Chapter 3 Interest and Equivalence

Faculty of Applied Engineering and
Urban Planning
Civil Engineering Department
Engineering Economy
Chapter 3
Interest and Equivalence
Lecture 5-6
Week 3
2nd Semester 20016/2017
Chapter 3 :Interest and Equivalence
Time Value of Money

Simple Interest
Compound
Examples
Interest
University Of Palestine
Eng. Islam Falouji 2
Time Value of Money
Question: Would you prefer $100 today or $100 after 1 year?
A dollar today is worth more than a dollar next year
 Money makes money -Investments are expected to earn a return
 Thechange in the amount of money (through investment) over a

given period of time is called “time value of money.”
 Money has a time value because it can earn more money over time
(earning power)
 Money has a time value because its purchasing power changes over
time (inflation)
 The“time value of money” is the most important concept in

engineering economy
 The amount and timing of a project’s cash flows (operating expenses;
revenues) are crucial to the value of a project’s worth. Eng. Islam Falouji 3
Interest
 Some people would pay to have money available for use. The
charge for its use is called interest rate.
Interest is a compensation for using money and for uncertainties
related to future value of money
 It also called Rate of Return (RoR) on investment.
 Two types of interest:
Simple interest: the practice of charging an interest rate only to an

initial sum (principal amount).
Interest on principal only
Compound interest: the practice of charging an interest rate to an initial

sum and to any previously accumulated interest that has not been
withdrawn.
Interest earns interest on interest; compounds over time
Simple Interest
 Simple interest is interest that is computed on the original sum.
Interest = (principal)(number of periods)(interest rate)
Example: A bank gave your friend a $1000 for three years at a

simple interest rate of 8% per year. How much money the bank
should be receiving from your friend at the end of these three years?
 Notation
P= Principal amount
= $1,000
i= Interest rate
= 8%
n= Number of interest periods
= 3 years
Simple Interest Formula
If you borrow an amount P for n years at a rate of i% a year, then
after n years you will have:
F = P + n (i P) = P + P in = P (1 + in)
where
P = Principal amount
i= Simple interest rate
n = Number of interest periods
F = Total amount accumulated at the end of period n
Previous Example:
F = $1,000 + (3) (0.08) ($1,000) = $1,240
Note:
The borrower has used the $80 for 3 years without paying
interest on it. University Of Palestine
Compound Interest
Compounded interest is interest that is charged on the original sum
and any accumulated, un-paid interest.
 Interest = (principal + all accrued interest) (interest rate)
Example: A bank gave your friend a $1000 for three years at a

compound interest rate of 8% per year. How much money the bank
should be receiving from your friend at the end of these three years?
Compounding Process
Example 3-4: Repaying a Debt
You borrowed $5,000 from a bank at 8% interest rate

and you have to pay it back in 5 years. There are many
ways the debt can be repaid:
Plan A: At end of each year pay $1,000 principal plus

interest due.
Plan B: Pay interest due at end of each year and
principal at end of five years.
Plan C: Pay in five end-of-year payments.
Plan D: Pay principal and interest in one payment at
end of five years. University Of Palestine
Example (cont'd)
Plan A: At end of each year pay $1,000 principal
plus interest due.
Example (cont'd)
Plan B: Pay interest due at end of each year
and principal at end of five years.
Example (cont'd)
Plan C: Pay in five end-of-year payments.
Example (cont'd)
Plan D: Pay principal and interest in one
payment at end of five years.
Example (cont'd)
Summary of Payment Plans
Question: What common property do all four plans have?
Interest rate = (total interest paid)/(total amount owed)

or Total interest paid = (interest rate) * (total amount owed)
Since the total amount owed vary for the four plans, but the interest rate does not, the
total interest paid also varies.
We can simply say that these four plans are EQUIVALENT.
Equivalence
Different sums of money at different times may be equivalent
(equal in economic value) to each other.
Each of the plans on the previous slide is equivalent because each
repays $5000 at the same 8% interest rate.
$100 now is said to be equivalent to $106 one year from now, if

the $100 is invested at the interest rate of 6% per year.
Iftwo or more situations are to be compared, their

characteristics must be placed on an equivalent basis.
Equivalence is dependent on interest rate.
Compound Interest Formula
Math Notation:
i= interest rate (per time period)
n = # of time periods
P = money at present (a.k.a. Principal)
F = money in future after n time periods
Equivalent to P now, at interest rate I
A = payment at end of each time period, e.g., annual
Assumptions:
All cash flow occurs at the end of each time period
No inflation, depreciation, or income taxes
Stable prices
Single Payment Compound Interest
Formula
n = 0:P
n = 1:F 1 = P +P i= P (1+i)
n = 2:F2 = F1(1+i) = P (1+i)2
.
.
.
n = N:F= P (1+i)N
The Fundamental Law of Engineering Economy
If you put Pin the bank now at an interest rate of i% for n years,
the future amount F you will have after n years is given by
F = P (1+i)n
The term (1+i)n is called the single-payment compound factor.
The factor is used to compute F, given P, and given I and n. Falouji
Eng. Islam 17
Standard Notation to Represent Interest
Factors
 Consists
of two cash flow symbols, the interest rate, and number of
compounding periods
General form: (X/Y, i%, n)
X represents what is unknown
Y represents what is known
I and n represent input parameters; can be known or unknown depending upon the
problem
 Example: (F/P,6%,20) is read as:
To find F, given P when the interest rate is 6% and the number of time periods
equals 20.
 Inproblem formulation, the standard notation is often used in place of
the closed-form equivalent relations (factor)
Example: The term (F/P, i, n) is equivalent to (1+i)n; therefore we can write:
F = P (1+i)n= P (F/P, i%, n)
 Tables at the back of the text provide tabulations of common values
for i% and n University Of Palestine
Single Payment Interest Factors
Example 1
A bank gave your friend a $1000 for three years at
a compound interest rate of 8% per year. How
much money the bank should be receiving from
your friend at the end of these three years?
F = P (F/P, i, n)
= P (1+i)n
= $1,000 (1+ 0.08)3
= $1,259.71
Example 2
If you deposit $100 now (n= 0) and $200 two
years from now (n= 2) in a savings account
that pays 10% interest, how much would you
have at the end of year 10?
Solution:
Example 3
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn 10% interest, what would be the
balance at the end of 4 years?
Example 3 -Tabular Solution
Example 4
If you want to have $800 in savings at the end of four years, and 5%
interest is paid annually, how much do you need to put into the
savings account today?
Solution:
We solve P (1+i)n= F for P with i= 0.05, n = 4, F = $800
P = F/(1+i)n= F(1+i)-n
= 800/(1.05)4= 800 (1.05)-4 = 800 (0.8227) = $658.16
Note:
Single Payment Present Worth Formula:
P = F/(1+i)n= F(1+i)-n
P = F (P/F,i,n)
The factor (1+i)-n is called the present worth OR discount amount
factor University Of Palestine
Factors in the Book (Appendix B)
Tables of Conversion Factors
All engineering economics textbooks provide tables of the various
conversion factors:
• Usually in an appendix at the end of the text
Refer to the back of your text for those tables
The unknown interest rate that you want will typically not be included
in those tables:
• But you can interpolate between two tabulated values to estimate it
Linear interpolation is not exact, because:
• The conversion factors are non-linear!
Therefore, interpolation can cause errors:
• Typically from 2-5%
Errors will be small when interpolating between values that are close to
each other Eng. Islam Falouji 26
Example 5
In 3 years, you need $400 to pay a debt. In two more years,
you need $600 more to pay a second debt. How much
should you put in the bank today to meet these two needs if
the bank pays 12% per year?
Example 6
Solution
Remember!
Next Class
Read Chapter 3 of textbook
Try to do some of the problems at end of
Chapter 3
Next time we’ll learn more interesting
formulas!

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Chapter 3 Interest and Equivalence

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Faculty of Applied Engineering and

Civil Engineering Department

Time Value of Money

 Thechange in the amount of money (through investment) over a

 The“time value of money” is the most important concept in

 Two types of interest:

Simple interest: the practice of charging an interest rate only to an

Compound interest: the practice of charging an interest rate to an initial

Example: A bank gave your friend a $1000 for three years at a

Example: A bank gave your friend a $1000 for three years at a

You borrowed $5,000 from a bank at 8% interest rate

Plan A: At end of each year pay $1,000 principal plus

Question: What common property do all four plans have?

Interest rate = (total interest paid)/(total amount owed)

$100 now is said to be equivalent to $106 one year from now, if

Iftwo or more situations are to be compared, their

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