

• Determine a single equivalent value at a

•Judge the relative attractiveness of the

𝐹𝐹 = 𝑃𝑃(𝐹𝐹 ⁄𝑃𝑃 , 𝑖𝑖, 𝑛𝑛) (3-4)

Find F, given P, at 𝑖𝑖, over 𝑛𝑛

Copyright Oxford University Press 2014

Beginning Interest for Ending

2 P(1+i) iP(1+i) P(1+i)2

3 P(1+i)2 iP(1+i)2 P(1+i)3

n P(1+i)n-1 iP(1+i)n-1 P(1+i)n

P at time 0 increases to P(1+i)n at the end of time n.

Copyright Oxford University Press 2014

𝑃𝑃 = 𝐹𝐹(𝑃𝑃⁄𝐹𝐹, 𝑖𝑖, 𝑛𝑛) (3-6)

Find P, given F, at 𝑖𝑖, over 𝑛𝑛

Copyright Oxford University Press 2014

Copyright Oxford University Press 2014

n 5% 10% 15% 14.000

0 1.000 1.000 1.000 12.000

5 1.276 1.611 2.011 10.000

10 1.629 2.594 4.046 8.000

20 2.653 6.727 16.367 4.000

Copyright Oxford University Press 2014